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, 2006





**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
                  filer  x
              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, 2006, there were issued and outstanding 6,648,415 shares of the
      registrant’s common stock. The aggregate market value of the voting stock held
      by non-affiliates of 4,343,330 shares of the registrant was $93,468,461 based
      on
      the closing sales price of the registrant’s common stock as quoted on the Nasdaq
      Market System which on June 30, 2006 was $21.52. (All amounts were adjusted
      for
      the five-for-four stock split paid on October 4, 2006).




As
        of
        February 27, 2007, there were issued and outstanding 6,681,954 shares of
        the
        registrant’s common stock.














**DOCUMENTS
      INCORPORATED BY REFERENCE**




1.
            Certain
                information required by Parts I and II is incorporated by reference
                to the
                Registrant’s Annual Report
                to Shareholders for the fiscal year ended December 31, 2006. 
 2.
            Certain
                information required by Part III incorporated by reference to the
                Registrant’s Proxy Statement dated March 16, 2007 for the 2007 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,”
        “expect,” or similar words may constitute forward-looking statements. 
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 Company’s
        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.
            Submission
                of Matters to a Vote of Security Holders.
            39**Part
                II**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 and Director
                Independence.
            43Item
                14.
            Principal
                Accounting Fees and Services.
            43**Part
                IV**Item
                15.
            Exhibits,
                Financial Statement Schedules.
            44SIGNATURES
            
            45




3


**PART
      I**


**Item
        1. Business.**
 
 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 “Banky). 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 (“FDICy). The Company
        is subject to regulation by the Federal Reserve Board.
 
 Our
        business consists of attracting deposits from the general public and small
        to
        medium size businesses 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 (“FHLBy) 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 consumer
        loan offices located in Orange Park, Florida and Mt. Clemens,
        Michigan. Our
        corporate office is located at 400 108th Avenue N.E., Bellevue, Washington
        98004. See “Item 2. - Propertiesy 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
  4
 structure
        of the Bank and is not necessarily comparable with similar information for
        any
        other financial institution.
 
 The
        reportable segments include the following:
 
 ·
            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 to build homes secured by one-to-four-unit family dwellings.
                It also finances 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 single-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 2006 Annual Report and Note 20 - “Segments” 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 spready) 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, 2006, our portfolio of loans consisted of 80% adjustable-rate
        and
        20% 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 Activitiesy in this Form 10-K and
“Market Risk Sensitive Instrumentsy in the “MD&A” section of the 2006 Annual
        Report.
  5
 **AVERAGE
        BALANCE SHEET**


The
      following table presents, for the periods indicated, information regarding
      average balances of assets and liabilities as well as the total dollar amounts
      of interest income from average
      interest-earning assets and interest expense on average interest-bearing
      liabilities, resulting interest rate spread, and ratios of interest-earning
      assets to interest-bearing liabilities.
      Averages are calculated using monthly averages. We follow the practice of
      stopping interest accruals on loans past due 90 days and over unless it is
      reasonably believed
      that all principal and interest due on the loan will be fully recovered.
      Interest income on tax-free municipal bonds is not shown on a tax-equivalent
      basis.




At
                December 31,2006
            
            2006
            
            2005
            
            2004Balance
            
            Average
                Yield/Cost
            
            Average
                Balance
            
            Interest
            
            Average
                Yield/Cost
            
            Average
                Balance
            
            Interest
            
            Average
                Yield/Cost
            
            Average
                Balance
            
            Interest
            
            Average
                Yield/CostInterest-earning
                assets:
            
            (Dollars
                in thousands)Loans
                receivable, net
            
            $
            897,436
            
            
            8.01
            %
            $
            905,302
            
            $
            74,847
            
            
            8.27
            %
            $
            847,495
            
            $
            61,624
            
            
            7.27
            %
            $
            782,566
            
            $
            50,195
            
            
            6.41
            %Mortgage-backed
                securities
            
            
            83,204
            
            
            4.29
            %
            
            91,259
            
            
            4,051
            
            
            4.44
            %
            
            108,604
            
            
            4,621
            
            
            4.25
            %
            
            100,116
            
            
            3,865
            
            
            3.86
            %Municipal
                securities
            
            
            1,144
            
            
            6.13
            %
            
            1,158
            
            
            78
            
            
            6.74
            %
            
            1,197
            
            
            79
            
            
            6.60
            %
            
            1,252
            
            
            80
            
            
            6.39
            %FHLB
                stock
            
            
            13,122
            
            
            0.01
            %
            
            13,122
            
            
            13
            
            
            0.10
            %
            
            13,057
            
            
            53
            
            
            0.41
            %
            
            12,200
            
            
            339
            
            
            2.78
            %US
                securities
            
            
            10,829
            
            
            4.05
            %
            
            12,619
            
            
            518
            
            
            4.10
            %
            
            17,971
            
            
            642
            
            
            3.57
            %
            
            14,585
            
            
            504
            
            
            3.46
            %Short-term
                investments and other
            
            
            6,990
            
            
            5.15
            %
            
            3,856
            
            
            665
            
            
            3.92
            %
            
            2,620
            
            
            344
            
            
            1.64
            %
            
            1,703
            
            
            144
            
            
            0.70
            %Total
                interest-earning assets
            
            
            1,012,725
            
            
            7.53
            %
            
            1,027,316
            
            
            80,172
            
            
            7.81
            %
            
            990,944
            
            
            67,363
            
            
            6.80
            %
            
            912,422
            
            
            55,127
            
            
            6.04
            %Noninterest-earning
                assets
            
            
            66,538
            
            
            
            
            
            55,398
            
            
            
            
            
            
            
            
            54,030
            
            
            
            
            
            
            
            
            19,892Total
                assets
            
            $
            1,079,263
            
            
            
            
            $
            1,082,714
            
            
            
            
            
            
            
            $
            1,044,974
            
            
            
            
            
            
            
            $
            932,314Interest-bearing
                liabilities:Deposits
            
            $
            750,435
            
            
            3.80
            %
            $
            719,151
            
            $
            26,910
            
            
            3.74
            %
            $
            674,413
            
            $
            18,191
            
            
            2.70
            %
            $
            606,036
            
            $
            12,292
            
            
            2.03
            %Long-term
                debentures (TPS)
            
            
            17,000
            
            
            7.82
            %
            
            17,000
            
            
            1,330
            
            
            7.82
            %
            
            17,000
            
            
            1,172
            
            
            6.89
            %
            
            17,000
            
            
            1,002
            
            
            5.89
            %FHLB
                and other advances
            
            
            176,533
            
            
            4.98
            %
            
            228,196
            
            
            11,832
            
            
            5.19
            %
            
            239,315
            
            
            7,817
            
            
            3.27
            %
            
            230,021
            
            
            5,799
            
            
            2.52
            %Total
                interest-bearing liabilities
            
            
            943,968
            
            
            4.09
            %
            
            964,347
            
            
            40,072
            
            
            4.16
            %
            
            930,728
            
            
            27,180
            
            
            2.92
            %
            
            853,057
            
            
            19,093
            
            
            2.24
            %Noninterest-bearing
                  liabilities - deposits and other
            
            
            65,274
            
            
            
            
            
            53,343
            
            
            
            
            
            
            
            
            54,509
            
            
            
            
            
            
            
            
            24,120Total
                liabilities
            
            
            1,009,242
            
            
            
            
            
            1,017,690
            
            
            
            
            
            
            
            
            985,237
            
            
            
            
            
            
            
            
            877,177Shareholders’
                equity
            
            
            70,021
            
            
            
            
            
            65,024
            
            
            
            
            
            
            
            
            59,737
            
            
            
            
            
            
            
            
            55,137Total
                liabilities and shareholders’ equity
            
            $
            1,079,263
            
            
            
            
            $
            1,082,714
            
            
            
            
            
            
            
            $
            1,044,974
            
            
            
            
            
            
            
            $
            932,314Net
                interest income
            
            
            
            
            
            
            
            
            
            
            $
            40,100
            
            
            
            
            
            
            
            $
            40,183
            
            
            
            
            
            
            
            $
            36,034Ratio
                  of average interest-earning assets to average interest-bearing
                  liabilities
            
            
            
            
            
            
            
            
            1.07x
            
            
            
            
            
            
            
            
            1.07x
            
            
            
            
            
            
            
            
            1.06xInterest
                rate spread
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            3.65
            %
            
            
            
            
            
            
            
            3.88
            %
            
            
            
            
            
            
            
            3.80
            %Net
                  yield (net interest income as a percentage of average interest-earning
                  assets)
            
            
            
            
            
            
            
            
            
            
            
            3.90
            %
            
            
            
            
            
            
            
            4.06
            %
            
            
            
            
            
            
            
            3.95
            %Amortized
                loan fees included in loan receivable interest income
            
            
            
            
            
            
            
            
            
            
            $
            1,309
            
            
            
            
            
            
            
            $
            599
            
            
            
            
            
            
            
            $
            516




6


**Rate
      Volume Analysis**





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




**Lending
      Activities**





**General** .
      Our
      loan portfolio totaled $897.4 million at December 31, 2006 (loans held-for-sale
      totaled $13.7 million of this amount). On that date before deductions (see
      Note
      5 - “Loans Receivable, Net and Loans Receivable Held-for-Sale” to the
      Consolidated Financial Statements for additional information), $264.3 million,
      or 26%, of total outstanding loans consisted of loans secured by
      one-to-four-unit residential properties; $138.3 million, or 14%, consisted
      of
      loans secured by mortgages on over-four-unit residential properties;
      construction loans constituted $235.1 million, or 24%; $163.3 million, or 16%,
      consisted of commercial real estate loans; $99.7 million, or 10%, consisted
      of
      consumer loans; and $96.0 million, or 10%, 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 $546.2 million and $526.0 million for the years ended December
      31, 2006 and 2005, respectively, and $469.7 million for the year ended December
      31, 2004.





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, 2006, $717.4 million, or 80%, 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 $204.3 million
      in residential mortgage loans with rates adjustable at periods ranging from
      one
      to five years, $338.6 million in business loans and loans secured by
      income-producing and multifamily residential properties, $147.8 million in
      net
      construction loans, and $26.7 million in consumer loans.





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.




7




As
                  of December 31,2006
              
              2005
              
              2004
              
              2003
              
              2002Amount
              
              Percent
              
              Amount
              
              Percent
              
              Amount
              
              Percent
              
              Amount
              
              Percent
              
              Amount
              
              Percent(Dollars
                  in thousands)Type
                  of loan:Real
                  estate loans:Interim
                  construction loans
              
              $
              235,112
              
              
              26.20
              %
              $
              248,283
              
              
              28.13
              %
              $
              184,064
              
              
              22.74
              %
              $
              163,309
              
              
              22.52
              %
              $
              107,266
              
              
              17.10
              %Loans
                  on existing property
              
              
              354,488
              
              
              39.50
              %
              
              359,059
              
              
              40.66
              %
              
              379,054
              
              
              46.83
              %
              
              299,401
              
              
              41.26
              %
              
              270,947
              
              
              43.18
              %Loans
                  refinanced
              
              
              211,521
              
              
              23.57
              %
              
              210,576
              
              
              23.86
              %
              
              180,115
              
              
              22.26
              %
              
              228,726
              
              
              31.53
              %
              
              219,125
              
              
              34.93
              %Insured
                  or guaranteed real estate loans
              
              
              —
              
              
              0.00
              %
              
              —
              
              
              0.00
              %
              
              —
              
              
              0.00
              %
              
              —
              
              
              0.00
              %
              
              103
              
              
              0.02
              %Consumer
                  loans and other
              
              
              99,657
              
              
              11.10
              %
              
              115,941
              
              
              13.14
              %
              
              94,776
              
              
              11.71
              %
              
              85,243
              
              
              11.75
              %
              
              57,627
              
              
              9.19
              %Business
                  lines of credit
              
              
              95,955
              
              
              10.69
              %
              
              67,223
              
              
              7.62
              %
              
              52,963
              
              
              6.54
              %
              
              20,089
              
              
              2.77
              %
              
              14,683
              
              
              2.34
              %Less:Undisbursed
                  loan proceeds
              
              
              (87,602
              )
              
              (9.76
              %)
              
              (109,568
              )
              
              (12.41
              %)
              
              (73,423
              )
              
              (9.07
              %)
              
              (64,140
              )
              
              (8.84
              %)
              
              (34,528
              )
              
              (5.50
              %)Reserve
                  for loan and lease losses
              
              
              (9,728
              )
              
              (1.08
              %)
              
              (10,069
              )
              
              (1.14
              %)
              
              (9,301
              )
              
              (1.15
              %)
              
              (8,406
              )
              
              (1.16
              %)
              
              (7,754
              )
              
              (1.24
              %)Unearned
                  discount on purchased leases
              
              
              (2,300
              )
              
              (0.22
              %)
              
              (44
              )
              
              0.00
              %
              
              —
              
              
              0.00
              %
              
              —
              
              
              0.00
              %
              
              —
              
              
              0.00
              %Net
                  deferred loan (fees)/costs
              
              
              333
              
              
              0.00
              %
              
              1,280
              
              
              0.15
              %
              
              1,158
              
              
              0.14
              %
              
              1,226
              
              
              0.17
              %
              
              (150
              )
              
              (0.02
              %)Total
              
              $
              897,436
              
              
              100.00
              %
              $
              882,681
              
              
              100.00
              %
              $
              809,406
              
              
              100.00
              %
              $
              725,448
              
              
              100.00
              %
              $
              627,319
              
              
              100.00
              %As
                  of December 31,2006
              
              
              2005
              
              
              2004
              
              
              2003
              
              
              2002Amount
              
              
              Percent
              
              
              Amount
              
              
              Percent
              
              
              Amount
              
              
              Percent
              
              
              Amount
              
              
              Percent
              
              
              Amount
              
              
              Percent(Dollars
                  in thousands)Type
                  of security:Residential:One-to-four
                  family
              
              $
              264,333
              
              
              29.45
              %
              $
              223,928
              
              
              25.37
              %
              $
              177,322
              
              
              21.91
              %
              $
              131,682
              
              
              18.15
              %
              $
              93,208
              
              
              14.86
              %Multifamily
              
              
              138,351
              
              
              15.42
              %
              
              153,988
              
              
              17.43
              %
              
              176,429
              
              
              21.80
              %
              
              184,919
              
              
              25.49
              %
              
              177,621
              
              
              28.31
              %Construction
              
              
              235,112
              
              
              26.20
              %
              
              248,283
              
              
              28.13
              %
              
              184,064
              
              
              22.74
              %
              
              163,309
              
              
              22.51
              %
              
              107,266
              
              
              17.10
              %Commercial
                  real estate
              
              
              163,325
              
              
              18.20
              %
              
              191,719
              
              
              21.72
              %
              
              205,418
              
              
              25.38
              %
              
              211,526
              
              
              29.16
              %
              
              219,346
              
              
              34.97
              %Consumer
                  loans and other
              
              
              99,657
              
              
              11.10
              %
              
              115,941
              
              
              13.14
              %
              
              94,776
              
              
              11.71
              %
              
              85,243
              
              
              11.75
              %
              
              57,627
              
              
              9.19
              %Business
                  lines of credit
              
              
              95,955
              
              
              10.69
              %
              
              67,223
              
              
              7.62
              %
              
              52,963
              
              
              6.54
              %
              
              20,089
              
              
              2.77
              %
              
              14,683
              
              
              2.34
              %Less:Undisbursed
                  loan proceeds
              
              
              (87,602
              )
              
              (9.76
              %)
              
              (109,568
              )
              
              (12.41
              %)
              
              (73,423
              )
              
              (9.07
              %)
              
              (64,140
              )
              
              (8.84
              %)
              
              (34,528
              )
              
              (5.50
              %)Reserve
                  for loan and lease losses
              
              
              (9,728
              )
              
              (1.08
              %)
              
              (10,069
              )
              
              (1.14
              %)
              
              (9,301
              )
              
              (1.15
              %)
              
              (8,406
              )
              
              (1.16
              %)
              
              (7,754
              )
              
              (1.24
              %)Unearned
                  discount on purchased leases
              
              
              (2,300
              )
              
              (0.22
              %)
              
              (44
              )
              
              (0.00
              %)
              
              —
              
              
              0.00
              %
              
              —
              
              
              0.00
              %
              
              —
              
              
              0.00
              %Net
                  deferred loan (fees)/costs
              
              
              333
              
              
              0.00
              %
              
              1,280
              
              
              0.15
              %
              
              1,158
              
              
              0.14
              %
              
              1,226
              
              
              0.17
              %
              
              (150
              )
              
              (0.02
              %)Total
              
              $
              897,436
              
              
              100.00
              %
              $
              882,681
              
              
              100.00
              %
              $
              809,406
              
              
              100.00
              %
              $
              725,448
              
              
              100.00
              %
              $
              627,319
              
              
              100.00
              %


**Loan
      Maturity.** The
      following table sets forth certain information at December 31, 2006, 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 and lease 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
            
            $
            147,510
            
            $
            —
            
            $
            —
            
            $
            —
            
            $
            —
            
            $
            147,510Loans
                on existing property
            
            
            146,121
            
            
            66,328
            
            
            77,507
            
            
            49,849
            
            
            14,683
            
            
            354,488Loans
                refinanced
            
            
            87,264
            
            
            39,503
            
            
            46,248
            
            
            29,745
            
            
            8,761
            
            
            211,521Consumer
                loans and other
            
            
            33,058
            
            
            2,020
            
            
            5,340
            
            
            37,939
            
            
            21,300
            
            
            99,657Business
                loans
            
            
            55,128
            
            
            17,687
            
            
            22,219
            
            
            803
            
            
            118
            
            
            95,955Total
                Loans
            
            $
            469,081
            
            $
            125,538
            
            $
            151,314
            
            $
            118,336
            
            $
            44,862
            
            $
            909,131





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
      and
      lease losses.


Due
                  Within One-Year
              
              Due
                  After One-YearAdjustable
              
              
              
              
              
              AdjustableFixed
                  Rate
              
              Rate
              
              Total
              
              Fixed
                  Rate
              
              Rate
              
              Total(Dollars
                  in thousands)Mortgage
                  loans
              
              $
              2,239
              
              $
              378,655
              
              $
              380,894
              
              $
              72,411
              
              $
              260,213
              
              $
              332,624Consumer
                  loans
              
              
              6,107
              
              
              26,952
              
              
              33,059
              
              
              66,599
              
              
              —
              
              
              66,599Business
                  loans
              
              
              47
              
              
              55,081
              
              
              55,128
              
              
              35,743
              
              
              5,084
              
              
              40,827Total
              
              $
              8,393
              
              $
              460,688
              
              $
              469,081
              
              $
              174,753
              
              $
              265,297
              
              $
              440,050





**Residential
      Loans** .
      At
      December 31, 2006, approximately 40% of the total loan portfolio, including
      loans held-for-sale and 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%.





Mortgage
      loan originations are generally long-term loans, amortized on a monthly basis,
      with principal and interest due each month. The 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 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.




9


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 3% 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 8% 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/or 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 $295 million at December 31, 2006. That figure compares
      to
      $327 million at year-end 2005.





At
      December 31, 2006, commercial real estate loans (excluding multifamily and
      construction loans) constituted $130 million of the loan portfolio as compared
      to $139 million at the end of 2005. 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 income property permanent 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, 2006, the largest multifamily loan was for $5.6 million. As of December 31, 2006,
        multifamily loans were $137 million of the loan portfolio as compared to
        $165 million in 2005.





**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 2006, total business banking loans grew to $145 million compared
      to
      $116 million the previous year. Non-real-estate business loans included in
      those
      totals were $94 million and $67 million at December 31, 2006 and 2005,
      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 $101 million at December 31, 2006, compared to $117
      million the previous year. Included in that total are sales finance loans
      totaling $73 million and $87 million at year-end 2006 and 2005 respectively.





The
      Sales
      Finance Department purchases consumer financing contracts from approved dealers
      in 45 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
      satellite sales finance offices located in Orange Park, Florida and Mt. Clemens,
      Michigan. Our employees based out of these offices work with contractors in
      the
      eastern and midwestern 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. Loans originated for sale in the secondary
      market are unsecured. The loans are sold non-recourse to various institutional
      purchasers.





11


In
      previous years to mitigate losses, we 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.





During
      2006, after evaluating our use of credit insurance, we concluded that the
      benefits of the insurance on sales finance loans no longer outweighed the costs
      and chose to forego the insurance and assume the credit risk on future sales
      finance loan production. Loans insured prior to August 1, 2006 will remain
      insured under previous policies. Some sales finance loans originated on or
      after
      August 1, 2006 were sold to institutional investors with insurance placed prior
      to sale. These loans were insured under the new policy effective August 1,
      2006.
      All other sales finance loans originated on or after August 1, 2006 will not
      be
      insured.





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,
      2006, consumer loans past due 90 days or more totaled $507,000 as compared
      to
      $574,000 at year-end 2005.




**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 84%
      of
      all residential loans closed during the year ended December 31, 2006, were
      obtained through mortgage brokers as compared to 89% during 2005. We also
      purchase retail installment contracts from home improvement dealers and
      contractors in 45 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.





12


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, O’Rourke, 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 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 banking 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 2006 to $546 million from $526 million in 2005, and
      the comparable figure for 2004 was $470 million. The increase in originations
      came largely from business banking loan closings which increased from $44
      million in 2005 to $85 million in 2006.





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, 2006, we serviced loans for others aggregating approximately
      $155 million as compared to $106 million in 2005. Net loan servicing fees
      totaled $1.3 million for the years ended December 31, 2006, and December 31,
      2005.





Currently,
      some residential, commercial, and sales finance loans are being originated
      for
      sale and sold to investors. During the year ended December 31, 2006, we sold
      $49
      million in residential loans, $59 million in sales finance loans, and $30
      million in commercial loans as compared to $38 million in residential, $18
      million in sales finance loans, and $11 million in commercial loans during
      2005.





13


Set
        forth
        below is a table showing our loan origina-tion and sales activity for the
        periods indicated.
  Years
                  Ended December 31,2006
              
              2005
              
              2004(Dollars
                  in thousands)Total
                  loans at beginning of period (net of undisbursed loan
                  proceeds)
              
              $
              891,513
              
              $
              817,549
              
              $
              732,628Loans
                  originated:Real
                  estate loans:Construction
                  loans
              
              
              212,988
              
              
              241,401
              
              
              170,824Loans
                  on existing property
              
              
              185,403
              
              
              163,682
              
              
              87,519Loans
                  refinanced
              
              
              62,655
              
              
              39,798
              
              
              62,021Consumer
                  and other loans
              
              
              85,173
              
              
              81,100
              
              
              149,353Total
                  loans originated
              
              
              546,219
              
              
              525,981
              
              
              469,717Principal
                  reductions
              
              
              (390,500
              )
              
              (384,805
              )
              
              (280,831
              )Loans
                  sold:Whole
                  loans
              
              
              (49,403
              )
              
              (30,841
              )
              
              (35,787
              )Participation
                  loans
              
              
              (88,698
              )
              
              (36,371
              )
              
              (68,178
              )Total
                  loans sold
              
              
              (138,101
              )
              
              (67,212
              )
              
              (103,965
              )Total
                    loans at end of period (net of undisbursed loan
                    proceeds)
              
              $
              909,131
              
              $
              891,513
              
              $
              817,549





**Loan
      Commitments.** Our
      commitments to make mortgage loans on existing residential dwellings are
      generally made for periods of 30 to 60 days. The borrower may reserve
      (“lock-iny) 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 $283.1 million at
      December 31, 2006 and $315.5 million at year-end 2005.





**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 - “Summary of Significant Accounting Policies” in the Notes to
      Consolidated Financial Statements in the 2006 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-saley until such time as it is sold or
      otherwise disposed. At December 31, 2006, the total of non-performing loans,
      repossessed assets, and real estate acquired through foreclosure was $3.5
      million as compared to $897,000 at year-end 2005.




14







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


As
                  of December 31,2006
              
              2005
              
              2004(Dollars
                  in thousands)Nonaccrual
                  loans
              
              $
              3,462
              
              $
              897
              
              $
              1,004Other
                    assets and real estate acquired through foreclosure
              
              
              —
              
              
              —
              
              
              3Total
                  non-performing assets
              
              $
              3,462
              
              $
              897
              
              $
              1,007As
                  a percentage of loans
              
              
              0.39
              %
              
              0.10
              %
              
              0.12
              %As
                  a percentage of total assets
              
              
              0.32
              %
              
              0.08
              %
              
              0.10
              %Gross
                      interest income that would have been recorded in the period
                      if loans had
                      been current with original terms
              
              $
              361
              
              $
              91
              
              $
              81Interest
                    income on loans included in net income for the
                    period
              
              $
              286
              
              $
              62
              
              $
              44





There
      were four impaired loans totaling $1.0 million (net of impairment allowances)
      at
      year end 2006 and two impaired loans totaling $136,170 (net of impairment
      allowances) at year end 2005, respectively. The amount of impairment totaled
      $236,000 for 2006 and $172,000 for 2005.





**Reserve
      for Loan and Lease Losses**





The
      reserve for loan and lease losses is maintained at a level sufficient to provide
      for probable 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 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
      determination of the level of reserves, and thus any additional provision,
      is
      arrived at through a process that begins with the Asset Management Department,
      which analyzes the loan portfolio from a historical loss perspective and a
      composition and geographic concentration viewpoint. The Asset Management
      Department then prepares an economic analysis of the Puget Sound region that
      includes, when appropriate, employment forecasts, housing sales, vacancy rates,
      and commercial real estate analysis. That information is then reviewed by our
      Loan Policy Committee, and Chief Risk Officer who makes a recommendation as
      to
      the loan loss provision to the Audit Committee of the Board of Directors. The
      Audit Committee considers the input and recommendations of the Asset Management
      Department, the Loan Policy Committee, and the Chief Risk Officer, and
      determines the appropriate level of reserves. The Board of Directors reviews
      the
      actions of the Audit Committee. 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, 2006, the reserve for loan and lease losses totaled
      $9.7 million which compares to $10.1 million at December 31, 2005. During 2006
      we reclassified $326,000 from the reserve for loan and lease losses and set
      up a
      liability for unfunded commitments which is located in “accounts payable and
      other liabilities” on the balance sheet.




15


While
      we
      believe we have established our existing reserve for loan and lease losses
      in
      accordance with accounting principles generally accepted in the United States of America as of December 31, 2006,
      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
      and
      lease 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 and lease
      losses for the periods indicated.


Years
                  Ended December 31,2006
              
              2005
              
              2004
              
              2003
              
              2002(Dollars
                  in thousands)Balance
                  at beginning of period
              
              $
              10,069
              
              $
              9,300
              
              $
              8,406
              
              $
              7,754
              
              $
              7,032Charge-offs:Residential
              
              
              (375
              )
              
              —
              
              
              (172
              )
              
              —
              
              
              —Commercial
                  and multifamily
              
              
              —
              
              
              —
              
              
              (1
              )
              
              —
              
              
              (6
              )Business
              
              
              (323
              )
              
              (273
              )
              
              (101
              )
              
              (174
              )
              
              (42
              )Consumer
                  and other
              
              
              (885
              )
              
              (773
              )
              
              (640
              )
              
              (466
              )
              
              (223
              )Total
                  charge-offs
              
              
              (1,583
              )
              
              (1,046
              )
              
              (914
              )
              
              (640
              )
              
              (271
              )Recoveries:Residential
              
              
              281
              
              
              4
              
              
              —
              
              
              —
              
              
              —Business
              
              
              14
              
              
              26
              
              
              25
              
              
              —
              
              
              8Consumer
                  and other
              
              
              308
              
              
              285
              
              
              218
              
              
              142
              
              
              75Total
                  recoveries
              
              
              603
              
              
              315
              
              
              243
              
              
              142
              
              
              83Provision
                  for loan and lease losses
              
              $
              965
              
              $
              1,500
              
              $
              1,565
              
              $
              1,150
              
              $
              910Subtotal
              
              
              10,054
              
              
              10,069
              
              
              9,300
              
              
              8,406
              
              
              7,754Amount
                    reclassified for unfunded commitments
              
              
              (326
              )
              
              —
              
              
              —
              
              
              —
              
              
              —Balance,
                  end of year
              
              $
              9,728
              
              $
              10,069
              
              $
              9,300
              
              $
              8,406
              
              $
              7,754Ratio
                    of net charge-offs to average loans outstanding
              
              
              0.11
              %
              
              0.09
              %
              
              0.08
              %
              
              0.07
              %
              
              0.03
              %





**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 31,2006
                  
                  2005**Available-for-sale:**
                  
                  Carrying
                      Value
                  
                  Percent
                      of Total
                  
                  Carrying
                      Value
                  
                  Percent
                      of Total(Dollars
                      in thousands)US
                      government treasury and agency obligations
                  
                  $
                  10,829
                  
                  
                  12
                  %
                  $
                  17,988
                  
                  
                  16
                  %Mortgage-backed
                      securities:Freddie
                      Mac
                  
                  
                  14,101
                  
                  
                  16
                  %
                  
                  16,110
                  
                  
                  14
                  %Ginnie
                      Mae
                  
                  
                  33,658
                  
                  
                  37
                  %
                  
                  43,122
                  
                  
                  38
                  %Fannie
                      Mae
                  
                  
                  31,140
                  
                  
                  35
                  %
                  
                  37,230
                  
                  
                  32
                  %Total
                      mortgage-backed securities
                  
                  
                  78,899
                  
                  
                  88
                  %
                  
                  96,462
                  
                  
                  84
                  %Total
                      available-for-sale securities
                  
                  $
                  89,728
                  
                  
                  100
                  %
                  $
                  114,450
                  
                  
                  100
                  %At
                      December 31,2006
                  
                  
                  2005**Held-to-maturity:**
                  
                  
                  Carrying
                      Value
                  
                  
                  Percent
                      of Total
                  
                  
                  Carrying
                      Value
                  
                  
                  Percent
                      of Total(Dollars
                      in thousands)Municipal
                      bonds
                  
                  $
                  1,144
                  
                  
                  20
                  %
                  $
                  1,188
                  
                  
                  17
                  %Mortgage-backed
                      securities:Freddie
                      Mac
                  
                  
                  300
                  
                  
                  6
                  %
                  
                  433
                  
                  
                  6
                  %Fannie
                      Mae
                  
                  
                  4,176
                  
                  
                  74
                  %
                  
                  5,345
                  
                  
                  77
                  %Total
                      mortgage-backed securities
                  
                  
                  4,476
                  
                  
                  80
                  %
                  
                  5,778
                  
                  
                  83
                  %Total
                      held-to-maturity securities
                  
                  $
                  5,620
                  
                  
                  100
                  %
                  $
                  6,966
                  
                  
                  100
                  %Estimated
                      market value
                  
                  $
                  5,585
                  
                  
                  
                  
                  $
                  6,971
  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, 2006.
 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
                
                $
                4,965
                
                
                4.00
                %
                $
                5,864
                
                
                4.08
                %
                $
                —
                
                
                0.00
                %
                $
                —
                
                
                0.00
                %
                $
                —
                
                
                0.00
                %
                $
                —
                
                
                0.00
                %
                $
                10,829
                
                
                4.04
                %Mortgage-backed
                    securities:Ginnie
                    Mae
                
                
                25,258
                
                
                4.07
                %
                
                8,400
                
                
                4.00
                %
                
                —
                
                
                0.00
                %
                
                —
                
                
                0.00
                %
                
                —
                
                
                0.00
                %
                
                —
                
                
                0.00
                %
                
                33,658
                
                
                4.05
                %Freddie
                    Mac
                
                
                274
                
                
                7.13
                %
                
                1,696
                
                
                4.04
                %
                
                5,731
                
                
                4.09
                %
                
                —
                
                
                0.00
                %
                
                6,400
                
                
                4.50
                %
                
                —
                
                
                0.00
                %
                
                14,101
                
                
                4.33
                %Fannie
                    Mae
                
                
                201
                
                
                6.95
                %
                
                3,648
                
                
                4.85
                %
                
                3,077
                
                
                4.11
                %
                
                —
                
                
                0.00
                %
                
                24,214
                
                
                4.29
                %
                
                —
                
                
                0.00
                %
                
                31,140
                
                
                4.36
                %Total
                    mortgage-backed securities
                
                
                25,733
                
                
                4.13
                %
                
                13,744
                
                
                4.23
                %
                
                8,808
                
                
                4.10
                %
                
                —
                
                
                0.00
                %
                
                30,614
                
                
                4.33
                %
                
                —
                
                
                0.00
                %
                
                78,899
                
                
                4.22
                %Total
                    carrying value
                
                $
                30,698
                
                
                4.11
                %
                $
                19,608
                
                
                4.19
                %
                $
                8,808
                
                
                4.10
                %
                $
                —
                
                
                0.00
                %
                $
                30,614
                
                
                4.33
                %
                $
                —
                
                
                0.00
                %
                $
                89,728
                
                
                4.20
                %Total
                    amortized cost
                
                $
                30,943
                
                
                4.10
                %
                $
                19,942
                
                
                4.18
                %
                $
                9,138
                
                
                4.10
                %
                $
                —
                
                
                0.00
                %
                $
                31,899
                
                
                4.33
                %
                $
                —
                
                
                0.00
                %
                $
                91,922
                
                
                4.20
                %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
                %
                $
                924
                
                
                6.31
                %
                $
                1,144
                
                
                6.13
                %Mortgage-backed
                    securities:Freddie
                    Mac
                
                
                300
                
                
                6.88
                %
                
                —
                
                
                0.00
                %
                
                —
                
                
                0.00
                %
                
                —
                
                
                0.00
                %
                
                —
                
                
                0.00
                %
                
                —
                
                
                0.00
                %
                
                300
                
                
                6.88
                %Fannie
                    Mae
                
                
                1,333
                
                
                7.10
                %
                
                1,291
                
                
                4.25
                %
                
                —
                
                
                0.00
                %
                
                —
                
                
                0.00
                %
                
                1,552
                
                
                4.78
                %
                
                —
                
                
                0.00
                %
                
                4,176
                
                
                5.36
                %Total
                    mortgage-backed securities
                
                
                1,633
                
                
                7.06
                %
                
                1,291
                
                
                4.25
                %
                
                —
                
                
                0.00
                %
                
                —
                
                
                0.00
                %
                
                1,552
                
                
                4.78
                %
                
                —
                
                
                0.00
                %
                
                4,476
                
                
                5.46
                %Total
                    carrying value
                
                $
                1,633
                
                
                7.06
                %
                $
                1,291
                
                
                4.25
                %
                $
                —
                
                
                0.00
                %
                $
                —
                
                
                0.00
                %
                $
                1,772
                
                
                4.85
                %
                $
                924
                
                
                6.31
                %
                $
                5,620
                
                
                5.59
                %Total
                    fair value
                
                $
                1,672
                
                
                7.05
                %
                $
                1,264
                
                
                4.26
                %
                $
                —
                
                
                0.00
                %
                $
                —
                
                
                0.00
                %
                $
                1,729
                
                
                4.86
                %
                $
                920
                
                
                6.32
                %
                $
                5,585
                
                
                5.62
                %




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 are
      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, 2006, the carrying value and the estimated fair market value of
      the
      investment securities portfolio totaled $95.3 million, as compared to $121.4
      million for both amounts for 2005. Securities with stated maturities greater
      than 10 years comprised 90% of the investment portfolio in 2006. 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 21%.





**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
      carrying value of $83.4 million and a market value totaling $83.3 million.
      In
      comparison, the related figures for 2005 totaled a carrying value and market
      value of $102.2 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 carrying values of
      mortgage-backed securities activity for the periods indicated.


Years
                  Ended December 31,2006
              
              2005
              
              2004(Dollars
                  in thousands)Beginning
                  balance
              
              $
              102,240
              
              $
              112,773
              
              $
              74,150Mortgage-backed
                  securities purchased
              
              
              —
              
              
              11,050
              
              
              55,179Amortization
                  of premiums and discounts
              
              
              (431
              )
              
              (1,213
              )
              
              (622
              )Principal
                  repayments
              
              
              (18,434
              )
              
              (20,370
              )
              
              (15,934
              )Ending
                  balance
              
              $
              83,375
              
              $
              102,240
              
              $
              112,773




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


Years
                  Ended December 31,2006
              
              2005
              
              2004Percent
              
              
              
              Percent
              
              
              
              PercentAmount
              
              of
                  Total
              
              Amount
              
              of
                  Total
              
              Amount
              
              of
                  Total(Dollars
                  in thousands)Mortgage-backed
                  securities:Freddie
                  Mac
              
              $
              14,401
              
              
              17.3
              %
              $
              16,543
              
              
              16.2
              %
              $
              19,380
              
              
              17.2
              %Fannie
                  Mae
              
              
              35,316
              
              
              42.3
              %
              
              42,575
              
              
              41.6
              %
              
              44,785
              
              
              39.7
              %Ginnie
                  Mae
              
              
              33,658
              
              
              40.4
              %
              
              43,122
              
              
              42.2
              %
              
              48,608
              
              
              43.1
              %Total
              
              $
              83,375
              
              
              100.0
              %
              $
              102,240
              
              
              100.0
              %
              $
              112,773
              
              
              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,
      2006, was approximately $95.3 million.





20




As
                  of December 31,2006
              
              2005
              
              2004(Dollars
                  in thousands)Investment
                  securities:US
                  government and agency obligations
              
              $
              10,829
              
              $
              17,988
              
              $
              17,954Corporate
                  and municipal securities
              
              
              1,144
              
              
              1,188
              
              
              1,217Mortgage-backed
                  securities
              
              
              83,375
              
              
              102,240
              
              
              112,773Total
              
              $
              95,348
              
              $
              121,416
              
              $
              131,944


At
      December 31, 2006, municipal bonds included seven Washington State municipal
      bonds that, if rated, were rated AA or better.





For
      further information concerning the investment portfolio, reference is made
      to
      Note 3 - “Mortgage-Backed and Other Securities Available-for-Sale” and Note 4 -
“Mortgage-Backed and Other Securities Held-to-Maturity” 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,
      2006.


One
                  Year
              
              One
                    to FiveYears
              
              Five
                    to TenYears
              
              Over
                    TenYearsCarrying
                Value
              
              Yield
              
              Carrying
                Value
              
              Yield
              
              Carrying
                Value
              
              Yield
              
              Carrying
                Value
              
              Yield
              
              Total
                Carrying
                Value
              
              Total
                Market
                Value
              
              Yield(Dollars
                  in thousands)Municipals*
              
              $
              —
              
              
              0.00
              %
              $
              —
              
              
              0.00
              %
              $
              —
              
              
              0.00
              %
              $
              1,144
              
              
              6.13
              %
              $
              1,144
              
              $
              1,141
              
              
              6.13
              %US
                  agencies
              
              
              —
              
              
              0.00
              %
              
              5,864
              
              
              4.08
              %
              
              —
              
              
              0.00
              %
              
              4,965
              
              
              4.00
              %
              
              10,829
              
              
              10,829
              
              
              4.05
              %Freddie
                  Mac
              
              
              —
              
              
              0.00
              %
              
              3,020
              
              
              3.69
              %
              
              —
              
              
              0.00
              %
              
              11,381
              
              
              4.57
              %
              
              14,401
              
              
              14,407
              
              
              4.38
              %Fannie
                  Mae
              
              
              —
              
              
              0.00
              %
              
              492
              
              
              5.50
              %
              
              —
              
              
              0.00
              %
              
              34,824
              
              
              4.46
              %
              
              35,316
              
              
              35,278
              
              
              4.47
              %Ginnie
                  Mae
              
              
              —
              
              
              0.00
              %
              
              —
              
              
              0.00
              %
              
              —
              
              
              0.00
              %
              
              33,658
              
              
              4.05
              %
              
              33,658
              
              
              33,658
              
              
              4.05
              %Total
              
              $
              —
              
              
              0.00
              %
              $
              9,376
              
              
              4.03
              %
              $
              —
              
              
              0.00
              %
              $
              85,972
              
              
              4.31
              %
              $
              95,348
              
              $
              95,313
              
              
              4.28
              %


*
      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 2006 and 2005, borrowings represented
      16.4% and 21.2% of assets, respectively.





**Deposits** .
      We
      offer a number of deposit accounts, including savings accounts, 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 a minimum term 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, 2006. Rates paid on jumbo time
      deposits are negotiable.


JumboMaturity
                  Period
              
              Time
                  Deposits(Dollars
                  in thousands)Three
                  months or less
              
              $
              81,938Four
                  through six months
              
              
              67,312Seven
                  through 12 months
              
              
              46,972Over
                  12 months
              
              
              23,938Total
              
              $
              220,160
  **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.





**Investments.**  In
      early
      2006 we entered into an agreement with Elliott Cove Capital Management to offer
      six balanced portfolios of funds to our customers.  These funds were
      created for Elliott Cove by Dimensional Fund Advisors from Santa Monica
      California, a company with over $73 billion in assets under management. 
These balanced portfolios range from a conservative portfolio with 70% in
      bonds/other to an All Equity portfolio.  The funds are sold via our Banking
      Centers, if we have a registered Investment Advisor (IA) present, or through
      a
      registered IA who works for Elliott Cove.


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,
              
              %
                  of2006
              
              Deposits
              
              (Decrease)
              
              2005
              
              Deposits
              
              (Decrease)
              
              2004
              
              Deposits(Dollars
                  in thousands)Personal
                  and business checking
              
              $
              79,495
              
              
              9.9
              %
              $
              9,773
              
              $
              69,722
              
              
              9.2
              %
              $
              9,453
              
              $
              60,269
              
              
              8.9
              %Jumbo
                  time deposits
              
              
              220,160
              
              
              27.3
              %
              
              3,653
              
              
              216,507
              
              
              28.5
              %
              
              50,141
              
              
              166,366
              
              
              24.6
              %Extreme
                  checking accounts
              
              
              29,570
              
              
              3.7
              %
              
              (3,764
              )
              
              33,334
              
              
              4.4
              %
              
              2,964
              
              
              30,370
              
              
              4.5
              %Savings
                  accounts
              
              
              6,702
              
              
              0.8
              %
              
              (1,352
              )
              
              8,054
              
              
              1.1
              %
              
              (380
              )
              
              8,434
              
              
              1.2
              %Money
                  market deposit accounts
              
              
              204,629
              
              
              25.4
              %
              
              44,240
              
              
              160,389
              
              
              21.1
              %
              
              (3,408
              )
              
              163,797
              
              
              24.3
              %Three
                  month or less time deposits
              
              
              1,148
              
              
              0.1
              %
              
              (601
              )
              
              1,749
              
              
              0.2
              %
              
              462
              
              
              1,287
              
              
              0.2
              %Four
                  to six month time deposits
              
              
              31,066
              
              
              3.9
              %
              
              24,068
              
              
              6,998
              
              
              0.9
              %
              
              (16,043
              )
              
              23,041
              
              
              3.4
              %Seven
                  month to one-year time deposits
              
              
              149,377
              
              
              18.6
              %
              
              45,481
              
              
              103,896
              
              
              13.6
              %
              
              11,121
              
              
              92,775
              
              
              13.7
              %13
                  month to five year time deposits
              
              
              83,347
              
              
              10.3
              %
              
              (76,397
              )
              
              159,744
              
              
              21.0
              %
              
              31,164
              
              
              128,580
              
              
              19.1
              %Six
                  to 10 year time deposits
              
              
              301
              
              
              0.0
              %
              
              (27
              )
              
              328
              
              
              0.0
              %
              
              (122
              )
              
              450
              
              
              0.1
              %Total
                  deposits
              
              $
              805,795
              
              
              100.0
              %
              $
              45,074
              
              $
              760,721
              
              
              100.0
              %
              $
              85,352
              
              $
              675,369
              
              
              100.0
              %IRA
                  accounts
              
              $
              28,808
              
              
              3.6
              %
              $
              (487
              )
              $
              29,295
              
              
              3.9
              %
              $
              1,174
              
              $
              28,121
              
              
              4.2
              %


The
      following table represents an analysis of the deposit accounts by interest
      rate
      and remaining time to maturity at December 31, 2006.


Less
                  than
              
              One
                  to
              
              Two
                  to
              
              OverOne
                  Year
              
              Two
                  Years
              
              Five
                  Years
              
              Five
                  Years
              
              Total(Dollars
                  in thousands)Less
                  than 2.01%
              
              $
              117,052
              
              $
              702
              
              $
              306
              
              $
              —
              
              $
              118,0602.01
                  to 3.00%
              
              
              41,252
              
              
              175
              
              
              22
              
              
              5
              
              
              41,4543.01
                  to 4.00%
              
              
              109,115
              
              
              11,938
              
              
              2,127
              
              
              6
              
              
              123,1864.01
                  to 5.00%
              
              
              345,827
              
              
              4,876
              
              
              12,477
              
              
              172
              
              
              363,3525.01
                  to 6.00%
              
              
              150,605
              
              
              1,123
              
              
              7,766
              
              
              —
              
              
              159,4946.01
                  to 8.00%
              
              
              249
              
              
              —
              
              
              —
              
              
              —
              
              
              249Total
              
              $
              764,100
              
              $
              18,814
              
              $
              22,698
              
              $
              183
              
              $
              805,795




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


Years
                  Ended December 31,2006
              
              2005
              
              2004(Dollars
                  in thousands)Deposits
              
              $
              4,337,324
              
              $
              3,327,093
              
              $
              2,089,551Withdrawals
              
              
              4,316,765
              
              
              3,258,771
              
              
              2,009,494Net
                  deposits before interest credited
              
              
              20,559
              
              
              68,322
              
              
              80,057Interest
                  credited
              
              
              24,515
              
              
              17,030
              
              
              11,421Net
                  increase in deposits
              
              $
              45,074
              
              $
              85,352
              
              $
              91,478





24


For
      further information concerning deposits, reference is made to Note 8 -
“Deposits” 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, 2006, we had advances
      totaling $171.9 million from the FHLB, which mature in 2007 through 2011 at
      interest rates ranging from 2.52% to 5.74%.





The
      Bank
      also has a note payable in connection with the 2004 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 2006.





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, 2006, the percentage of assets
      represented by FHLB borrowings was 16%. For further information regarding
      borrowings and the FHLB see Note 9 - “FHLB and Other Advances” in the Notes to
      Consolidated Financial Statements in the Annual Report and “Regulation and
      Supervision - -Federal Home Loan Bank Systemy in the 10-K.





**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. Our significant accounting policies are discussed in
      Note 1 - “Summary of Significant Accounting Policies” to the Notes to
      Consolidated Financial Statements.




We
      have
      identified the following 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 critical accounting policies that we have
      identified are related to the assumptions and estimates underlying the allowance
      for loan and lease losses, the value of servicing assets, the value of loans
      held-for-sale, the useful lives of fixed assets, credit insurance premiums
      payable, amortization of deferred loan fees/costs, the value of derivative
      instruments, the calculations to determine the value of stock option expense,
      deferred taxes, and the valuation of real estate acquired in connection with
      foreclosures or in satisfaction of loans. We believe that the judgments,
      estimates, and assumptions used in the preparation of our Consolidated Financial
      Statements are appropriate given the factual circumstances as of December 31,
      2006. 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.





**Allowance
      for Loan and Lease Losses.** The
      allowance for loan and lease losses represents management’s estimate of probable
      credit losses inherent in the portfolio as of the balance sheet date. The
      estimation of the allowance is based on a variety of factors, including past
      loan loss experience, the current credit profile of the borrower, adverse




25


situations
      that have occurred that may affect the borrower’s ability to repay, the
      estimated value of underlying collateral, the interest rate climate as it
      affects adjustable-rate loans and general economic conditions. Loans held in
      the
      portfolio that are evaluated for collective impairment and loans held in the
      portfolio that are individually reviewed for impairment but deemed not to be
      impaired may have both an allocated and unallocated allowance. Loans that are
      individually deemed to be impaired may only have an allocated
      allowance.





The
      allowance for loans evaluated for collective impairment is comprised of an
      allocated allowance that is computed for each portfolio based on specific loan
      portfolio metrics and an unallocated allowance that is computed based on certain
      qualitative and environmental factors we believe are not adequately captured
      in
      the allocated allowance computations. Determining the adequacy of the allowance,
      particularly the unallocated allowance, is complex and requires judgment by
      management about the effect of matters that are inherently uncertain. Subsequent
      evaluations of the loan portfolio, in light of the factors then prevailing,
      may
      result in significant changes in the allowance for loan and lease losses in
      future periods.





The
      allowance is comprised of an allowance for individually impaired loans, as
      well
      as an allowance for other individually unimpaired loans that share common risk
      characteristics that, in the aggregate, have incurred a probable loss on a
      collective basis. The determination of common risk factors that indicate a
      probable loss on a collective basis is complex and requires significant judgment
      by management about the shared risk characteristics that suggest a probable
      loss.





The
      allowance for loan and lease losses is reported within the Consolidated
      Statements of Financial Condition and the provision for loan and lease losses
      is
      reported within the Consolidated Statements of Income.





The
      estimates and judgments are described in further detail in the Management’s
      Discussion and Analysis - “Reserve and Provision for Loan and Lease
      Losses.”




**Servicing
      Assets.** Servicing rights assets related to sales finance loans and commercial loans
      do
      not trade in an active, open market with readily quoted prices. Although sales
      do occur from time to time, the terms of such sales are generally not readily
      available. Consequently, we estimate the fair value of servicing utilizing
      internal discounted cash flow models.





The
      discounted cash flow model for servicing rights calculates the present value
      of
      the expected future net cash flows of the servicing portfolio based on various
      assumptions, such as estimated future servicing costs, expected servicing
      portfolio prepayment speeds and discount rates that are commensurate with the
      risk profile of the serviced assets. This model is highly sensitive to changes
      in certain assumptions. Different expected prepayment speeds, in particular,
      can
      result in substantial changes in the estimated fair value of servicing rights.
      If actual prepayment experience differs materially from the expected prepayment
      speeds used in the model, this difference would likely result in a material
      change in fair value of the servicing rights. Changes in the servicing rights
      values are reported in the Consolidated Statements of Income under the
      noninterest income caption “Service Fees, Net of Amortization.”  Additional
      discussion regarding the estimation of servicing rights fair value are described
      in the Management’s Discussion and Analysis - “Noninterest Income - Servicing
      Fee Income/(Loss).”  Key assumptions are described in Note 6 - “Servicing
      Assets and Servicing Fees” to the Consolidated Financial
      Statements.





**Loans
      Held-For-Sale** .
      Loans
      held-for-sale are carried on the Consolidated Statement of Financial Condition
      at the lower of aggregate cost or estimated fair value. The fair value of loans
      designated as held-for-sale is generally based on observable market prices
      of
      securities that have loan collateral or interests in loans that are similar
      to
      the held-for-sale loans. If market prices are not readily available, fair value
      is based on a discounted cash flow model, which takes into account expected
      prepayment factors and the degree of credit risk associated with the loans
      and
      the estimated effects of changes in market interest rates relative to the loans’
interest rates.









26


**Fixed
      Assets.**Property, plant, and equipment are carried at cost. Depreciation is calculated
      on a straight-linebasis, over the estimated useful lives of the assets.
      Gains or losses resulting from dispositions are included in income. Betterments
      and renewals, which improve and extend the life of an asset are capitalized;
      maintenance and repair costs are expensed.





**Credit
      Insurance Premiums Payable** .
      The
      majority of credit insurance premiums are attributable to our sales finance
      loans, including both those loans retained in our portfolio as well as those
      loans serviced for other institutions. In previous periods, to mitigate losses,
      we entered into agreements with 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.





During
      2006, after evaluating our use of credit insurance, we concluded that the
      benefits of the insurance on sales finance loans with low credit scores no
      longer outweighed the costs and chose to forego the insurance and assume the
      credit risk on future sales finance loan production.   Loans with
      credit scores below the cutoff credit score constitute about 20-30% of the
      loans
      originated. Investors who purchase loans with low credit scores are offered
      the
      choice of a lower pass through rate with the Bank guaranteeing a portion of
      their losses or a higher pass through rate where the investor assumes all the
      credit risk. When loans are sold under the agreement that the Bank will absorb
      a
      set percentage of the credit losses, a liability is set up that is equal to
      the
      present value of the future cash flows expected to be disbursed.  Each
      quarter this liability is evaluated and adjusted to reflect a level sufficient
      to cover the remaining estimated losses.  This estimate also incorporates
      the timing of the remaining estimated defaults based on historical charge off
      experience.  As claims are submitted, they are applied against this
      liability up to the maximum allowed.





**Deferred
      Loan Fees/Costs** .
      Loan
      origination fees, net of certain direct origination costs, are deferred and
      recognized as an adjustment of the related loan yield using the interest method
      or the straight-line method of amortization. Remaining net deferred fees/costs
      related to loans sold are recognized in income at the time the loans are
      sold.





**Derivative
      Instruments.** The
      Company enters into derivative contracts to manage the various risks associated
      with certain assets, liabilities, or probable forecasted transactions. When
      the
      Company enters into derivative contracts, the derivative instrument is
      designated as: (1) a hedge of the fair value of a recognized asset or
      liability or of an unrecognized firm commitment (a “fair value” hedge);
      (2) a hedge of the variability in expected future cash flows associated
      with an existing recognized asset or liability or a probable forecasted
      transaction (a “cash flow” hedge); or (3) held for other risk management
      purposes (“risk management derivatives”).





All
      derivatives, whether designated in hedging relationships or not, are recorded
      at
      fair value as either assets or liabilities on the Consolidated Statements of
      Financial Condition. Changes in fair value of derivatives that are not in hedge
      accounting relationships (as in (3) above) are recorded within the
      Consolidated Statements of Income in the period in which the change in value
      occurs. Changes in the fair value of derivatives that are designated as cash
      flow hedges (as in (2) above), to the extent such hedges are deemed highly
      effective, are recorded as a separate component of accumulated other
      comprehensive income and reclassified into earnings when the earnings effect
      of
      the hedged cash flows is recognized. Changes in the fair value of derivatives
      in
      qualifying fair value hedge accounting relationships
      (as in (1) above) are recorded each period in earnings along with
      the change in fair value of the hedged item.




The
      determination of whether a derivative qualifies for hedge accounting requires
      complex judgments about the application of Statement of Financial Accounting
      Standard No. 133 (SFAS 133). Additionally, this Statement requires
      contemporaneous documentation of the Company’s hedge relationships. Such
      documentation includes the nature of the risk being hedged, the identification
      of the hedged item, or the group of hedged items, that share the risk exposure
      that is designated as being hedged, the selection of the instrument that will
      be
      used to hedge the identified risk, and the method used to assess the
      effectiveness of the hedge relationship. The effectiveness assessment requires
      calculations that utilize standard statistical methods of correlation that
      must
      support the determination that the hedging relationship is expected to be highly
      effective, during the period that the hedge is designated, in achieving
      offsetting




27


changes
      in fair value or cash flows attributable to the hedged risk. If the Company’s
      documentation and assessment of effectiveness are not considered to be adequate
      to achieve hedge accounting treatment, the derivative is treated as a
      free-standing risk management instrument.





**Stock
      Option Expense** .
      Effective January 1, 2006, we adopted SFAS 123(R), on a modified
      prospective basis, which requires all share-based payments to employees and
      directors to be recognized in the financial statements based on their fair
      values using an option-pricing model at the date of grant. We use a
      Black-Scholes-Merton option-pricing model to calculate the fair value of
      options. This model requires various judgmental assumptions including
      volatility, forfeiture rates and expected option life. If any of the assumptions
      used in the model change significantly, share-based compensation may differ
      materially in the future from that recorded in the current period. Stock options
      are discussed in more detail in Note 16 - “Stock Option Plans” in the Notes to
      Consolidated Financial Statements.





**Accrued
      Taxes.** The
      Company estimates tax expense based on the amount it expects to owe various
      tax
      authorities. Taxes are discussed in more detail in Note 11 - “Federal Taxes on
      Income” of the Notes to Consolidated Financial Statements. Accrued taxes
      represent the net estimated amount due or to be received from taxing
      authorities. In estimating accrued taxes, management assesses the relative
      merits and risks of the appropriate tax treatment of transactions taking into
      account statutory, judicial and regulatory guidance in the context of the
      Company’s tax position.





**Real
      Estate Acquired in Connection with Foreclosures or in Satisfaction of
      Loans** .
      Assets
      acquired through, or in lieu of, loan foreclosures are held-for-sale and are
      initially recorded at fair value less cost to sell at the date of foreclosure,
      establishing a new cost basis. Subsequent to foreclosure, valuations are
      periodically performed by management and the assets are carried at the lower
      of
      carrying amount or fair value less cost to sell. Revenue and expenses from
      operations and changes in the valuation allowance are included in net expenses
      from foreclosed assets. The amounts that will ultimately be recovered from
      foreclosed assets may differ substantially from the carrying value of the assets
      because of future market factors beyond management’s control.




**Recently
      Issued Accounting Standards**





Refer
      to
      Note 1 - “Summary of Significant Accounting Policies” in the Notes to the
      Consolidated Financial Statements in the 2006 Annual Report.





**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.




28


**Deposit
      Insurance**.
      The
      Bank’s deposits are insured up to applicable limits by the Deposit Insurance
      Fund(“DIF”) of the FDIC. The DIF was created by the merger of the Bank
      Insurance Fund (“BIF”) and Savings Association Insurance Fund (“SAIF”) provided
      for in the Federal Deposit Insurance Reform Act of 2005 (“FDIRA”), as enacted in
      February 2006. This legislation also increased insurance coverage for
      retirement accounts to $250,000 and indexed the insurance levels for inflation,
      among other changes. In addition, as a result of the FDIRA, the FDIC has adopted
      a revised, risk-based assessment system to determine assessment rates to be
      paid
      by member institutions, such as the Bank. Under this revised assessment system,
      risk is defined and measured using an institution’s supervisory ratings,
      combined with certain other risk measures, including certain financial ratios
      and long-term debt issuer ratings. The annual risk based assessment rates for
      2007 range from $0.05 to $0.43 per $100 of insured deposits. The FDIRA also
      provided for a one-time assessment credit, to be allocated among member
      institutions. The FDIC one-time assessment credit may be used to offset future
      deposit insurance assessments beginning in 2007.





In
      addition to DIF assessments, beginning in 1997 the FDIC assessed BIF-assessable
      and SAIF-assessable deposits to fund the repayment of debt obligations of the
      Financing Corporation. The Financing Corporation is a government-sponsored
      entity that was formed to borrow the money necessary to carry out the closing
      and ultimate disposition of failed thrift institutions by the Resolution Trust
      Corporation. As of January 1, 2007, the annualized rate of risk-adjusted
      deposits, established by the FDIC for all DIF-assessable deposits, was 1.22
      basis points. Under federal law, deposits and certain claims for administrative
      expenses and employee compensation against insured depository institutions
      are
      afforded a priority over other general unsecured claims against such an
      institution, including federal funds and letters of credit, in the liquidation
      or other resolution of such an institution by any receiver appointed by
      regulatory authorities. Such priority creditors would include the
      FDIC.





**Capital
      Requirements.** FDIC
      regulations recognize two types or tiers of capital: core (“Tier 1y) capital and
      supplementary (“Tier 2y) 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 12.4% as of
      December 31, 2006, and our Tier 1 risk-based capital ratio to be 11.2% 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.





29


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(R) 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).
      In conjunction with the TPS issued in
      2002
      we entered into an interest rate swap with the FHLB. The purpose of the swap
      was
      to protect against potential adverse interest rate volatility that could be
      realized from TPSs issued with an adjustable interest rate in June 2002. The
      swap accomplished this by fixing the interest rate payable for the first five
      years of the TPS’ life. This swap is set to expire in 2007, coinciding with the
      first call date for the TPS. As the pricing on TPS has improved significantly
      since the time we issued these securities, it is our intention to refinance
      the
      $9 million in securities with a new TPS issue in 2007. Based on the current
      levels of interest rates and TPS pricing, we expect the replacement TPS will
      be
      issued at a rate lower than that of the issue to be retired. Other
      than the refinance of this TPS, there are no present plans to issue additional
      TPS securities. We believe that our current capital, plus retained earnings
      for
      year 2007, 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 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 review of
      compliance with laws and regulations.









30


**Federal
      Home Loan Bank System.**The FHLB
      serves as a reserve or central bank for the member institutionswithin
      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 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 4.0% 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 0.50% of the
                member’s home mortgage loans outstanding as of the most recent calendar
                year end.





As
      of
      December 31, 2006, we held stock in the FHLB in the amount of $13.1 million
      which was sufficient to fulfill the FHLB’s membership requirements.





**Federal
      Reserve System.** The
      Federal Reserve Board requires (under “Regulation Dy) that all depository
      institutions maintain reserves on transaction accounts or certain 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. Under Regulation D, the
      first $7.8 million (will increase to $8.5 million in 2007) of net transactions
      are exempt from reserve requirements. We must maintain a 3% reserve ratio on
      net
      transaction accounts over $7.8 million up to and including $48.3 million (will
      decrease to $45.8 million in 2007). A 10 percent reserve ratio will be assessed
      on net transaction accounts in excess of $48.3 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, 2006, 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




31


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.





**Community
      Reinvestment Act.** During
      the second quarter of 2006, the FDIC completed a Community Reinvestment Act
      examination to assess our record of meeting the credit needs of our entire
      community, including low- and moderate-income neighborhoods, consistent with
      safe and sound operations. We were rated “needs to improve” for the three-year
      period ending December 31, 2005. The FDIC public disclosure performance
      evaluation is available from the Bank’s CRA officer and is available on the
      FDIC’s website. This rating will be taken into account by the FDIC in
      considering an application for approval of the establishment of a new banking
      center, the relocation of our main office or a banking center, or the merger,
      consolidation, acquisition of assets, or assumption of liabilities. This rating
      may be the basis for denying or conditioning approval of such an
      application.





**Stock
      Repurchases.** Bank
      holding companies, except for certain “well-capitalizedy 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 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, 2006, the Company’s total risk-based capital to
      risk-weighted assets was 12.1% and its Tier 1 capital to risk-weighted assets
      was 10.9%.





**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.




32


The
      current thrift bad debt rules were passed by Congress as part of “The Small
      Business Job Protection Act of 1996.y 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. The Bank also files a number of state tax returns
      in
      states in which sales finance activities are conducted or where we have
      salespeople employed.





Reference
      is made to Note
      11 -
“Federal Taxes on Income” of the Notes to Consolidated Financial Statements in
      the 2006 Annual Report for additional information regarding income taxes payable
      by the Company.





**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.





33


**Employees**





At
      December 31, 2006, we employed 226 full-time and 12 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.





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.





**Geographic
      Concentration and Local Economic Conditions.** The
      vast
      majority of our funding, lending, and management activities are based in the
      Puget Sound area. 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 to a lesser extent, through 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 and lease 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 and Lease 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.




34


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. It 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 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 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.





35


**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 area. 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.




**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.





36


Lease
                  InformationYear
              
              Net
                  Book
              
              Square
              
              Owned
                  /
              
              Initial
              
              Date
                  of
              
              RenewalLocation
              
              Opened
              
              Value
                  of Assets
              
              Feet
              
              Leased
              
              Lease
              
              Termination
              
              Terms(Dollars
                  in thousands)Bellevue
                  Banking Center &
              
              
              1985
              
              $
              17,141
              
              
              76,919
              
              
              Owned
              
              
              —
              
              
              —
              
              
              —Corporate
                  Offices (1) & (2)400
                  108th Avenue NEBellevue,
                  WA 98004(Originally
                  opened 1953)Issaquah
                  Banking Center
              
              
              1977
              
              $
              539
              
              
              2,860
              
              
              Owned
              
              
              —
              
              
              —
              
              
              —855
                  Rainier Blvd. NIssaquah,
                  WA 98027(Originally
                  opened 1965)Monroe
                  Banking Center (2)
              
              
              1993
              
              $
              1,040
              
              
              5,373
              
              
              Owned
              
              
              —
              
              
              —
              
              
              —19265
                  State Route 2Monroe,
                  WA 98272(Originally
                  opened 1968)Crossroads
                  Banking Center
              
              
              1969
              
              $
              2,106
              
              
              3,894
              
              
              Owned
              
              
              —
              
              
              —
              
              
              —15635
                  NE 8th StreetBellevue,
                  WA 98008Redmond
                  Banking Center &
              
              
              1977
              
              $
              1,448
              
              
              6,474
              
              
              Owned
              
              
              —
              
              
              —
              
              
              —Training
                  Center16900
                  Redmond WayRedmond,
                  WA 98052Ballard
                  Banking Center
              
              
              2002
              
              $
              1,879
              
              
              2,400
              
              
              Owned
              
              
              —
              
              
              —
              
              
              —6301
                  15th Avenue NWSeattle,
                  WA 98107(Originally
                  opened 1994)West
                  Seattle Banking Center
              
              
              2006
              
              $
              2,954
              
              
              3,265
              
              
              Owned
              
              
              —
              
              
              —
              
              
              —4102
                  California Ave. SWSeattle,
                  WA 98116(Originally
                  opened 1996)Bellevue
                  West Banking Center (2)
              
              
              1997
              
              $
              2,831
              
              
              7,807
              
              
              Owned
              
              
              —
              
              
              —
              
              
              —10001
                  NE 8th StreetBellevue,
                  WA 98004Kirkland
                  Banking Center
              
              
              2000
              
              $
              169
              
              
              3,692
              
              
              Leased
              
              
              September
              
              
              September
              
              
              Two
                  five-278
                  Central Way
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              16,
                  1999
              
              
              16,
                  2009
              
              
              year
                  optionsKirkland,
                  WA 98033Juanita
                  Banking Center
              
              
              2001
              
              $
              1,039
              
              
              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
            
            $
            1,622
            
            
            2,893
            
            
            Owned
            
            
            —
            
            
            —
            
            
            —13415
                NE 175th StreetWoodinville,
                WA 98072Sammamish
                Banking Center
            
            
            2003
            
            $
            353
            
            
            3,721
            
            
            Leased
            
            
            December
            
            
            December
            
            
            Two
                five-336
                - 228th Avenue NE
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            23,
                2002
            
            
            23,
                2012
            
            
            year
                optionsSuite
                100Sammamish,
                WA 98074Loan
                Production OfficesFlorida
                Loan Office
            
            
            2006
            
            
            (1
            )
            
            325
            
            
            Leased
            
            
            September
                1,
            
            
            August
                31,
            
            
            Year-to-year414
                Old Hard Road, Suite 108
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            2006
            
            
            2007Orange
                Park, FL 32003Michigan
                Loan Office
            
            
            2006
            
            
            (1
            )
            
            300
            
            
            Leased
            
            
            April
                1,
            
            
            June
                30,
            
            
            Year-to-year56
                Macomb Place
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            2006
            
            
            2007Mt.
                Clemens, MI 48046




(1)
        Net
        book values of assets are included with Bellevue Administrative
        offices.
 (2)
        Includes leasable area





In
      2006
      several facility projects were completed. We completed construction on a new
      banking center facility for our West Seattle office. We started and completed
      construction on a new drive-up banking addition at our Corporate Headquarters
      in
      Bellevue, WA. We completed a Training Center at our Redmond office. In addition,
      we started construction on a new facility located in Bothell, WA (the “Canyon
      Park” site), and we anticipate completion of this project in 2007. In light of
      the recent CRA examination results discussed previously, we will need approval
      from the FDIC in order to conduct business from this banking center. As a
      result, we are focused on ensuring that we meet the credit needs of our entire
      community, including low- and moderate-income neighborhoods.





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.




**Item
      3. Legal Proceedings.**





At
      December 31, 2006, 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, 2006.





38


**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 Informationy in the Annual Report
      is incorporated herein by reference.





The
      Company did not sell any unregistered securities during 2006.




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


Quarter
                  Ending
              
              Fiscal
                  2006
              
              Fiscal
                  2005
              
              Fiscal
                  2004
              
              Fiscal
                  2003
              
              Fiscal
                  2002Fiscal
                  year
              
              $
              0.32
              
              $
              1.10
              
              $
              0.26
              
              $
              0.20
              
              $
              0.19March
                  31
              
              
              0.08
              
              
              0.07
              
              
              0.06
              
              
              0.05
              
              
              0.04June
                  30
              
              
              0.08
              
              
              0.07
              
              
              0.06
              
              
              0.05
              
              
              0.05September
                  30
              
              
              0.07
              
              
              0.08
              
              
              0.07
              
              
              0.05
              
              
              0.05December
                  31
              
              
              0.09
              
              
              0.88
              
              
              0.07
              
              
              0.05
              
              
              0.05





**Item
      6. Selected Financial Data.**





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





**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 Instrumentsy 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.





39




**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
              
              
              762,107
              
              $
              15.37
              
              
              656,891Equity
                  compensation plans notapproved
                  by security holders
              
              
              N/A
              
              
              N/A
              
              
              N/ATotal
              
              
              762,107
              
              $
              15.37
              
              
              656,891


**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 “Acty)) 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 Datey). 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.





**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, 2006,
      based upon the criteria related to internal control over financial reporting
      described in “Internal Control--Integrated Frameworky 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,
      2006.





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




40


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, Executive Officers and Corporate
      Governance.**





The
      information contained under the sections captioned “Election of Directors -
      Proposal One of One” and “Board Operations and Corporate Governance” in the
      Company’s Proxy Statement are 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,
                  2006
              Company
              BankJohn
                  R. Valaas
              62
              President
                  and Chief Executive
              President
                  and Chief ExecutiveOfficer
              OfficerRoger
                  A. Mandery
              64
              Executive
                  Vice President, Chief
              Executive
                  Vice President - Chief FinancialFinancial
                  Officer, and Treasurer
              Officer
                    and TreasurerRichard
                  J. Collette
              59
              
              Executive
                  Vice President - CommercialBanking
                  GroupGeorge
                  D. Smeby
              63
              
              Executive
                  Vice President - Chief Risk OfficerJoseph
                  P. Zavaglia
              58
              
              Executive
                  Vice President - Retail BankingGroupScott
                  B. Harlan
              45
              
              Executive
                  Vice President - Residential and Consumer LendingRobin
                  R. Carey
              49
              
              Executive
                  Vice President - Operations andAdministration
                  and Assistant SecretaryKari
                  A. Stenslie
              42
              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 33 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 Bank of America where he
      was
      employed from 1969 to 2004. Mr. Smeby has over 38 years of experience in
      commercial banking.




42


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 30 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.




**Item
      11. Executive Compensation.**





The
      information required by this item is incorporated by reference to the sections
      captioned - “Executive Compensationy and “Report of the Compensation and Stock
      Option Committee” in the Proxy Statement for the Company’s 2007 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
      section captioned “Stock Ownership of Directors, Management & Principal
      Shareholders - Principal Holders of Voting Securities and Managementy in the
      Company’s Proxy Statement for the 2007 Annual Meeting of
      Shareholders.





**Item
      13. Certain Relationships and Related Transactions, and Director
      Independence.**





The
      information required by this item is incorporated by reference to the section
      captioned “Board Operations and Corporate Governance“ in the Company’s Proxy
      Statement for the 2007 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 “Audit Committee - Report of the Audit Committee and Audit Fees” in
      the Company’s Proxy Statement for the Company’s 2007 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, 2006 and
                2005


Consolidated
                Statements of Income for the three years ended December 31,
                2006


Consolidated
                Statements of Stockholders’ Equity and Comprehensive Income for the three
                years ended December
                31, 2006


Consolidated
                Statements of Cash Flows for the three years ended December 31,
                2006


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)


(4)
            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)
            2006
                Annual Report to Shareholders


(14)
            Code
                of Business Conduct and Ethics, incorporated by reference on Form
                10-K
                filed with the SECon
                March 16, 2005.


(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 the Sarbanes-Oxley Act of
                  2002









(*)  Incorporated
      by reference from 2006 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 14, 2007
            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 14, 2007
              Date:
                  March 14, 2007By:/s/
                  Kari A. Stenslie
                  
                  Kari
                      A. Stenslie
              By:/s/
                  George W. Rowley, Jr.
                George
                  W. Rowley, Jr.Principal
                  Accounting Officer
              DirectorDate:
                  March 14, 2007
              Date:
                  March 14, 2007By:/s/
                  F. Kemper Freeman, Jr.
                  
                  F.
                      Kemper Freeman, Jr.
              By:/s/
                  Richard S. Sprague
                  
                  Richard
                      S. SpragueChairman
                  of the Board
              DirectorDate:
                  March 14, 2007
              Date:
                  March 14, 2007By:/s/
                  James J. Doud, Jr.
                James
                  J. Doud, Jr.
              By:/s/
                  John R. Valaas
                John
                  R. ValaasDirector
              DirectorDate:
                  March 14, 2007
              Date:
                  March 14, 2007By:/s/
                  Mary Case Dunnam
                Mary
                  Case Dunnam
              By:/s/
                  Robert C. Wallace
                Robert
                  C. WallaceDirector
              DirectorDate:
                  March 14, 2007
              Date:
                  March 14, 2007By:/s/
                  Janine Florence
                Janine
                  Florence
              By:/s/
                  Robert J. Herbold
                Robert
                  J. HerboldDirector
              DirectorDate:
                  March 14, 2007
              Date:
                  March 14, 2007






45