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  **UNITED STATESSECURITIES AND EXCHANGE COMMISSION****Washington, D.C. 20549** **Form 10-K**   þ **ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934****For the fiscal year ended December 31, 2006****OR**   o **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934****For the transition period from                      to                     ****Commission file number: 001-33188** **WSB Financial Group, Inc.***(Exact name of registrant as specified in its charter)*   **Washington** **20-3153598***(State of incorporation or organization)* *(I.R.S. Employer Identification No.)*   **607 Pacific Avenue**  **Bremerton, Washington** **98337***(Address of principal executive offices)* *(Zip Code)*Registrant’s telephone number, including area code: **(360) 405-1200**Securities registered pursuant to Section 12(b) of the Act:   **Title of each class** **Name of each exchange on which registered**   Common Stock ($1.00 par value) The NASDAQ Stock Market LLCSecurities registered pursuant to Section 12(g) of the Act: NoneIndicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.Yes o No þIndicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.Yes o No þIndicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes o No þIndicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, andwill not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment to this Form 10-K. þIndicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):Large accelerated filer o     Accelerated Filer o     Non-accelerated Filer þIndicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).Yes o No þAs of March 15, 2007, 5,554,886 shares of the registrant’s common stock were outstanding. The aggregate market value of sharesof common stock held by non-affiliates as of December 31, 2006was $88,617,082 (based upon the closing sales price of $19.20 pershare).**DOCUMENTS INCORPORATED BY REFERENCE**Portions of Annual Report to Shareholders for fiscal year ended December 31, 2006 – Part II.Portions of Definitive Proxy Statement to be filed with the Securities and Exchange Commission, relating to the 2007 AnnualMeeting of Shareholders, to be held on May 16, 2007 – Part III.  
 

 
**TABLE OF CONTENTS**     **Item**    **Number**   **Page**PART I    1 Business 1 – 251A Risk Factors 25 - 331B Unresolved Staff Comments 332 Properties 33 - 343 Legal Proceedings 344 Submission of Matters to a Vote of Security Holders 34     PART II    5 Market for Registrant’s Common Equity and Related Stockholder Matters 35 - 366 Selected Financial Data 36 - 387 Management’s Discussion and Analysis of Financial Condition and Results of Operations 387A Quantitative and Qualitative Disclosures about Market Risk 388 Financial Statements and Supplementary Data 389 Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 389A Controls and Procedures 38 - 399B Other Information 39     PART III    10 Directors, Executive Officers and Corporate Governance 4011 Executive Compensation 4012 Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 4013 Certain Relationships and Related Transactions, and Director Independence 4014 Principal Accountant Fees and Services 41     PART IV    15 Exhibits and Financial Statement Schedules 42  Signatures 43 - 44 EXHIBIT 11 EXHIBIT 13 EXHIBIT 14 EXHIBIT 21 EXHIBIT 23 EXHIBIT 31.1 EXHIBIT 31.2 EXHIBIT 32.1 EXHIBIT 32.2
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**PART I**     This Report includes a number of forward-looking statements that reflect the Company’s currentviews with respect to future events and financial performance. Please refer to the sectionaddressing forward-looking information on page 23-24 for further discussion. In this report, “we,”“our,” “us,” “Company,” and “WSB Financial” refer to WSB Financial Group, Inc. and subsidiaries,unless otherwise noted or context otherwise indicates.**Item 1. Business**     We are a bank holding company headquartered in Bremerton, Washington. We emphasize aservice-oriented culture with a sales-based delivery model focused primarily on real estate lendingproducts and supplemented by commercial banking products and services. We currently operate througheight full service branches and two loan production offices that are located primarily in the westPuget Sound area. At December 31, 2006, we had total assets of $386.8 million, net loans of $340.2million, total deposits of $315.0 million and stockholders’ equity of $61.7 million.     Westsound Bank, our wholly owned subsidiary, is a Washington commercial bank that was openedfor business in March 1999 by local community leaders and experienced bankers with the mission ofproviding a superior community banking service model to the west Puget Sound area. We believe thisis an attractive market that benefits not only from its proximity to the economic activity in theSeattle Metropolitan Statistical Area, but also the high quality of living it offers its residentsand seasonal visitors. From our base in Bremerton, we quickly expanded into other Puget Soundmarkets, adding three branches between 2001 and 2004. Our growth has accelerated recently, withopenings of two new branches and a loan production office in 2005 and a branch and two loanproduction offices in 2006. Additionally, we converted our Federal Way loan production office intoa branch in February 2007. We formed our holding company, WSB Financial Group, Inc., in 2005.     Our growth has been due to a variety of factors, including the addition of offices in growingcommunities, adding sales-oriented employees with a customer-service mentality, expansion of ourproduct offerings, continued growth of our real estate and business lending, and selling additionalproducts and services to our real estate and business customers.     Our headquarters and administrative offices are located at our downtown branch at 607 PacificAvenue, Bremerton, Washington 98337 and our telephone number is (360) 405-1200. We maintain awebsite at www.westsoundbank.com.**Our Business Strategy**     We strive to be a high performing financial institution that delivers superior returns to ourshareholders through exceptional employees and focus on our customers. We have built our companybased on the following fundamental business strategies: **•** *Hire motivated, sales-oriented personnel*. We believe successful employees aredeveloped from talented, motivated people. We seek to find such individuals with variedbackgrounds and then train them to be successful in delivering financial services. Wecombine an internal training program with a new state-of-the-art training center toensure that our employees are skilled in their respective areas of responsibility, andto enable us to responsibly maintain our growth. Moreover, our compensation structureallows for some employees to be paid largely on production, which provides incentivesfor superior performance and customer development. Our variable compensation totaled40% of total compensation in 2006.  **•** *Grow through de novo branches in attractive communities.*Since 2001, we haveadded seven branches and two loan production offices and we intend to add two or threebranches or loan production offices per year over the next several years. Our focus ison finding prospective locations that have positive long-term demographic and businesstrends. Historically, we have achieved profitability in our new branches within 12months, on average. Our branching strategy is often initiated with loan productionoffices,
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   which we open in attractive markets with the intent of transitioning these offices intofull-service branches. With strong loan demand in our west Puget Sound market, we are alsoexploring markets with high deposit potential. **•** *Deliver extraordinary customer service via a professional sales culture.*Weemphasize and train our staff to provide superior customer service. We believe that themodels employed by high-end department stores and other successful retailers can beeffectively applied to the financial services industry. Our staffing structure andbusiness practices reflect a professional retail sales culture, rather than atraditional banking environment. We separate the sales and credit functions that aretypically both performed by a single loan officer in conventionally-organizedcommercial banks. Our salespeople are the calling officers and business generators thatare supported by credit analysts who underwrite the loan and manage the back-officelending functions. We also have relationship managers who are the primary points ofcontact for deposit customers and the initial contact persons for customers who comeinto our branches.  **•** *Proactively manage credit quality and pricing.*We focus on originating andmaintaining a high quality loan portfolio by employing focused credit analysts,applying disciplined underwriting standards, and benefiting from our directors’ andofficers’ thorough knowledge of the markets we serve. Our loan personnel are expectedto monitor projects and we require third-party inspections to approve construction loandraws. All loans over $100,000 must be approved by our loan committee, which includesour chief executive officer and three of our directors. Our loan approval process ishighly collaborative, with the committee taking an active role in the structuring andpricing of loans. Our loan officers have no discretionary authority with respect topricing loans except for rate sheet pricing for residential mortgage loans sold in thesecondary market. Loan personnel are incentivized to produce high quality loans, andreceive deductions to their variable compensation packages for loans that go intonon-accrual status or receive an internal risk rating of anything below a “pass.”  **•** *Continue to identify opportunities in real estate and construction lending.*Ourloan portfolio is comprised of 94.5% in real estate loans, including 56.5% constructionand land development, 19.5% commercial real estate, and 18.5% residential real estate.We believe we are the most active community bank in this segment in the west PugetSound market and have an experienced group of professionals with expertise in realestate lending. We focus on maintaining strong relationships with commercial andresidential builders and on the life cycle of a project, from construction to take-outfinancing.  **•** *Emphasize our risk management functions.*We believe that our growth requires usto proactively address our risk management efforts and as such, we have devotedsignificant resources to this area, including recently appointing a chief risk officer.We seek to (i) identify risks in all functions of our business, including credit,operations and asset and liability management, (ii) evaluate such risks and theirtrends and (iii) adopt strategies to manage such risks based upon our evaluations. Inparticular, we actively manage interest rate and market risks by matching the volumeand maturity of our rate sensitive assets to our interest sensitive liabilities inorder to mitigate adverse effects of changes in interest rates.**Our Growth Strategy**     According to financial data published by the FDIC, we have been the fastest growing bank inthe Pacific Northwest (Washington, Oregon and Idaho) based on percentage annual growth rates ofassets from December 31, 2001 to June 30, 2006 (the most recent FDIC data available) for banksformed in 1999 or earlier. In order to continue to grow responsibly, we are deploying the followingstrategies: **•** *Add new sales personnel focused on high-quality growth.*We are constantlylooking to hire talented, motivated employees to help support the planned expansion ofour business. In the short term, we are focused on expanding our lending and depositoperations and enhancing our deposit salesforce while maintaining our pricingdiscipline and asset quality.  **•** *Establish new branches and loan production offices.*We continually monitor andtrack opportunities in contiguous, attractive growth or deposit-rich markets inWashington. We opened our eighth branch in
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   February 2007 in Federal Way and we are currently targeting two to three additionalbranches or loan production offices per year. **•** *Continue to emphasize our real estate lending practice to both existing and newcustomers.*We believe our expertise in real estate loan products, that run from landacquisition to permanent financing on both residential and commercial properties,distinguishes us from most of the local community banks. Our track record of timelinessand responsiveness to our real estate loan customers has made us a desired lender inour markets and a beneficiary of customer referrals.  **•** *Expand our commercial lending activities in our existing footprint.*We arefocused on growing and diversifying our loan portfolio by expanding our commercial andindustrial, or C&I, lending through our existing branch structure. We intend to addexperienced commercial lenders who desire to be associated with a successful,customer-oriented community bank.  **•** *Grow our core deposits to help fund our existing and anticipated loan growth.*In order to maintain our net interest margin at current levels, we are focused onfunding as much of our growth as possible with local, core deposits. We incentivize ourproducers to leverage relationships to produce both loan and deposit growth.**Our Business Activities**     The principal business of the bank is to utilize deposits and other funding sources in makingloans which generate interest income. The principal sources of funds for the bank’s loans andinvestments are demand, time, savings and other deposits, repayment of loans and borrowings. Theprincipal expenses associated with the bank are interest paid on deposits, employee compensation,office expenses and other operating expenses. The bank does not currently offer trust or fiduciaryservices.     We provide banking services throughout our primary market area to real estate developers,contractors and small- to medium-sized businesses in our market. Many of our real estate customersare involved in the development, construction and resale of commercial and residential propertiesin and around the west Puget Sound and the Seattle Metropolitan Statistical Area. Our businesscustomers are involved in light manufacturing, distribution or other services. We also provide abroad range of banking services and products to individuals, including personal checking andsavings accounts and other consumer banking products, including electronic banking.     We staff our bank with sales oriented employees who are focused on service and customerattention. We also structure our staffing to provide the appropriate checks and balances and toprovide an environment that allows individuals to excel in the areas of their core competencies.For example, we employ sales people who are responsible for maintaining lending relationships withour existing and prospective customers. Rather than having the sales person focus on anything butcustomer service, we have credit analysts that perform analysis and credit review as specificopportunities are identified. Finally, we have relationship managers who are responsible for new,unsolicited customers and ensuring that deposit products are an integral part of the customer salespackage.***Lending***     While our historical focus has been on real estate lending, we also offer a full range ofshort- to long-term C&I and consumer lending products and services. We have established portfoliothresholds for each of our lending categories and constantly monitor the diversification of ourportfolio. We originate a variety of types of loans, including construction, commercial realestate, residential real estate, commercial, and to a lesser extent consumer based loans. From timeto time we purchase and sell commercial loan participations to or from other banks within ourmarket area. All loan participations purchased have been underwritten using the bank’s standard andcustomary underwriting criteria and are performing.     Our customers are generally comprised of the following groups:
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 **•** Real estate developers and contractors in need of land, construction andpermanent financing for commercial and residential developments;  **•** Small- to medium-sized businesses in need of secured and unsecured lines ofcredit or permanent C&I loans;  **•** Individuals in need of residential mortgage products and consumer loanproducts; and  **•** Professionals and professional firms, such as architectural, engineering, andinsurance and financial firms, in need of operating facilities.     Our lending activities are concentrated in two main categories: real estate andcommercial/consumers.***Real Estate:***     We are focused on commercial and residential real estate lending throughout a project’s lifecycle, from acquisition and development loans to acquire property, to permanent, long-term mortgagefinancing.     *Construction and Development Loans.*Our construction loan portfolio consists of single-familyresidential properties, multi-family properties and commercial projects. Construction lendingentails significant additional risks compared with residential mortgage lending. Construction loansoften involve larger loan balances concentrated with single borrowers or groups of relatedborrowers. Construction loans also involve additional risks since funds are advanced while theproperty is under construction, which property has uncertain value prior to the completion ofconstruction. Thus, it is more difficult to evaluate accurately the total loan funds required tocomplete a project and whether related loan-to-value ratios will be sufficient to compensate forfluctuations in the real estate market to minimize the risk of loss. Maturities for constructionloans generally range from 6 to 18 months for residential property and from 12 to 24 months fornon-residential and multifamily properties.     Our development loans are secured by the entire property being platted and developed. Lendingon raw land carries the significant risk of a change in market conditions during the developmentprocess. Our borrowers’ projects currently range from short plats (2-6 lots) to subdivisions withup to 55 lots. During the development process, we fund costs for site clearing and grading andinfrastructure, including utilities and roads. Lot release minimum prices are agreed upon at loanclosing. We target most developments to be paid out at 75% of sales. Loan to value ratios typicallyrange from 65% to 75%, depending on the financial strength and experience of the developer. Mostdevelopment loans have maturities of 18 to 30 months.     *Commercial Mortgage Loans.*We also originate commercial mortgage loans. These loans areprimarily secured by commercial real estate, including office, retail, warehouse, industrial, andother non-residential properties and are made to the owners and/or occupants of such properties.The majority of these loans have maturities generally ranging from one to ten years.     Commercial mortgage lending entails significant additional risk compared with the residentialmortgage lending. Commercial mortgage loans typically involve larger loan balances concentratedwith single borrowers or groups of related borrowers. Additionally, the repayment of loans securedby income-producing properties is typically dependent on the successful operation of a business ora real estate project and thus may be subject, to a greater extent than is the case withresidential mortgage loans, to adverse conditions in the commercial real estate market or in thegeneral economy. Our commercial real estate loan underwriting criteria require an examination ofdebt service coverage ratios, the borrower’s creditworthiness and prior credit history andreputation, and we generally require personal guarantees or endorsements with respect to theseloans. In the loan underwriting process, we also carefully consider the location of the propertythat will be collateral for the loan.     Loan-to-value ratios for commercial mortgage loans generally do not exceed 75%. We permitloan-to-value ratios of up to 80% if the property is owner occupied and the borrower has unusuallystrong liquidity, net worth and cash flow. We have been active in both the construction lending andpermanent financing of our commercial real estate portfolio. Construction and raw land loans areshort-term in nature and generally do not exceed 18 months.
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Permanent commitments are primarily restricted to no greater than 10 year maturities with rateadjustment periods every 36 months when fixed commitments exist.     As of December 31, 2006 our commercial real estate portfolio was comprised of the followingproperty types.               **% of****Loan Type** **$ Outstanding** **Loan Portfolio**  **(In thousands)**Retail $22,914   6.6%Office  16,621   4.8%Warehouse  5,146   1.5%Industrial  5,197   1.5%Hotel  2,434   0.7%Restaurant/Bar  1,276   0.4%Other  13,636   4.0%     *Residential Mortgage Loans.*Our residential mortgage loans consist of residential first andsecond mortgage loans, residential construction loans and home equity line of credit and term loanssecured by first and second mortgages on the residences of borrowers. Second mortgage loans andhome equity lines of credit are used for home improvements, education and other personalexpenditures. We make mortgage loans with a variety of terms, including fixed, floating andvariable interest rates and a variety of loan maturities. We sell the majority of the residentialmortgage loans that we originate (99% in 2006) to larger financial institutions.     Residential mortgage loans generally are made on the basis of the borrower’s ability to repaythe loan from his or her salary and other income and are secured by residential real estate, thevalue of which is generally readily ascertainable. These loans are made consistent with ourappraisal and real estate lending policies, which detail maximum loan-to-value ratios andmaturities. Residential mortgage loans and home equity lines of credit secured by owner-occupiedproperty generally are made with a loan-to-value ratio of up to 80%. Loan-to-value ratios of up to90% may be allowed on residential owner-occupied property, certain land loans, or if it is theintent to convert to a construction loan in a relatively quick timeframe, and the borrower exhibitsunusually strong liquidity, net worth and cash flow.***Commercial and Consumer:***     *Commercial and Industrial Loans.*We make C&I loans to qualified businesses in our market area.Our commercial lending portfolio consists primarily of commercial and industrial loans for thefinancing of accounts receivable, inventory, property, plant and equipment. We also offer loansguaranteed by the U.S. Small Business Administration, or SBA.     Commercial and industrial loans generally have a higher degree of risk than commercial realestate loans, but have commensurately higher yields. Commercial real estate loans generally aremade on the basis of the value of an income-producing property and the ability to repay the loan isdependent upon the successful operation of a business. In contrast, C&I loans typically are made onthe basis of the borrower’s ability to repay the loan from the cash flow from its business and aresecured by business assets with less easily determinable or achievable value, such as accountsreceivable, equipment and inventory. Lines of credit typically have a 12 month commitment and willbe secured by the trading asset that is being financed. In cases of larger commitments, a borrowingbase certificate may be required to determine eligible collateral and advance parameters. Termloans seldom exceed 60 months, but in no case exceed the depreciable life of the tangible assetbeing financed.     To manage these risks, our policy is to secure the commercial loans we make with both theassets of the borrowing business and other additional collateral and guarantees that may beavailable. In addition, we actively monitor certain measures of the borrower, including advancerate, cash flow, collateral value and other appropriate credit factors.
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     *Consumer Loans.*Our consumer loans consist primarily of installment loans made to individualsfor personal, family and household purposes. The specific types of consumer loans we make includehome improvement loans, automobile loans, debt consolidation loans and general consumer lending.     Consumer loans may entail greater risk than real estate loans, particularly in the case ofconsumer loans that are unsecured, such as lines of credit, or secured by rapidly depreciableassets, such as automobiles. In such cases, any repossessed collateral for a defaulted consumerloan may not provide an adequate source of repayment of the outstanding loan balance as a result ofthe greater likelihood of damage, loss or depreciation. The remaining deficiency often does notwarrant further substantial collection efforts against the borrower. In addition, consumer loancollections are dependent on the borrower’s continuing financial stability, and thus are morelikely to be adversely affected by job loss, divorce, illness, or personal bankruptcy. Furthermore,the application of various federal and state laws, including federal and state bankruptcy andinsolvency laws, may limit the amount that can be recovered on such loans. A loan may also giverise to claims and defenses by a consumer loan borrower against an assignee of such loan, such asthe bank, and a borrower may be able to assert against such assignee claims and defenses that ithas against the seller of the underlying collateral.     Our policy for consumer loans is to accept moderate risk while minimizing losses, primarilythrough a careful credit and financial analysis of the borrower. In evaluating consumer loans, werequire our lending officers to review the borrower’s level and stability of income, past credithistory, amount of debt currently outstanding and the impact of these factors on the ability of theborrower to repay the loan in a timely manner. In addition, we require our banking officers tomaintain an appropriate margin between the loan amount and collateral value.     We also issue credit cards to certain of our customers. In determining to whom we will issuecredit cards, we evaluate the borrower’s level and stability of income, past credit history andother factors. Finally, we make additional loans that are not classified in one of the abovecategories. In making such loans, we attempt to ensure that the borrower meets our loanunderwriting standards.***Credit Policies:***     We have historically maintained very strong credit quality. Generally, the developers ofmultifamily construction loans for apartment type dwellings do not have any leases in place forthese projects, but we require a maximum loan to value of 85%, minimum debt service coverage ratioof 1.2:1 at stabilized occupancy, full recourse to the borrower and personal guarantees from theprincipals of corporate borrowers to reduce our risks associated with these loans. For constructionloans for commercial and industrial projects, we usually require a minimum of 50% of the spaceleased with reasonable projections supporting a minimum debt service coverage ratio of 1.2:1 atstabilized occupancy, or executed leases must be in place to provide a minimum debt servicecoverage ratio of 1.1:1 with reasonable projections to meet the minimum stabilized coverage ratioof 1.2:1. While we prefer a minimum of 50% of the project’s space to be leased, a lesser percentagemay be approved depending on the amount by which the projected debt service coverage ratio exceedsthe minimum debt service coverage ratio. Because this type of loan represents a higher degree ofrisk to the Bank, normally this loan is only made to developers with well-established track recordsin the industry, substantial cash flow, and with tenants with strong credit supporting the loan. Wealso provide land development loans to qualified developers and builders who are experienced andwell-capitalized. Normally the principals of the developer are required to personally guarantee theloan, although exceptions may be made on a case-by-case basis for well-establishedbuilders/developers or exceptionally strong properties that have a substantial debt coverageratios. Where possible, permanent take out commitments from financially sound lenders or otherevidence of a source of repayment acceptable to the Bank may be required, or the Bank may offerpermanent financing at the conclusion of the project.     The board of directors of Westsound Bank establishes our lending policies. These lendingpolicies are reviewed at least annually and evaluated from time to time by the board. Key elementsof our current policies are debt service coverage, monitoring concentration levels and maintainingstrict approval and underwriting procedures.     *Debt Service Coverage.*Our risk management philosophy is to extend credit only when anapplicant has proven cash flow to service the proposed debt. Additionally, it is generallynecessary for the applicant to demonstrate an independent secondary source of repayment.
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     *Monitor Concentration Levels.*We have established maximum levels of concentration levels foreach loan type to ensure diversification of our loan portfolio and mitigate concentration risks.     *Strict Approval and Underwriting Procedures.*If a credit falls outside of the guidelines setforth in our lending policies, the loan is not approved until it is reviewed by a higher level ofcredit approval authority. Credit approval authority has three levels, as listed below from lowestto highest level. Based on the historical strong emphasis on business development, the board ofdirectors of Westsound Bank has intentionally kept approval authorities low to assure a high degreeof secondary review for a credit consideration. Management believes that the current authoritylevels provide satisfactory management and a reasonable percentage of secondary review. Anyconditions placed on loans in the approval process must be satisfied before our creditadministration will release loan documentation for execution. Our credit administration worksentirely independent of loan production and has full responsibility for all loan disbursements. **•** *Individual Authorities.*Individual loan officers have approval authority up to$25,000 for secured and unsecured loans. The chief executive officer and the chieflending officer have approval authority of up to $100,000 for secured and unsecuredloans.  **•** *Senior Loan Committee.*The senior loan committee consists of the chiefexecutive officer, the chief lending officer and the executive vice president of salesand lending. The committee has approval authority up to $100,000 for secured andunsecured loans.  **•** *Directors Loan Committee.*The directors loan committee consists of fourdirectors of Westsound Bank, and the chief executive officer. It has approval authorityup to our legal lending limit, which was approximately $13.6 million at December 31,2006.     *Loan Grading and Loan Review.*We seek to quantify the risk in our lending portfolio bymaintaining a loan grading system consisting of seven different categories (Grades 1-7). Thegrading system is used to determine, in part, the provision for loan losses. The first three gradesin the system are considered satisfactory. The other four grades range from a “Watch/Pass” categoryto a “Loss” category. These four grades are further discussed below under the section subtitled“Classified Assets.”     The originating loan officer initially assigns a grade to each credit as part of the loanapproval process. Such grade may be changed as a loan application moves through the approvalprocess. In addition to any dollar limitations that may require higher credit approval authority,each loan that is graded “Watch/Pass” or worse requires prior approval of the directors loancommittee of Westsound Bank.     The grade on each individual loan is subject to review from time to time, and may be changedif warranted. The board of directors of Westsound Bank reviews monthly the aggregate amount of allloans graded as special mention, substandard or loss. Additionally, changes in the grade for a loanmay occur through any of the following means: **•** random reviews of the loan portfolio conducted by loan administration;  **•** annual reviews conducted by an outside loan reviewer;  **•** bank regulatory examinations;  **•** monthly action plans submitted to loan administration by the responsiblelending officers for each credit graded 4-7; or  **•** at the monthly credit risk managers meeting if a loan is exhibiting certaindelinquency tendencies.     *Loan Delinquencies.*When a borrower fails to make a committed payment, we attempt to cure thedeficiency by contacting the borrower to seek payment. Habitual delinquencies and loans delinquent10 days or more are reviewed at the weekly directors loan committee meeting for possible changes ingrading.
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     *Classified Assets.*Federal regulations require that each insured bank classify its assets on aregular basis. In addition, in connection with examinations of insured institutions, examiners haveauthority to identify problem assets, and, if appropriate, classify them. We use grades 4-7 of ourloan grading system to identify potential problem assets. There were $3.3 million, $637,000 and$121,000 in classified loans at December 31, 2006, December 31, 2005 and December 31, 2004,respectively.     The following describes grades 4-7 of our loan grading system: **•** *Special Mention — Grade 4.*These assets have potential weaknesses that mayresult in deterioration of the repayment prospects and, therefore, deserve theattention of management. Usually, these assets are long-term problems that are likelyto remain and require management action plans. These loans exhibit an increasingreliance on collateral for repayment.  **•** *Substandard — Grade 5.*These assets are inadequately protected by the currentworth and paying capacity of the borrower or of the collateral pledged, if any.Although loss may not be imminent, if the weaknesses are not corrected, there is a goodpossibility that we will sustain some loss.  **•** *Doubtful — Grade 6.*These assets have all the weaknesses inherent in an assetclassified as “substandard,” with the added characteristic that the weaknesses makecollection or liquidation in full, on the basis of currently existing facts, conditionand values, highly questionable and improbable. At the point where a loss isidentified, all or that portion deemed a loss is immediately classified as “Loss” andcharged off.  **•** *Loss — Grade 7.*These assets have been determined to have identifiable,uncollectible components. Typically, a partial charge-off of the loss will haveoccurred, and the balance remaining would be reflective of management’s best estimateof collectibility.***Our Investment Activities***     Our investment strategy is designed to be complementary to and interactive with the our otheractivities (i.e. cash position; borrowed funds; quality, maturity, stability and earnings of loans;nature and stability of deposits; capital and tax planning). Investment securities consistprimarily of U.S. Agency issues and municipal bonds. In addition, for bank liquidity purposes, weuse Fed Funds Sold which are temporary overnight sales of excess funds to correspondent banks. Oursecurities portfolio is managed in accordance with guidelines set by our investment policy.Specific day-to-day transactions affecting the securities portfolio are managed by our chieffinancial officer. These securities activities are reviewed monthly or more often, as needed, byour investment committee and are reported monthly to our board of directors.     Our general objectives with respect to our investment portfolio are to: **•** maintain collateral for pledging requirements;  **•** achieve an acceptable asset/liability gap position (based on our separatepolicy related to asset/liability management that provides guidance for how investmentsare to be used to manage asset/liability gaps); and  **•** provide a suitable balance of quality and diversification to our assets.***Deposit Products and Other Sources of Funds***     Our primary sources of funds for use in our lending and investing activities consist of: **•** deposits;  **•** maturities and principal and interest payments on loans and securities;
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 **•** other borrowings; and  **•** funds down-streamed into Westsound Bank from time to time by WSB Financial Group.     We closely monitor rates and terms of competing sources of funds and utilize those sources webelieve to be the most cost effective, consistent with our asset and liability management policies.     *Deposits.*An important balance sheet component affecting our net interest margin is thecomposition and cost of our deposit base. We can improve our net interest margin to the extent thatgrowth in deposits can be focused in the less volatile and somewhat more traditional core deposits,or total deposits less CDs greater than $100,000, commonly referred to as Jumbo CDs. We attempt toprice our deposit products in order to promote deposit growth and satisfy our liquidityrequirements and offer a variety of deposit products in order to satisfy our customers’ needs.     We provide a wide array of deposit products. We have historically relied upon, and expect tocontinue to rely upon, deposits to satisfy our needs for sources of funds. We offer regularchecking, savings, NOW and money market deposit accounts. We also offer fixed-rate, fixed maturityretail CDs ranging in terms from 30 days to five years, individual retirement accounts and JumboCDs. The primary sources of deposits are small-and medium-sized businesses and individuals withinour target market. Senior management has the authority to set rates within specified parameters inorder to remain competitive with other financial institutions in our market area. All deposits areinsured by the Federal Deposit Insurance Corporation up to the maximum amount permitted by law. Wehave a service fee schedule, which is competitive with other financial institutions in our market,covering such matters as maintenance fees on checking accounts, per item processing fees onchecking accounts, returned check charges and other similar fees.     We intend to continue our efforts at attracting deposits from our business lendingrelationships in order to reduce our cost of funds and improve our net interest margin. Also, webelieve that we have the ability to attract sufficient additional funding by re-pricing the yieldson our CDs in order to meet loan demands during times that growth in core deposits differs fromloan demand. In order to fund loan demand, we have also utilized wholesale funding from time totime, as well as Internet-based rate offerings to attract large sums of deposits.     In addition to our traditional marketing methods, we attract new clients and deposits by: **•** expanding long-term business customer relationships, including referrals from our customers; and  **•** building deposit relationships through our branch relationship officers who arecompensated based upon the profitability of such relationships.     *Other Borrowings.*We may occasionally use our Fed funds lines of credit to support liquidityneeds created by seasonal deposit flows, to temporarily satisfy funding needs from increased loandemand, and for other short-term purposes. We have three Fed funds lines with other financialinstitutions pursuant to which we can borrow up to $15 million on an unsecured basis. These linesmay be terminated by the respective lending institutions at any time.     We also borrow from the Federal Home Loan Bank, or FHLB, pursuant to an existing commitmentbased on the value of the collateral pledged (either loans or securities). FHLB borrowings havebeen only occasional and based upon pricing opportunities.***Other Products and Services***     We offer a variety of other products and services, including: **•** Courier Services. We offer courier services to our business customers. Courierservices permit us to provide the convenience and personalized service that ourcustomers require by scheduling pick-ups of deposits and facilitating other bankingtransactions.
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 **•** *Telephone and Internet Banking.*We believe there is a strong demand within ourmarket for telephone and Internet banking. These services allow both consumer andbusiness customers to access detailed account information and manage their accounts,including on-line balance transfers and bill payment. These services enable ourcustomers to conduct their banking business and monitor their bank accounts from remotelocations and at any time. We believe our telephone and Internet banking services areinvaluable in attracting and retaining customers and encourage them to considerWestsound Bank for all their banking and financial needs.  **•** *Automatic Teller Machines (ATM).*In 2005 we analyzed our ATM services and foundthat it would be more cost effective for us, and more beneficial to our customers, todiscontinue ATMs at our branches and instead offer ATM fee reimbursement to ourcustomers, allowing them to use ATMs nationwide without paying a per transaction fee.Each checking and deposit account has a monthly reimbursement limit.  **•** *Real Estate Services.*We offer certain fee-based services to real estatecontractors, including project inspections and mortgage banking consulting.  **•** *Other Products.*We offer other banking-related specialized products andservices to our customers, such as cashier’s checks, money orders, debit/credit cards,wire transfers, travelers’ checks and safe deposit services. While we sell many of ourconsumer and commercial real estate term loans, we have not engaged in anysecuritizations of loans.**Our Concentrations/Customers**     No individual or single group of related accounts is considered material in relation to ourassets or deposits or in relation to our overall business. However, approximately 94.5% of our loanportfolio at December 31, 2006 consisted of real estate-secured loans, including commercial loanssecured by real estate, construction loans and real estate mortgage loans. Moreover, our businessactivities are currently focused in west Puget Sound, particularly Kitsap County. Consequently, ourbusiness is dependent on the trends of this local economy, and in particular, the commercial andresidential real estate markets. At December 31, 2006, we had 14 loans in excess of $1.5 millioneach, totaling $28.3 million. These loans comprise approximately 0.9% of our loan portfolio bynumber of loans and 8.2% by total loans outstanding. Not including credit card and consumeroverdraft lines and purchased participation loans, our average loan size as of December 31, 2006was approximately $215,000.     Our lending policies also establish customer and product concentration guidelines to controlsingle customer and product exposures. As these guidelines are not absolute, at any particularpoint in time the ratios may be higher or lower because of funding on outstanding commitments. Setforth below are our concentration guidelines and the segmentation of our loan portfolio by loantype as of December 31, 2006.               **Percent of**    **Total Tier**    **1 Capital** **Percent of Total Loans**  **Actual** **Policy Limit** **Actual**Real Estate            Construction  202%  50%  41%Land development  77%  25%  16%Commercial real estate  96%  40%  19%Residential real estate  92%  40%  19%Commercial and industrial  22%  50%  5%Consumer  5%  25%  1%**Risk Management**     Our strategic plan continues to promote a rapid growth rate. We are equally committed tomaintaining internal controls to manage the risk associated with such growth. Our risk managementcommittee has defined our most significant risks and measures the trends from low to high. Thecommittee has identified credit risk and operational risk as the two areas that could have thegreatest impact on capital. In order to mitigate and proactively
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manage these areas of risk, we have established sound procedures and committed experiencedhuman resources to this effort.     We have focused on enhancing two functions: **•** Credit administration has been staffed to maintain all credit policies andprocedures, loan documentation, disbursement of loan proceeds and to review theintegrity of the credit risk rating system; and  **•** Operations support has been significantly enhanced by the board’s appointmentof Veronica R. Colburn as our chief risk officer. She is familiar with our overalloperations, having previously served as our chief financial officer and as our chiefoperating officer. Ms. Colburn is responsible for enhancing our risk management programand directing our compliance staff, and will work with the chair of the audit committeeto identify particular risks that may require the attention of our internal andexternal auditors.     We believe that the established organization allows management to maintain an accurateunderstanding of risk levels at all times. With this level of understanding, strategic plans aredeveloped with the necessary risk parameters to adequately protect our capital.**Training Program**     With the move to our new headquarters in Bremerton, Washington in 2006, we now have astate-of-the-art training facility which houses 16 interactive training stations in a classroomtype setting. We are using the training program to provide both continuing education and regulatorytraining, as well as general operational and sales training for all new hires. The program coversall aspects of banking, from regulatory and financial topics to customer courtesy and sales. Thishas allowed us to hire individuals without prior banking experience that meet the criteria for ourhigh achieving culture. It has afforded us the luxury of hiring for attitude, then training foraptitude, enabling us to replicate our culture and business service model each time a new branch orloan production office is opened.     Our marketing department has also taken advantage of the training facility by offering classesto our customers and the general public, to better educate our customers on our products andservices. Some recent topics have included accounting for builders, banking on-line, and balancinga checkbook.**Information Technology Systems**     We have recently made significant investments in core informational technology systems for ourbanking and lending operations and management activities. These computer systems automate banktransactions for our branches, mortgage originations, other loans and electronic banking, databaseand direct response marketing, and provide cash management, streamlined reporting andreconciliation support as well as sales support.     With this investment in technology, the bank offers Internet-based delivery of products forboth its consumer and business customers. Customers can open accounts, apply for loans, checkbalances, check account history, transfer funds, pay bills, use interactive calculators andcorrespond via e-mail with the bank over the Internet. The Internet provides an inexpensive way forthe bank to expand its geographic reach and branch activities while providing the kinds of servicesone would expect from larger banks.     We outsource our major systems including our EFT, credit card and transaction processing andour online Internet bill payment and banking services to third-party service providers to thebanking and lending industries, principally Fiserv, Inc. and its affiliates. While there are risksassociated with outsourcing these systems, including the potential interruption of our operationsas a result of the failure of a third-party’s system or the termination of its service, we believethese risks are outweighed by the advantages of outsourcing, particularly the flexibility thesesystems offer us to upgrade and scale these systems and services to accommodate our growth withoutrequiring us to invest substantial additional capital and staff resources.
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**Our Market Area**     We operate primarily in the west Puget Sound area, which encompasses the Kitsap and Olympicpeninsulas and islands west of Seattle, and recently opened a branch along the I-5 corridor inFederal Way, Washington. According to our federal banking regulator, the Federal Deposit InsuranceCorporation, or FDIC, our headquarters in downtown Bremerton is located in “a low income” area andour other branches are located in “middle income” areas. The west Puget Sound market benefits froma high quality of life, with significant outdoor recreational opportunities, median home pricessignificantly below the Seattle Metropolitan Statistical Area and a small community lifestyle. Inaddition, our markets are benefiting from a growing base of small- and medium-sized businesses, aswell as a number of growing military operations. We also benefit from the significant economicactivity generated in and around the Seattle Metropolitan Statistical Area as defined by the U.S.Census Bureau, which includes King, Pierce and Snohomish counties. While we have a limited presencein the Seattle Metropolitan Statistical Area with our Federal Way and Gig Harbor branches, theselocations have not yet greatly impacted our overall performance and we do not have any locations inthe city of Seattle. The Seattle Metropolitan Statistical Area has a diversified economy with majoremployers in a number of growth industries including aerospace, technology, health care, computerand telecommunications. Approximately 6,000 commuters ride the state ferries each day between theirhomes on Bainbridge Island and in other Kitsap County communities and downtown Seattle.***Kitsap County***     With four branches, Kitsap County is the largest market we serve. Along with our headquarters,approximately 72% of our deposits and approximately 82% of our loans, are in Kitsap County. Basedon FDIC data as of June 30, 2006, we had an 8.5% deposit market share in Kitsap County. In KitsapCounty, total bank and thrift deposits grew at an 8.0% rate in 2006, and have increased on average7.3% annually since 2000. As of December 2006, the unemployment rate for Kitsap County was 4.6%which was slightly above the rate for the Seattle Metropolitan Statistical Area for the same periodof 4.1%. Job growth is strong, with the area adding 1,700 jobs between the first quarter of 2005and 2006. The median home price for Kitsap County increased 20.8% in 2005 to $250,000, but remained35.8% below the median home price for the Seattle Metropolitan Statistical Area. According to theU.S. Department of Housing and Urban Development, the estimated median family income for KitsapCounty in 2005 was $62,000, ranking it sixth highest out of 39 counties in the state of Washington.     The military is a major source of employment, providing approximately 32,000 jobs orapproximately 27.6% of the employment within the county. Most of the military jobs in the countyare associated with two major U.S. Navy bases, the nuclear submarine base in Bangor (which is theonly deep water port for nuclear submarines on the West Coast) and the ship repair and dry dockfacilities in Bremerton (which is the only facility with the capacity for aircraft carriers on theWest Coast). While many naval installations were being considered for downsizing during the latestBase Realignment and Closure Committee review in 2005, Kitsap was slated for a modest gain in jobs.Although a number of military bases have been closed in recent years in other parts of the country,we believe the risk of a base closure is remote because of these bases’ unique capabilities andstrategic importance on the West Coast.     Kitsap County, and Bremerton in particular, are beginning to garner attention. Inc. magazinerecently ranked Bremerton as one of the country’s “hottest small cities for entrepreneurs,” in itsMay 1, 2006 issue for cities with an employment base under 150,000 people. In addition, in June2004 MONEY magazine called Bremerton “one of the top 5 up and coming ‘hot’ cities in the countrywith populations under 250,000.” The accolades can be partly attributed to $500 million in buildingand revitalization projects currently underway and recently completed. A luxury condominiumcomplex, four-star hotel, and waterfront maritime park are only a few of the projects currentlybeing undertaken. A $27 million tunnel project is scheduled to commence in the spring of 2007 inBremerton to improve traffic flow. The Kitsap County Trends report claims the investments willproduce more than 3,000 new jobs by 2010.***Clallam County***     We have two branches in Clallam County. Based on FDIC data as of June 30, 2006, we had a 5.0%deposit market share in Clallam County. In terms of population growth, Clallam County, whichincludes the city of Port Angeles, is the fastest expanding market we serve and has grown at anaverage annual rate of 1.6% from 2000
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through 2005. In Clallam County, total bank and thrift deposits grew 5.1% in 2006.Unemployment in the county as of December 2006 is 6.0%. While slightly higher than surroundingcounties, the unemployment rate has seen steep declines, falling more than 30% since January 2005.Health care and tourism from Canada are among the key industries. The Kiplinger Letter recentlynamed Port Angeles as a top area to start a new business. The city of Sequim, long known as aretirement haven, is establishing itself as a regional shopping center for the Olympic Peninsula.With an abundance of adequately zoned lot inventory, the population of Sequim, currently at 6,800,has been projected to double by 2011.***Seattle Metropolitan Statistical Area***     We currently have one branch in Pierce County in Gig Harbor, approximately thirty-five milesfrom the city of Seattle. Based on FDIC data as of June 30, 2006, we had a deposit market share ofless than 1.0% in Pierce County, which includes the city of Tacoma, located thirty miles south ofSeattle. In Pierce County, total bank and thrift deposits as of June 30, 2006 were $8.1 billion, up6.4% from the same period in 2005. Between 2000 and 2005 the county added new residents at a rate40% faster than the nation as a whole. The Port of Tacoma, which is a major center of business inthe county, is expected to grow approximately 50% in the next five years according to the PierceCounty Economic Index. A vibrant real estate market offered homeowners significant gains. Themedian home price in the county increased 20.6% to $240,000 in 2005. A second Tacoma Narrows bridgelinking Pierce County commuters with Gig Harbor in west Puget Sound is also scheduled to becompleted in 2008. We believe the opening of the second bridge could bring numerous additionalresidents to the Gig Harbor/South Kitsap area, by making commuting from Tacoma and the south KingCounty area to Seattle a viable option.     We opened a loan production office in south King County in Federal Way in 2005 and convertedit into a branch in February 2007. Federal Way is approximately twenty miles from the city ofSeattle. Like our west Puget Sound market area, south King County enjoys lower housing costs thanthe Seattle Metropolitan Statistical Area generally. The largest employer in south King County isWeyerhaeuser Company, a paper and wood products manufacturer.     As of December 31, 2006 we estimate that 7.3% of our loans and 5.4% of our deposits originatedin our two Seattle Metropolitan Statistical Area locations, a level that has not yet greatlyimpacted our overall performance. We do not have any locations in the city of Seattle and webelieve the amounts, if any, of our loans and deposits that originate in the city of Seattle areinsignificant. The Seattle Metropolitan Statistical Area economy is currently one of the topperforming major markets in the nation. The Seattle Metropolitan Statistical Area added 58,600 jobsin the twelve months ended August 2006. Driven by the increase in jobs, unemployment has decreasedsteadily over the last year, declining from 4.8% in August 2005 to 4.1% in December 2006. Homeprices continue to appreciate and experienced yearly gains of 17.8% in the fourth quarter of 2005to a median of $390,000. Conway and Pedersen’s Economic Forecaster expects the Seattle MetropolitanStatistical Area to add nearly 50,000 jobs annually over the next two years. For example, Microsoftrecently announced plans to spend $1 billion to expand its campus, making room for another 12,000potential employees.**Our Competition**     The banking and financial services business in the west Puget Sound and Seattle MetropolitanStatistical Area is highly competitive. This competitive environment is a result primarily ofgrowth in community banks, changes in regulation, changes in technology and product deliverysystems, and the accelerating pace of consolidation among financial services providers. We competefor loans, deposits and customers with other commercial banks, savings and loan associations,securities and brokerage companies, mortgage companies, insurance companies, finance companies,money market funds, credit unions, and other nonbank financial service providers. Many of thesecompetitors are much larger in total assets and capitalization, have greater access to capitalmarkets and offer a broader range of financial services than we offer.     According to the FDIC’s deposit market share report, as of June 30, 2006 18 banks operated inKitsap County and 14 operated in Clallam county. In Kitsap County, two large national banks, Bankof America, N.A. and Washington Mutual Bank, had approximately 34% of all deposits and two othercommunity banks, American Marine Bank and Kitsap Bank, had approximately 30% of all deposits.
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     We believe that our focus on customer service and relationship-banking distinguishes us fromthe larger banks, and that our professional retail sales culture and real estate lending expertise,provide us with a sustainable competitive advantage over our competitors in the west Puget Soundmarket, including other community banks.     Management believes that the principal competitive factors affecting our markets includeinterest rates paid on deposits and charged on loans, the range of banking products available andcustomer service and support. Although management believes that our products currently competefavorably with respect to these factors, there can be no assurance that we can maintain ourcompetitive position against current and potential competitors, especially those with significantlygreater financial resources.**Employees**     We had a total of 130 full-time equivalent employees at December 31, 2006. Our employees arenot represented by a labor organization, and we are not aware of any activity seeking suchorganization. We believe that our relationship with our employees is good.     We believe that a key reason for our success is our unique incentive compensation package thatwe have developed to directly reward our employees for their individual production and sales. Asubstantial portion of our loan production staff’s pay is based on commissions. The incentives aretiered to emphasize cross-selling of our products and services, with higher rewards for gainingmultiple relationships with customers. Our senior management is not eligible to receive incentivecompensation based on account production.**SUPERVISION AND REGULATION**     The following discussion is only intended to provide summaries of significant statutes andregulations that affect the banking industry and is therefore not complete. Changes in applicablelaws or regulations, and in the policies of regulators, may have a material effect on our businessand prospects. We cannot accurately predict the nature or extent of the effects on our business andearnings that fiscal or monetary policies, or new federal or state laws, may have in the future.**General**     We are extensively regulated under federal and state law. These laws and regulations areprimarily intended to protect depositors, not shareholders. The discussion below describes andsummarizes certain statutes and regulations. These descriptions and summaries are qualified intheir entirety by reference to the particular statute or regulation. Changes in applicable laws orregulations may have a material effect on our business and prospects. Our operations may also beaffected by changes in the policies of banking and other government regulators. We cannotaccurately predict the nature or extent of the possible future effects on our business and earningsof changes in fiscal or monetary policies, or new federal or state laws and regulations.**Compliance**     In order to assure that we are in compliance with the laws and regulations that apply to ouroperations, including those summarized below, we employ a compliance officer, and we engage anindependent compliance auditing firm. We are regularly reviewed by the Federal Reserve, the FDIC,and the Washington Department of Financial Institutions, Division of Banks, or DFI, during whichreviews such agencies assess our compliance with applicable laws and regulations. Based on theassessments of our outside compliance consultants and the FDIC, we believe that we materiallycomply with all of the laws and regulations that apply to our operations.**Federal Bank Holding Company Regulation**     *General.*WSB Financial Group, Inc. is a registered financial holding company as defined in theBank Holding Company Act of 1956, as amended, or the Bank Holding Company Act, and is thereforesubject to regulation, supervision and examination by the Federal Reserve. In general, the BankHolding Company Act limits the business of bank holding companies to owning or controlling banksand engaging in other activities closely
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related to banking. WSB Financial Group must file reports with the Federal Reserve and mustprovide it with such additional information as it may require.     The Federal Reserve may require WSB Financial Group to terminate an activity or terminatecontrol or liquidate or divest certain subsidiaries, affiliates or investments when the FederalReserve believes the activity or the control of the subsidiary or affiliates constitutes asignificant risk to the financial safety, soundness or stability of any of its bankingsubsidiaries.     The Federal Reserve also has the authority to regulate provisions of certain bank holdingcompany debt, including the authority to impose interest ceilings and reserve requirements on suchdebt. Under certain circumstances, WSB Financial Group must file written notice and obtain FederalReserve approval prior to purchasing or redeeming its equity securities. Additionally, WSBFinancial Group is required by the Federal Reserve to maintain certain levels of capital. See“Capital Adequacy” below for a discussion of the applicable federal capital requirements.     *Financial Holding Company Status.*Under the Financial Services Modernization Act of 1999, abank holding company may apply to the Federal Reserve to become a financial holding company, andthereby engage (directly or through a subsidiary) in certain activities deemed financial in nature.WSB Financial Group’s election of financial holding company status was effective October 3, 2006.     As a financial holding company, WSB Financial Group may affiliate with securities firms andinsurance companies and engage in other activities that are financial in nature or are incidentalor complementary to activities that are financial in nature. “Financial in nature” activitiesinclude: **•** Securities underwriting;  **•** Dealing and market making;  **•** Sponsoring mutual funds and investment companies;  **•** Insurance underwriting and brokerage;  **•** merchant banking; and  **•** Activities that the Federal Reserve, in consultation with the Secretary of theTreasury, determines from time to time to be so closely related to banking or managingor controlling banks as to be a proper incident thereto.     In order to become or remain a financial holding company, Westsound Bank must be wellcapitalized, well managed, and, except in limited circumstances, in satisfactory compliance withthe Community Reinvestment Act. Failure to sustain compliance with such requirements or correct anynon-compliance within a fixed time period could lead to divesture of subsidiary banks or require usto conform all of our activities to those permissible for a bank holding company. A bank holdingcompany that is not also a financial holding company can only engage in banking and such otheractivities determined by the Federal Reserve to be so closely related to banking or managing orcontrolling banks as to be a proper incident thereto.     We do not believe that the Financial Services Modernization Act will negatively affect ouroperations in the short term. However, to the extent the legislation permits banks, securitiesfirms and insurance companies to affiliate, the financial services industry may experience furtherconsolidation. This consolidation could result in a growing number of larger financial institutionsthat offer a wider variety of financial services than we currently offer, and these companies maybe able to aggressively compete in the markets we currently serve.     *Acquisition of Banks.*The Bank Holding Company Act requires every bank holding company toobtain the Federal Reserve Board’s prior approval before:
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 **•** acquiring direct or indirect ownership or control of any voting shares of anybank if, after the acquisition, the bank holding company will directly or indirectlyown or control more than 5% of the bank’s voting shares;  **•** acquiring all or substantially all of the assets of any bank; or  **•** merging or consolidating with any other bank holding company.     Additionally, the Bank Holding Company Act provides that the Federal Reserve Board may notapprove any of these transactions if it would result in or tend to create a monopoly, substantiallylessen competition or otherwise function as a restraint of trade, unless the anti-competitiveeffects of the proposed transaction are clearly outweighed by the public interest in meeting theconvenience and needs of the community to be served. The Federal Reserve Board is also required toconsider the financial and managerial resources and future prospects of the bank holding companiesand banks concerned and the convenience and needs of the community to be served. The FederalReserve Board’s consideration of financial resources generally focuses on capital adequacy, whichis discussed below.     *Restrictions on Ownership of WSB Financial Group.*The Bank Holding Company Act requires any“bank holding company” (as defined in that Act) to obtain the approval of the Board of Governors ofthe Federal Reserve System prior to acquiring more than 5% of WSB Financial Group’s outstandingcommon stock. Any person other than a bank holding company is required to obtain prior approval ofthe Federal Reserve Board to acquire 10% or more of WSB Financial Group’s outstanding common stockunder the Change in Bank Control Act. Any holder of 25% or more of WSB Financial Group’soutstanding common stock, other than an individual, is subject to regulation as a bank holdingcompany under the Bank Holding Company Act.     *Holding Company Control of Nonbanks.*With some exceptions, the Bank Holding Company Act alsoprohibits a bank holding company from acquiring or retaining direct or indirect ownership orcontrol of more than 5% of the voting shares of any company which is not a bank or bank holdingcompany, or from engaging directly or indirectly in activities other than those of banking,managing or controlling banks, or providing services for its subsidiaries. The principal exceptionsto these prohibitions involve certain non-bank activities which, by statute or by Federal Reserveregulation or order, have been identified as activities closely related to the business of bankingor of managing or controlling banks.     *Transactions with Affiliates.*Subsidiary banks of a bank holding company are subject torestrictions imposed by the Federal Reserve Act on extensions of credit to the holding company orits subsidiaries, on investments in their securities and on the use of their securities ascollateral for loans to any borrower. These regulations and restrictions may limit WSB FinancialGroup’s ability to obtain funds from Westsound Bank for its cash needs, including funds for paymentof dividends, interest and operational expenses.     *Tying Arrangements.*We are prohibited from engaging in certain tie-in arrangements inconnection with any extension of credit, sale or lease of property or furnishing of services. Forexample, with certain exceptions, neither WSB Financial Group nor Westsound Bank may condition anextension of credit to a customer on either (i) a requirement that the customer obtain additionalservices provided by us or (ii) an agreement by the customer to refrain from obtaining otherservices from a competitor.     *Support of Subsidiary Banks.*Under Federal Reserve policy, WSB Financial Group is expected toact as a source of financial and managerial strength to Westsound Bank. This means that WSBFinancial Group is required to commit, as necessary, resources to support Westsound Bank. Anycapital loans a bank holding company makes to its subsidiary banks are subordinate to deposits andto certain other indebtedness of those subsidiary banks.**Federal and State Regulation of Westsound Bank**     *General.*Westsound Bank is a Washington chartered commercial bank with deposits insured by theFDIC. As a result, Westsound Bank is subject to supervision and regulation by the Washington DFIand the FDIC. These
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agencies have the authority to prohibit banks from engaging in what they believe constituteunsafe or unsound banking practices.     *Lending Limits.*Washington banking law generally limits the amount of funds that a bank maylend to a single borrower to 20% of stockholders’ equity.     *Control of Financial Institutions.*The acquisition of 25% or more of a state chartered bank’svoting power by any individual, group or entity, is deemed a change in control under Washingtonbanking law, requiring notice and application and prior approval of the DFI.     *Community Reinvestment.*The Community Reinvestment Act requires that, in connection withexaminations of financial institutions within their jurisdiction, the FDIC evaluate the record ofthe financial institution in meeting the credit needs of its local communities, including low andmoderate income neighborhoods, consistent with the safe and sound operation of the institution.These factors are also considered in evaluating mergers, acquisitions and applications to open abranch or facility.     *Insider Credit Transactions.*Banks are also subject to certain FDIC restrictions on extensionsof credit to executive officers, directors, principal shareholders or any related interests of suchpersons (i.e., insiders). Extensions of credit (i) must be made on substantially the same terms andpursuant to the same credit underwriting procedures as those for comparable transactions withpersons who are neither insiders nor employees, and (ii) must not involve more than the normal riskof repayment or present other unfavorable features. Banks are also subject to certain lendinglimits and restrictions on overdrafts to insiders. A violation of these restrictions may result inregulatory sanctions on the bank or its insiders.     *Regulation of Management.*Federal law sets forth circumstances under which officers ordirectors of a bank may be removed by the institution’s federal supervisory agency. Federal lawalso prohibits management personnel of a bank from serving as a director or in a managementposition of another financial institution whose assets exceed a specified amount or which has anoffice within a specified geographic area.     *Safety and Soundness Standards.*Federal law imposes upon banks certain non-capital safety andsoundness standards. These standards cover internal controls, information systems, internal auditsystems, loan documentation, credit underwriting, interest rate exposure, asset growth,compensation and benefits. Additional standards apply to asset quality, earnings and stockvaluation. An institution that fails to meet these standards must develop a plan acceptable to itsregulators, specifying the steps that the institution will take to meet the standards. Failure tosubmit or implement such a plan may subject the institution to regulatory sanctions. UnderWashington state law, if the stockholders’ equity of a Washington state-chartered bank becomesimpaired, the Commissioner of the Washington DFI will require the bank to make the impairment good.Failure to make the impairment good may result in the Commissioner’s taking possession of the bankand liquidating it.     *Dividends*. The principal source of WSB Financial Group’s cash reserves will be dividendsreceived from Westsound Bank. Washington law limits the bank’s ability to pay cash dividends. Underthese restrictions, a bank may not declare or pay any dividend greater than its retained earningswithout approval of the Washington DFI. The Washington DFI has the power to require anystate-chartered bank to suspend the payment of any and all dividends.     In addition, a bank may not pay cash dividends if doing so would reduce its capital belowminimum applicable federal capital requirements. See “Capital Adequacy” below for a discussion ofthe applicable federal capital requirements.     *Other Regulations.*The loan operations of our Bank are subject to state usury laws and federallaws concerning interest rates.     *Federal Laws Applicable to Credit Transactions.*The loan operations of our Bank are alsosubject to federal laws applicable to credit transactions, such as the: **•** Truth-In-Lending Act, governing disclosures of credit terms to consumerborrowers;
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 **•** Home Mortgage Disclosure Act of 1975, requiring financial institutions toprovide information to enable the public and public officials to determine whether afinancial institution is fulfilling its obligation to help meet the housing needs ofthe community it serves;  **•** Equal Credit Opportunity Act, prohibiting discrimination on the basis of race,creed or other prohibited factors in extending credit;  **•** Fair Credit Reporting Act of 1978, governing the use and provision ofinformation to credit reporting agencies;  **•** Fair Debt Collection Practices Act, governing the manner in which consumerdebts may be collected by collection agencies;  **•** Servicemembers Civil Relief Act, which amended the Soldiers’ and Sailors’ CivilRelief Act of 1940, governing the repayment terms of, and property rights underlying,secured obligations of persons in military service; and  **•** the rules and regulations of the various federal agencies charged with theresponsibility of implementing these federal laws.     *Federal Laws Applicable to Deposit Operations.*The deposit operations of our Bank are subjectto: **•** the Right to Financial Privacy Act, which imposes a duty to maintainconfidentiality of consumer financial records and prescribes procedures for complyingwith administrative subpoenas of financial records; and  **•** the Electronic Funds Transfer Act and Regulation E issued by the FederalReserve Board to implement that act, which govern automatic deposits to and withdrawalsfrom deposit accounts and customers’ rights and liabilities arising from the use ofautomated teller machines and other electronic banking services.     *Brokered Deposits.*Under the Federal Deposit Insurance Corporation Improvement Act, or FDICIA,banks may be restricted in their ability to accept brokered deposits, depending on their capitalclassification. “Well-capitalized” banks are permitted to accept brokered deposits, but all banksthat are not well-capitalized are not permitted to accept such deposits. The FDIC may, on acase-by-case basis, permit banks that are adequately capitalized to accept brokered deposits if theFDIC determines that acceptance of such deposits would not constitute an unsafe or unsound bankingpractice with respect to the bank. As of December 31, 2006, we had $20.6 million of brokereddeposits. As described below, the Bank is currently well-capitalized and therefore is not subjectto any limitations with respect to its brokered deposits.     *Check Clearing for the 21st Century Act.*On October 28, 2003, President Bush signed into lawthe Check Clearing for the 21st Century Act, also known as Check 21. The new law gives “substitutechecks,” such as a digital image of a check and copies made from that image, the same legalstanding as the original paper check. Some of the major provisions include: **•** allowing check truncation without making it mandatory;  **•** demanding that every financial institution communicate to accountholders inwriting a description of its substitute check processing program and their rights underthe law;  **•** legalizing substitutions for and replacements of paper checks without agreementfrom consumers;  **•** retaining in place the previously mandated electronic collection and return ofchecks between financial institutions only when individual agreements are in place;
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 **•** requiring that when accountholders request verification, financial institutionsproduce the original check (or a copy that accurately represents the original) anddemonstrate that the account debit was accurate and valid; and  **•** requiring recrediting of funds to an individual’s account on the next businessday after a consumer proves that the financial institution has erred.     This new legislation will likely affect bank capital spending as many financial institutionsassess whether technological or operational changes are necessary to stay competitive and takeadvantage of the new opportunities presented by Check 21.     *Federal Home Loan Bank System.*The Federal Home Loan Bank system, of which our Bank is amember, consists of 12 regional FHLBs governed and regulated by the Federal Housing Finance Board,or FHFB. The FHLBs serve as reserve or credit facilities for member institutions within theirassigned regions. They are funded primarily from proceeds derived from the sale of consolidatedobligations of the FHLB system. They make loans (i.e., advances) to members in accordance withpolicies and procedures established by the FHLB and the boards of directors of each regional FHLB.     As a system member, our Bank is entitled to borrow from the FHLB of its region and is requiredto own a certain amount of capital stock in the FHLB. Our Bank is in compliance with the stockownership rules described above with respect to such advances, commitments and letters of creditand home mortgage loans and similar obligations. All loans, advances and other extensions of creditmade by the FHLB to our Bank are secured by a portion of its mortgage loan portfolio, certain otherinvestments and the capital stock of the FHLB held by the Bank.     *Mortgage Banking Operations.*Our Bank is subject to the rules and regulations of FHA, VA,FNMA, FHLMC and GNMA with respect to originating, processing, selling and servicing mortgage loansand the issuance and sale of mortgage-backed securities. Those rules and regulations, among otherthings, prohibit discrimination and establish underwriting guidelines which include provisions forinspections and appraisals, require credit reports on prospective borrowers and fix maximum loanamounts, and, with respect to VA loans, fix maximum interest rates. Mortgage origination activitiesare subject to, among others, the Equal Credit Opportunity Act, Federal Truth-in-Lending Act andthe Real Estate Settlement Procedures Act and the regulations promulgated thereunder which, amongother things, prohibit discrimination and require the disclosure of certain basic information tomortgagors concerning credit terms and settlement costs.     *Commercial Real Estate Guidance.*The FDIC and the Federal Reserve Board issued joint Guidanceon Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices on December 6,2006. The Guidance provides supervisory criteria, including the following numerical indicators, toassist bank examiners in identifying banks with potentially significant commercial real estate loanconcentrations that may warrant greater supervisory scrutiny: (1) commercial real estate loansexceed 300% of capital and increased 50% or more in the preceding three years, or (2) constructionand development loans exceed 100% of capital. The Guidance does not limit banks’ levels ofcommercial real estate lending activities. The Guidance applies to Westsound Bank, based on ourcurrent loan portfolio. We believe that our loan portfolio has been subject to rigorous examinationby banking regulators and that we have taken appropriate precautions to address the risksassociated with our concentrations in commercial real estate lending. We do not expect the Guidanceto adversely affect our operations or our ability to execute our growth strategy.**Privacy**     Federal banking rules limit the ability of banks and other financial institutions to disclosenon-public information about consumers to nonaffiliated third-parties. Pursuant to these rules,financial institutions must provide: **•** initial notices to customers about their privacy policies, describing theconditions under which they may disclose nonpublic personal information tononaffiliated third-parties and affiliates;
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 **•** annual notices of their privacy policies to current customers; and  **•** a reasonable method for customers to “opt out” of disclosures to nonaffiliated third-parties.     These privacy provisions affect how consumer information is transmitted through diversifiedfinancial companies and conveyed to outside vendors. We have implemented privacy policies inaccordance with the law.**Interstate Banking And Branching**     The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (“Interstate Act”)permits nationwide interstate banking and branching under certain circumstances. This legislationgenerally authorizes interstate branching and relaxes federal law restrictions on interstatebanking. Currently, bank holding companies may purchase banks in any state, and states may notprohibit these purchases. Additionally, banks are permitted to merge with banks in other states, aslong as the home state of neither merging bank has opted out under the legislation. The InterstateAct requires regulators to consult with community organizations before permitting an interstateinstitution to close a branch in a low-income area.     FDIC regulations prohibit banks from using their interstate branches primarily for depositproduction. The FDIC has implemented a loan-to-deposit ratio screen to ensure compliance with thisprohibition.     Washington enacted “opting in” legislation in accordance with the Interstate Act, allowingbanks to engage in interstate merger transactions, subject to certain “aging” requirements. Untilrecently, Washington restricted out-of-state banks from opening de novo branches; however, in 2005,Washington interstate branching laws were amended so that an out-of-state bank may, subject to theDFI’s approval, open de novo branches in Washington or acquire an in-state branch so long as thehome state of the out-of-state bank has reciprocal laws with respect to de novo branching or branchacquisitions. Once an out-of-state bank has acquired a bank within Washington, either throughmerger or acquisition of all or substantially all of the bank’s assets or through authorized denovo branching, the out-of-state bank may open additional branches within the state.**Deposit Insurance**     Westsound Bank’s deposits are currently insured to a maximum of $100,000 per depositor throughthe Bank Insurance Fund administered by the FDIC. Westsound Bank is required to pay depositinsurance premiums, which are assessed semiannually and paid quarterly. The premium amount is basedupon a risk classification system established by the FDIC. Banks with higher levels of capital anda low degree of supervisory concern are assessed lower premiums than banks with lower levels ofcapital or a higher degree of supervisory concern.     The FDIC is also empowered to make special assessments on insured depository institutions inamounts determined by the FDIC to be necessary to give it adequate assessment income to repayamounts borrowed from the U.S. Treasury and other sources or for any other purpose the FDIC deemsnecessary.     Legislative reforms to modernize the Federal Deposit Insurance System, including merging theBank Insurance Fund and the Savings Association Insurance Fund into a new Deposit Insurance Fund,were approved by Congress on February 15, 2006. In addition to merging the insurance funds, thelegislation: **•** raised the deposit insurance limit on certain retirement accounts to $250,000and indexes that limit for inflation;  **•** requires the FDIC and National Credit Union Administration boards, starting in2010 and every succeeding five years, to consider raising the standard maximum depositinsurance; and  **•** eliminated the current fixed 1.25 percent Designated Reserve Ratio and providesthe FDIC with the discretion to set the DRR within a range of 1.15 to 1.50 percent forany given year.
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**Capital Adequacy**     *Regulatory Capital Guidelines.*Federal bank regulatory agencies use capital adequacyguidelines in the examination and regulation of bank holding companies and banks. The guidelinesare “risk-based,” meaning that they are designed to make capital requirements more sensitive todifferences in risk profiles among banks and bank holding companies.     *Tier I and Tier II Capital.*Under the guidelines, an institution’s capital is divided into twobroad categories, Tier I capital and Tier II capital. Tier I capital generally consists of commonstockholders’ equity, surplus and undivided profits. Tier II capital generally consists of theallowance for loan losses, hybrid capital instruments, and subordinated debt. The sum of Tier Icapital and Tier II capital represents an institution’s total capital. The guidelines require thatat least 50% of an institution’s total capital consist of Tier I capital.     *Risk-based Capital Ratios.*The adequacy of an institution’s capital is gauged primarily withreference to the institution’s risk weighted assets. The guidelines assign risk weightings to aninstitution’s assets in an effort to quantify the relative risk of each asset and to determine theminimum capital required to support that risk. An institution’s risk weighted assets are thencompared with its Tier I capital and total capital to arrive at a Tier I risk-based ratio and atotal risk-based ratio, respectively. The guidelines provide that an institution must have aminimum Tier I risk-based ratio of 4% and a minimum total risk-based ratio of 8%.     *Leverage Ratio.*The guidelines also employ a leverage ratio, which is Tier I capital as apercentage of total assets less intangibles, to be used as a supplement to risk-based guidelines.The principal objective of the leverage ratio is to constrain the maximum degree to which a bankholding company may leverage its equity capital base. The minimum leverage ratio is 3%; however,for all but the most highly rated bank holding companies and for bank holding companies seeking toexpand, regulators generally expect an additional cushion of at least 1% to 2%.     *Prompt Corrective Action.*Under the guidelines, an institution is assigned to one of fivecapital categories depending on its total risk-based capital ratio, Tier I risk-based capitalratio, and leverage ratio, together with certain subjective factors. The categories range from“well capitalized” to “critically undercapitalized.” Institutions that are deemed to be“undercapitalized,” depending on the category to which they are assigned, are subject to certainmandatory supervisory corrective actions.**State Corporate Law Restrictions**     As a Washington corporation, WSB Financial Group is subject to certain limitations andrestrictions under applicable Washington corporate law. For example, state law restrictions inWashington include limitations and restrictions relating to indemnification of directors;distributions to shareholders; transactions involving directors, officers, or interestedshareholders; maintenance of books, records, and minutes; and observance of certain corporateformalities.**Corporate Governance and Accounting Legislation**     *Sarbanes-Oxley Act of 2002.*On July 30, 2002, the Sarbanes-Oxley Act of 2002, or SOX, wassigned into law to address corporate and accounting fraud. SOX establishes a new accountingoversight board that will enforce auditing standards and restricts the scope of services thataccounting firms may provide to their public company audit clients. Among other things, SOX also(i) requires chief executive officers and chief financial officers to certify to the accuracy ofperiodic reports filed with the SEC; (ii) imposes new disclosure requirements regarding internalcontrols, off-balance-sheet transactions, and pro forma (non-GAAP) disclosures; (iii) acceleratesthe time frame for reporting of insider transactions and periodic disclosures by public companies;and (iv) requires companies to disclose whether or not they have adopted a code of ethics forsenior financial officers and whether the audit committee includes at least one “audit committeefinancial expert.”     Under SOX, the SEC is required to regularly and systematically review corporate filings, basedon certain enumerated factors. To deter wrongdoing, SOX (i) subjects bonuses issued to topexecutives to disgorgement if a restatement of a company’s financial statements was due tocorporate misconduct; (ii) prohibits an officer or director
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from misleading or coercing an auditor; (iii) prohibits insider trades during pension fund“blackout periods”; (iv) imposes new criminal penalties for fraud and other wrongful acts; and (v)extends the period during which certain securities fraud lawsuits can be brought against a companyor its officers.     As a public reporting company, we are subject to the requirements of SOX and related rules andregulations issued by the SEC and Nasdaq. We anticipate that we will incur additional expense as aresult of the Act, but we do not expect that such compliance will have a material impact on ourbusiness.**Anti-terrorism Legislation**     *USA Patriot Act of 2001.*On March 9, 2006, President Bush signed the renewal of the Unitingand Strengthening America by Providing Appropriate Tools Required to Intercept and ObstructTerrorism, or the Patriot Act, of 2001. Among other things, the Patriot Act (i) prohibits banksfrom providing correspondent accounts directly to foreign shell banks; (ii) imposes due diligencerequirements on banks opening or holding accounts for foreign financial institutions or wealthyforeign individuals; (iii) requires financial institutions to establish an anti-money-launderingcompliance program; and (iv) eliminates civil liability for persons who file suspicious activityreports. The Patriot Act also increases governmental powers to investigate terrorism, includingexpanded government access to account records. The Department of the Treasury is empowered toadminister and make rules to implement the Patriot Act. While we believe the Patriot Act may, tosome degree, affect our recordkeeping and reporting expenses, we do not believe that it will have amaterial adverse effect on our business and operations.**Effects of Government Monetary Policy**     Our earnings and growth are affected not only by general economic conditions, but also by thefiscal and monetary policies of the federal government, particularly the Federal Reserve. TheFederal Reserve can and does implement national monetary policy for such purposes as curbinginflation and combating recession. The nature and impact of future changes in monetary policies andtheir impact on us cannot be predicted with certainty.**Nonbank Subsidiary**     Our non-bank subsidiary, WSB Financial Group Trust I, a Delaware statutory trust, is subjectto the laws and regulations of both the federal government and the state in which it conductsbusiness.**Available Information of the Registrant**     The Company is subject to the information reporting requirements of the Securities ExchangeAct of 1934, as amended, or Securities Exchange Act, and files reports, proxy statements and otherinformation with the Securities and Exchange Commission, or SEC. Reports, proxy statements andother information filed by the Company may be reviewed and copied at the SEC’s public referencefacilities at 100 F Street, NE, Washington, D.C. 20549. You may also obtain information on theoperation of the public reference rooms by calling the SEC at 1-800-SEC-0330. The SEC alsomaintains an Internet website that contains periodic reports, proxy statements and otherinformation about issuers, like us, that we file electronically with the SEC. The address of thatsite is http://www.sec.gov.     We also maintain a website at http://www.westsoundbank.com. We make available through ourwebsite, free of charge, copies of our annual report on Form 10-K, quarterly reports on Form 10-Q,current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section13(a) or Section 15(d) of the Securities Exchange Act as soon as reasonably practicable afterfiling such material electronically or otherwise furnishing it to the SEC. Our corporate governanceguidelines and charters for our board committees, and our Code of Ethics and Professional Conduct,which includes a code of ethics applicable to our accounting and financial employees, including ourChief Executive Officer and Chief Financial Officer, are also available on our website. Each ofthese documents is also available in print (at no charge) to any shareholder upon request. Ourwebsite and the information contained therein or connected thereto are not incorporated byreference into this Report.
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**Executive Officers of the Registrant**     The names and ages of all executive officers of the Company and the positions and offices heldby such persons as of March 15, 2007 are as follows:       **Name** **Position with the Company** **Age**David K. Johnson President, Chief Executive Officer and Director  42 Mark D. Freeman Executive Vice President of Finance and Operations, Chief Financial Officer  54 Brett T. Green Executive Vice President of Sales and Lending  44 Veronica R. Colburn Senior Vice President, Chief Risk Officer  44 Brent A. Stenman Senior Vice President, Chief Lending Officer  42 Robin A. Seelye Senior Vice President, Operations  36 **Forward-Looking Statements**     This annual report on Form 10-K includes forward-looking statements. These statements may beidentified by the use of forward-looking terminology such as “anticipate,” “believe,” “continue,”“could,” “estimate,” “expect,” “intend,” “may,” “might,” “plan,” “potential,” “predict,” “should”or “will” or the negative thereof or other variations thereon or comparable terminology. Inparticular, statements about our expectations, beliefs, plans, objectives, assumptions or futureevents or performance contained in this report under the headings “Risks Relating to Our Business,”“Management’s Discussion and Analysis of Financial Condition and Results of Operations” and“Business” are forward-looking statements.     We have based these forward-looking statements on our current expectations, assumptions,estimates and projections. While we believe these expectations, assumptions, estimates andprojections are reasonable, such forward-looking statements are only predictions and involve knownand unknown risks and uncertainties, many of which are beyond our control. These and otherimportant factors, including those discussed in this report under the headings “Risks Relating toOur Business,” “Management’s Discussion and Analysis of Financial Condition and Results ofOperations” and “Business” may cause our actual results, performance or achievements to differmaterially from any future results, performance or achievements expressed or implied by theseforward-looking statements. Some of the key factors that could cause actual results to differ fromour expectations are: **•** changes in general economic conditions, either nationally or locally in thewest Puget Sound and Seattle Metropolitan Statistical Area;  **•** inflation, interest rate, market and monetary fluctuations;  **•** changes in consumer spending habits and savings habits;  **•** increases in competitive pressures among financial institutions and businessesoffering similar products and services;  **•** higher defaults on our loan portfolio than we expect;  **•** changes in management’s estimate of the adequacy of the allowance for loan losses;  **•** risks associated with our growth and expansion strategy and related costs;  **•** increased lending risks associated with our high concentrations of real estate loans;  **•** ability to successfully grow our business in west Puget Sound and the SeattleMetropolitan Statistical Area;  **•** legislative or regulatory changes or changes in accounting principles, policies or guidelines;
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 **•** technological changes; and  **•** regulatory or judicial proceedings.     Given these risks and uncertainties, you are cautioned not to place undue reliance on suchforward-looking statements. The forward-looking statements included or incorporated by referenceinto this report are made only as of the date hereof. We do not undertake and specifically declineany obligation to update any such statements or to publicly announce the results of any revisionsto any such statements to reflect future events or developments.**Item 1A. Risk Factors**     An investment in our common stock involves a high degree of risk. Before investing in ourcommon stock, you should carefully consider the risks described below, as well as the otherinformation contained in this report, including our consolidated financial statements and the notesthereto and “Management’s Discussion and Analysis of Financial Condition and Results ofOperations.” Any of the risks described below could significantly and adversely affect ourbusiness, prospects, financial condition and results of operations. If one or more of these risksand uncertainties is realized, the trading price of our common stock could decline, and you couldlose all or part of your investment.**Risks Relating to Our Business and Market****If we are not able to maintain our past level of growth, our future prospects and competitiveposition could be diminished and our profitability could be reduced.**     We may not be able to sustain our growth at the rate we have enjoyed during the past severalyears. Our business strategy calls for, among other things: **•** continued growth of our assets, loans, deposits and customer base through ourexisting locations and new branches and loan production offices;  **•** recruitment of sales-oriented personnel and other key employees; and  **•** expansion of our real estate lending activities.     Our rapid growth over the past several years has been driven in part by a strong residentialhousing market in west Puget Sound and our ability to identify attractive expansion opportunities.A downturn in local economic market conditions, particularly in the real estate market, a failureto attract and retain high performing employees, heightened competition from other financialservices providers, and an inability to attract additional core deposits and lending customers,among other factors, could limit our ability to grow as rapidly as we have in the past.     Over 94% of our loans are real estate related, including loans for construction and landdevelopment projects and for the purchase, improvement or refinancing of residential and commercialreal estate. An adverse change in the real estate market could cause collateral for loans made byus to decline in value, and loan delinquencies and problem assets to increase.     Approximately 94.5% of our loan portfolio as of December 31, 2006 was comprised of loanssecured by real estate, including construction and development, commercial and residential realestate loans. Approximately 75% of our residential real estate loans are single family (1-4 units)and 25% are multifamily. A downturn in the real estate market could increase loan delinquencies,defaults and foreclosures, and significantly impair the value of our collateral and our ability tosell the collateral upon foreclosure. The real estate collateral in each case provides an alternatesource of repayment in the event of default by the borrower and may deteriorate in value during thetime the credit is extended. If real estate values decline, it is also more likely that we would berequired to increase our allowance for loan losses. If during a period of reduced real estatevalues we are required to liquidate the property collateralizing a loan to satisfy the debt or toincrease our allowance for loan losses, it could materially reduce our profitability and adverselyaffect our financial condition.
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**Over 56% of our loans are real estate construction and development loans, which have a higherdegree of risk and a greater potential for losses that would reduce our earnings.**     Approximately 56.5% of our loan portfolio as of December 31, 2006 consisted of real estateconstruction and development loans, which generally have a higher degree of risk than long-termfinancing of existing properties because repayment depends on the completion of the project andusually on the sale of the property.     In addition, these loans are normally interest only. Interest-only loans carry greater riskthan principal and interest loans do, to the extent that no principal is paid prior to maturity,particularly during a period of rising interest rates and declining real estate values. If there isa significant decline in the real estate market due to a material increase in interest rates or forother reasons, many of these loans could default and result in foreclosure. Moreover, most of theseloans are for projects located in the west Puget Sound area. If we are forced to foreclose on aproject prior to completion, we may not be able to recover all of the unpaid portion of the loan orwe may be required to fund additional money to complete the project or hold the property for anindeterminate period of time. Any of these outcomes may result in losses and reduce our earnings.**Our allowance for loan losses may not be adequate to cover actual losses.**     A significant source of risk arises from the possibility that we could sustain losses due toloan defaults and non-performance on loans. We maintain an allowance for loan losses in accordancewith accounting principles generally accepted in the United States to provide for such defaults andother non-performance. As of December 31, 2006, our allowance for loan losses as a percentage ofloans was 1.15%. The determination of the appropriate level of loan loss allowance is an inherentlydifficult process and is based on numerous assumptions. The amount of future losses is susceptibleto changes in economic, operating and other conditions, including changes in interest rates, thatmay be beyond our control. In addition, our underwriting policies, adherence to credit monitoringprocesses, and risk management systems and controls may not prevent unexpected losses. Ourallowance for loan losses may not be adequate to cover actual loan losses. Moreover, any increasein our allowance for loan losses will adversely affect our earnings.**We serve a limited geographic area, and an economic downturn in the west Puget Sound or SeattleMetropolitan Statistical Area could limit our growth and reduce our profitability.**     Our current geographic market consists primarily of the west Puget Sound area, includingKitsap County. The FDIC has characterized our headquarters in downtown Bremerton as being locatedin a “low income” area and our other branches and loan production offices as being located in“middle income” areas. As of December 31, 2006, our Kitsap County customers accounted forapproximately 72% of our deposits and 82% of our loans. Because of our relatively small size andgeographic concentration, adverse changes in local economic conditions, such as income levels,deposits and housing starts, would have a relatively greater affect on us than they would on thelarger national and regional competitors that are active in our market areas. If local or regionaleconomic conditions were to deteriorate, demand for our products and services likely would declineand the quality of our loan portfolio could be reduced.     Kitsap County’s economy substantially depends on the military and tourism. While we believethat the local economy is diverse, the military has a significant presence in Kitsap County,including two major Navy bases which account for significant employment in the county. Although thefederal government recently decided not to close any military bases in our market area, we cannotbe certain that it will not do so in the future. We believe that few of our customers come from themilitary or its members, because most of their needs are met by a credit union. However, asignificant reduction in the military presence in our market could have a material adverse effecton the local economy and potentially on our customers and business. In addition, the west PugetSound area serves as a seasonal destination for many residents of the Seattle MetropolitanStatistical Area and a decline in that economy could affect real estate prices due to a slowdown inpurchases by Seattle area residents as well as service businesses that rely on the seasonaltraffic.
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**Our loan portfolio is concentrated in real estate and a substantial majority of our loans andoperations are in west Puget Sound, and therefore our business is particularly vulnerable to adownturn in the local real estate market.**     As of December 31, 2006 approximately 94.5% of our loans were secured by real estate,primarily located in our west Puget Sound market. If the local economy, and particularly the realestate market, declines, the rates of delinquencies, foreclosures, bankruptcies and losses in ourloan portfolio would likely increase. As a result of this lack of diversification in our loanportfolio a downturn in the local real estate market could significantly reduce our profitabilityand adversely affect our financial condition.**We have a relatively high percentage of unseasoned credits, which are considered to pose apotential greater repayment risk than loans that have been outstanding for a longer period of time.**     As a result of our strong growth during the past five years and our focus on real estateconstruction and development lending, a significant portion of our loan portfolio is represented bynew credits. Generally, loans that are relatively new, referred to as unseasoned loans, do not havesufficient repayment history to determine the likelihood of repayment in accordance with theirterms. At December 31, 2006, 88.2% of our total loan portfolio consisted of loans booked within thepast two years, including loan renewals.**If we are unable to manage our growth effectively, we may incur higher than anticipated costs andour ability to execute our growth strategy could be impaired.**     We expect to continue to grow our assets and deposits by increasing our product and servicesofferings and expanding our operations through new branches, loan production offices and possiblyacquisitions. Our ability to manage growth successfully will depend on our ability to: **•** identify suitable markets for expansion;  **•** attract and retain qualified management;  **•** attract funding to support additional growth;  **•** maintain asset quality and cost controls; and  **•** maintain adequate regulatory capital and profitability to support our lending activities.     If we do not manage our growth effectively, we may be unable to realize the benefit from theinvestments in technology, infrastructure, and personnel that we have made to support ourexpansion. In addition, we may incur higher costs and realize less revenue growth than we expect,which would reduce our earnings and diminish our future prospects, and we may not be able tocontinue to implement our business strategy and successfully conduct our operations. Risksassociated with failing to maintain effective financial and operational controls as we grow, suchas maintaining appropriate loan underwriting procedures, determining adequate allowances for loanslosses and complying with regulatory accounting requirements, include increased loan losses,reduced earnings and potential regulatory penalties and restrictions on growth.**Our growth could be hindered unless we are able to recruit additional qualified employees. We mayhave difficulty attracting additional necessary personnel, which may divert resources and limit ourability to successfully expand our operations.**     The west Puget Sound and Seattle Metropolitan Statistical Area are experiencing a period ofsignificant growth, placing a premium on highly qualified employees in a number of industries,including the financial services industry. Our business plan includes, and is dependent upon, ourhiring and retaining highly qualified and motivated employees at every level. In addition, weanticipate that the reporting and related obligations to which we will become subject as a publicreporting company will require us to hire additional accounting and finance staff. We expect toexperience substantial competition in identifying, hiring and retaining top-quality employees. Ifwe are
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unable to hire and retain qualified employees in the near term, we may be unable tosuccessfully execute our business strategy and manage our growth.**The unexpected loss of key officers would materially and adversely affect our ability to executeour business strategy, and diminish our future prospects.**     We believe that our success to date and our prospects for success in the future aresubstantially dependent on our senior management team, which includes our president and chiefexecutive officer, David K. Johnson, and certain other key executives. The loss of Mr. Johnson’sservices or that of other key executives could materially and adversely affect our ability tosuccessfully implement our business plan and, as a result, our future prospects. In light of therelatively small pool of persons involved in the banking industry in western Washington, we couldhave difficulty replacing any of our senior management team or senior officers with equallycompetent persons who also are familiar with our market area.**We are subject to extensive government regulation. Non-compliance with or material changes toexisting regulations could adversely affect our business, financial condition, results ofoperations or cash flows.**     We are subject to extensive regulation by federal, state and local governmental authoritiesand are subject to various laws and judicial and administrative decisions imposing requirements andrestrictions on part or all of our operations. Because our business is highly regulated, the laws,rules and regulations applicable to us are subject to regular modification and change. For example,the FDIC and the Federal Reserve Board recently issued joint Guidance on Concentrations inCommercial Real Estate Lending, Sound Risk Management Practices, that sets forth supervisorycriteria to assist bank examiners in identifying banks with potentially significant commercial realestate loan concentrations that may warrant greater supervisory scrutiny. The Guidance applies toWestsound Bank, based on our current loan portfolio, and we expect that our business and operationswill be subject to enhanced regulatory review for the foreseeable future. Our failure to complywith applicable laws and regulations, or changes to the existing regulatory structure, couldadversely affect our business, financial condition, results of operations or cash flows.**The FDIC recently found that we violated the reporting requirements of the Home Mortgage DisclosureAct and other consumer banking laws, imposed penalties of $6,000 and required our board to enterinto a memorandum of understanding to correct the violations and related deficiencies in ourinternal controls. Our failure to correct violations in our reporting procedures could result infurther regulatory action.**     The FDIC recently conducted an examination relating to Westsound Bank’s compliance withvarious banking regulations, which examination was unrelated to safety and soundness of the Bank.The FDIC noted deficiencies in the Bank’s regulatory compliance management system relating tooversight, procedures, training and our audit program for compliance. The FDIC found failures tocomply with the reporting requirements of the Home Mortgage Disclosure Act, or HMDA, and violationsof other banking-related consumer laws, including the Equal Credit Opportunity Act, theTruth-in-Lending Act and the Truth-in-Savings Act. In addition, the FDIC imposed civil moneypenalties of $6,000 for violations that it characterized as significant and repeated, and requiredWestsound Bank and our board to enter into a confidential memorandum of understanding with the FDICin May 2006 to correct the regulatory violations and deficiencies in our internal controls forregulatory compliance. We have taken the corrective measures outlined in the memorandum and believewe are in substantial compliance with the memorandum. If we fail to comply with the memorandum inthe future, the FDIC has the authority to impose civil monetary penalties of up to $5,500 per dayfor violations of this nature, depending on our financial resources as compared to other financialinstitutions, the severity of the violations, whether our failure to comply was intentional, theduration and frequency of the violations, our cooperation with the agency to resolve the problemand other facts and circumstances. In addition, the Bank’s record of compliance will be anadditional factor in any application filed with federal regulators, including applications for newbank branches and acquisitions.
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**As a result of our initial public offering, we became a public reporting company subject tofinancial reporting and other requirements for which our accounting, internal audit and othermanagement systems and resources may not be adequately prepared.**     As a result of our initial public offering, we became subject to reporting and otherobligations under the Securities Exchange Act of 1934, as amended, or the Exchange Act, includingthe requirements of Section 404 of the Sarbanes-Oxley Act. Section 404 requires annual managementassessment of the effectiveness of our internal controls over financial reporting and a report byour independent auditors addressing these assessments. These reporting and other obligations willplace significant demands on our management, administrative, operational, internal audit andaccounting resources. We anticipate that we will need to upgrade our reporting systems andprocedures, implement additional financial and management controls, enhance our internal auditfunction, and hire additional accounting and finance staff. If we are unable to accomplish theseobjectives in a timely and effective fashion, our ability to comply with our financial reportingrequirements and other rules that apply to reporting companies could be impaired. Any failure tomaintain effective internal controls could have a material adverse effect on our business,operating results and stock price. In addition, expenses related to services rendered by ouraccountants, legal counsel and consultants will increase in order to ensure compliance with theselaws and regulations.**Our profitability depends on interest rates generally, and we may be adversely affected by changesin market interest rates.**     Our profitability depends in substantial part on our net interest income. Our net interestincome depends on many factors that are partly or completely outside of our control, includingcompetition, federal economic, monetary and fiscal policies, and economic conditions generally. Ournet interest income will be adversely affected if market interest rates change so that the interestwe pay on deposits and borrowings increases faster than the interest we earn on loans andinvestments. In addition, an increase in interest rates could adversely affect borrowers’ abilityto pay the principal or interest on existing loans or reduce their desire to borrow more money.This may lead to an increase in our nonperforming assets, a decrease in loan originations, or areduction in the value of and income from our loans, any of which could have a material andnegative effect on our results of operations. Fluctuations in market rates and other marketdisruptions are neither predictable nor controllable and may adversely affect our financialcondition and earnings.     The ratio of variable to fixed rate loans in our loan portfolio, the ratio of short-term(maturing at a given time within 12 months) to long-term loans, and the ratio of our demand, moneymarket and savings deposits to CDs (and their time periods), are the primary factors affecting thesensitivity of our net interest income to changes in market interest rates. As of December 31,2006, 45.4% of our $344.7 million gross loan portfolio were variable rate loans and 54.6% werefixed rate loans. Our short-term loans are typically priced at prime plus a margin, and ourlong-term loans are typically priced based on a U.S. Treasury index for comparable maturities, plusa margin. In addition, approximately 71.9% of our fixed-rate loans receivable were short-term andapproximately 28.1% were long-term, and 45.5% of our deposits were demand, money market and savingsaccounts and 54.5% were CDs. The composition of our rate sensitive assets or liabilities is subjectto change and could result in a more unbalanced position that would cause market rate changes tohave a greater impact on our earnings.**We face strong competition from banks and other financial services providers that offer bankingservices, which may limit our ability to attract and retain banking clients.**     Competition in the banking industry generally, and in our geographic market specifically, isintense. Competitors include banks, as well as other financial services providers, such as savingsand loan institutions, consumer finance companies, brokerage firms, insurance companies, creditunions, mortgage banks and other financial intermediaries. In particular, our competitors includeseveral larger national and regional financial institutions whose greater resources may afford thema marketplace advantage by enabling them to maintain numerous banking locations and ATMs, offer awider array of banking services and conduct extensive promotional and advertising campaigns.Additionally, banks and other financial institutions with larger capitalization and financialintermediaries not subject to bank regulatory restrictions have larger lending limits and arethereby able to serve the credit needs of a broader customer base than us. Larger competitors mayalso be able to offer better lending and deposit rates to customers, and could increase theircompetition as we become a public company and
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our growth becomes more visible. Moreover, larger competitors may not be as vulnerable as usto downturns in the local economy and real estate market since they have a broader geographic areaand their loan portfolio is diversified. We also compete against community banks that have stronglocal ties. These smaller institutions are likely to cater to the same small- and medium-sizedbusinesses that we target. If we are unable to attract and retain banking customers, we may beunable to continue to grow our loan and deposit portfolios and our results of operations andfinancial condition may otherwise be adversely affected. Ultimately, we may be unable to competesuccessfully against current and future competitors.**If we need additional capital in the future to continue our growth, we may not be able to obtain iton terms that are favorable. This could negatively affect our performance and the value of ourcommon stock.**     Our business strategy calls for continued growth. We anticipate that we will be able tosupport this growth through the net proceeds from our initial public offering, as well as by addingdeposits at existing and new branch locations. However, we may need to raise additional capital inthe future to support our continued growth and to maintain our capital levels. Our ability to raisecapital through the sale of additional securities will depend primarily upon our financialcondition and the condition of financial markets at that time. We may not be able to obtainadditional capital in the amounts or on terms satisfactory to us. Our growth may be constrained ifwe are unable to raise additional capital as needed.**We are exposed to risk of environmental liabilities with respect to properties to which we taketitle.**     Approximately 94.5% of our outstanding loan portfolio at December 31, 2006 was secured by realestate. In the course of our business, we may foreclose and take title to real estate, and could besubject to environmental liabilities with respect to these properties. We may be held liable to agovernmental entity or to third-parties for property damage, personal injury, investigation andclean-up costs incurred by these parties in connection with environmental contamination, or may berequired to investigate or clean up hazardous or toxic substances, or chemical releases at aproperty. The costs associated with investigation or remediation activities could be substantial.In addition, if we are the owner or former owner of a contaminated site, we may be subject tocommon law claims by third-parties based on damages and costs resulting from environmentalcontamination emanating from the property. If we ever become subject to significant environmentalliabilities, our business, financial condition, liquidity and results of operations could bematerially and adversely affected.**We may grow through acquisitions, which strategy may not be successful or, if successful, mayproduce risks in successfully integrating and managing the acquisition.**     As part of our growth strategy, we intend to pursue acquisitions of financial institutionswithin and outside of our market. At this time we have no agreements or understandings to acquireany financial institution, and may not find suitable acquisition opportunities. Acquisitionsinvolve numerous risks, any of which could harm our business, including: **•** difficulties in integrating the operations, technologies, existing contracts,accounting processes and personnel of the target and realizing the anticipatedsynergies of the combined businesses;  **•** difficulties in supporting and transitioning customers of the target company;  **•** diversion of financial and management resources from existing operations;  **•** the price we pay or other resources that we devote may exceed the value werealize, or the value we could have realized if we had allocated the purchase price orother resources to another opportunity;  **•** risks of entering new markets or areas in which we have limited or no experience;  **•** potential loss of key employees and customers from either our business or the target’s business;  **•** assumption of unanticipated problems or latent liabilities of the target; and
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 **•** inability to generate sufficient revenue to offset acquisition costs.     Acquisitions also frequently result in the recording of goodwill and other intangible assetswhich are subject to potential impairments in the future that could harm our financial results. Inaddition, if we finance acquisitions by issuing convertible debt or equity securities, our existingshareholders may be diluted, which could affect the market price of our common stock. As a result,if we fail to properly evaluate acquisitions or investments, we may not achieve the anticipatedbenefits of any such acquisitions, and we may incur costs in excess of what we anticipate. Thefailure to successfully evaluate and execute acquisitions or investments or otherwise adequatelyaddress these risks could materially harm our business and financial results.**We may be unable to, or choose not to, pay dividends on our common stock.**     Our ability to pay dividends depends on the following factors, among others: **•** we may not have sufficient earnings since our primary source of income, thepayment of dividends to us by our subsidiary, Westsound Bank, is subject to federal andstate laws that limit the ability of the Bank to pay dividends;  **•** Federal Reserve Board policy requires bank holding companies to pay cashdividends on common stock only out of net income available over the past year and onlyif prospective earnings retention is consistent with the organization’s expected futureneeds and financial condition;  **•** we are also restricted from paying dividends on our common stock if we havedeferred payments of the interest on, or an event of default has occurred with respectto, our junior subordinated debentures; and  **•** our board of directors may determine that, even though funds are available fordividend payments, retaining the funds for internal uses, such as expansion of ouroperations, is a better strategy.     We have not paid, and currently have no plans to pay, cash dividends to our shareholders afterthis offering.**We face a variety of threats from technology based frauds and scams.**     Financial institutions are a prime target of criminal activities through various channels ofinformation technology. We attempt to mitigate risk from such activities through policies,procedures, and preventative and defensive measures. In addition, we maintain insurance coveragedesigned to provide a level of financial protection to our business. However, risks posed bybusiness interruption, fraud losses, business recovery expenses, and other potential losses orexpenses that we may incur from a significant event are not readily predictable and, therefore,could have an impact on our results of operations.**We rely on our information technology and telecommunications systems and third-party servicers, andthe failure of these systems could adversely affect our business.**     Our business is highly dependent on the successful and uninterrupted functioning of ourinformation technology and telecommunications systems and third-party servicers. We outsource ourmajor systems including our electronics funds transfer, or EFT, credit card and transactionprocessing and our online Internet bill payment and banking services. We rely on these systems toprocess new and renewal loans, provide customer service, facilitate collections and share dataacross our organization. The failure of these systems, or the termination of a third-party softwarelicense or service agreement on which any of these systems is based, could interrupt ouroperations. Because our information technology and telecommunications systems interface with anddepend on third-party systems, we could experience service denials if demand for such servicesexceeds capacity or such third-party systems fail or experience interruptions. If sustained orrepeated, a system failure or service denial could result in a deterioration of our ability toprocess new and renewal loans and provide customer service or compromise our ability to collectloan payments in a timely manner.
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**Risks Related to the Public Markets****There has been no prior active trading market for our common stock. We cannot assure you that anactive public trading market will develop or be maintained and, even if it does, our stock pricemay trade below the public offering price.**     There was no public market for our common stock prior to our initial public offering. Wecannot predict the extent to which investor interest in our company will lead to the development ormaintenance of an active trading market on the Nasdaq or otherwise, or how liquid that market maybecome, especially if few stock analysts follow our stock or issue research reports concerning ourbusiness. In addition, we estimate that approximately 27% of our outstanding common stock isbeneficially owned by our principal shareholders, executive officers and directors, who also holdoptions exercisable for an additional 148,135 shares of our common stock. The substantial amount ofcommon stock that is owned by and issuable to our principal shareholders, executive officers anddirectors may adversely affect the development of an active and liquid trading market.     Even if a market develops for our common stock, the market price of our common stock mayexperience significant volatility. Factors that may affect the price of our common stock includethe depth and liquidity of the market for our common stock, investor perception of our financialstrength, conditions in the banking industry such as credit quality and monetary policies, andgeneral economic and market conditions. Our quarterly operating results, changes in analysts’earnings estimates, changes in general conditions in the economy or financial markets or otherdevelopments affecting us could cause the market price of our common stock to fluctuatesubstantially.**One of the intended use of proceeds of our initial public offering is to implement our growthstrategy, which includes expansion in the west Puget Sound and the Seattle Metropolitan StatisticalArea. We may not successfully implement our growth strategy and therefore, our intended use ofproceeds from the initial public offering may not result in an increase in our market value andprofitability.**     One of the principal reasons for our raising the capital in the initial public offering was tobe able to create a source of funds to be used for growth of our current operations and opening newbranches and loan production offices. If we are not successful in implementing our growth strategy,our market value and profitability may suffer.**A significant number of shares of our common stock will become eligible for sale in the publicmarket 180 days (and in one case 60 days) after the completion of our initial public offering onDecember 19, 2006, which could cause the price of our common stock to decline.**     Our officers, directors, and one of our principal shareholders (shareholders holding more than5.0% of our common stock), have agreed with the underwriters not to sell or otherwise dispose ofany of their shares for a period of 180 days after December 19, 2006, except that one of ourdirectors is permitted to sell up to 3,000 shares for living expenses after this offering, subjectto the resale restrictions of Rule 144 under the Securities Act. When these lock-up agreementsexpire, these shares and the shares underlying any options held by these individuals will becomeeligible for sale, in some cases subject only to the volume, manner of sale and notice requirementsof Rule 144 of the Securities Act. Sales of a substantial number of these shares in the publicmarket after this offering, or the perception that these sales could occur, could cause the marketprice of our common stock to decline. In addition, the sale of these shares could impair ourability to raise capital through the sale of additional equity securities.**Our directors and senior management exert significant influence over us. Their interests may notcoincide with yours and they may make decisions with which you may disagree.**     Our executive officers, directors, and principal shareholders beneficially own, in theaggregate, approximately 27% of our outstanding common stock and approximately 28% of our commonstock on a fully-diluted basis, assuming exercise of all outstanding stock options for 954,960shares. Another 322,765 shares are reserved for future issuance under our Stock Option Plan. As aresult, these shareholders, acting together, could control substantially all matters requiringshareholder approval, including the election of directors and approval of significant corporatetransactions. In addition, this concentration of ownership may delay or prevent a change in controlof our company and make some transactions more difficult or impossible without the support of these
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shareholders. The interests of these shareholders may not always coincide with our interestsas a company or the interest of other shareholders. Accordingly, these shareholders could cause usto enter into transactions or agreements that you would not approve or make decisions with whichyou may disagree.**Item 1B. Unresolved Staff Comments**     There are no unresolved SEC staff comments.**Item 2. Properties**     We own the buildings and land for four of our offices, in addition to our headquarters. Theseproperties are not subject to any mortgages or encumbrances and consist of the following: **•** Headquarters located at 607 Pacific Avenue, Bremerton, Washington, which is20,196 square feet. Our headquarters and administrative offices are located in the mainbranch.  **•** Bremerton support facility located at 190 Pacific Avenue, Bremerton,Washington, which is 6,668 square feet.  **•** Port Angeles branch located at 602 E. Front Street, Port Angeles, Washington,which is 2,358 square feet.  **•** Poulsbo branch located at 21895 Viking Way NW, Poulsbo, Washington, which is 2,000 square feet.  **•** Sequim branch located at 1320 W. Washington, Sequim, Washington, which is 924 square feet.     We lease four of our branches and two of our LPOs: **•** Port Orchard branch located at 100 Bethel Avenue, Port Orchard, Washington,which is 1,400 square feet. The lease is for a five-year term, expiring May 2008. Ourcurrent monthly rent is $2,100.  **•** Silverdale branch located at 9960 Silverdale Way NW, Silverdale, Washington,which is 6,031 square feet. The lease expires in October 2011. Our current monthly rentis $11,998, which increases to $14,307 by the end of the lease.  **•** Gig Harbor branch located at 5775 Soundview Drive, Gig Harbor, Washington,which is 3,950 square feet. The lease is for a five-year term, expiring April 2010. Ourcurrent monthly rent is $4,822, which increases to $5,409 by the end of the lease.  **•** Federal Way branch located at 2505 South 320th Street, Federal Way, Washington,which is 3,420 square feet. The lease is for a five-year term, expiring June 2010. Ourcurrent monthly rent is $9,024, which increases to $10,676 by the end of the lease.  **•** Belfair LPO located at 23552 NE State Route 3, Belfair, Washington, which is800 square feet. The lease is for a one-year term, expiring June 2007. Our currentmonthly rent is $1,200.  **•** Port Townsend LPO located at 2500 West Sims Way, Port Townsend, Washington,which is for a single office of approximately 100 square feet. The lease is on amonth-to-month basis with monthly rent of $500.     Although we are currently targeting two to three branches or loan production offices per year,we believe that our existing facilities are adequate for our present purposes. We presently have nopreliminary agreements or understandings with any third-party to acquire additional branchlocations.
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**Item 3. Legal Proceedings**     There are no material pending legal proceedings to which we or Westsound Bank is a party or towhich any of our properties are subject, except the memorandum of understanding with the FDIC withrespect to Westsound Bank’s compliance with HMDA and certain other banking-related consumer laws,which is described in “Management’s Discussion and Analysis of Financial Condition and Results ofOperations — Regulatory Compliance.” There are no material proceedings known to us to becontemplated by any governmental authority. We are involved in a variety of litigation matters inthe ordinary course of our business and anticipate that we will become involved in new litigationmatters from time to time in the future.**Item 4. Submission of Matters to a Vote of Security Holders**     No matter was submitted to a vote of security holders during the fourth quarter of the fiscalyear ended December 31, 2006.
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**PART II****Item 5. Market for Registrant’s Common Equity and Related Stockholder Matters**     (a) *Market for Registrant’s Common Stock.*Prior to our initial public offering there was nopublic market for our common stock. Our common stock and prior to the formation of WSB FinancialGroup, the common stock of Westsound Bank, has been traded, from time to time, by individuals on anegotiated basis between the parties. The following table sets forth those trades since January 1,2005 through December 13, 2006 of which we have knowledge, and the trading history on NASDAQ fromDecember 14, 2006 to December 31, 2006, including the quarter in which the trades occurred, theaggregate number of shares traded during such quarter and the range of sales price per share:     **Quarter of Trade** **Number of Shares** **Price Per Share**1st ‘05 — —2nd ‘05 37,754 $8.673rd ‘05 3,993 8.794th ‘05 3,526 9.771st ‘06 112 10.742nd ‘06 3,600 12.143rd ‘06 3,225 12.064th ‘06    (through 12/13/06) 14,068 13.15(12/14/06 through 12/31/06 981,700 18.56/19.20     We have not paid, and currently have no plans to pay, cash dividends to our shareholders. Thepayment of dividends is within the discretion of our board of directors and will depend upon ourearnings, capital requirements and operating and financial position, among other factors. We expectto retain all of our earnings to finance the expansion and development of our business.     Additionally, our junior subordinated debt agreement prohibits us from paying dividends if wehave deferred payment of interest on outstanding trust preferred securities. See “Management’sDiscussion and Analysis of Financial Condition and Results of Operations — Capital Resources.”     We are a legal entity separate and distinct from Westsound Bank. Because we are a holdingcompany with no significant assets other than Westsound Bank, we will be dependent upon dividendsfrom Westsound Bank for cash with which to pay dividends when, and if, our dividend policy changes.For a discussion of the regulatory limitations on Westsound Bank’s ability to pay dividends, see“Supervision and Regulation — Federal and State Regulation of Westsound Bank — Dividends.”     On March 15, 2007, there were 1,826 holders of record of our common stock.     The principal market for our common stock is The NASDAQ Stock Market LLC.     (b) *Recent Sales of Unregistered Securities.*The following sets forth information regardingall unregistered securities sold by the registrant in 2006:          (1) *Securities Issued Upon Exercise of Stock Options.*The following shares of common stockwere issued by registrant in 2006 pursuant to the exercise of stock options under the 1999Incentive Stock Option Plan (the “Plan”): 1,842 shares to an employee in January, 12,285 shares toa director in February, 6,143 shares to a director in June, and 7,371 shares to an employee inJuly, 104,429 shares to a former director, 19,657 shares to an executive officer in September and30,721 shares to a director in December 2006, for an aggregate purchase price of $1,186,256.
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               Such shares of common stock were issued pursuant to a written compensatory benefit plan undercircumstances that comply with the requirements of Rule 701 promulgated under the Securities Act,and are thus exempted from the registration requirements of the Securities Act by virtue of Rule701.          (2) *Securities Issued as Directors’ Fees.*In August 2006, the registrant issued an aggregateof 10,473 shares of common stock to seven directors and a former director in payment of theirdirectors’ fees accrued through June 30, 2006, for an aggregate fair value of $123,933. The numberof shares paid was based on independent valuations of our shares as of December 31, 2005 and March31, 2006 at an average price of $11.83 per share.               Such transactions by the registrant did not involve a public offering. The registrant reliedon the exemption provided by Section 4(2) of the Securities Act of 1933.          (c) *Issuer Purchases of Equity Securities in 2006.*The following table summarizes stockrepurchase activity for the three months ended December 31, 2006 (in thousands, except per shareamounts):                               **Approximate Dollar**           **Total Number of**  **Value of Shares that**           **Shares Purchased as**  **May Yet be**   **Total Number of**  **Average Price Paid**  **Part of Publicly**  **Purchased Under**   **Shares Purchased**  **per Share**  **Announced Program**  **the Program** October, 2006  9,306  $13.15   —  $— November, 2006  4,762   13.15   —   — December, 2006  -0-   -0-   —   —              Total  14,068  $13.15   —  $—                   (d) *Initial Public Offering.*On December 12, 2006, the Company’s Registration Statement onForm S-1 covering the offering of 2,300,000 shares of the Company’s common stock, Commission filenumber 333-137038 was declared effective. The Company signed the underwriting agreement on December12, 2006 and the offering closed on December 19, 2006. As of the date of the filing of this report,all offered securities have been sold and the offering has terminated. The offering was managed byD.A. Davidson & Co., the underwriter.     On December 18, 2006, the underwriter exercised an over-allotment option to purchase anadditional 345,000 shares of the Company’s common stock. The total price to the public for theshares offered and sold by the Company, including the over-allotment, was $43.6 million. The amountof expenses incurred for the Company’s account in connection with the offering includesapproximately $2.5 million of underwriting discounts and commissions and offering expenses ofapproximately $0.9 million.     All of the foregoing expenses were direct or indirect payments to persons other than (i)directors, officers or their associates; (ii) persons owning ten percent (10%) or more of theCompany’s common stock; or (iii) affiliates of the Company.     The net proceeds of the offering, including the exercise of the over-allotment option, to theCompany (after deducting the foregoing expenses) were $40.2 million. Presently, the net proceedsare temporarily being held as available cash in our banking subsidiaries, which in turn allows themto use the proceeds in their normal day to day funding needs. There has been no material change inthe planned use of proceeds from this initial public offering as described in the Company’s finalprospectus filed with the SEC.**Item 6. Selected Financial Data**     You should read the summary consolidated financial data set forth below in conjunction withour historical consolidated financial statements and related notes and “Management’s Discussion andAnalysis of Financial Condition and Results of Operations,” included elsewhere in this report. Thesummary consolidated statement of operations data for the years ended December 31, 2006, 2005 and2004 and the summary consolidated balance sheet
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data as of December 31, 2006 and 2005 have been derived from our audited consolidatedfinancial statements included elsewhere in this report. The summary consolidated statement ofoperations data for the years ended December 31, 2003 and 2002 and the summary consolidated balancesheet data as of December 31, 2003 and 2002 have been derived from our audited financial statementsthat are not included in this report.     During the year ended December 31, 2005, shareholders of Westsound Bank exchanged their commonstock in Westsound Bank for common stock in the newly formed holding company, WSB Financial Group,Inc. The transaction was accounted for based on historical carrying amounts. The consolidatedfinancial statements include the accounts of WSB Financial Group, Inc. and its wholly ownedsubsidiary, Westsound Bank. Year-end data for 2002, 2003 and 2004 reflect financial data forWestsound Bank.                       **Years Ended December 31,**   **2006**  **2005**  **2004**  **2003**  **2002**   (Dollars in thousands, except share and per share data) **Consolidated Balance Sheet Data:**                    Cash due from banks $9,048  $8,158  $2,534  $2,852  $1,284 Federal funds sold  17,150   18,400   8,650   6,500   4,400 Investment securities  8,244   8,235   4,558   6,273   5,318 Loans, net(1)  340,208   207,172   117,623   58,222   39,769 Total assets  386,754   249,998   137,416   76,012   52,765 Deposits  315,022   224,167   123,593   68,003   48,017 Junior subordinated debt  8,248   8,248   0   0   0 Stockholders’ equity  61,657   16,006   12,912   7,901   4,619 **Consolidated Income Data:**                    Interest income $28,342  $15,693  $7,943  $4,396  $3,113 Interest expense  11,785   5,182   1,705   1,110   1,035                 Net interest income  16,557   10,511   6,238   3,286   2,078 Provision for loan losses  1,523   1,351   654   231   138                 Net interest income after provision for loan losses  15,034   9,160   5,584   3,055   1,940 Non-interest income  4,672   5,241   2,806   293   202 Non-interest expense  13,854   10,692   6,370   2,384   1,710                 Income before income taxes  5,852   3,709   2,020   964   432 Provision for income taxes  1,967   1,297   680   333   146                 Net income $3,885  $2,412  $1,340  $631  $286                 **Share Data:**                    Earnings per share                    Basic $1.35  $0.91  $0.59  $0.36  $0.19 Diluted  1.18   0.82   0.55   0.35   0.19 Book value per share  11.12   5.88   4.98   3.91   3.07 Shares outstanding at period end  5,545,673   2,722,048   2,594,485   2,019,171   1,505,318 Weighted average shares outstanding                     Basic  2,870,022   2,642,628   2,270,211   1,734,434   1,489,006 Diluted  3,285,622   2,925,092   2,429,577   1,801,667   1,526,723 
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                       **Years Ended December 31,**   **2006**  **2005**  **2004**  **2003**  **2002** **Selected Performance Ratios:**                    Return on average assets  1.28%  1.28%  1.37%  1.04%  0.68%Return on average stockholders’ equity  19.6%  16.6%  13.6%  9.9%  6.5%Net interest margin  5.65%  5.90%  6.77%  5.71%  5.18%Efficiency ratio  65.3%  67.9%  70.4%  66.6%  75.0%**Selected Liquidity and Asset Ratios:**                    Net loan to deposit ratio  108.0%  92.4%  95.2%  85.6%  82.8%Average stockholders’ equity to average assets  6.5%  7.8%  10.1%  10.4%  10.4%Risk-based capital ratios:                    Leverage capital  19.8%  9.3%  10.6%  11.8%  8.9%Tier 1 risk-based capital  20.2%  10.2%  11.2%  13.1%  11.3%Total risk-based capital  21.4%  12.8%  12.2%  14.0%  12.2%**Selected Asset Quality Ratios:**                    Non-performing loans to total loans  0.06%  0.06%  0.09%  0.00%  0.27%Non-performing assets to total assets  0.06%  0.05%  0.09%  0.04%  0.27%Allowance for loan losses to totalloans  1.15%  1.20%  1.00%  0.98%  0.87%Allowance for loan losses to non-performing loans  1,813.7%  1968.8%  1189.0%  N/A   319.1%Net charge-offs (recoveries) to average loans  0.01%  0.00%  0.03%  (0.01)%  0.20% (1) Includes loans held for sale.**Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations**     Management’s Discussion and Analysis of Financial Condition and Results of Operations isincluded in the Annual Report to Shareholders for the fiscal year ended December 31, 2006 and ishereby incorporated by reference. This portion of the Annual Report to Shareholders is included inExhibit 13 to this report, and set forth in Exhibit 13.**Item 7A. Quantitative and Qualitative Disclosures about Market Risk**     See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results ofContinuing Operations – Quantitative and Qualitative Disclosures About Market Risk.”**Item 8. Financial Statements and Supplementary Data**     The report of Moss Adams LLP, Independent Registered Public Accounting Firm, and theconsolidated financial statements are included in the Annual Report to Shareholders for the fiscalyear ended December 31, 2006 and are hereby incorporated by reference. Quarterly results ofoperations are reported in Note 19 of the Company’s Annual Report to Shareholders for the fiscalyear ended December 31, 2006 and are hereby incorporated by reference. This portion of the AnnualReport to Shareholders is included in Exhibit 13 to this report.**Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure**     None.**Item 9A. Controls and Procedures*****Disclosure Controls and Procedures***     Our principal executive and financial officers evaluated our disclosure controls andprocedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of December 31,2006. Based upon that evaluation, they concluded as of December 31, 2006, that our disclosurecontrols and procedures were effective to ensure that information we are required to disclose inthe reports that we file under the Exchange Act is recorded, processed, summarized and reportedwithin time periods specified in Securities and Exchange Commission rules and forms. In addition,our principal executive and financial officers concluded as of December 31, 2006 that ourdisclosure controls and procedures are also effective to ensure that information required to bedisclosed in reports that we file
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or submit under the Exchange Act is accumulated and communicated to our management, includingour Chief Executive Officer and Chief Financial Officer, to allow timely decisions regardingrequired disclosure.***Management’s Report on Internal Control Over Financial Reporting***     This annual report does not include a report of management’s assessment regarding internalcontrol over financial reporting or an attestation report of the company’s registered publicaccounting firm due to a transition period established by rules of the Securities and ExchangeCommission for newly public companies.***Changes in Internal Control Over Financial Reporting***     During the three months ended December 31, 2006, there were no changes in our internal controlover financial reporting that materially affected, or are reasonably likely to materially affect,our internal control over financial reporting.**Item 9B. Other Information**     None.
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**PART III****Item 10. Directors, Executive Officers and Corporate Governance**     We hereby incorporate by reference the information set forth under Shareholder Proposals, Codeof Ethics, “Proposal 1: Election of Directors,” and “Section 16(a) Beneficial Ownership ReportingCompliance” in the definitive form of the Company’s Proxy Statement, relating to its Annual Meetingof Shareholders to be held on May 16, 2007.     Information regarding our executive officers required by this item appears in Item 1 of thisreport under “Executive Officers of the Registrant.”**Item 11. Executive Compensation**     We hereby incorporate by reference the information set forth under “Executive Compensation”and “Compensation of Directors,” in the definitive form of the Company’s Proxy Statement, relatingto its Annual Meeting of Shareholders to be held on May 16, 2007.**Item 12. Security Ownership of Certain Beneficial Owners and Management and Related StockholderMatters**     The following table gives information about the shares of Common Stock that may be issued uponthe exercise of options, warrants and rights under the 1999 Incentive Stock Option Plan, or theStock Option Plan, the only equity compensation plan of the Company in effect as of the end of theCompany’s last fiscal year.               **Equity Compensation Plan Information**          **Number of securities**          **remaining available for**          **future issuance under**  **Number of securities to** **Weighted-average** **equity compensation**  **be issued upon exercise** **exercise price of** **plans (excluding**  **of outstanding options,** **outstanding options,** **securities reflected in the****Plan Category** **warrants and rights** **warrants and rights** **first column)**Equity compensationplans approved bysecurity holders  940,172   $7.42   346,765 Equity compensationplans not approvedby security holders  —   —   —              Total  940,172   $7.42   346,765                   We hereby incorporate by reference the information set forth under “Security Ownership ofCertain Beneficial Owners and Management” and “Equity Compensation Plan Information” in thedefinitive form of the Company’s Proxy Statement, relating to its Annual Meeting of Shareholders tobe held on May 16, 2007.**Item 13. Certain Relationships and Related Transactions**     The information required by this Item is incorporated by reference from the information in thesection entitled “Certain Transactions” in the Proxy Statement.
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**Item 14. Principal Accountant Fees and Services**     We hereby incorporate by reference the information set forth under “Proposal 2: Ratificationof Selection of Independent Registered Public Accountants – Fees for Professional Services” in thedefinitive form of the Company’s Proxy Statement relating to the 2007 Annual Meeting ofShareholders to be held on May 16, 2007.
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**PART IV****Item 15. Exhibits and Financial Statement Schedules***(a)(1) Financial Statements.*     The following consolidated financial statements of WSB Financial Group, Inc. and Subsidiaries,together with the report of Moss Adams LLP, Independent Registered Public Accounting Firm, datedMarch 27, 2007, appearing in the Company’s Annual Report to Shareholders for the fiscal year endedDecember 31, 2006.       **Annual Report**  **Reference**Report of Moss Adams LLP, Independent Registered Public Accountant  *      Consolidated Statement of Financial Condition – December 31, 2006 andDecember 31, 2005  *      Consolidated Statement of Income – Fiscal years 2006, 2005, and 2004  *      Consolidated Statement of Changes in Stockholders’ Equity – Fiscalyears 2006, 2005, and 2004  *      Consolidated Statement of Cash Flows – Fiscal years 2006, 2005, and 2004  *      Notes to Consolidated Fiscal Statements – December 31, 2006  *  * Incorporated by reference to the Annual Report to Shareholders for the fiscal year endedDecember 31, 2006. This portion of the Annual Report to Shareholders is included as Exhibit 13to this Report.     Refer also to Part II, Item 8 – Financial Statements and Supplementary Data foradditional information.*(a)(2) Financial Statement Schedules.*     All schedules for which provision is made in the applicable accounting regulations of theSecurities and Exchange Commission are not required under the related instructions or areinapplicable and therefore have been omitted.*(a)(3) Exhibits.*     See Exhibit Index on pages 45 – 46.
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**SIGNATURES**     Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934,the Company has duly caused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.      WSB FINANCIAL GROUP, INC.