UNITED
      STATES


SECURITIES
      AND EXCHANGE COMMISSION


**Washington,
      D.C. 20549**





FORM
      10-K





x
            ANNUAL
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                ACT OF
                1934





For
                the Fiscal Year Ended December 31, 2005





**OR**





o
            TRANSITION
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                ACT OF
                1934





Commission
      File Number: 005-57091





FIRST
      MUTUAL BANCSHARES, INC.


(Exact
      name of registrant as specified in its charter)





**State
                of Washington**
            **91-2005970**(State
                or other jurisdiction of incorporation or organization)
            (I.R.S.
                EmployerIdentification
                No.)**400
                108th Avenue N.E., Bellevue, Washington**
            **98004**(Address
                of principal executive offices)
            (Zip
                Code)Registrant’s
                telephone
                number, including area code
            **(425)
                455-7300**





Securities
      registered pursuant to Section 12(b) of the Act: None





Securities
      registered pursuant to Section 12(g) of the Act:





**Common
      Stock, par value $1.00 per share**


(Title
      of
      Class)




Indicate
      by check mark if the registrant is a well-known seasoned issuer, as defined
      in
      Rule 405 of the Securities Act. YES
o NO 
x





Indicate
      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  x




Indicate
      by check mark whether the registrant (1) has filed all reports required to
      be
      filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
      the
      preceding 12 months (or for such shorter period that the registrant was required
      to file such reports), and (2) has been subject to such filing requirements
      for
      the past 90 days.  YES x NO 
      o




Indicate
      by check mark if disclosure of delinquent filers pursuant to Item 405 of
      Regulation S-K (229.405 of this chapter) is not contained herein, and will
      not
      be contained, to the best of the registrant’s knowledge,
      in
      definitive proxy or information statements incorporated by reference in Part
      III
      of this Form 10-K or any amendment to this Form 10-K.  o




Indicate
      by a check mark whether the registrant is a large accelerated filer, an
      accelerated filer, or a non-accelerated filer. See definition of “accelerated
      filer and large accelerated filer” in Rule 12b-2 of the Exchange
      Act.




Large accelerated
                filer o
              Accelerated filerx
              Non-accelerated filer  o




Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Act).  YES  o NO x





As
      of
      June 30, 2005, there were issued and outstanding 5,342,191 shares of the
      registrant’s common stock. The aggregate market value of the voting stock held
      by non-affiliates of 3,294,377 shares of the registrant was $85,324,364 based
      on
      the closing sales price of the registrant’s common stock as quoted on the Nasdaq
      Market System which on June 30, 2005 was $25.90.





As
      of
      February 24, 2006, there were issued and outstanding 5,302,107 shares of the
      registrant’s common stock.














**DOCUMENTS
      INCORPORATED BY REFERENCE**





1.
            Certain
                information required by Parts I, III, and IV is incorporated by reference
                to the Registrant’s Annual Report to Shareholders for the fiscal year
                ended December 31, 2005.







2.
            Certain
                information required by Parts I, III, and IV is incorporated by reference
                to the Registrant’s Proxy Statement dated March 17, 2006 for the 2006
                Annual Meeting of Shareholders.











**Forward-Looking
      Statements Disclaimer**





This
      Form
      10-K Report and the other Securities and Exchange Commission filings made by
      the
      Company, which are incorporated by reference, contain statements concerning
      future operations, trends, expectations, plans, capabilities, and prospects
      of
      the Company that are forward-looking statements for purposes of the safe harbor
      provisions under the Private Securities Litigation Reform Act of 1995.
      Statements containing words such as “anticipate,”“believe,”
      “intend,” “expect,” “objective,” “plan,” “should,” or similar words may
      constitute forward-looking statements.  (I deleted the reference
      to GAP and Simulation since I don’t believe that applies.)
 Although the Company believes that the expectations expressed in these
      forward-looking statements are based on reasonable assumptions within the bounds
      of its knowledge of its business and operations, actual events, results, or
      developments may differ materially from those expressed or implied in
      forward-looking statements due to a number of risks and uncertainties. Factors
      which could affect actual results include economic conditions in the Companies
      market area, interest rate fluctuations, the impact of competitive products,
      services and pricing, loan delinquency rates, and the legislative and regulatory
      changes affecting the banking industry. Certain risks and uncertainties
      which could affect the Company are discussed in the Risk Factors
      section of this Report and from time to time in the filings made by the Company
      with the Securities and Exchange Commission, including cautionary statements
      regarding the forward-looking information in such filings. These risks and
      uncertainties should be considered in evaluating the forward-looking statements,
      and undue reliance should not be placed on such statements. The Company shall
      not be responsible to update any such forward-looking statements.




2


**Table
      of Contents**


**Page****PART
                I**Item
                1.
            Business
            4Overview
                of Business Lines.
            4Yields
                Earned and Rates Paid.
            5Rate
                Volume Analysis.
            7Lending
                Activities.
            7Reserve
                for Loan Losses.
            15Securities.
            16Investment
                Activities.
            19Deposit
                Activities and Other Sources of Funds.
            23Critical
                Accounting Policies.
            25Recently
                Issued Accounting Standards.
            28Regulation
                and Supervision.
            29Federal
                and State Taxation.
            33Competition.
            34Employees.
            34Item
                1A.
            Risk
                Factors.
            34Item
                1B.
            Unresolved
                Staff Comments.
            36Item
                2.
            Properties
            37Item
                3.
            Legal
                Proceedings.
            39Item
                4.
            
            39**Part
                II**
            
            Submission
                of Matters to a Vote of Security Holders.Item
                5.
            Market
                for Registrant’s Common Equity, Related Stockholder Matters
                andIssuer
                Purchases of Equity Securities.
            39Item
                6.
            Selected
                Financial Data.
            39Item
                7.
            Management’s
                Discussion and Analysis of Financial Condition and Results of
                Operations.
            39Item
                7A.
            Quantitative
                and Qualitative Disclosures About Market Risk.
            40Item
                8.
            Financial
                Statements and Supplementary Data.
            40Item
                9.
            Changes
                in and Disagreements With Accountants on Accounting and Financial
                Disclosure.
            40Item
                9A.
            Controls
                and Procedures.
            40Item
                9B.
            Other
                Information.
            41**Part
                III**Item
                10.
            Directors
                and Executive Officers of the Registrant.
            41Item
                11.
            Executive
                Compensation.
            43Item
                12.
            Security
                Ownership of Certain Beneficial Owners and Management and
                RelatedStockholder
                Matters.
            43Item
                13.
            Certain
                Relationships and Related Transactions.
            43Item
                14.
            Principal
                Accounting Fees and Services.
            43**Part
                IV**Item
                15.
            Exhibits,
                Financial Statement Schedules.
            44SIGNATURES
            
            45




3


**PART
      I**





**Item
      1. Business.**





(a)  General





First
      Mutual Bancshares, Inc. (the “Company”)
      is a Washington
      corporation, which was formed for the purpose of becoming the bank holding
      company for First Mutual Bank (the “Bank”). The
      Bank’s
      reorganization was completed on October 26, 1999, on which date the Bank became
      the wholly-owned banking subsidiary of the Company, and the stockholders of
      the
      Bank became stockholders of the Company. The Company’s only significant activity
      is holding the stock of the Bank and engaging in certain passive investment
      activities. This discussion refers to the consolidated statements of the Company
      and the Bank, and therefore the references to “Bank” in this discussion refer to
      both entities.





First
      Mutual Bank was incorporated as a Washington state-chartered mutual savings
      bank
      in 1968 known as First Mutual Savings Bank and was the successor to Eastside
      Savings and Loan Association, which was organized in 1952 and commenced
      operations in 1953. The Bank converted from mutual to stock form through the
      sale and issuance of 966,000 shares of Common Stock in December 1985. In
      connection with the holding company reorganization, the Bank changed its name
      to
      First Mutual Bank. Effective in June 2000, the Federal Reserve Bank approved
      the
      election for the Company to become a financial holding company. The Bank is
      subject to regulation by the State of Washington Department of Financial
      Institutions and the Federal Deposit Insurance Corporation (“FDIC”). The
      Company is subject to regulation by the Federal Reserve Board.





Our
      business consists of attracting deposits from the general public as well as
      obtaining funds from wholesale funding sources and investing those funds
      primarily in commercial and residential real estate loans, business
      loans,  construction
      loans, and consumer loans. We also invest in federal government and agency
      obligations, mortgage-backed securities, and municipal securities. In addition
      to portfolio lending, we participate in mortgage banking activities that
      encompass the selling of primarily fixed-rate loans into the secondary mortgage
      market.





The
      principal sources of funds for lending and investment activities are deposits,
      repayment of loans, loan sales and Federal Home Loan Bank (“FHLB”)
      of Seattle
      advances. The primary sources of income are interest on loans, gains on sales
      of
      loans and investments, ser-vicing fees on loans, service-charge income on
      deposit accounts and interest and dividends on investment securities. Principal
      expenses are interest paid on deposits and borrowings, and general and
      administrative costs.





The
      savings and lending operations are conducted through 12 full-service banking centers located in Bellevue (3), Issaquah, Kirkland (2),
      Monroe, Redmond, Sammamish, Seattle (2), and Woodinville. We also have a
      consumer loan office located in Jacksonville, Florida. Our
      corporate office is located at 400 108th Avenue N.E., Bellevue, Washington
      98004. See “Item 2.
      -
      Properties” herein for additional information regarding our
      facilities.





We
      post
      our annual report, Form 10-K, quarterly reports on Form 10-Q, current reports
      on
      Form 8-K, and press releases on our investor relations page at www.firstmutual.com .
      These
      reports are posted as soon as reasonably practicable after they are
      electronically filed with the Securities and Exchange Commission (the “SEC”).
      All SEC filings of the Company are also available free of charge at the SEC’s
      website, www.sec.gov or by
      calling the SEC at 1-800-SEC-0330.




**Overview
      of Business Lines**





The
      management reporting process measures the performance of the operating segments
      based on the management structure of the Bank and is not necessarily comparable
      with similar information for any other financial institution.





The
      reportable segments include the following:




4




·
            Consumer
                Lending - Consumer lending includes home equity lending, direct consumer
                loans, and indirect home improvement loans (sales finance). These
                loans
                include lines of credit and loans for primarily consumer purposes.





·
            Residential
                Lending - Residential lending offers loans to borrowers to purchase,
                refinance, or build homes secured by one-to-four-unit family dwellings.
                They also finance the purchase or refinance of buildable residential
                lots.





·
            Business
                Banking Lending - Business Banking lending offers a full range of
                banking
                services to small and medium size businesses including deposit and
                cash
                management products, loans for financing receivables, inventory,
                and
                equipment as well as permanent and interim construction loans for
                commercial real estate. The underlying real estate collateral or
                business
                asset being financed typically secures these
                loans.





·
            Income
                Property Lending - Income Property lending offers permanent and interim
                construction loans for multifamily housing (over four units), manufactured
                housing communities, commercial real estate properties, and singe-family
                spec construction. The underlying real estate collateral being financed
                typically secures these loans.





Each
      of
      these business segments also sells loans into the secondary market. We may
      choose to retain or sell the right to service the loans sold (i.e., collection
      of principal and interest payments) depending upon market
      conditions.





These
      segments are managed separately because each business unit requires different
      processes and different marketing strategies to reach the customer base that
      purchases the products and services. The segments derive a majority of their
      revenue from interest income, and we rely primarily on net interest revenue
      in
      managing these segments. No single customer provides more than 10% of the Bank’s
      revenues .
      Please
      refer to the section titled “Business Segments” in the “Management’s Discussion
      and Analysis of Financial Condition and Results of Operations (“MD&A”)”
portion of our 2005 Annual Report and Note 22 in the “Notes to Consolidated
      Financial Statements” in the annual report for more information.




**Yields
      Earned and Rates Paid**





Pretax
      earnings depend significantly upon net interest income, which is the difference
      between the income we receive on our loan portfolio and other investments and
      our cost of money, consisting primarily of interest paid on deposits and
      borrowings. Net interest income is affected by: (i) the difference between
      rates
      of interest earned on our interest-earning assets and rates paid on our
      interest-bearing liabilities (“interest
      rate
      spread”) and (ii) the relative amounts of our interest-earning assets and
      interest-bearing liabilities. When interest-earning assets approximate or exceed
      interest-bearing liabilities, any positive interest rate spread will generate
      net interest income.





At
      December 31, 2005, our portfolio of loans consisted of 87% adjustable-rate
      and
      13% fixed-rate loans. We have employed various measures designed to make yields
      on our loan portfolio and investments interest-rate sensitive. They have
      included: (i) adoption of a policy under which we generally originate and sell
      long-term, fixed-rate mortgage loans which have been underwritten to
      specifications of secondary market investors and qualify for sale in the
      secondary market, (ii) emphasis on origination of adjustable-rate mortgage
      loans
      on residential and commercial properties, (iii) origination of construction
      loans secured by residential and commercial proper-ties, at interest rates
      subject to periodic adjustment based upon the prevailing market rates, and
      (iv)
      origination of business loans at interest rates subject to periodic adjustment
      based on prevailing market rates. See “Lending
      Activities” in this Form 10-K and “Market
      Risk
      Sensitive Instruments” in the “MD&A” section of the 2005 Annual
      Report.


5


At
                  December 31,2005
              
              2005
              
              2004
              
              2003Balance
              
              Average
                  Yield/Cost
              
              Average
                  Balance
              
              Interest
              
              Average
                  Yield/Cost
              
              Average
                  Balance
              
              Interest
              
              Average
                  Yield/Cost
              
              Average
                  Balance
              
              Interest
              
              Average
                  Yield/CostInterest
                  earning assets:Loans
                  receivable, net
              
              $
              882,681
              
              
              7.53
              %
              $
              847,495
              
              $
              61,624
              
              
              7.27
              %
              $
              782,566
              
              $
              50,195
              
              
              6.41
              %
              $
              683,249
              
              $
              45,487
              
              
              6.66
              %Mortgage-backed
                  securities
              
              
              102,004
              
              
              4.26
              %
              
              108,604
              
              
              4,621
              
              
              4.25
              %
              
              100,116
              
              
              3,865
              
              
              3.86
              %
              
              68,841
              
              
              2,902
              
              
              4.22
              %Municipal
                  securities
              
              
              1,188
              
              
              6.11
              %
              
              1,197
              
              
              79
              
              
              6.60
              %
              
              1,252
              
              
              80
              
              
              6.39
              %
              
              1,330
              
              
              81
              
              
              6.09
              %FHLB
                  stock
              
              
              13,122
              
              
              0.41
              %
              
              13,057
              
              
              53
              
              
              0.41
              %
              
              12,200
              
              
              339
              
              
              2.78
              %
              
              10,728
              
              
              707
              
              
              6.59
              %US
                  securities
              
              
              17,988
              
              
              3.15
              %
              
              17,971
              
              
              642
              
              
              3.57
              %
              
              14,585
              
              
              504
              
              
              3.46
              %
              
              11,425
              
              
              473
              
              
              4.14
              %Short-term
                  investments and other
              
              
              1,229
              
              
              3.90
              %
              
              2,620
              
              
              344
              
              
              1.64
              %
              
              1,703
              
              
              144
              
              
              0.70
              %
              
              1,568
              
              
              11
              
              
              0.70
              %Total
                  interest-earning assets
              
              
              1,018,212
              
              
              7.03
              %
              
              990,944
              
              
              67,363
              
              
              6.80
              %
              
              912,422
              
              
              55,127
              
              
              6.04
              %
              
              777,141
              
              
              49,661
              
              
              6.39
              %Noninterest
                  earning assets
              
              
              67,953
              
              
              
              
              
              54,030
              
              
              
              
              
              
              
              
              19,892
              
              
              
              
              
              
              
              
              25,929Total
                  assets
              
              $
              1,086,165
              
              
              
              
              $
              1,044,974
              
              
              
              
              
              
              
              $
              932,314
              
              
              
              
              
              
              
              $
              803,070Interest-bearing
                  liabilities:Deposits
              
              $
              715,703
              
              
              2.90
              %
              $
              674,413
              
              $
              18,191
              
              
              2.70
              %
              $
              606,036
              
              $
              12,292
              
              
              2.03
              %
              $
              531,674
              
              $
              11,984
              
              
              2.25
              %Long-term
                  debentures (TPS)
              
              
              17,000
              
              
              6.89
              %
              
              17,000
              
              
              1,172
              
              
              6.89
              %
              
              17,000
              
              
              1,002
              
              
              5.89
              %
              
              13,333
              
              
              716
              
              
              5.37
              %FHLB
                  and other advances
              
              
              230,306
              
              
              3.14
              %
              
              239,315
              
              
              7,817
              
              
              3.27
              %
              
              230,021
              
              
              5,799
              
              
              2.52
              %
              
              202,266
              
              
              6,212
              
              
              3.08
              %Total
                  interest-bearing liabilities
              
              
              963,009
              
              
              3.03
              %
              
              930,728
              
              
              27,180
              
              
              2.92
              %
              
              853,057
              
              
              19,093
              
              
              2.24
              %
              
              747,273
              
              
              18,912
              
              
              2.53
              %Noninterest-bearing
                  liabilities - depositsand
                  other
              
              
              63,129
              
              
              
              
              
              54,509
              
              
              
              
              
              
              
              
              24,120
              
              
              
              
              
              
              
              
              8,241Total
                  liabilities
              
              
              1,026,138
              
              
              
              
              
              985,237
              
              
              
              
              
              
              
              
              877,177
              
              
              
              
              
              
              
              
              755,514Shareholders’
                  equity
              
              
              60,027
              
              
              
              
              
              59,737
              
              
              
              
              
              
              
              
              55,137
              
              
              
              
              
              
              
              
              47,556Total
                  liabilities and shareholders’ equity
              
              $
              1,086,165
              
              
              
              
              $
              1,044,974
              
              
              
              
              
              
              
              $
              932,314
              
              
              
              
              
              
              
              $
              803,070Net
                  interest income
              
              
              
              
              
              
              
              
              
              
              $
              40,183
              
              
              
              
              
              
              
              $
              36,034
              
              
              
              
              
              
              
              $
              30,738Ratio
                  of average interest-earning assetsto
                  average interest-bearing liabilities
              
              
              
              
              
              
              
              
              1.07x
              
              
              
              
              
              
              
              
              1.06x
              
              
              
              
              
              
              
              
              1.05xInterest
                  rate spread
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              3.88
              %
              
              
              
              
              
              
              
              3.80
              %
              
              
              
              
              
              
              
              3.86
              %Net
                  yield (net interest income as apercentage
                  of average interest-earning
                  assets)
              
              
              
              
              
              
              
              
              
              
              
              4.06
              %
              
              
              
              
              
              
              
              3.95
              %
              
              
              
              
              
              
              
              3.96
              %Amortized
                  loan fees included in loanreceivable
                  interest income
              
              
              
              
              
              
              
              
              
              
              $
              599
              
              
              
              
              
              
              
              $
              516
              
              
              
              
              
              
              
              $
              1,040
  6


**Rate
      Volume Analysis**





The
“Rate
      Volume
      Analysis” table is contained in the section captioned “MD&A”
in the
      Annual Report, which is incorporated herein by reference.




**Lending
      Activities**





**General** .
      Our
      loan portfolio totaled $882.7 million at December 31, 2005 (loans held-for-sale
      totaled $14.7 million of this amount). On that date before deductions (see
      Note
      5 to the Consolidated Financial Statements for additional information), $223.9
      million, or 22%, of total outstanding loans, including loans held-for-sale,
      consisted of loans secured by one-to-four-unit residential properties; $154.0
      million, or 15%, consisted of loans secured by mortgages on over-four-unit
      residential properties; construction loans constituted $248.3 million, or 25%;
      $191.7 million, or 19%, consisted of commercial real estate loans; $115.9
      million, or 12%, consisted of consumer loans; and $67.2 million, or 7%,
      consisted of business loans.





Our
      principal lending activities have focused on the origination of residential,
      commercial real estate, business banking, and consumer loans. Total loans
      originated were $526.0 million and $469.7 million for the years ended December
      31, 2005 and 2004, respectively, and $424.4 million for the year ended December
      31, 2003.





In
      order
      to maintain the interest rate sensitivity of our loan portfolio and investments,
      we place an emphasis on the origination of adjustable-rate mortgage loans on
      residential and commercial properties, and construction, business, and consumer
      loans at interest rates subject to periodic adjustment based upon the prevailing
      market rates. At December 31, 2005, $747.3 million, or 85%, of net loans
      receivable, including loans held-for-sale, were comprised of loans that were
      other than long-term, fixed-rate loans. This amount consists of $200.4 million
      in residential mortgage loans with rates adjustable at periods ranging from
      one
      to five years, $382.1 million in business loans and loans secured by
      income-producing and multifamily residential properties, $137.3 million in
      net
      construction loans, and $27.5 million in consumer loans.




7




The
      following tables provide selected data relating to the composition of our loan
      portfolio by type of loan and type of security on the dates
      indicated.




As
                  of December 31,2005
              
              2004
              
              2003
              
              2002
              
              2001Amount
              
              Percent
              
              Amount
              
              Percent
              
              Amount
              
              Percent
              
              Amount
              
              Percent
              
              Amount
              
              Percent(Dollars
                  in Thousands)Type
                  of loan:Real
                  estate loans:Interim
                  construction loans
              
              $
              248,283
              
              
              28.13
              %
              $
              184,064
              
              
              22.74
              %
              $
              163,309
              
              
              22.52
              %
              $
              107,266
              
              
              17.10
              %
              $
              84,245
              
              
              14.84
              %Loans
                  on existing property
              
              
              359,059
              
              
              40.66
              %
              
              379,054
              
              
              46.83
              %
              
              299,401
              
              
              41.26
              %
              
              270,947
              
              
              43.18
              %
              
              250,038
              
              
              44.05
              %Loans
                  refinanced
              
              
              210,576
              
              
              23.86
              %
              
              180,115
              
              
              22.26
              %
              
              228,726
              
              
              31.53
              %
              
              219,125
              
              
              34.93
              %
              
              208,383
              
              
              36.72
              %Insured
                  or guaranteedreal
                  estate loans
              
              
              —
              
              
              0.00
              %
              
              —
              
              
              0.00
              %
              
              —
              
              
              0.00
              %
              
              103
              
              
              0.02
              %
              
              244
              
              
              0.04
              %Consumer
                  loans and other
              
              
              115,941
              
              
              13.14
              %
              
              94,776
              
              
              11.71
              %
              
              85,243
              
              
              11.75
              %
              
              57,627
              
              
              9.19
              %
              
              42,488
              
              
              7.49
              %Business
                  lines of credit
              
              
              67,223
              
              
              7.62
              %
              
              52,963
              
              
              6.54
              %
              
              20,089
              
              
              2.77
              %
              
              14,683
              
              
              2.34
              %
              
              11,995
              
              
              2.11
              %Less:Undisbursed
                  loan proceeds
              
              
              (109,568
              )
              
              (12.41
              %)
              
              (73,423
              )
              
              (9.07
              %)
              
              (64,140
              )
              
              (8.84
              %)
              
              (34,528
              )
              
              (5.50
              %)
              
              (22,270
              )
              
              (3.92
              %)Reserve
                  for loan losses
              
              
              (10,069
              )
              
              (1.14
              %)
              
              (9,301
              )
              
              (1.15
              %)
              
              (8,406
              )
              
              (1.16
              %)
              
              (7,754
              )
              
              (1.24
              %)
              
              (7,032
              )
              
              (1.24
              %)Net
                  deferred loan (fees)/costs
              
              
              1,236
              
              
              0.14
              %
              
              1,158
              
              
              0.14
              %
              
              1,226
              
              
              0.17
              %
              
              (150
              )
              
              (0.02
              %)
              
              (537
              )
              
              (0.09
              %)Total
              
              $
              882,681
              
              
              100.00
              %
              $
              809,406
              
              
              100.00
              %
              $
              725,448
              
              
              100.00
              %
              $
              627,319
              
              
              100.00
              %
              $
              567,554
              
              
              100.00
              %As
                  of December 31,2005
              
              
              2004
              
              
              2003
              
              
              2002
              
              
              2001Amount
              
              
              Percent
              
              
              Amount
              
              
              Percent
              
              
              Amount
              
              
              Percent
              
              
              Amount
              
              
              Percent
              
              
              Amount
              
              
              Percent(Dollars
                  in Thousands)Type
                  of security:Residential:One-to-four
                  family
              
              $
              223,928
              
              
              25.37
              %
              $
              177,322
              
              
              21.91
              %
              $
              131,682
              
              
              18.15
              %
              $
              93,208
              
              
              14.86
              %
              $
              83,887
              
              
              14.78
              %Multifamily
              
              
              153,988
              
              
              17.43
              %
              
              176,429
              
              
              21.80
              %
              
              184,919
              
              
              25.49
              %
              
              177,621
              
              
              28.31
              %
              
              174,062
              
              
              30.67
              %Construction
              
              
              248,283
              
              
              28.13
              %
              
              184,064
              
              
              22.74
              %
              
              163,309
              
              
              22.51
              %
              
              107,266
              
              
              17.10
              %
              
              84,245
              
              
              14.84
              %Commercial
                  real estate
              
              
              191,719
              
              
              21.72
              %
              
              205,418
              
              
              25.38
              %
              
              211,526
              
              
              29.16
              %
              
              219,346
              
              
              34.97
              %
              
              200,716
              
              
              35.37
              %Consumer
                  loans and other
              
              
              115,941
              
              
              13.14
              %
              
              94,776
              
              
              11.71
              %
              
              85,243
              
              
              11.75
              %
              
              57,627
              
              
              9.19
              %
              
              42,488
              
              
              7.49
              %Business
                  lines of credit
              
              
              67,223
              
              
              7.62
              %
              
              52,963
              
              
              6.54
              %
              
              20,089
              
              
              2.77
              %
              
              14,683
              
              
              2.34
              %
              
              11,995
              
              
              2.11
              %Less:Undisbursed
                  loan proceeds
              
              
              (109,568
              )
              
              (12.41
              %)
              
              (73,423
              )
              
              (9.07
              %)
              
              (64,140
              )
              
              (8.84
              %)
              
              (34,528
              )
              
              (5.50
              %)
              
              (22,270
              )
              
              (3.92
              %)Reserve
                  for loan losses
              
              
              (10,069
              )
              
              (1.14
              %)
              
              (9,301
              )
              
              (1.15
              %)
              
              (8,406
              )
              
              (1.16
              %)
              
              (7,754
              )
              
              (1.24
              %)
              
              (7,032
              )
              
              (1.24
              %)Net
                  deferred loan (fees)/costs
              
              
              1,236
              
              
              0.14
              %
              
              1,158
              
              
              0.14
              %
              
              1,226
              
              
              0.17
              %
              
              (150
              )
              
              (0.02
              %)
              
              (537
              )
              
              (0.09
              %)Total
              
              $
              882,681
              
              
              100.00
              %
              $
              809,406
              
              
              100.00
              %
              $
              725,448
              
              
              100.00
              %
              $
              627,319
              
              
              100.00
              %
              $
              567,554
              
              
              100.00
              %





**Loan
      Maturity.** The
      following table sets forth certain information at December 31, 2005, regarding
      the dollar amount of loans maturing based on their contractual terms to maturity
      or repricing. Demand loans, loans having no stated schedule of repayments and
      no
      stated maturity, are reported as due in one year or less. Loan balances exclude
      unearned discounts, deferred loan origination fees, and allowance for loan
      losses.





8


Due
                  within
                One
                  Year
              
              Two
                  to
                Three
                  Years
              
              Three
                  to
                Five
                  Years
              
              Five
                  to Ten
                Years
              
              Beyond
                Ten
                  Years
              
              Total(Dollars
                  in Thousands)Real
                  estate loans:Interim
                  construction loans
              
              $
              138,715
              
              $
              —
              
              $
              —
              
              $
              —
              
              $
              —
              
              $
              138,715Loans
                  on existing property
              
              
              204,269
              
              
              65,703
              
              
              43,781
              
              
              35,812
              
              
              9,494
              
              
              359,059Loans
                  refinanced
              
              
              119,752
              
              
              38,577
              
              
              25,677
              
              
              21,002
              
              
              5,568
              
              
              210,576Consumer
                  loans and other
              
              
              31,571
              
              
              2,623
              
              
              6,807
              
              
              44,177
              
              
              30,763
              
              
              115,941Business
                  loans
              
              
              46,552
              
              
              8,497
              
              
              11,431
              
              
              443
              
              
              300
              
              
              67,223Total
                  loans
              
              $
              540,859
              
              $
              115,400
              
              $
              87,696
              
              $
              101,434
              
              $
              46,125
              
              $
              891,514





The
      following table sets forth the dollar amount of all loans, categorized by fixed
      interest rates and floating or adjustable interest rates. Loan balances exclude
      unearned discounts, deferred loan origination fees, and allowance for loan
      losses.




Due
                  Within One-Year
              
              Due
                after One-YearAdjustable
              
              
              
              
              
              AdjustableFixed
                  Rate
              
              Rate
              
              Total
              
              Fixed
                  Rate
              
              Rate
              
              Total(Dollars
                  in Thousands)Mortgage
                  loans
              
              $
              3,043
              
              $
              459,692
              
              $
              462,735
              
              $
              27,271
              
              $
              218,344
              
              $
              245,615Consumer
                  loans
              
              
              4,303
              
              
              27,267
              
              
              31,570
              
              
              84,370
              
              
              —
              
              
              84,370Business
                  loans
              
              
              265
              
              
              46,288
              
              
              46,553
              
              
              16,495
              
              
              4,175
              
              
              20,670Total
              
              $
              7,611
              
              $
              533,247
              
              $
              540,858
              
              $
              128,136
              
              $
              222,519
              
              $
              350,655




**Residential
      Loans** .
      At
      December 31, 2005, approximately 37% of the total loan portfolio, including
      loans held-for-sale and single-family construction loans, consisted of loans
      secured by one-to-four-unit family dwellings principally located within the
      states of Washington, Oregon, and Idaho.





Our
      lending policies generally limit the maximum loan-to-value ratio on residential
      mortgage loans to 97% of the appraised value as determined by an independent
      appraiser, with the condition that private mortgage insurance is required on
      home loans with loan-to-value ratios in excess of 80%.





The
      loan-to-value ratio, maturity, and other provisions of the loans originated
      generally have reflected the policy of making less than the maximum loan
      permissible in accordance with sound lending practices, market conditions,
      and
      underwriting standards established by management. Mortgage loan originations
      are
      generally long-term loans, amortized on a monthly basis, with principal and
      interest due each month. The initial contractual loan payment period for
      residential loans typically ranges from five to 30 years. Our past experience
      indicates that real estate loans remain outstanding for significantly shorter
      periods than their contractual terms. Borrowers may refinance or prepay loans
      at
      their option, subject to prepayment penalty provisions when included in the
      note.





We
      offer
      loans that adjust every one or two years and that have initial fixed-rate
      periods between one and 10 years. These loans generally have a maximum rate
      adjustment of two percent in any one year with a maximum lifetime interest
      rate
      adjustment of between four and six percent. We also offer fixed rate 15- or
      30-year loans that we sell into the secondary market. At times, we may choose
      to
      portfolio some of these loans that are underwritten to certain
      criteria.





All
      improved real estate which serves as security for a loan must be insured by
      companies we have approved




9




against
      fire, extended coverage, vandalism, malicious mischief, and other hazards.
      Such
      insurance must be maintained throughout the term of the loan and in an amount
      not less than that amount necessary to meet the replacement cost of the property
      structures, subject to insurance carrier limits.





Included
      in our residential portfolio are single-family construction loans. These loans
      are further designated into two categories -- speculative and custom.
      Speculative (“spec”) construction loans, which represent 2% of the loan
      portfolio, are approved for builder-developers who generally first build the
      residence and then sell the property to the end buyer. Those loans typically
      are
      made for a 12-month period, which may be extended subject to negotiation and
      the
      payment of an extension fee. Interest rates on spec loans are tied to the prime
      rate and are adjusted when the prime rate changes. At the present time, rates
      quoted range from 0.5% to 1.0% above the prevailing prime rate and are dependent
      upon the type of loan and its terms.





Custom
      construction loans, which represent 10% of the loan portfolio, are originated
      directly to the borrower. The builder, with whom the borrower has contracted
      to
      build the residence, must be acceptable to the Bank. We oversee the disbursement
      of construction funds to the borrower and builder. These loans generally have
      15- or 30-year terms with the construction period ranging from six to 12 months,
      with interest collected monthly based upon the disbursed balance of the loan.
      At
      the end of the construction period the terms of payment are modified to fully
      amortize the loan balance over the subsequent 15- or 30-year term.





The
      loan
      programs and interest rates offered for custom construction loans are typically
      the same as those offered for other one-to-four-family residential loans. The
      fee and interest rate structure for custom construction loans are typically
      higher than those assessed on non-construction single-family loans with similar
      terms and conditions. The additional loan fee and interest rate compensate
      us
      for the extra cost and interest rate risk associated with this type of
      lending.




**Income
      Property Loans.** Income
      property loans, consisting of multifamily, construction, and commercial real
      estate loans, totaled $327 million at December 31, 2005. That figure compares
      to
      $347 million at year-end 2004.





At
      December 31, 2005, commercial real estate loans (excluding multifamily and
      construction loans) constituted $139 million of the loan portfolio as compared
      to $141 million at the end of 2004. These loans are typically secured by office
      buildings, warehouses, commercial and retail centers located in our primary
      lending area of Washington State and Western Oregon. Permanent commercial real
      estate loans are normally made up to 75% of the appraised value of the property
      and generally have interest rates that are adjusted annually based on the
      short-term FHLB advance rate plus a spread ranging from 2.0% to
      3.5%.





Income
      property real estate financing is generally considered to involve a somewhat
      higher degree of credit risk than financing of residential properties. The
      risk
      of loss on an income property construction loan is dependent largely upon the
      accuracy of the initial estimate of the property’s value at completion of
      construction or development and the estimated cost (including interest) of
      construction. If the estimate of the construction cost of the property upon
      completion of the project proves to be inaccurate, we may be required to advance
      funds beyond the amount originally committed to permit completion of the
      development. If the estimate of value proves to be inaccurate, we may be
      confronted, at or prior to the maturity of the loan, with collateral that is
      insufficient to assure full repayment. On permanent income property real estate
      loans, the risk is primarily attributable to the cash flow from the property
      being financed. If the cash flow from the property is reduced (e.g., if leases
      are not obtained or renewed), the borrower’s ability to repay the loan may be
      impaired.





Our
      underwriting criteria are designed to evaluate and minimize the risk of income
      property real estate lending. Among other things, we consider the credit history
      and reputation of the borrower, the borrower’s net worth and liquidity, the
      amount of the borrower’s equity in the project, independent appraisal and review
      of cost estimates, pre-construction sale and leasing information, and cash
      flow
      projections of the borrower. In addition our loan policy limits the maximum
      loan(s) to any one borrower, at any time, to not exceed the maximum allowed
      under state regulations.





10





Multifamily
      loans are generally made in amounts between $500,000 and $2.0 million and at
      December 31, 2005, the largest multifamily loan was for $6.1 million. As of
      December 31, 2005, multifamily loans were $165 million of the loan portfolio
      as
      compared to $181 million in 2004.





**Business
      Banking.** The
      Business Banking Department makes loans for “owner-occupied” commercial real
      estate properties, construction loans and non-real-estate-based business loans.
      At year-end 2005, total business banking loans grew to $116 million compared
      to
      $110 million the previous year. Non-real-estate business loans included in
      those
      totals were $67 million and $55 million at December 31, 2005 and 2004,
      respectively.





Business
      banking commercial real estate loans are typically made on “owner-occupied”
properties. The Business Banking Department analyzes the owner’s business that
      occupies the property and looks at the business’ cash flow as the primary source
      of repayment. The real estate collateral provides secondary security to the
      loan. Non-real-estate business loans are typically extended to medium-sized
      businesses for the purpose of financing inventory, accounts receivable,
      equipment, etc.





Interest
      rates on business loans are generally tied to the prime rate, plus a spread
      ranging from 0.0% to 2.0%, or to the short-term FHLB advance rate, plus a spread
      ranging from 2% to 3%. The rates are adjusted when the index rate changes.
      Most
      prime-based loans reprice immediately while the loans tied to other indexes
      reprice based on set schedules, generally annually and after a fixed period
      of
      time. Annual fees are also usually assessed to line-of-credit business
      loans.





Commercial
      business lending generally involves greater risk than residential mortgage
      lending and involves risks that are different from those associated with
      residential, commercial, and multifamily real estate lending. Real estate
      lending is generally considered to be collateral-based lending with loan amounts
      based on predetermined loan-to-collateral values, and liquidation of the
      underlying real estate collateral is viewed as the primary source of repayment
      in the event of borrower default. Although commercial business loans are often
      collateralized by equipment, inventory, accounts receivable or other business
      assets, the liquidation of collateral in the event of a borrower default is
      often not a sufficient source of repayment because accounts receivable may
      be
      uncollectible and inventories and equipment may be obsolete or of limited use,
      among other reasons. Accordingly, the repayment of a commercial business loan
      depends primarily on the creditworthiness and cash flow of the borrower (and
      any
      guarantors), while liquidation of collateral is a secondary source of
      repayment.


**Consumer
      Loans.** We
      originate consumer loans through two principal methods: sales finance lending
      (indirect lending) and direct consumer lending (consumer and home equity loans).
      Consumer loans totaled $117 million at December 31, 2005, compared to $96
      million the previous year. Included in that total are sales finance loans
      totaling $87 million and $69 million at year-end 2005 and 2004 respectively.





The
      Sales
      Finance Department purchases consumer financing contracts from approved dealers
      in over 40 states. The purchases are generally without recourse to the dealers.
      Typical collateral for these contracts includes retrofitted windows, siding,
      roofs, spas, and other home improvements. Dealers must be acceptable to the
      Bank
      prior to the purchase of contracts. Before a contract is purchased, Bank
      personnel make independent credit decisions on the borrowers by checking the
      creditworthiness of the borrower using various underwriting
      criteria.




We
      have a
      satellite sales finance office located in Jacksonville, Florida. Our employees
      based out of this office work with contractors in the eastern portion of the
      United States to generate home improvement contracts for assignment to the
      Bank.





The
      Sales
      Finance Department originates loans both for portfolio and for sale in the
      secondary market. Loans originated for portfolio can either be unsecured or
      secured by the use of a financing statement filed against the real property
      where the goods were installed. The terms of the contracts are fixed rate and
      vary in term from two to 12 years.




11




Loans
      originated for sale in the secondary market are unsecured. The loans are sold
      non-recourse to various institutional purchasers.





To
      mitigate future losses, we have entered into agreements with two national
      insurance companies to provide credit default insurance on a portion of the
      sales finance loans. The default insurance pays 100% of the loss on any given
      loan up to an overall liability cap as defined in the insurance policy. The
      insurance coverage, when applicable, is typically purchased for loans that
      fall
      below a cutoff credit score. That cutoff credit score is currently at 720.





The
      Direct Consumer Lending Department processes and closes consumer loan requests
      generated within the banking centers and from lending officers. The lending
      products offered fall into two categories: collateral-based loans (automobiles,
      boats, recreational vehicles, home improvement, etc.) and unsecured
      lines-of-credit. The underwriting criteria for collateral-based loans are
      similar to those of the sales finance loans noted above. Primary consideration
      is given to the borrower’s capacity to repay the obligation. A secondary
      consideration on secured consumer loans is the value of the loan collateral
      as a
      source of repayment. The underwriting criteria on the unsecured lines-of-credit
      call for a higher level of borrower creditworthiness because of the unsecured
      nature of these loans. The terms on the collateral- based loans are fixed rates
      with terms up to 10 years. The unsecured lines-of-credit are variable and tied
      to the prime rate plus a margin.





Consumer
      loans entail greater risk than do residential mortgage loans, particularly
      in
      the case of loans that are unsecured or secured by rapidly depreciating assets
      such as automobiles. In such cases, any repossessed collateral for a defaulted
      consumer loan may not provide an adequate source of repayment of the outstanding
      loan balance as a result of the greater likelihood of damage, loss or
      depreciation. The remaining deficiency often does not warrant further
      substantial collection efforts against the borrower beyond obtaining a
      deficiency judgment. In addition, consumer loan collections are dependent on
      the
      borrower’s continuing financial stability and thus are more likely 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 and insolvency laws, may limit the amount which
      can
      be recovered on such loans. Such loans may also give rise to claims and defenses
      by a consumer loan borrower against an assignee of such loans such as the Bank,
      and a borrower may be able to assert against such assignee claims and defenses
      that it has against the seller of the underlying collateral. At December 31,
      2005, consumer loans past due 90 days or more totaled $574,000 as compared
      to
      $299,000 at year-end 2004.




**Loan
      Solicitation and Processing** .
      We rely
      upon our employees to solicit and/or originate business, consumer, income
      property, and residential loans. We also utilize the services of mortgage
      brokers and home improvement dealers and contractors. Residential mortgage
      brokers take applications from borrowers, process the credit information, obtain
      property appraisals, and then submit the loan to us for approval. If approved,
      the loan is funded by and closed in the name of the Bank. Income property
      brokers are generally limited to taking the initial application from borrowers.
      Mortgage brokers provide us with a cost-effective method of originating loans
      in
      a broader geographic area than our primary lending areas. Approxi-mately 89%
      of
      all residential loans closed during the year ended December 31, 2005, were
      obtained through mortgage brokers as compared to 86% during 2004. We also
      purchase retail installment contracts from home improvement dealers and
      contractors in 42 states.  In the process of selling home improvement
      products, the contractors have the borrower complete an application for credit
      to finance the purchase and installation of those products.   The
      application is forwarded to the Bank where the decision is made to purchase
      the
      contract.  Once the goods are installed to the satisfaction of the
      customer, the Bank purchases the contract from the contractor and the Bank
      assumes responsibility for collecting the borrower’s monthly payments. 
With the exception of specific recourse purchase programs offered to a small
      number of contractors, all of the contracts purchased by the Bank are without
      recourse except in instances of fraud or misrepresentation of the work performed
      or the goods installed.





Our
      lending policy is reviewed annually and approved by the Board of Directors.
      Residential loans up to specified limits may be approved by a designated
      underwriter or member of the Consumer Loan Committee, which is comprised of
      officers Boudreau, Boyd, Harlan, Haley, Smeby, and Zavaglia. Commercial real
      estate loans can be approved by the Chief or Senior Risk Officer up to $2.0
      million or by a designated member of the Commercial Loan




12




Committee
      up to $1.0 million. Commercial Loan Committee can approve these loans up to
      $6.5
      million. This committee can also approve other secured business loans up to
      $6.5
      million and unsecured up to $5.0 million. Four designated members of the
      Commercial Loan Committee must approve loans above these amounts. The members
      of
      the committee are officers Collette, Boudreau, Everett, Harlan, Kasanders,
      Mandery, Smeby, Valaas, Reininger, and Zavaglia. Except for small consumer
      or
      community business loans, the Commercial Loan Committee must also approve loans
      where the cumulative debt exceeds $4.0 million for residential and consumer
      loans or $3.0 million for income property or business loans.





**Loan
      Originations and Sales of Loans into the Secondary Market** .
      Loan
      originations increased in 2005 to $526 million from $470 million in 2004, and
      the comparable figure for 2003 was $424 million. The increase in originations
      came largely from residential loan closings which increased from $197 million
      in
      2004 to $255 million in 2005.





Selling
      loans in the secondary mortgage market reduces the risk that interest rates
      will
      escalate while holding long-term, fixed-rate loans in the portfolio. The sale
      of
      loans into the secondary market also allows us to continue to make loans during
      periods when savings inflows decline or funds are not otherwise available for
      lending purposes. In connection with such sales, we have the option of selling
      the servicing rights (i.e., collection of principal and interest payments).
      As
      of December 31, 2005, we serviced loans for others aggregating approximately
      $106 million as compared to $118 million in 2004. Net loan servicing fees
      totaled $1.3 million for the year ended December 31, 2005, and $314,000 for
      the
      year ended December 31, 2004.





Currently,
      some residential, commercial, and sales finance loans are being originated
      for
      sale and sold to investors. During the year ended December 31, 2005, we sold
      $38
      million in residential loans, $18 million in sales finance loans, and $11
      million in commercial loans as compared to $36 million each in residential
      and
      sales finance loans, and $32 million in commercial loans during
      2004.





Set
      forth
      below is a table showing our loan origina-tion and sales activity for the
      periods indicated.





13


Years
                  Ended December 31,2005
              
              2004
              
              2003(Dollars
                  in Thousands)Total
                  loans at beginning of period (net ofundisbursed
                  loan proceeds)
              
              $
              817,549
              
              $
              732,628
              
              $
              635,223Loans
                  originated:Real
                  estate loans:Construction
                  loans
              
              
              241,401
              
              
              170,824
              
              
              138,238Loans
                  on existing property
              
              
              163,682
              
              
              87,519
              
              
              133,341Loans
                  refinanced
              
              
              39,798
              
              
              62,021
              
              
              75,385Consumer
                  and other loans
              
              
              81,100
              
              
              149,353
              
              
              77,400Total
                  loans originated
              
              
              525,981
              
              
              469,717
              
              
              424,364Principal
                  reductions
              
              
              (384,805
              )
              
              (280,831
              )
              
              (231,131
              )Loans
                  sold:Whole
                  loans
              
              
              (30,841
              )
              
              (35,787
              )
              
              (71,299
              )Participation
                  loans
              
              
              (36,371
              )
              
              (68,178
              )
              
              (24,529
              )Total
                  loans sold
              
              
              (67,212
              )
              
              (103,965
              )
              
              (95,828
              )Total
                  loans at end of period (net of undisbursedloan
                  proceeds)
              
              $
              891,513
              
              $
              817,549
              
              $
              732,628


**Loan
      Commitments.** Our
      commitments to make conventional mortgage loans on existing residential
      dwellings are generally made for periods of 30 to 60 days. The borrower may
      reserve (“lock-in”) an
      interest rate and loan fee for a period of 10 to 60 days from the date of
      application. This reservation is conditioned upon loan approval and closing
      within this time frame. Interest rates and loan fees committed at the time
      of
      the lock-in are based upon the prevailing market rate at the time of approval.
      Outstanding commitments to borrowers totaled $315.5 million at December 31,
      2005
      and $239.3 million at year-end 2004.





**Loan
      Origination Fees and Other Fees.** In
      addition to interest earned on loans and servicing fees on loans sold and
      securitized, we receive loan origination fees for originating mortgage loans.
      See Note 1 of “Notes to Consolidated Financial Statements” in the Annual Report
      for information as to the recognition of loan fee income.





Loan
      origination fees vary with the volume and type of loans made and with
      competitive conditions in mortgage markets. Loan demand and availability of
      money affect these market conditions. Recent trends have kept loan origination
      fees in the 0.5% to 2.0% range for permanent real estate loans. Construction
      loan fees at the present time range from 1.0% to 2.0% of the loan amount. We
      also receive other fees and charges relating to existing loans, which include
      late charges, prepayment fees, and fees collected in connection with a change
      in
      borrower or other loan modifications, including construction loan extensions.





**Real
      Estate Held-for-Sale and Non-performing Loans.** Loans
      are defined as non-performing when payment of principal and/or interest is
      90
      days past due unless we are reasonably assured that all principal and interest
      due on the loan will be fully recovered. Generally we are able to work out
      a
      satisfactory repayment schedule with a delinquent borrower; however, the Bank
      will undertake foreclosure proceedings if the delinquency is not otherwise
      re-solved. Property we acquire as a result of foreclosure or by deed-in-lieu
      of
      foreclosure is classified as “held-for-sale”
      until such time as it is sold or otherwise disposed. At December 31, 2005,
      the
      total of non-performing loans, repossessed assets,




14




and
      real
      estate acquired through foreclosure was $897,000 as compared to $1.0 million
      at
      year-end 2004.





The
      following table sets forth information regarding non-performing assets at the
      dates indicated.




As
                  of December 31,2005
              
              2004
              
              2003(Dollars
                  in Thousands)Nonaccrual
                  loans
              
              $
              897
              
              $
              1,004
              
              $
              527Other
                  assets and real estate acquiredthrough
                  foreclosure
              
              
              —
              
              
              3
              
              
              11Total
                  non-performing assets
              
              $
              897
              
              $
              1,007
              
              $
              538As
                  a percentage of loans
              
              
              0.10
              %
              
              0.12
              %
              
              0.07
              %As
                  a percentage of total assets
              
              
              0.08
              %
              
              0.10
              %
              
              0.06
              %Gross
                  interest income that would havebeen
                  recorded in the period if loanshad
                  been current with original terms
              
              $
              91
              
              $
              81
              
              $
              104Interest
                  income on loans includedin
                  net income for the period
              
              $
              62
              
              $
              44
              
              $
              87




There
      were two impaired loans totaling $136,281 (net of impairment allowances) at
      year
      end 2005 and three impaired loans totaling $139,833 (net of impairment
      allowances) at year end 2004, respectively. The amount of impairment totaled
      $172,000 for 2005 and $177,000 for 2004.





**Reserve
      for Loan Losses**





The
      reserve for loan losses is maintained at a level sufficient to provide for
      estimated losses based on known and inherent risks in the loan portfolio. This
      reserve is based upon management’s continuing analysis of the factors underlying
      the quality of the loan portfolio. These factors include changes in the size
      and
      composition of the loan portfolio; actual loan loss experience; current and
      anticipated economic conditions; detailed analysis of individual loans for
      which
      full collection may not be assured and for which impairment may be present;
      and
      determination of the existence and fair value of the collateral and guarantees
      securing the loans. The reserve is based upon factors and trends identified
      by
      management at the time the financial statements are prepared. The ultimate
      recovery of loans is susceptible to future market factors beyond our control,
      which may result in losses or recoveries differing significantly from those
      provided in the financial statements. At December 31, 2005, the reserve for
      loan
      losses totaled $10.1 million which compares to $9.3 million at December 31,
      2004.




While
      we
      believe we have established our existing reserve for loan losses in accordance
      with generally accepted accounting principles as of December 31, 2005, there
      can
      be no assurance that regulators, when reviewing our loan portfolio in the
      future, will not request us to increase or decrease our reserve for loan losses,
      thereby adversely affecting our financial condition and earnings. See the
      Consolidated Financial Statements contained in the Annual Report.





The
      following table sets forth an analysis of the allowance for loan losses for
      the
      periods indicated.





15


Years
                  Ended December 31,2005
              
              2004
              
              2003
              
              2002
              
              2001(Dollars
                  in Thousands)Balance
                  at beginning of period
              
              $
              9,300
              
              $
              8,406
              
              $
              7,754
              
              $
              7,032
              
              $
              6,729Charge-offs:Residential
                  real estate
              
              
              —
              
              
              (172
              )
              
              —
              
              
              —
              
              
              —Commercial
                  and multifamilyreal
                  estate
              
              
              —
              
              
              (1
              )
              
              —
              
              
              (6
              )
              
              —Business
              
              
              (273
              )
              
              (101
              )
              
              (174
              )
              
              (42
              )
              
              (14
              )Consumer
                  and other
              
              
              (773
              )
              
              (640
              )
              
              (466
              )
              
              (223
              )
              
              (130
              )Total
                  charge-offs
              
              
              (1,046
              )
              
              (914
              )
              
              (640
              )
              
              (271
              )
              
              (144
              )Recoveries:Residential
                  real estate
              
              
              4
              
              
              —
              
              
              —
              
              
              —
              
              
              —Business
              
              
              26
              
              
              25
              
              
              —
              
              
              8
              
              
              3Consumer
                  and other
              
              
              285
              
              
              218
              
              
              142
              
              
              75
              
              
              79Total
                  recoveries
              
              
              315
              
              
              243
              
              
              142
              
              
              83
              
              
              82Provision
              
              
              1,500
              
              
              1,565
              
              
              1,150
              
              
              910
              
              
              365Balance
                  at end of period
              
              $
              10,069
              
              $
              9,300
              
              $
              8,406
              
              $
              7,754
              
              $
              7,032Ratio
                  of net charge-offs to averageloans
                  outstanding
              
              
              0.09
              %
              
              0.08
              %
              
              0.07
              %
              
              0.03
              %
              
              0.01
              %


**Securities**





The
      following table sets forth certain information regarding carrying values and
      percentage of total carrying values of the consolidated portfolio of securities
      classified as available-for-sale and held-to-maturity.




16


At
                  December 31,2005
              
              2004**Available
                  for sale:**
              
              Carrying
                  Value
              
              Percent
                  of Total
              
              Carrying
                  Value
              
              Percent
                  of Total(Dollars
                  in Thousands)US
                  government treasury and agency obligations
              
              $
              17,988
              
              
              16
              %
              $
              17,954
              
              
              14
              %Mortgage-backed
                  securities:Freddie
                  Mac
              
              
              16,110
              
              
              14
              %
              
              18,888
              
              
              15
              %Ginnie
                  Mae
              
              
              43,122
              
              
              38
              %
              
              48,608
              
              
              39
              %Fannie
                  Mae
              
              
              37,230
              
              
              32
              %
              
              38,775
              
              
              32
              %Total
                  mortgage-backed securities
              
              
              96,462
              
              
              84
              %
              
              106,271
              
              
              86
              %Total
                  available for sale securities
              
              $
              114,450
              
              
              100
              %
              $
              124,225
              
              
              100
              %At
                  December 31,2005
              
              
              2004**Held
                  to maturity:**
              
              
              Carrying
                  Value
              
              
              Percent
                  of Total
              
              
              Carrying
                  Value
              
              
              Percent
                  of Total(Dollars
                  in Thousands)Municipal
                  bonds
              
              $
              1,188
              
              
              17
              %
              $
              1,217
              
              
              16
              %Mortgage-backed
                  securities:Freddie
                  Mac
              
              
              433
              
              
              6
              %
              
              493
              
              
              6
              %Fannie
                  Mae
              
              
              5,345
              
              
              77
              %
              
              6,010
              
              
              78
              %Total
                  mortgage-backed securities
              
              
              5,778
              
              
              83
              %
              
              6,503
              
              
              84
              %Total
                  held to maturity securities
              
              $
              6,966
              
              
              100
              %
              $
              7,720
              
              
              100
              %Estimated
                  market value
              
              $
              6,971
              
              
              
              
              $
              7,827


17





The
        following table shows the maturity or period to repricing of the Bank’s consolidated
        portfolio of securities available-for-sale and held-to-maturity at December
        31,
        2005.
  One
                  Year or Less
              
              One
                  to Three Years
              
              Three
                  to Five Years
              
              Five
                  to Ten Years
              
              Ten
                  to Twenty Years
              
              Over
                  Twenty Years
              
              TotalCarrying
                Value
              
              Weighted
                  Average Yield
              
              Carrying
                  Value
              
              Weighted
                  Average Yield
              
              Carrying
                  Value
              
              Weighted
                  Average Yield
              
              Carrying
                  Value
              
              Weighted
                  Average Yield
              
              Carrying
                  Value
              
              Weighted
                  Average Yield
              
              Carrying
                  Value
              
              Weighted
                  Average Yield
              
              Carrying
                  Value
              
              Weighted
                  Average Yield(Dollars
                  in Thousands)**Available
                  for sale:**US
                  government treasury and agency obligations
              
              $
              7,213
              
              
              1.82
              %
              $
              —
              
              
              0.00
              %
              $
              5,864
              
              
              4.08
              %
              $
              —
              
              
              0.00
              %
              $
              4,911
              
              
              4.00
              %
              $
              —
              
              
              0.00
              %
              $
              17,988
              
              
              3.15
              %Mortgage-backed
                  securities:Ginnie
                  Mae
              
              
              —
              
              
              0.00
              %
              
              43,122
              
              
              4.06
              %
              
              —
              
              
              0.00
              %
              
              —
              
              
              0.00
              %
              
              —
              
              
              0.00
              %
              
              —
              
              
              0.00
              %
              
              43,122
              
              
              4.06
              %Freddie
                  Mac
              
              
              285
              
              
              5.46
              %
              
              402
              
              
              5.50
              %
              
              4,811
              
              
              3.58
              %
              
              3,327
              
              
              4.61
              %
              
              7,285
              
              
              4.50
              %
              
              —
              
              
              0.00
              %
              
              16,110
              
              
              4.29
              %Fannie
                  Mae
              
              
              507
              
              
              5.14
              %
              
              5,471
              
              
              4.79
              %
              
              3,645
              
              
              4.11
              %
              
              —
              
              
              0.00
              %
              
              27,607
              
              
              4.29
              %
              
              —
              
              
              0.00
              %
              
              37,230
              
              
              4.36
              %Total
                  mortgage-backed securities
              
              
              792
              
              
              5.26
              %
              
              48,995
              
              
              4.16
              %
              
              8,456
              
              
              3.81
              %
              
              3,327
              
              
              4.61
              %
              
              34,892
              
              
              4.34
              %
              
              —
              
              
              0.00
              %
              
              96,462
              
              
              4.22
              %Total
                  carrying value
              
              $
              8,005
              
              
              2.16
              %
              $
              48,995
              
              
              4.16
              %
              $
              14,320
              
              
              3.97
              %
              $
              3,327
              
              
              4.61
              %
              $
              39,803
              
              
              4.30
              %
              $
              —
              
              
              0.00
              %
              $
              114,450
              
              
              4.05
              %Total
                  amortized cost
              
              $
              7,994
              
              
              2.16
              %
              $
              49,518
              
              
              4.15
              %
              $
              14,753
              
              
              3.92
              %
              $
              3,387
              
              
              4.61
              %
              $
              41,037
              
              
              4.29
              %
              $
              —
              
              
              0.00
              %
              $
              116,689
              
              
              4.05
              %One
                  Year or Less
              
              One
                  to Three Years
              
              Three
                  to Five Years
              
              Five
                  to Ten Years
              
              Ten
                  to Twenty Years
              
              Over
                  Twenty Years
              
              TotalCarrying
                  Value
              
              
              Weighted
                  Average Yield
              
              
              Carrying
                  Value
              
              
              Weighted
                  Average Yield
              
              
              Carrying
                  Value
              
              
              Weighted
                  Average Yield
              
              
              Carrying
                  Value
              
              
              Weighted
                  Average Yield
              
              
              Carrying
                  Value
              
              
              Weighted
                  Average Yield
              
              
              Carrying
                  Value
              
              
              Weighted
                  Average Yield
              
              
              Carrying
                  Value
              
              
              Weighted
                  Average Yield(Dollars
                  in Thousands)**Held
                  to maturity:**Municipal
                  bonds
              
              $
              —
              
              
              0.00
              %
              $
              —
              
              
              0.00
              %
              $
              —
              
              
              0.00
              %
              $
              —
              
              
              0.00
              %
              $
              220
              
              
              5.38
              %
              $
              968
              
              
              6.28
              %
              $
              1,188
              
              
              6.11
              %Mortgage-backed
                  securities:Freddie
                  Mac
              
              
              433
              
              
              5.22
              %
              
              —
              
              
              0.00
              %
              
              —
              
              
              0.00
              %
              
              —
              
              
              0.00
              %
              
              —
              
              
              0.00
              %
              
              —
              
              
              0.00
              %
              
              433
              
              
              5.22
              %Fannie
                  Mae
              
              
              1,838
              
              
              5.78
              %
              
              272
              
              
              6.48
              %
              
              1,502
              
              
              4.41
              %
              
              —
              
              
              0.00
              %
              
              1,733
              
              
              4.77
              %
              
              —
              
              
              0.00
              %
              
              5,345
              
              
              5.10
              %Total
                  mortgage-backed securities
              
              
              2,271
              
              
              5.67
              %
              
              272
              
              
              6.48
              %
              
              1,502
              
              
              4.41
              %
              
              —
              
              
              0.00
              %
              
              1,733
              
              
              4.77
              %
              
              —
              
              
              0.00
              %
              
              5,778
              
              
              5.11
              %Total
                  carrying value
              
              $
              2,271
              
              
              5.67
              %
              $
              272
              
              
              6.48
              %
              $
              1,502
              
              
              4.41
              %
              $
              —
              
              
              0.00
              %
              $
              1,953
              
              
              4.84
              %
              $
              968
              
              
              6.28
              %
              $
              6,966
              
              
              5.28
              %Total
                  amortized cost
              
              $
              2,330
              
              
              5.67
              %
              $
              284
              
              
              6.48
              %
              $
              1,477
              
              
              4.42
              %
              $
              —
              
              
              0.00
              %
              $
              1,913
              
              
              4.84
              %
              $
              967
              
              
              6.28
              %
              $
              6,971
              
              
              5.30
              %
  18





**Investment
      Activities**





Under
      Washington law, savings banks are permitted to own government and government
      agency obligations, commercial paper, corporate bonds, mutual fund shares,
      debt
      and equity obligations issued by creditworthy entities, whether traded on public
      securities exchanges or placed privately for investment purposes. We retain
      a
      portfolio of mortgage-backed securities, US treasury and agency securities,
      and
      municipal bonds. Subject to certain exceptions, we are prohibited by FDIC
      regulations from making equity investments of a type, or in an amount, that
      is
      not permissible for national banks.





The
      Chief
      Financial Officer determines appropriate investments in accordance with approved
      policies of the Investment Committee of the Board of Directors. The policy
      generally limits investments to US government and agency securities and
      mortgage-backed securities issued and guaranteed by Freddie Mac, Fannie Mae,
      and
      Ginnie Mae. Investments are made based on certain considerations, which include
      the interest rate, yield, settlement date and maturity of the investment, our
      liquidity position, and anticipated cash needs and sources. In addition, the
      effect on our credit and interest rate risk and risk-based capital is also
      included in the evaluation.





At
      December 31, 2005, the book value of the investment securities portfolio totaled
      $123.6 million, while the estimated fair market value amounted to $121.4 million
      as compared to $132.7 million and $132.0 million, respectively, for 2004.
      Securities with stated maturities greater than 10 years comprised 85.3% of
      the
      investment portfolio in 2005. From time to time, investment levels may be
      increased or decreased depending upon a number of factors. These factors include
      the yields on investment alternatives and upon management’s judgment as to the
      attractiveness of the yields then available in relation to other opportunities
      and its expectations of the level of yield that will be available in the future.
      In addition, management’s projections as to the short-term demand for funds to
      be used in origination of loans and other activities are also a consideration.
      During the past year the investment portfolio decreased 8%.





**Mortgage-Backed
      Securities.** We
      purchase mortgage-backed securities to: (i) generate positive interest rate
      spreads on large principal balances with minimal administrative expense, (ii)
      lower our credit risk as a result of the guarantees provided by Freddie Mac,
      Fannie Mae, and Ginnie Mae, (iii) enable the use of mortgage-backed securities
      as collateral for financing, and (iv) invest excess funds during periods of
      reduced loan demand. Included in the mortgage-backed securities portfolio are
      Fannie Mae, Freddie Mac, and Ginnie Mae mortgage-backed obligations with a
      book
      value of $104.3 million and a market value totaling $102.2 million. In
      comparison, the related figures for 2004 totaled a book value of $113.6 million
      and a market value of $112.9 million.





Mortgage-backed
      securities typically represent a participation interest in a pool of
      single-family or multifamily mortgages. The principal and interest payments
      on
      these mortgages are passed from the mortgage originators, through intermediaries
      (generally US government agencies and government-sponsored enterprises) that
      pool and resell the participation interests in the form of securities to
      investors such as the Bank. These US government agencies and
      government-sponsored enterprises, which guarantee the payment of principal
      and
      interest to investors, primarily include Freddie Mac, Fannie Mae, and Ginnie
      Mae. Mortgage-backed securities typically are issued with stated principal
      amounts, and the securities are backed by pools of mortgages that have loans
      with interest rates that fall within a specified range and have varying
      maturities. Mortgage-backed securities generally yield less than loans that
      underlie such securities because of the cost of payment guarantees and credit
      enhancements. In addition, mortgage-backed securities are usually more liquid
      than individual mortgage loans and may be used to collateralize certain
      liabilities and obligations of the Bank. These types of securities also permit
      us to optimize our regulatory capital because they have a low risk
      weighting .





The
      actual maturity of a mortgage-backed security may be less than its stated
      maturity due to prepayments of the underlying mortgages. Prepayments that are
      faster than anticipated shorten the life of the security, may result in a loss
      of  any
      premiums paid, and thereby reduce the net yield on such securities. Although
      prepayments of underlying mortgages depend on many factors, including the type
      of mortgages, the coupon rate, the age of mortgages, the geographical




19




location
      of the underlying real estate collateralizing the mortgages and general levels
      of market interest rates, the difference between the interest rates on the
      underlying mortgages and the prevailing mortgage interest rates generally is
      the
      most significant determinant of the rate of prepayments. During periods of
      declining mortgage interest rates, if the coupon rate of the underlying
      mortgages exceeds the prevailing market interest rates offered for mortgage
      loans, refinancing generally increases and accelerates the prepayment of the
      underlying mortgages and the related security. Under such circumstances, we
      may
      be subject to reinvestment risk because, to the extent that the mortgage-backed
      securities amortize or prepay faster than anticipated, we may not be able to
      reinvest the proceeds of such repayments and prepayments at a comparable rate.





The
      following table sets forth information regarding the mortgage-backed securities
      (including REMICs) activity for the periods indicated.





Years
                  Ended December 31,2005
              
              2004
              
              2003(Dollars
                  in Thousands)Beginning
                  balance
              
              $
              112,773
              
              $
              74,150
              
              $
              60,320Mortgage-backed
                  securities purchased
              
              
              11,050
              
              
              55,179
              
              
              69,104Amortization
                  of premiums and discounts
              
              
              (1,213
              )
              
              (622
              )
              
              (1,865
              )Principal
                  repayments
              
              
              (20,370
              )
              
              (15,934
              )
              
              (53,409
              )Ending
                  balance
              
              $
              102,240
              
              $
              112,773
              
              $
              74,150




The
      following table sets forth the composition of the mortgage-backed securities
      portfolio at the dates indicated.




Years
                  Ended December 31,2005
              
              2004
              
              2003Percent
              
              
              
              Percent
              
              
              
              PercentAmount
              
              of
                  Total
              
              Amount
              
              of
                  Total
              
              Amount
              
              of
                  Total(Dollars
                  in Thousands)Mortgage-backed
                  securities:Freddie
                  Mac
              
              $
              16,543
              
              
              16.2
              %
              $
              19,380
              
              
              17.2
              %
              $
              16,096
              
              
              21.7
              %Fannie
                  Mae
              
              
              42,575
              
              
              41.6
              %
              
              44,785
              
              
              39.7
              %
              
              50,067
              
              
              67.5
              %Ginnie
                  Mae
              
              
              43,122
              
              
              42.2
              %
              
              48,608
              
              
              43.1
              %
              
              7,986
              
              
              10.8
              %REMICs
              
              
              —
              
              
              0.0
              %
              
              -
              
              
              0.0
              %
              
              1
              
              
              0.0
              %Total
              
              $
              102,240
              
              
              100.0
              %
              $
              112,773
              
              
              100.0
              %
              $
              74,150
              
              
              100.0
              %




The
      following table presents the carrying value of the investment securities
      portfolio. The market value of the investments in the table at December 31,
      2005, was approximately $121.4 million.




20




As
                  of December 31,2005
              
              2004
              
              2003(Dollars
                  in Thousands)Investment
                  securities:US
                  government and agency obligations
              
              $
              17,988
              
              $
              17,954
              
              $
              11,053Corporate
                  and municipal securities
              
              
              1,188
              
              
              1,217
              
              
              1,324Mortgage-backed
                  securities
              
              
              102,240
              
              
              112,773
              
              
              74,150Total
              
              $
              121,416
              
              $
              131,944
              
              $
              86,527




At
      December 31, 2005, municipal bonds included seven Washington State municipal
      bonds that are rated AA or better.





For
      further information concerning the investment portfolio, reference is made
      to
      Note 3 and 4 of the “Notes to Consolidated Financial Statements” in the Annual
      Report.




21




The
      following table provides the scheduled maturities, carrying values, market
      values, and average yields for the investment securities at December 31,
      2005.




One
                  to Five
              
              Five
                  to Ten
              
              Over
                  TenOne
                  Year
              
              Years
              
              Years
              
              Years
              
              Total
              
              TotalBook
              
              Yield
              
              Book
              
              Yield
              
              Book
              
              Yield
              
              Book
              
              Yield
              
              Book
              
              Market
              
              Yield(Dollars
                  in Thousands)Municipals*
              
              $
              —
              
              
              0.00
              %
              $
              —
              
              
              0.00
              %
              $
              —
              
              
              0.00
              %
              $
              1,188
              
              
              8.92
              %
              $
              1,188
              
              $
              1,188
              
              
              8.92
              %US
                  agencies
              
              
              7,220
              
              
              1.82
              %
              
              5,987
              
              
              4.08
              %
              
              —
              
              
              0.00
              %
              
              5,000
              
              
              4.00
              %
              
              18,207
              
              
              17,988
              
              
              3.16
              %Freddie
                  Mac
              
              
              —
              
              
              0.00
              %
              
              3,852
              
              
              3.70
              %
              
              —
              
              
              0.00
              %
              
              13,221
              
              
              4.48
              %
              
              17,073
              
              
              16,552
              
              
              4.31
              %Fannie
                  Mae
              
              
              300
              
              
              5.69
              %
              
              866
              
              
              5.50
              %
              
              —
              
              
              0.00
              %
              
              42,389
              
              
              4.42
              %
              
              43,555
              
              
              42,571
              
              
              4.45
              %Ginnie
                  Mae
              
              
              —
              
              
              0.00
              %
              
              —
              
              
              0.00
              %
              
              —
              
              
              0.00
              %
              
              43,632
              
              
              4.06
              %
              
              43,632
              
              
              43,122
              
              
              4.06
              %Total
              
              $
              7,520
              
              
              1.98
              %
              $
              10,705
              
              
              4.06
              %
              $
              —
              
              
              0.00
              %
              $
              105,430
              
              
              4.31
              %
              $
              123,655
              
              $
              121,421
              
              
              4.15
              %





*
      Municipal bond yields are not shown on a tax equivalent basis.





22




**Deposit
      Activities and Other Sources of Funds**





**General.** Savings
      accounts and other deposits are important sources of our funds for use in
      lending, security investments, and for other general business purposes. In
      addition to deposit accounts, we derive funds from loan repayments, interest
      payments, loan sales, FHLB advances and other borrowings, and operations. The
      availability of funds from loan sales is influenced by general interest rates
      and other market conditions. Loan repayments and interest payments are a
      relatively stable source of funds, while deposit inflows and outflows vary
      widely and are influenced by prevailing interest rates and market conditions.
      Borrowings are used to complement deposit inflows. Although the use of borrowed
      funds changes from year to year, our internal target is a maximum funding
      position of 30% of assets. At year-end 2005 and 2004, borrowings represented
      21.2% and 23.5% of assets, respectively.





**Deposits** .
      We
      offer a number of deposit accounts, including savings accounts, NOW checking,
      business checking accounts, money market accounts, and time deposit accounts,
      ranging in maturity from 30 days to 10 years. Deposit account terms vary with
      the principal differences being the minimum balance required, the time period
      the funds must remain on deposit and the interest rate.





**Jumbo
      Time Deposits.** We offer
      jumbo, mini-jumbo and public funds mini-jumbo time deposits, and these accounts
      are offered for minimum terms of 30 days and in minimum amounts of $100,000,
      $50,000, and $20,000, respectively.




The
      following table indicates the amount of the jumbo time deposits by time
      remaining until maturity as of December 31, 2005. Rates paid on jumbo time
      deposits are negotiable.


JumboMaturity
                  Period
              
              Time
                  Deposits(Dollars
                  in Thousands)Three
                  months or less
              
              $
              53,732Four
                  through six months
              
              
              55,802Seven
                  through 12 months
              
              
              57,603Over
                  12 months
              
              
              49,370Total
              
              $
              216,507


**IRA
      Accounts.** We offer
      tax-deferred individual retirement accounts (“IRA”). IRA accounts are offered on
      the same terms as the time deposits. In addition, we offer a money market
      account to IRA customers. The money market IRA requires a minimum balance of
      $100.




23


**Deposit
      Flows.** The
      following table sets forth the balance of deposits in the various types of
      accounts that we offered at the dates indicated.




Balance
                  at
              
              
              
              
              
              Balance
                  at
              
              
              
              
              
              Balance
                  atDecember
                  31,
              
              %
                  of
              
              Increase
                  /
              
              December
                  31,
              
              %
                  of
              
              Increase
                  /
              
              December
                  31,
              
              %
                  of2005
              
              Deposits
              
              (Decrease)
              
              2004
              
              Deposits
              
              (Decrease)
              
              2003
              
              Deposits(Dollars
                  in Thousands)NOW
                  and business checking accounts
              
              $
              69,722
              
              
              9.2
              %
              $
              9,453
              
              $
              60,269
              
              
              8.9
              %
              $
              12,573
              
              $
              47,696
              
              
              8.2
              %Jumbo
                  time deposits
              
              
              216,507
              
              
              28.5
              %
              
              50,141
              
              
              166,366
              
              
              24.6
              %
              
              17,458
              
              
              148,908
              
              
              25.5
              %Extreme
                  checking accounts
              
              
              33,334
              
              
              4.4
              %
              
              2,964
              
              
              30,370
              
              
              4.5
              %
              
              16,867
              
              
              13,503
              
              
              2.3
              %Savings
                  accounts
              
              
              8,054
              
              
              1.1
              %
              
              (380
              )
              
              8,434
              
              
              1.2
              %
              
              (277
              )
              
              8,711
              
              
              1.5
              %Money
                  market deposit accounts
              
              
              160,389
              
              
              21.1
              %
              
              (3,408
              )
              
              163,797
              
              
              24.3
              %
              
              33,047
              
              
              130,750
              
              
              22.4
              %Three
                  month or less time deposits
              
              
              1,749
              
              
              0.2
              %
              
              462
              
              
              1,287
              
              
              0.2
              %
              
              (2,147
              )
              
              3,434
              
              
              0.6
              %Four
                  to six month time deposits
              
              
              6,998
              
              
              0.9
              %
              
              (16,043
              )
              
              23,041
              
              
              3.4
              %
              
              12,876
              
              
              10,165
              
              
              1.7
              %Seven
                  month to one-year time deposits
              
              
              103,896
              
              
              13.6
              %
              
              11,121
              
              
              92,775
              
              
              13.7
              %
              
              (39,796
              )
              
              132,571
              
              
              22.7
              %13
                  month to five year time deposits
              
              
              159,744
              
              
              21.0
              %
              
              31,164
              
              
              128,580
              
              
              19.1
              %
              
              41,225
              
              
              87,355
              
              
              15.0
              %Six
                  to 10 year time deposits
              
              
              328
              
              
              0.0
              %
              
              (122
              )
              
              450
              
              
              0.1
              %
              
              (348
              )
              
              798
              
              
              0.1
              %Total
                  deposits
              
              $
              760,721
              
              
              100.0
              %
              $
              85,352
              
              $
              675,369
              
              
              100.0
              %
              $
              91,478
              
              $
              583,891
              
              
              100.0
              %IRA
                  accounts
              
              $
              29,295
              
              
              3.9
              %
              $
              1,174
              
              $
              28,121
              
              
              4.2
              %
              $
              800
              
              $
              27,321
              
              
              4.7
              %




The
      following table represents an analysis of the deposit accounts by interest
      rate
      and remaining time to maturity at December 31, 2005.




Less
                  than
              
              One
                  to
              
              Two
                  to
              
              OverOne
                  Year
              
              Two
                  Years
              
              Five
                  Years
              
              Five
                  Years
              
              Total(Dollars
                  in Thousands)Less
                  than 2.01%
              
              $
              145,786
              
              $
              814
              
              $
              5
              
              $
              —
              
              $
              146,6052.01
                  to 3.00%
              
              
              185,440
              
              
              1,600
              
              
              207
              
              
              5
              
              
              187,2523.01
                  to 4.00%
              
              
              273,256
              
              
              26,548
              
              
              13,360
              
              
              27
              
              
              313,1914.01
                  to 5.00%
              
              
              47,904
              
              
              46,069
              
              
              14,843
              
              
              —
              
              
              108,8165.01
                  to 6.00%
              
              
              266
              
              
              1,902
              
              
              171
              
              
              —
              
              
              2,3396.01
                  to 8.00%
              
              
              2,301
              
              
              217
              
              
              —
              
              
              —
              
              
              2,518Total
              
              $
              654,953
              
              $
              77,150
              
              $
              28,586
              
              $
              32
              
              $
              760,721




The
      following table provides the deposit activity for the periods
      indicated.





24


Years
                  Ended December 31,2005
              
              2004
              
              2003(Dollars
                  in Thousands)Deposits
              
              $
              3,327,093
              
              $
              2,089,551
              
              $
              1,421,920Withdrawals
              
              
              3,258,771
              
              
              2,009,494
              
              
              1,346,744Net
                  deposits/(withdrawals)before
                  interest credited
              
              
              68,322
              
              
              80,057
              
              
              75,176Interest
                  credited
              
              
              17,029
              
              
              11,421
              
              
              11,345Net
                  increase/(decrease) in deposits
              
              $
              85,351
              
              $
              91,478
              
              $
              86,521




For
      further information concerning deposits, reference is made to Note 9 of the
      “Notes to Consolidated Financial Statements” in the Annual Report.





**Borrowings.** The FHLB
      serves as our primary borrowing source. Advances from the FHLB are typically
      secured by a portion of our residential mortgage loans, multifamily permanent
      loans, home equity loans, and securities. At December 31, 2005, we had advances
      totaling $225.7 million from the FHLB, which mature in 2006 through 2011 at
      interest rates ranging from 1.81% to 6.25%.





The
      Bank
      also has a note payable in connection with the 1994 purchase of land in West
      Seattle for construction of the permanent location of the West Seattle banking
      center. The $600,000 note payable was negotiated with the previous owner of
      the
      property. The rate on the note is 6.00% with a maturity date of November 1,
      2009.





At
      the
      Company level we borrow from other banks. Those borrowings totaled $4.0 million
      at the end of 2005.





The
      FHLB
      functions as a central reserve bank providing credit for commercial banks,
      savings banks, savings and loan associations and certain other member financial
      institutions. As a member, we are required to own capital stock in the FHLB
      and
      are authorized to apply for advances on the security of our home mortgages
      and
      other assets such as securities which are obligations of, or guaranteed by,
      the
      United States government provided certain standards related to creditworthiness
      have been met. Advances are made pursuant to several different programs. Each
      credit program has its own interest rate and range of maturities. Limitations
      on
      the amount of advances are based on the FHLB’s assessment of the institution’s
      creditworthiness. Under its current credit policies, the FHLB has limited
      advances to 40% of our assets. At December 31, 2005, the percentage of assets
      represented by FHLB borrowings was 21%. For further information regarding
      borrowings and the FHLB see Note 10 of the “Notes to Consolidated Financial
      Statements” in the Annual Report and “Regulation
      and
      Supervision - -Federal Home Loan Bank System” below.





**Critical
      Accounting Policies**





We
      prepare our Consolidated Financial Statements in conformity with accounting
      principles generally accepted in the United States of America (“GAAP”). In
      accordance with GAAP, management is required to make a number of judgments,
      estimates, and assumptions that affect the reported amounts of assets,
      liabilities, income, and expenses in our Consolidated Financial Statements
      and
      accompanying footnotes. We have identified four policies as being critical
      because they require management to make particularly difficult, subjective
      and/or complex judgments about matters that are inherently uncertain and because
      the likelihood that materially different amounts would be reported under
      different conditions or using different assumptions. The four critical
      accounting policies that we have identified are related to the allowance for
      loan losses, determining the fair value of servicing assets, estimating the
      premiums for credit loss insurance, and determining the value and amortization
      methods regarding loan origination fees and costs. We believe that the
      judgments, estimates, and assumptions used in the preparation of our
      Consolidated Financial Statements are




25




appropriate
      given the factual circumstances as of December 31, 2005. However, given the
      sensitivity of our Consolidated Financial Statements to these critical
      accounting policies, the use of other judgments, estimates, and assumptions
      could result in material differences in our results of operations or financial
      condition. Management has discussed these critical accounting policies with
      the
      Audit Committee of our Board of Directors.





The
      table
      below represents information about the nature of and rational for our critical
      accounting policies.





Critical
                Accounting
                Policy
              
              Consolidated
                Balance
                  Sheet
                Caption
              
              Consolidated
                Income
                  Statement
                Caption
              
              Nature
                  of Estimates Required
              
              ReferenceAllowance
                  for loan losses
              
              Reserve
                  for loan losses
              
              Provision
                  for loan losses
              
              The
                  allowance for loan losses represents management’s estimate of credit
                  losses inherent in the Bank’s loan portfolio as of the balance sheet date.
                  The estimation of the allowance is based on a variety of factors,
                  including the profile of the loan portfolio, the local and national
                  economic outlook, and the current and historical performance of
                  the loan
                  portfolio. The Bank’s methodology for assessing the adequacy of the
                  allowance includes the evaluation of three distinct elements: the
                  formula
                  allowance, the specific allowance and the unallocated allowance.
                  The
                  ultimate recovery of all loans is susceptible to future market
                  factors
                  beyond the Bank’s control.
              
              The
                  estimates and judgments are described in further detail in the
                  Management’s Discussion and Analysis - “Reserve and Provision for Loan
                  Losses” and in Note 1 to the Consolidated Financial Statements - “Summary
                  of Significant Accounting Policies.”Fair
                  value of servicing assets
              
              Servicing
                  assets
              
              Noninterest
                  income, servicing fees, net of amortization
              
              Determining
                  the fair value of servicing assets requires us to formulate conclusions
                  about anticipated changes in future market conditions, including
                  interest
                  rates. Our servicing portfolio is subject to prepayment risk, which
                  subjects our servicing assets to impairment risk. We use a valuation
                  model
                  to calculate the present value of the future cash flows to determine
                  the
                  value of our servicing assets. Assumptions used in the valuation
                  model
                  include market discount rates and anticipated prepayment speeds.
                  The
                  prepayment speeds are based upon loan prepayment forecasts
              
              See
                  further discussion in the Management’s Discussion and Analysis section of
                  the Annual Report - “Review of Financial Condition”, “Servicing Assets”,
                  as well as Note 1 to the Consolidated Financial Statements in the
                  Annual
                  Report - “Servicing Assets.”
  26
  derived
                  from the consensus of investment banking firms as reported by online
                  quotation systems for the residential and income property participations;
                  for the sales finance loans the actual previous three-month prepayment
                  history is utilized. Additionally, estimates of the cost of servicing
                  a
                  loan, an inflation rate, ancillary income per loan, and default
                  rates are
                  used in the valuation process. We assess impairment of the capitalized
                  servicing assets based on recalculations of the present value of
                  the
                  remaining future cash flows using updated prepayment speeds. Impairment
                  is
                  assessed on a stratum-by-stratum basis with any impairment recognized
                  through a valuation for each impaired stratum.
 Credit
                  insurance premiums
              
              Accounts
                  payable and other liabilities
              
              Noninterest
                  expense
              
              Credit
                  insurance is purchased to cover credit losses on certain pools
                  of sales
                  finance loans on a yearly basis. The cost of the credit insurance
                  is based
                  upon various factors such as actual loss experience, the size of
                  the pool,
                  etc. The contract with the credit insurer also includes a maximum
                  exposure
                  limit to the insurer of 10% of the original loan balances. As a
                  result,
                  the monthly premiums paid are based on an estimate at the beginning
                  of the
                  contract year and any additional premiums are not due until the
                  end of the
                  contract year. We have analyzed the contracts and accrue on a monthly
                  basis the estimated amount payable at the end of each contract
                  year.
              
              See
                  further discussion in the Management’s Discussion and Analysis section
                  under “Results of Operations, Noninterest Expense.”Loan
                  origination fees and costs
              
              Loans
                  receivable
              
              Interest
                  income, loans receivable
              
              Loan
                  origination fees and costs are netted and deferred over the life
                  of each
                  loan. These net fees and costs are amortized into income over the
                  life of
                  the underlying loan using one of two methods: the straight-line
                  method
              
              See
                  further discussion in Note 1 to the Consolidated Financial Statements,
                  in
                  the Annual Report -




27


or
                the constant-level-yield method. If the loan is prepaid prior to
                maturity,
                the remaining net fees/costs are recognized when the loan is paid
                off.
                Included in these deferred fees/costs is a standard loan cost. The
                standard loan cost is calculated for each loan class using a model
                that
                incorporates the costs associated with originating and processing
                a loan.
                This cost is netted against the qualifying fees received from the
                borrower
                to determine the net deferred fee or cost associated with each loan.
                The
                amortization of these net fees/costs is then recognized into income
                as the
                loan matures. Estimates and assumptions are used to determine the
                cost of
                each process that is essential to process the loan request and originate
                it on our books. These estimates mainly include the number of hours
                and
                rate of compensation paid to all parties involved in the origination
                process of a loan. These estimates are updated on a yearly basis
                to ensure
                that any new loan classes have been added and any new processes have
                been
                incorporated as well as incorporating any changes in the average
                compensation rates. These estimates can vary significantly from year
                to
                year depending upon demand and overall mix of the varying loan types
                from
                year to year as well as the changes in the processes involved in
                the
                various kinds of loans.
            
            “Loans”
                as well as Note 5 - “Loans Receivable, Net and Loans Receivable
                Held-for-Sale.”




**Recently
      Issued Accounting Standards**





On
      December 16, 2004, the Financial Accounting Standards Board (“FASB”) issued FASB
      Statement No. 123(R), *Accounting
      for Stock-Based Compensation* .
      Statement 123(R) requires all share-based payments to employees, including
      grants of employee stock options, to be recognized in the income statement
      based
      on their fair values. Pro forma disclosure is no longer an alternative. We
      adopted Statement 123(R) on January 1, 2006 using the modified retrospective
      method, restating all prior periods.




28




As
      permitted by Statement 123, we currently account for share-based payments to
      employees using the intrinsic value method allowed under FASB Opinion No. 25
      and, as such, recognize no compensation cost for employee stock options.
      Accordingly, the adoption of Statement 123(R)’s fair value method will have a
      significant impact on our results of operations, although it will have no impact
      on our overall financial position. The impact of adoption of Statement 123(R)
      is
      expected to be similar to the pro forma expense amount for 2005, but it will
      depend on the levels of share-based payments granted in the future. Statement
      123(R) also requires the benefit of tax deductions in excess of recognized
      compensation cost to be reported as a financing cash flow, rather than as an
      operating cash flow as required under current literature. This requirement
      will
      reduce net operating cash flows and increase net financing cash flows in periods
      after adoption. While we cannot estimate what those amounts will be in the
      future (because they depend on, among other things, when employees exercise
      stock options), the amount of operating cash flows recognized in prior periods
      for such excess tax deductions were $220,000, $87,000, and $13,000 in 2005,
      2004, and 2003, respectively.





**Regulation
      and Supervision**





**General.** As
      a
      state-chartered, federally-insured financial institution, the Bank is subject
      to
      extensive federal and state regulation. Lending activities and other investments
      must comply with various statutory and regulatory requirements, including
      prescribed minimum capital standards. The Bank is examined by the Federal
      Deposit Insurance Corporation (FDIC) and the Department of Financial
      Institutions of the State of Washington and files periodic reports concerning
      the Bank’s activities and financial condition with its federal and state
      regulators. Our relationship with depositors and borrowers also is regulated
      to
      a great extent by both federal and state law, especially in such matters as
      the
      ownership of savings accounts and the form and content of mortgage
      documents.





Federal
      and state banking laws and regulations govern all areas of the operation of
      banks, including reserves, loans, mortgages, capital, issuance of securities,
      payment of dividends and establishment of banking centers. Federal and state
      bank regulatory agencies also have the general authority to limit the dividends
      paid by insured banks and bank holding companies if such payments should be
      deemed to constitute an unsafe and unsound practice. The respective primary
      federal regulators of the Company and the Bank have authority to impose
      penalties, initiate civil and administrative actions and take other steps
      intended to prevent banks from engaging in unsafe or unsound
      practices.





**Deposit
      Insurance.** The FDIC
      is an independent federal agency that insures the deposits, up to prescribed
      statutory limits, of depository institutions. The FDIC administers two separate
      deposit insurance funds: the Bank Insurance Fund (“BIF”) and the Savings
      Association Insurance Fund (“SAIF”). The BIF is a deposit insurance fund for
      commercial banks and some state-chartered savings banks, such as the Bank.
      The
      SAIF is a deposit insurance fund for most savings associations. As an insurer
      of
      our deposits, the FDIC has examination, supervisory, and enforcement authority
      over us.





The
      FDIC
      has established a risk-based system for setting deposit insurance assessments.
      Under the risk-based assessment system, an institution’s insurance assessment
      varies according to the level of capital the institution holds and the degree
      to
      which it is the subject of supervisory concern. In addition, regardless of
      the
      potential risk to the insurance fund, federal law requires the ratio of reserves
      to insured deposits to be no less than $1.25 per $100. Both funds currently
      meet
      this reserve ratio. During 2005, the assessment rate for both SAIF and BIF
      deposits ranged from zero to 0.27% of covered deposits. As a well-capitalized
      bank, we qualified for the lowest rate on our deposits for 2005.





In
      addition to deposit insurance assessments, the FDIC is authorized to collect
      assessments against insured deposits to be paid to the Finance Corporation
      (“FICO”) to service FICO debt incurred in the 1980’s to help fund the thrift
      industry cleanup. The FICO assessment rate is adjusted quarterly. During 2005
      the FICO assessment rates ranged from 1.34 cents to 1.44 cents per $100 of
      insured deposits.





Any
      insured bank which does not operate in accordance with or conform to supervisory
      regulations, policies




29




and
      directives may be sanctioned for non-compliance. For example, proceedings may
      be
      instituted against any insured bank or any director, officer, or employee of
      such bank who engages in unsafe and unsound practices, including the violation
      of applicable laws and regulations. The FDIC has the authority to terminate
      deposit insurance pursuant to procedures established for that purpose.
      Management is not aware of any existing circumstances that could result in
      termination of the deposit insurance or any sanctions for the Bank.





**Capital
      Requirements.** FDIC
      regulations recognize two types or tiers of capital: core (“Tier 1”) capital
      and supplementary (“Tier 2”) capital.
      Tier 1 capital generally includes common stockholders’ equity,
      non-cumulative perpetual preferred stock, and hybrid capital instruments
      designated by the FDIC less most intangible assets. Tier 2 capital, which
      includes 100 percent of Tier 1 capital plus such items as qualifying general
      loan loss reserves, cumulative perpetual preferred stock, mandatory convertible
      debt, term subordinated debt and limited life preferred stock; however, the
      amount of term subordinated debt and intermediate term preferred stock (original
      maturity of at least five years but less than 20 years) that may be included
      in
      Tier 2 capital is limited to 50 percent of Tier 1 capital.





The
      FDIC
      currently measures an institution’s capital using a leverage limit together with
      certain risk-based ratios. The FDIC’s minimum leverage capital requirement
      specifies a minimum ratio of Tier 1 capital to average total assets. Most banks
      are required to maintain a minimum leverage ratio of at least 4% to 5% of total
      assets.





FDIC
      regulations also establish a measure of capital adequacy based on ratios of
      qualifying capital to risk-weighted assets. Assets are placed in one of four
      categories and given a percentage weight -- 0%, 20%, 50% or 100% -- based on
      the
      relative risk of that category. In addition, certain off-balance-sheet items
      are
      converted to balance sheet credit equivalent amounts, and each amount is then
      assigned to one of the four categories. Under the guidelines, the ratio of
      total
      capital (Tier 1 capital plus Tier 2 capital) to risk-weighted assets must be
      at
      least 8%, and the ratio of Tier 1 capital to risk-weighted assets must be at
      least 4%. We have calculated the Bank’s total risk-based ratio to be 11.1% as of
      December 31, 2005, and our Tier 1 risk-based capital ratio to be 9.9% for the
      Bank.





Federal
      statutes establish a supervisory framework based on five capital categories:
      well capitalized, adequately capitalized, undercapitalized, significantly
      undercapitalized and critically undercapitalized. An institution’s category
      depends upon where its capital levels are in relation to relevant capital
      measures, which include a risk-based capital measure, a leverage ratio capital
      measure, and certain other factors. The federal banking agencies have adopted
      regulations that implement this statutory framework. Under these regulations,
      an
      institution is treated as well capitalized if its ratio of total capital to
      risk-weighted assets is 10% or more, its ratio of Tier I capital to
      risk-weighted assets is 6% or more, its ratio of Tier I capital to adjusted
      total assets is 5% or more, and it is not subject to any federal supervisory
      order or directive to meet a specific capital level.





During
      2002 and 2003, in addition to capital provided through retained earnings, we
      augmented our regulatory capital with trust preferred securities (“TPS”). These
      securities have a maturity of 30 years and are redeemable by the Company at
      par
      after five years, with certain exceptions. The TPS securities have been
      deconsolidated from our financial statements in accordance with FASB
      Interpretation No. 46 as amended but qualify as capital for regulatory capital
      limits. They are eligible for Tier 1 leverage capital treatment up to 25% of
      Tier 1 capital and for risk-weighted capital up to 50% of Tier 1 capital. We
      issued $17 million in securities ($9 million in 2002 and $8 million in 2003).
      There are no present plans to issue additional TPS securities, and we believe
      that our current capital, plus retained earnings for year 2006, will meet our
      budgeted growth in assets for the forthcoming year.





Management
      believes that, under the current regulations, we will continue to meet our
      minimum capital requirements as a well capitalized institution in the
      foreseeable future. However, events beyond our control, such as a downturn
      in
      the economy in areas where we have most of our loans, could adversely affect
      future earnings and, consequently, the ability to meet our capital requirements.





**Federal
      Deposit Insurance Corporation Improvement Act (“FDICIA”).** The Bank
      has surpassed the $500 million asset threshold and as such is required to be
      compliant with the FDICIA originally enacted in 1991 and with




30




enhanced
      provisions adopted in 1993. In general, FDICIA requires us to conduct an annual
      independent audit of our financial statements, appoint an independent audit
      committee of outside directors, report on and assess management’s
      responsibilities for preparing financial statements, and establish an internal
      control structure.





An
      independent accountant must attest to and report on the assertions in
      management’s report concerning these internal controls, with the desired outcome
      of efficient and effective operations; the safeguarding of assets; reliable
      financial reporting; and compliance with applicable laws and
      regulations.





The
      FDIC,
      our primary regulator, has outlined, in general, the requirements for compliance
      with FDICIA but does not provide specific guidance on the internal control
      structure, documentation, or procedures to test the effectiveness. It is up
      to
      each bank to establish, document and design procedures to evaluate and test
      the
      internal control structure over financial reporting and compliance with
      designated laws and regulations that minimally include loans to insiders and
      dividend restrictions.





We
      have
      identified and documented existing controls with consideration given to the
      control environment, risk assessment, control activities, information and
      communication systems, and monitoring activities to ensure compliance with
      the
      regulatory requirements. These systems and controls are reviewed, at a minimum,
      on a yearly basis to comply with the FDICIA requirements.




Under
      FDICIA, the Audit Committee of the Board of Directors has several
      responsibilities that include but are not limited to overseeing the internal
      audit function; conducting periodic meetings with management, the independent
      public accountants, and the internal auditors; review of significant accounting
      policies and audit conclusions regarding significant accounting estimates;
      review of the assessments prepared by management and the independent auditors
      on
      the adequacy of internal controls and the resolution of identified material
      weaknesses and reportable conditions in internal controls; and the review of
      compliance with laws and regulations.





**Federal
      Home Loan Bank System.** The FHLB
      serves as a reserve or central bank for the member institutions within its
      assigned region. It is funded primarily from proceeds derived from the sale
      of
      consolidated obligations of the FHLBs. It makes loans ( *i.e.* ,
      advances) to members in accordance with policies and procedures established
      by
      the Federal Housing Finance Board and the Board of Directors of the FHLB of
      Seattle. As a member, we are required to purchase and hold Class B(1) stock
      in
      the FHLB of Seattle. The amount of stock a member institution is required to
      hold is based on the cumulative value of three criteria:





·
            Advance
                Stock Purchase - Under this requirement, a member must currently
                hold
                stock with a par value equal to 3.5% of the outstanding principal
                balance
                of advances extended to the member.


·
            Mortgage
                Purchase Program - Under this requirement, a member must currently
                hold
                stock with a par value equal to 5.0% of the outstanding principal
                balance
                of the loans sold to the FHLB, by the member, under the Mortgage
                Purchase
                Program, minus the Membership Stock Purchase requirement.


·
            Membership
                Stock Purchase - Under this requirement, a member must currently
                hold
                stock with a par value equal to the greater of $500 or 0.75% of the
                member’s home mortgage loans outstanding as of the most recent calendar
                year end.





As
      of
      December 31, 2005, we held stock in the FHLB in the amount of $13.1 million.





**Federal
      Reserve System.** The
      Federal Reserve Board requires (under “Regulation
      D”)
      that all depository institutions, including savings banks, maintain reserves
      on
      transaction accounts or non-personal time deposits. These reserves may be in
      the
      form of cash or non-interest bearing deposits with the regional Federal Reserve
      Bank. NOW accounts and other types of accounts that permit payments or transfers
      to third parties fall within the definition of transaction accounts and are
      subject to Regulation D reserve requirements, as are any non-personal time
      deposits at a savings bank. Under Regulation D, the first $7.0 million (will
      increase to $7.8 million in 2006) of net transactions are




31




exempt
      from reserve requirements. We must maintain a 3% reserve ratio on net
      transaction accounts over $7.0 million up to and including $47.6 million (will
      increase to $48.3 million in 2006). A 10 percent reserve ratio will be assessed
      on net transaction accounts in excess of $47.6 million. These amounts and
      percentages are subject to adjustment by the Federal Reserve Board. The reserve
      requirement on non-personal time deposits with original maturities of less
      than
      1.5 years is 0%. As of December 31, 2005, our deposit with the Federal Reserve
      Bank and vault cash exceeded the reserve requirements.





**Control
      Acquisitions** .
      The
      Change in Bank Control Act prohibits a person or group of persons from acquiring
      “control” of a bank holding company unless the Federal Reserve Board has been
      notified and has not objected to the transaction. Under a rebuttable presumption
      established by the Federal Reserve Board, the acquisition of 10% or more of
      a
      class of voting stock of a bank holding company with a class of securities
      registered under Section 12 of the Exchange Act, such as the Company, would,
      under the circumstances set forth in the presumption, constitute acquisition
      of
      control of the Company.





In
      addition, any entity is required to obtain the approval of the Federal Reserve
      Board under the Bank Holding Company Act before acquiring 25% (5% in the case
      of
      an acquirer that is a bank holding company) or more of the outstanding Common
      Stock of the Company or otherwise obtaining control or a “controlling influence”
over the Company.





**Regulatory
      Restrictions on Dividends.** It
      is the policy of the Federal Reserve Board that bank holding companies should
      pay cash dividends on common stock only out of income available over the past
      year and only if prospective earnings retention is consistent with the
      organization’s expected future needs and financial condition. The policy
      provides that bank holding companies should not maintain a level of cash
      dividends that undermines the bank holding company’s ability to serve as a
      source of strength to its banking subsidiaries.





**Scope
      of Permissible Activities** .
      Except
      as provided below, the Company is prohibited from acquiring a direct or indirect
      interest in or control of more than 5% of the voting shares of any company
      which
      is not a bank or bank holding company and from engaging directly or indirectly
      in activities other than those of banking, managing or controlling banks or
      furnishing services to its subsidiary banks, except the Company may engage
      in or
      own shares of companies engaged in certain activities found by the Federal
      Reserve Board to be so closely related to banking or managing and controlling
      banks as to be a proper incident thereto. These activities include, among
      others, operating a mortgage, finance, credit card or factoring company;
      performing certain data processing operations; providing investment and
      financial advice; acting as an insurance agent for certain types of
      credit-related insurance; and providing certain stock brokerage and investment
      advisory services. In approving acquisitions or the addition of activities,
      the
      Federal Reserve considers whether the acquisition or the additional activities
      can reasonably be expected to produce benefits to the public, such as greater
      convenience, increased competition, or gains in efficiency, that outweigh
      possible adverse effects such as undue concentration of resources, decreased
      or
      unfair competition or unsound banking practices.





In
      2001,
      the Gramm-Leach-Bliley Act granted certain expanded powers to bank holding
      companies and allowed them to become financial holding companies and thereby
      affiliate with securities firms and insurance companies and engage in other
      activities that are financial in nature. The Gramm-Leach-Bliley Act defines
      “financial in nature” to include securities underwriting, dealing and market
      making; sponsoring mutual funds and investment companies; insurance underwriting
      and agency; merchant banking activities; and activities that the Federal Reserve
      has determined to be closely related to banking. No regulatory approval will
      be
      required for a financial holding company to acquire a company, other than a
      bank
      or savings association, engaged in activities that are financial in nature
      or
      incidental to activities that are financial in nature, as determined by the
      Federal Reserve.





**Stock
      Repurchases.** Bank
      holding companies, except for certain “well-capitalized”
      and highly-rated bank holding companies, such as the Company, are required
      to
      give the Federal Reserve prior written notice of any purchase or redemption
      of
      its outstanding equity securities if the gross consideration for the purchase
      or
      redemption, when combined with the net consideration paid for all such purchases
      or redemptions during the preceding 12 months, is equal




32




to
      10% or
      more of their consolidated net worth. The Federal Reserve may disapprove such
      a
      purchase or redemption if it determines that the proposal would constitute
      an
      unsafe or unsound practice or would violate any law, regulation, Federal Reserve
      order, or any condition imposed by, or written agreement with, the Federal
      Reserve.





**Capital
      Requirements.** The
      Federal Reserve has established capital adequacy guidelines for bank holding
      companies that generally parallel the capital requirements of the FDIC for
      the
      Bank.





The
      Company’s total risk-based capital must equal 8% of risk-weighted assets. As of
      December 31, 2005, the Company’s total risk-based capital to risk-weighted
      assets was 11.2% and its Tier 1 capital to risk-weighted assets was
      10.0%.




**Federal
      and State Taxation**





**Federal
      Taxation**





**General** .
      The
      Company and its subsidiaries report their income on a fiscal year basis using
      the accrual method of accounting and are subject to federal income taxation
      in
      the same manner as other corporations with some exceptions, including
      particularly the Bank’s reserve for bad debts discussed below. The following
      discussion of tax matters is intended only as a summary and does not purport
      to
      be a comprehensive description of the tax rules applicable to the
      Bank.





The
      current thrift bad debt rules were passed by Congress as part of “The Small
      Business
      Job Protection Act of 1996.” The rules adopted a method for deducting additions
      to the tax bad debt reserves for all financial institutions for tax years
      beginning after December 31, 1995. These rules also require that all
      institutions recapture all or a portion of their bad debt reserves added since
      the base year (last taxable year beginning before January 1, 1988). We have
      previously recorded a deferred tax liability equal to the bad debt recapture
      and
      as such the rules will have no effect on the net income or federal income tax
      expense. For taxable years since 1995, the Bank’s bad debt deduction is
      determined on the basis of net charge-offs during the taxable year.





**Minimum
      Tax.** In
      addition to regular corporate income tax, corporations are subject to an
      alternative minimum tax which generally is equal to 20% of alternative minimum
      taxable income (taxable income, increased by tax preference items and adjusted
      for certain regular tax items). The preference items which are generally
      applicable include an amount equal to 75% of the amount by which a financial
      institution’s adjusted current earnings (generally alternative minimum taxable
      income computed without regard to this preference and prior to reduction for
      net
      operating losses) exceed its alternative minimum taxable income without regard
      to this preference and the excess of the institution’s bad debt deduction over
      the amount deductible under the experience method. Alternative minimum tax
      paid
      can be credited against regular tax due in later years.





Our
      federal income tax returns have been audited by the Internal Revenue Service
      through year-end 1991.





**State
      Taxation**





We
      are
      subject to a business and occupation tax, which is imposed under Washington
      law
      at the rate of 1.5% of gross receipts. However, interest received on loans
      secured by first lien mortgages or deeds of trust on residential properties
      is
      not subject to such tax.





Reference
      is made to Note 12, of the “Notes to Consolidated Financial Statements” in the
      Annual Report for additional information regarding income taxes payable by
      the
      Company.




33




**Competition**





Competition
      for deposits comes from securities brokerage firms and other financial
      institutions, many of which have greater resources than we do. In addition,
      during times of low interest rates we experience significant competition for
      investors’ funds from bond mutual funds.





We
      compete for deposits principally by offering depositors a wide variety of
      savings programs, convenient banking center locations, pre-authorized payment
      and withdrawal systems, on-line banking services, tax deferred retirement
      programs, and other miscellaneous services.





Our
      competition for real estate and other loans comes principally from mortgage
      banking companies, savings banks, savings and loan associations, commercial
      banks, insurance companies and other institutional lenders. We compete for
      loan
      originations primarily through the interest rates and loan fees we charge and
      the efficiency and quality of services we provide borrowers, business owners,
      real estate brokers and builders. The competition for loans we encounter, as
      well as the types of institutions with which we compete, varies from time to
      time depending upon certain factors. The conditions that affect competition
      include, among others, the general availability of funds and credit, general
      and
      local economic conditions, current interest rate levels, volatility in the
      mortgage markets and other factors which are not readily
      predictable.





**Employees**





At
      December 31, 2005, we employed 221 full-time and 9 part-time employees. Our
      employees are not represented by any collective bargaining agreement. Management
      considers relations with our employees to be good.




**Item
      1A. Risk Factors.**





The
      following are risks that we view as being among the most significant to our
      operations and financial results. This list should not be considered as an
      all-inclusive assessment of risks, nor should the order in which risks are
      presented below be considered representative of that risk’s significance to our
      operations.





**Interest
      Rates and Other Macroeconomic Factors.** Our
      profitability is largely dependent on our net interest income. Consequently,
      one
      of our primary exposures to risk arises from the interest rate risk inherent
      in
      our lending, mortgage banking, investment, deposit, and borrowing activities.
      Interest rate risk is the risk to earnings and capital resulting from adverse
      movements in interest rates. Please see Item 7A, “Quantitative and Qualitative
      Disclosures about Market Risk,” in Part II for additional information on our
      interest rate risk management practices.





In
      addition to affecting our asset yields and funding costs, and thus our net
      interest income, movements in interest rates can impact our performance in
      other
      ways, including, but not limited to influencing the overall level of loan
      originations and deposit demand, loan payoff rates, and the market values of
      assets, which could affect loan sales and gains thereon, as well as future
      servicing fee income.





While
      we
      actively monitor and manage our exposure to this risk, we would point out that
      interest rates are highly sensitive to factors outside of our control, including
      but not limited to general economic conditions, behaviors of capital market
      participants, and the actions or expected actions of regulatory and government
      agencies, including the Federal Reserve Bank.





Macroeconomic
      factors outside of interest rate movements can further impact our profitability.
      For example, economic downturns can threaten the ability of borrowers to repay
      their loans and reduce collateral values, while rising stock markets can lead
      to
      investors shifting funds out of deposit accounts and into equity
      markets.





34





**Geographic
      Concentration and Local Economic Conditions.** The
      vast
      majority of our funding, lending, and management activities are based in the
      Puget Sound region, primarily on the east side of Lake Washington. Consequently,
      in addition to the potential effects of adverse movements in interest rates
      or
      events in the national economy, our profitability could be disrupted by local
      or
      regional economic factors impacting our market area, including, but not limited
      to local unemployment rates, vacancy rates, and slowdowns in the local housing
      and construction markets.








**Credit
      Risk and Loan Losses Exceeding Allowance.** Credit
      risk is the risk of our borrowers failing to repay the principal and/or interest
      in accordance with the terms of their loan agreements. Our lending operations
      subject us to credit risk, including particular risks pertaining to our
      consumer, custom construction, and non-conforming residential loans., We
      generally manage our credit risk through our underwriting standards and, as
      deemed appropriate, the purchase of credit insurance coverage.





To
      the
      extent that payments are not received from our borrowers in a timely manner,
      their loans are moved to non-accrual status and eventually charged-off. We
      establish, based upon various assumptions and judgments about the collectibility
      of loans, a reserve for loan losses, which could potentially be insufficient
      to
      cover extraordinary losses. To the extent that charged-off loans exceed the
      expected amount set aside for such occurrences, our financial results would
      be
      negatively impacted. Please refer to “Lending Activities,” and “Reserve for Loan
      Losses,” in Part I, Item 1 for additional information.




**Operational
      Risks.** As
      is the
      case with most financial institutions, we are exposed to many forms of
      operational risk, including, but not limited to transaction, compliance,
      strategic, and reputation risks.





Transaction
      risk is defined as the risk to earnings or capital arising from problems with
      service or product delivery. Transaction risk exists in all products and
      services within the bank, and is a function of our internal controls,
      information systems, employee integrity, and operating processes. The risk
      for
      operating problems arises on a daily basis as transactions are processed. Thus,
      transaction risk transcends all of our divisions and all products we
      offer.





Compliance
      risk is the risk to earnings and capital arising from violations of or
      nonconformance with laws, rules, regulations, prescribed practices, or ethical
      standards, and exposes the bank to potential fines, civil money penalties,
      payment of damages, and voiding of contracts. Compliance risk can lead to a
      diminished reputation, limited business opportunities, and lessened expansion
      potential. Compliance risk is not limited solely to risk from failure to comply
      with consumer protection laws, as it also includes all laws as well as prudent
      ethical standards and contractual obligations. In addition, compliance risk
      includes the exposure to litigation from all aspects of banking.





Strategic
      risk is the risk to earnings or capital arising from adverse business decisions
      or improper implementation of those decisions. Strategic risk is a function
      of
      our strategic goals, the business strategies developed to achieve these goals,
      the resources deployed to meet these goals, and how well the strategies are
      implemented. Strategic risk focuses on more than just an analysis of the
      strategic plan. It focuses on how our plans, systems, and implementation affect
      our franchise value, and incorporates how management analyzes external factors
      that impact our strategic direction. Our growth objectives may, to some extent,
      be dependent on the introduction of new products, services, or banking centers.
      As the market reception of new products, services, or facilities can be
      difficult to estimate, and those estimates may change over the course of the
      timeframe during which the product or facility is developed, there can be no
      assurances as to the future development, implementation, and profitability
      of
      such ventures.




Reputation
      risk is the risk to earnings or capital arising from the potential that negative
      publicity regarding our business practices, whether true or not, will cause
      a
      decline in the customer base and/or costly litigation. Reputation risk affects
      our ability to establish new relationships or services and to continue servicing
      existing relationships. The risk can potentially expose us to litigation,
      financial loss, or other damage to our reputation. Reputation risk exposure
      exists




35




throughout
      an organization and is the reason that banks have the responsibility to exercise
      an abundance of caution in dealing with customers and their communities.
      Reputation risk exists in activities such as asset management and agency
      transactions. The assessment of reputation risk recognizes the potential impact
      of the public’s opinion on our franchise value. Reputation risk is inherent in
      all bank activities. As our vulnerability to public reaction increases, our
      ability to offer competitive products and services could potentially be
      affected.





The
      banking industry is subject to rapid technological change and we will need
      to
      keep pace with the evolving technological requirements of the financial services
      industry. Such technological improvement involves substantial cost and risks.
      We
      are dependent on data processing, communication, and information exchange on
      a
      variety of computer platforms and networks, and we cannot be assured that our
      systems are free of defects or vulnerabilities to attack. If informational
      security is breached, information could be lost or misappropriated, resulting
      in
      the potential for financial loss or loss of reputation.





Additionally,
      significant facets of our operations are dependent on a relatively small group
      of experienced key executives and an experienced and very involved Board of
      Directors. Consequently, we believe that the loss of key management personnel
      could potentially result in an adverse effect our operations and
      earnings.





**Increased
      Competition.** We
      operate in a highly competitive environment, with a large and growing number
      of
      other market participants, many of which are significantly larger and possess
      greater financial resources than we do. From time to time, and for various
      reasons, one or more of these competitors may approach the market more
      aggressively, typically through offers of either higher rates on deposits or
      lower margins on loans. In either case, responding to such competitive actions
      will typically result in a negative impact to our financial results, either
      through reduced revenues, higher costs, or, should we decide not to compete
      aggressively, slower growth.





**Potential
      Legislative or Regulatory Changes.** As
      a
      depository institution, we are subject to extensive state and federal
      regulation, supervision, and legislation that govern virtually every aspect
      of
      our operations. These laws and regulations are subject to change over time,
      typically for the increased protection of consumers, depositors, and deposit
      insurance funds. Such changes, which are beyond our control and frequently
      unpredictable, could have the potential to adversely impact our operations
      or
      financial performance.





**Natural
      Disaster.** As
      previously noted, the vast majority of our funding, lending, and management
      activities are based in the Puget Sound region, primarily on the east side
      of
      Lake Washington. This region is known to be a seismic area, and the potential
      exists for a natural disaster, such as an earthquake, to negatively impact
      our
      performance by disrupting our operations, damaging our facilities, or damaging
      facilities owned by our borrowers, thus impacting their activities and ability
      to service debt, as well as potentially reducing the value of our
      collateral.








**Item
      1B. Unresolved Staff Comments.**





None.




36




**Item
      2. Properties.**





The
      following table provides the location of the banking centers and loan offices,
      as well as certain information relating to these offices.


Lease
                  InformationYear
              
              Net
                  Book
              
              Square
              
              Owned
                  /
              
              Initial
              
              Date
                  of
              
              RenewalLocation
              
              Opened
              
              Value
              
              Feet
              
              Leased
              
              Lease
              
              Termination
              
              Terms(Dollars
                  in
                Thousands)Bellevue
                  Banking Center &
              
              
              1985
              
              $
              16,272
              
              
              73,290
              
              
              Owned
              
              
              —
              
              
              —
              
              
              —Corporate
                  Offices (3)400
                  108th Avenue NEBellevue,
                  WA 98004(Originally
                  opened 1953)Issaquah
                  Banking Center
              
              
              1977
              
              
              580
              
              
              2,860
              
              
              Owned
              
              
              —
              
              
              —
              
              
              —855
                  Rainier Blvd. NIssaquah,
                  WA 98027(Originally
                  opened 1965)Monroe
                  Banking Center (3)
              
              
              1993
              
              
              1,060
              
              
              5,373
              
              
              Owned
              
              
              —
              
              
              —
              
              
              —19265
                  State Route 2Monroe,
                  WA 98272(Originally
                  opened 1968)Crossroads
                  Banking Center
              
              
              1969
              
              
              2,201
              
              
              3,894
              
              
              Owned
              
              
              —
              
              
              —
              
              
              —15635
                  NE 8th StreetBellevue,
                  WA 98008Redmond
                  Banking Center &
              
              
              1977
              
              
              1,547
              
              
              6,474
              
              
              Owned
              
              
              —
              
              
              —
              
              
              —Training
                  Center16900
                  Redmond WayRedmond,
                  WA 98052Ballard
                  Banking Center
              
              
              2002
              
              
              1,929
              
              
              2,400
              
              
              Owned
              
              
              —
              
              
              —
              
              
              —6301
                  15th Avenue NWSeattle,
                  WA 98107(Originally
                  opened 1994)West
                  Seattle Banking Center (2)
              
              
              1996
              
              
              1,072
              
              
              2,200
              
              
              Leased
              
              
              March
                  1,
              
              
              May
                  31,
              
              
              Not
                  Renewed4520
                  California Ave. SW
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              1996
              
              
              2006Seattle,
                  WA 98116Bellevue
                  West Banking Center (3)
              
              
              1997
              
              
              2,849
              
              
              8,259
              
              
              Owned
              
              
              —
              
              
              —
              
              
              —10001
                  NE 8th StreetBellevue,
                  WA 98004Kirkland
                  Banking Center
              
              
              2000
              
              
              203
              
              
              3,692
              
              
              Leased
              
              
              September
              
              
              September
              
              
              Two
                  five-278
                  Central Way
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              16,
                  1999
              
              
              16,
                  2009
              
              
              year
                  optionsKirkland,
                  WA 98033Juanita
                  Banking Center
              
              
              2001
              
              
              1,143
              
              
              4,118
              
              
              Owned
              
              
              —
              
              
              —
              
              
              —13633
                  100th Avenue NEKirkland,
                  WA 98034




37




Lease
                  InformationYear
              
              Net
                  Book
              
              Square
              
              Owned
                  /
              
              Initial
              
              Date
                  of
              
              RenewalLocation
              
              Opened
              
              Value
              
              Feet
              
              Leased
              
              Lease
              
              Termination
              
              Terms(Dollars
                  in
                Thousands)Woodinville
                  Banking Center
              
              
              2003
              
              $
              1,695
              
              
              2,893
              
              
              Owned
              
              
              —
              
              
              —
              
              
              —13415
                  NE 175th StreetWoodinville,
                  WA 98072Sammamish
                  Banking Center
              
              
              2003
              
              
              435
              
              
              3,721
              
              
              Leased
              
              
              December
              
              
              December
              
              
              Two
                  five-336
                  - 228th Avenue NE
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              23,
                  2002
              
              
              23,
                  2012
              
              
              year
                  optionsSuite
                  100Sammamish,
                  WA 98074Loan
                  Production OfficesTacoma
                  Loan Office
              
              
              1999
              
              
              (1
              )
              
              300
              
              
              Leased
              
              
              January
                  1,
              
              
              December
                  31,
              
              
              Not
                  Renewed2323
                  N 31st Street
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              1999
              
              
              2005Suite
                  200Tacoma,
                  WA 98403(Originally
                  opened 1996)Bellingham
                  Loan Office
              
              
              2003
              
              
              (1
              )
              
              898
              
              
              Leased
              
              
              February
                  28,
              
              
              February
                  28,
              
              
              Not
                  Renewed1200
                  Tenth Street
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              2003
              
              
              2006Suite
                  103Bellingham,
                  WA 98225(Originally
                  opened 1998)Vancouver
                  Loan Office
              
              
              2005
              
              
              (1
              )
              
              170
              
              
              Leased
              
              
              April
                  1,
              
              
              March
                  31,
              
              
              Not
                  Renewed900
                  Washington Street, #8007
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              2005
              
              
              2006Vancouver,
                  WA 98660Florida
                  Loan Office
              
              
              2001
              
              
              (1
              )
              
              416
              
              
              Leased
              
              
              July
                  6, 2001
              
              
              July
                  31, 2006
              
              
              Year-to-year3015
                  Hartley Road#12B/12CJacksonville,
                  FL 32257
 (1)
        Net
        book values of assets are included with Bellevue Administrative
        offices.
 (2)
        Purchase of land for construction of new West Seattle Banking
        Center.
 (3)
        Includes leasable area.


In
      2005
      we completed the remodel of our Redmond and Bellevue Financial Center Banking
      Centers, as well as constructed an entire new facility for our Crossroads
      Banking Center. In addition, we substantially completed a major upgrade of
      our
      seven-story corporate headquarters. We began construction in 2005 of a
      replacement facility for our West Seattle Banking Center, and we anticipate
      that
      project completion will occur in second quarter, 2006. We are also planning
      to
      construct a new banking center in Bothell, Washington (the “Canyon Park” site)
      and the design and permitting process was substantially completed in 2005.
      We
      anticipate construction will begin on this site in second quarter, 2006 and
      be
      completed prior to year end.





We
      review
      the utilization of our properties on a regular basis and believe that we have
      adequate facilities for current operations. We may open new banking centers
      from
      time-to-time, depending on the availability of capital resources and the
      locations’ potential for growth and profitability.





We
      regularly analyze demographic and geographic data as well as information
      regarding our competitors and our current loan and deposit customers in order
      to
      locate potential future bank sites.





38







**Item
      3. Legal Proceedings.**





At
      December 31, 2005, the Bank was not engaged in any litigation, which in the
      opinion of management, after consultation with its counsel, would be material
      to
      the Company.





**Item
      4. Submission of Matters to a Vote of Security
      Holders.**





No
      matters were submitted to a vote of security holders during the fourth quarter
      of the fiscal year ended December 31, 2005.





**PART
      II**





**Item
      5. Market for Registrant**’**s Common Equity, Related Stockholder
      Matters and Issuer Purchases of Equity Securities.**





The
      information contained under the caption “Stock Information”
      in the Annual Report is incorporated herein by reference.





The
      Company did not sell any unregistered securities during 2005.




The
      following table provides the cash dividends declared by the Company during
      the
      last five fiscal years.





Quarter
                  Ending
              
              Fiscal
                  2005
              
              Fiscal
                  2004
              
              Fiscal
                  2003
              
              Fiscal
                  2002
              
              Fiscal
                  2001Fiscal
                  year
              
              $
              1.38
              
              $
              0.32
              
              $
              0.28
              
              $
              0.28
              
              $
              0.22March
                  31
              
              
              0.09
              
              
              0.07
              
              
              0.07
              
              
              0.07
              
              
              0.05June
                  30
              
              
              0.09
              
              
              0.07
              
              
              0.07
              
              
              0.07
              
              
              0.05September
                  30
              
              
              0.10
              
              
              0.09
              
              
              0.07
              
              
              0.07
              
              
              0.05December
                  31
              
              
              1.10
              
              
              0.09
              
              
              0.07
              
              
              0.07
              
              
              0.07




In
      November 2005 the Company repurchased 144,036 shares from members of Bellevue
      Square Managers Limited Partnership. The shares were repurchased at $25.37
      per
      share which was the average closing price for the 30 most recent days in which
      the stock traded, ending on October 27, 2005.




**Item
      6. Selected Financial Data.**





The
      information contained in the section captioned “Selected
      Financial
      Data” in the Annual Report is incorporated herein by reference.





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





The
      information contained under the section captioned “Management’s
      Discussion and Analysis of Financial Condition and Results of Operations” in the
      Annual Report is incorporated herein by reference.




39




**Item
      7A. Quantitative and Qualitative Disclosures About Market
      Risk.**





The
      information contained in the section captioned “Management’s
      Discussion and Analysis of Financial Condition and Results of Operations --
      Market Risk Sensitive Instruments” in the Annual Report is incorporated herein
      by reference.





**Item
      8. Financial Statements and Supplementary Data.**





The
      financial statements contained in the Annual Report, which are listed under
      Item
      15 herein, are incorporated herein by reference.





The
      following table provides the equity compensation plan
      information.


**Number
                  of**
                **securities
                  to be**
                **issued
                  upon**
                **exercise
                  of**
                **outstanding
                  options**
              
              **Weighted-average**
                **exercise
                  price of**
                **outstanding**
                **options**
              
              **Number
                  of securities**
                **remaining
                  available for**
                **future
                  issuance under**
                **equity
                  compensation**
                **plans
                  (excluding**
                **securities
                  reflected in**
                **(a))**(column
                  a)Equity
                  compensation plans approvedby
                  security holders
              
              
              558,577
              
              $
              17.22
              
              
              614,435Equity
                  compensation plans notapproved
                  by security holders
              
              
              N/A
              
              
              N/A
              
              
              N/ATotal
              
              
              558,577
              
              $
              17.22
              
              
              614,435


**Item
      9. Changes in and Disagreements with Accountants on Accounting and Financial
      Disclosure.**





Not
      applicable.




**Item
      9A. Controls and Procedures.**





**Evaluation
      of Disclosure Controls and Procedures.**





An
      evaluation of the Company’s disclosure controls and procedures (as defined in
      Rules 13a-15(e) of the Securities Exchange Act of 1934 (the “Act”)) was
      carried
      out under the supervision and with the participation of the Company’s Chief
      Executive Officer, Chief Financial Officer, and other members of the Company’s
      senior management, as of the end of the period covered by this report (the
“Evaluation
      Date”).
      Based upon this evaluation, the Company’s Chief Executive Officer and Chief
      Financial Officer concluded that, as of the Evaluation Date, the Company’s
      disclosure controls and procedures are effective in providing reasonable
      assurance that the material information required to be disclosed by the Company
      in the reports it files or submits under the Act is (i) accumulated and
      communicated to the Company’s management (including the Company’s Chief
      Executive Officer and Chief Financial Officer) in a timely manner, and (ii)
      recorded, processed, summarized, and reported within the time periods specified
      in the SEC’s rules and forms.




40




**Management**’**s
      Annual Report on Internal Control over Financial Reporting** :





The
      management of First Mutual Bancshares, Inc. (the Company) is responsible for
      establishing and maintaining an adequate system of internal control over
      financial reporting in order to provide reasonable assurance regarding the
      integrity, reliability and fair presentation of its published financial
      statements and other information presented in the annual report. Pursuant to
      Section 404 of the Sarbanes-Oxley Act of 2002, management assessed the design
      and effectiveness of its internal control for the year ended December 31, 2005,
      based upon the criteria related to internal control over financial reporting
      described in “Internal
      Control--Integrated Framework” issued by the Committee of Sponsoring
      Organizations of the Treadway Commission (COSO). Based on that assessment,
      the
      Company’s management concluded that the Company’s internal control over
      financial reporting was effective as of December 31, 2005.





The
      financial statements have been prepared in accordance with accounting principles
      generally accepted in the United States of America and, as such, include amounts
      based on informed judgments and estimates made by management. Even though
      estimates and judgments are used, we believe we have taken measures to provide
      reasonable assurance of the integrity and reliability of the financial
      information contained in the annual report. These measures include an effective
      control-oriented environment in which the internal audit function plays an
      important role and the Audit Committee of the Board of Directors oversees the
      financial reporting process.





Management’s
      internal control system is augmented by written policies and procedures and
      by
      audits performed by the internal audit staff, which monitor the operations
      of
      the internal control system and report findings to management and the Audit
      Committee. When appropriate, corrective actions are taken to address identified
      control deficiencies and other opportunities for improving the system. However,
      it should be noted that all internal control systems, no matter how well
      designed, have inherent limitations and even those systems determined to be
      effective can provide only reasonable assurance regarding financial statement
      preparation and presentation.





In
      the
      opinion of management, the financial statements and other information in the
      annual report present fairly the financial condition and operations of the
      Company at the dates indicated on such financial reports in conformity with
      accounting principles generally accepted in the United States of
      America.





Our
      independent registered public accounting firm, which audits our financial
      statements, also attested to, and reported on, management’s assessment and on
      the effectiveness of internal control over financial reporting. The independent
      registered public accounting firm’s attestation report is included in this Form
      10-K.




**Item
      9B. Other Information.**





Not
      applicable.




**PART
      III**





**Item
      10. Directors and Executive Officers of the
      Registrant.**





The
      information contained under the section captioned “Election of Directors” in the
      Company’s Proxy Statement is incorporated herein by reference. Reference is made
      to the cover page of this report for information regarding compliance with
      Section 16(a) of the Exchange Act.





The
      following table sets forth certain information with respect to the executive
      officers of the Company and the Bank.


41


Age
                  atDecember
              PositionName
              31,
                  2005
              Company
              BankJohn
                  R. Valaas
              61
              President
                  and Chief Executive
              President
                  and Chief ExecutiveOfficer
              OfficerRoger
                  A. Mandery
              63
              Executive
                  Vice President, Chief
              Executive
                  Vice President - Chief FinancialFinancial
                  Officer, and Treasurer
              Officer,
                  and TreasurerRichard
                  J. Collette
              58
              
              Executive
                  Vice President - CommercialBanking
                  GroupGeorge
                  D. Smeby
              62
              
              Executive
                  Vice President - Chief Risk OfficerJoseph
                  P. Zavaglia
              57
              
              Executive
                  Vice President - Retail BankingGroupScott
                  B. Harlan
              44
              
              Executive
                  Vice President - Residential and Consumer LendingRobin
                  R. Carey
              48
              
              Executive
                  Vice President - Operations andAdministration
                  and Assistant SecretaryKari
                  A. Stenslie
              41
              Senior
                  Vice President, Controller
              Senior
                  Vice President - Controller andand
                  Assistant Treasurer
              Assistant
                  Treasurer





The
      following is a description of the principal occupation and employment of the
      executive officers of the Bank during at least the past five years:





JOHN
      R.
      VALAAS is the President and Chief Executive Officer for the Bank and the
      Company. Prior to his appointment as President of the Bank in 1992, Mr. Valaas
      was Senior Vice President and manager of the Commercial Financial Services
      Division at Seafirst Bank where he was employed from 1983 to 1992. Mr. Valaas
      has over 30 years of experience in commercial banking.





ROGER
      A.
      MANDERY, CPA, is Executive Vice President for the Bank and the Company. Prior
      to
      serving in that capacity, from March 1984 to 1989, he was Senior Vice President
      of Finance. Mr. Mandery serves as the Bank’s Chief Financial Officer and in this
      capacity is responsible for the Bank’s treasury, accounting, internal audit, and
      asset/liability functions.





RICHARD
      J. COLLETTE is the Bank’s Executive Vice President and Manager of its Commercial
      Banking Group. His responsibilities include overseeing commercial real estate
      lending and business banking. Prior to joining the Bank in December of 2001,
      he
      was the Northwest Region’s Senior Credit Risk Management Executive for Bank of
      America where he was employed from 1973 to 2001. Mr. Collette has over 32 years
      of experience in commercial banking.





GEORGE
      D.
      SMEBY is the Bank’s Executive Vice President and Chief Risk Officer. Prior to
      joining the Bank in 2004, he was a Senior Vice President and Senior Credit
      Administrator for the Commercial Banking Group of




42




Bank
      of
      America where he was employed from 1969 to 2004. Mr. Smeby has over 37 years
      of
      experience in commercial banking.





JOSEPH
      P.
      ZAVAGLIA is the Bank’s Executive Vice President of the Retail and Community
      Business Banking Groups. His responsibilities include overseeing the banking
      center distribution network and the community business banking department.
      Prior
      to joining the Bank in February 2003, Mr. Zavaglia was Senior Vice President
      and
      Consumer Market Executive for Bank of America where he was employed from 1975
      to
      2003. Mr. Zavaglia has over 29 years of commercial and retail banking
      experience.





SCOTT
      B.
      HARLAN is the Bank’s Executive Vice President of Consumer and Residential
      Lending and has been employed by the Bank since 1985. He is responsible for
      consumer and residential lending as well as the information systems
      department.





ROBIN
      R.
      CAREY is the Bank’s Executive Vice President of Operations and Administration
      and has been employed by the Bank since 1979. She is responsible for overseeing
      facilities and security, human resources and customer service and support,
      which
      includes lending and deposit support functions.





KARI
      A.
      STENSLIE, CPA, CMA, is Senior Vice President and Controller for the Bank and
      the
      Company and has been employed by the Bank since 1988. She is responsible for
      the
      Bank’s accounting systems, financial reporting, and tax accounting
      functions.




The
      information required by this item in regards to the delinquent filing of a
      Form
      4 is incorporated by reference to the section captioned - “Section 16(a)
      Beneficial Ownership Reporting Compliance” in the Proxy Statement for the
      Company’s 2006 Annual Meeting of Shareholders.





**Item
      11. Executive Compensation.**





The
      information required by this item is incorporated by reference to the section
      captioned - “Executive
      Compensation” in the Proxy Statement for the Company’s 2006 Annual Meeting of
      Shareholders.





**Item
      12. Security Ownership of Certain Beneficial Owners and Management and Related
      Stockholder Matters.**





The
      information required by this item is incorporated herein by reference to the
      sections captioned “Election
      of
      Directors” and “Principal
      Holders
      of Voting Securities and Management” in the Company’s Proxy Statement for the
      Company’s 2006 Annual Meeting of Shareholders.





**Item
      13. Certain Relationships and Related Transactions.**





The
      information required by this item is incorporated by reference to the sections
      captioned “Election
      of
      Directors” and “Board Operations and Corporate Governance” in the Company’s
      Proxy Statement for the Company’s 2006 Annual Meeting of
      Shareholders.





**Item
      14. Principal Accounting Fees and Services.**





The
      information required by this item is incorporated by reference to the section
      captioned “Report of the Audit Committee and Audit Fees” in the Company’s Proxy
      Statement for the Company’s 2006 Annual Meeting of Shareholders.





43





**PART
      IV**





**Item
      15. Exhibits, Financial Statement Schedules.**





(a)
              (1)
            Consolidated
                Financial Statements(*)





Report
                of Independent Registered Public Accounting
                Firm


Consolidated
                Statements of Financial Condition at December 31, 2005 and
                2004


Consolidated
                Statements of Income for the three years ended December 31,
                2005


Consolidated
                Statements of Stockholders’ Equity and Comprehensive Income for the three
                years ended


December
                31, 2005


Consolidated
                Statements of Cash Flows for the three years ended December 31,
                2005


Notes
                to Consolidated Financial
                Statements





(2)
            All
                required financial statement schedules are included in the Notes
                to
                Consolidated Financial Statements.




(3)
            Exhibits





(3)
            a.
                Articles of Incorporation (a)


b.
      Bylaws
      (a)


We
                are parties to certain debt instruments under which the total amount
                of
                securities authorizedmay
                not exceed 10 percent of our total consolidated assets. Pursuant
                to
                paragraph 4(iii)(A) ofItem
                601(b) of Regulation S-K, we agree to furnish a copy of those instruments
                to the Securitiesand
                Exchange Commission upon request.


(11)
            Statement
                regarding computation of per share earnings. Reference is made to
                the
                Company’sConsolidated
                Statements of Income attached hereto as part of Exhibit 13, which
                are
                incorporatedherein
                by reference.


(13)
            2005
                Annual Report to Shareholders


(21)
            Subsidiaries


(23.1)
            Consent
                of Moss Adams LLP, Independent Registered Public Accounting
                Firm


(31.1)
            Certification
                of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley
                Act of 2002


(31.2)
            Certification
                of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley
                Act of 2002


(32.0)
            Certification
                of Chief Executive Officer and Chief Financial Officer Pursuant to
                Section
                906 of theSarbanes-Oxley
                Act of 2002







(*)  Incorporated
      by reference from 2005 Annual Report to Shareholders attached hereto as Exhibit
      13.


(a)  Incorporated
      by reference to the Current Report on Form 8-K filed with the SEC on September
      21, 2000.




44





**SIGNATURES**





Pursuant
      to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
      1934, the registrant has duly caused this report to be signed on its behalf
      by
      the undersigned, thereunto duly authorized.




FIRST
              MUTUAL
              BANCSHARES, INC.DATE:
              March 15, 2006
            By:
            /s/ John
              R.
              ValaasJohn
                R. Valaas, President and Chief Executive
              Officer
                and Duly Authorized Representative




Pursuant
      to the requirements of the Securities
      Exchange Act of 1934, this report has been signed below by the following persons
      on behalf of the Registrant and in the capacities and on the dates
      indicated.




By:/s/
                  Roger A. Mandery
                
                Roger
                  A. Mandery
              By:/s/
                  Victor E. Parker
                Victor
                  E. ParkerPrincipal
                  Financial Officer
              DirectorDate:
                  March 15, 2006
              Date:
                  March 15, 2006By:/s/
                  Kari A. Stenslie
                  
                  Kari
                      A. Stenslie
              By:/s/
                  George W. Rowley, Jr.
                George
                  W. Rowley, Jr.Principal
                  Accounting Officer
              DirectorDate:
                  March 15, 2006
              Date:
                  March 15, 2006By:/s/
                  F. Kemper Freeman, Jr.
                  
                  F.
                      Kemper Freeman, Jr.
              By:/s/
                  Richard S. Sprague
                  
                  Richard
                      S. SpragueChairman
                  of the Board
              DirectorDate:
                  March 15, 2006
              Date:
                  March 15, 2006By:/s/
                  James J. Doud, Jr.
                James
                  J. Doud, Jr.
              By:/s/
                  John R. Valaas
                John
                  R. ValaasDirector
              DirectorDate:
                  March 15, 2006
              Date:
                  March 15, 2006By:/s/
                  Mary Case Dunnam
                Mary
                  Case Dunnam
              By:/s/
                  Robert C. Wallace
                Robert
                  C. WallaceDirector
              DirectorDate:
                  March 15, 2006
              Date:
                  March 15, 2006By:/s/
                  Janine Florence
                Janine
                  Florence
              By:/s/
                  Robert J. Herbold
                Robert
                  J. HerboldDirector
              DirectorDate:
                  March 15, 2006
              Date:
                  March 15, 2006






45