**First
      Mutual Bancshares Annual Report 2005**




















**2005
      Financial Information for**


First
      Mutual Bancshares, Inc.



















LOGO
            **First**
              **Mutual**
              **Bancshares**










**FIRST
      MUTUAL BANCSHARES, INC.**


**AND
      SUBSIDIARIES**




**INDEPENDENT
      AUDITOR’S REPORT**


**AND**


**CONSOLIDATED
      FINANCIAL STATEMENTS**




**DECEMBER
      31, 2005 AND 2004**








**FIRST
      MUTUAL BANCSHARES, INC.**




**TABLE
      OF CONTENTS**




**2005
      FINANCIAL INFORMATION**




**PAGE**Forward-looking
              StatementsManagement’s
                Discussion and Analysis of Financial Condition and Results of
                Operations
            1Report
                of Independent Registered Public Accounting Firm
            33Consolidated
                Statements of Financial Condition
            35Consolidated
                Statements of Income
            37Consolidated
                Statements of Stockholders’ Equity and Comprehensive Income
            39Consolidated
                Statements of CashFlows
            40Notes
                to Consolidated Financial Statements
            42







This
      section contains the 2005 Financial Information for First Mutual Bancshares,
      Inc. Please refer to the attached
      Annual Report for the Annual Letter to Shareholders and Stock
      Information.









**FORWARD-LOOKING
      STATEMENTS**




This
      Management’s Discussion and Analysis contains statements concerning anticipated
      future operations, trends, expectations and prospects of First Mutual
      Bancshares, Inc. and First Mutual Bank (together,
      the “Company”) that are forward-looking statements for the purposes of the safe
      harbor provisions under
      the Private Securities Litigation Reform Act of 1995. Statements containing
      words such as “ a nticipate”,
      “believe”, “estimate”, “expect”, “expectation”, “hopeful”, “indicate” and
“likely” generally constitute forward-looking statements. Such forward-looking statements include
      statements referring to our expectations regarding our future net interest
      rate
      margins and the anticipated effects of changes in interest rates
      on
      the Company and rate related income growth; our anticipated growth in volume
      of
      loan originations  from
      various segments and our sales of a portion of such loans, particularly
      commercial real estate loans and  consumer
      loans; and our expectations regarding our relatively low ratio of non-performing
      loans. Information regarding our simulation and GAP models and our hedging strategies may also
      constitute forward-looking statements. Although the Company believes that the
      expectations expressed in these forward-looking statements are based upon
      reasonable assumptions within the bounds of our knowledge of our business,
      operations and prospects, these forward-looking statements are subject to
      numerous uncertainties and risks, many of which are beyond the control of the
      Company. Actual events, results, and developments will ultimately differ from
      the expectations and may differ materially from those expressed or implied
      in
      such forward-looking statements. Factors which could affect actual results
      include economic conditions in the Company’s market area and nationally that
      affect our loan and deposit growth; interest rate fluctuations, timing
      and related risks; the impact of competitive products, services and pricing;
      the
      success of our credit risk management; our ability to control costs and expenses; loan repayment and
      delinquency rates and the legislative
      and regulatory changes affecting the banking industry. There are other risks
      and
      uncertainties that  could
      affect the Company which are discussed from time to time in the filings made
      by
      the Company with the Securities and Exchange Commission. 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.








**MANAGEMENT’S
      DISCUSSION AND ANALYSIS OF**


**FINANCIAL
      CONDITION AND RESULTS OF OPERATIONS**




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




First
      Mutual Bancshares, Inc. (the “Company”), a Washington corporation, is a holding
      company owning
      all of the equity of its wholly owned subsidiary, First Mutual Bank (the
“Bank”). The Company also owns
      100% of the equity in three trusts, First Mutual Capital Trust I, First Mutual
      Capital Trust II, and First Mutual Statutory Trust III.




**Financial
      Highlights**




In
      2005,
      we posted our thirteenth consecutive year of earnings growth, as net income
      increased 11% over  the
      prior
      year, to $10.3 million, or $1.86 per diluted share in the year, compared to
      $9.3
      million, or $1.68 per  diluted
      share in 2004 and $8.4 million, or $1.57 per diluted share in 2003. Record
      earnings were based largely on solid
      loan growth and continued expansion of our net interest margin. For 2005, we
      met
      our general corporate
      goals, which consist of obtaining an ROE of at least 15% and year-over-year
      net
      income growth in  the
      range
      of 10% to 12%. Our return on average equity (ROE) for the year was 16.6%,
      compared to 16.8% in the
      prior year and 17.7% in 2003. We consider these targets to be our corporate
      goals, and not indicative of current forecasts or expected future operating
      results.




Our
      net
      income growth goal was established in the first quarter of 2005, and represented
      a reduction from  our
      previous target of a 15% year-over-year increase. We reduced our target in
      response to a number of factors including general economic conditions and trends, the current competitive
      environment for loan and deposit products in our local market, and the continued
      investment required in our Business Banking division. Although this division
      has
      not yet achieved its objectives, we remain committed to developing this business
      line. Business Banking attracts low-cost core deposits, which help reduce our
      overall cost of funds, brings diversification
      to our portfolio of earning assets, and others the potential to generate
      longer-term relationship -banking
      opportunities and additional sources of noninterest income.




The
      primary source of revenue for each of our business lines is net interest income,
      which is generally measured with the net interest margin ratio. For 2005, our
      overall net interest margin improved to 4.08%, an improvement
      of seven basis points over the 4.01% achieved in 2004. Controlling the interest
      expense paid on our
      liabilities is a critical element to maintaining a consistent net interest
      margin in the current economic environment, and we continue to focus our efforts
      on improving the percentage of lower-cost non-maturity deposit products in
      our
      funding mix. When estimates of marginal funding costs indicate it may be advantageous
      to do so, we utilize wholesale funding sources to facilitate our loan growth,
      and avoid the use of promotional deposit rates when possible.




Another
      key driver of net interest income is the growth of the business lines’ earning
      assets, which averaged
      $987 million in 2005, an increase of $97 million, or 11% over the 2004 level.
      The vast majority of this growth
      can be attributed to additional balances in our loan portfolio, with our
      Residential Lending and Business
      Banking segments showing the most substantial asset growth over the last twelve
      months. Please see  the
“Net
      Interest Income,” “Business Segments,” and “Asset and Liability Management”
sections for further discussions of net interest income, earning assets, and the processes by which
      we manage that source of revenue.




A
      secondary source of revenue is our noninterest income, which increased 26%
      compared to the prior year,
      as
      a significant increase in loan servicing income and higher loan fees offset
      reductions in loan sales and  resulting
      gains thereon. While the reduction in loan sale gains negatively impacted our
      noninterest income in  2005,
      reducing these sales allowed us to retain a greater volume of these assets
      within our portfolio, generating incremental net interest income.




Another
      critical factor in achieving our goal of consistent earnings is the credit
      quality of our loan portfolio, which has exceeded the national average for
      many
      years. For 2005, our credit quality remained strong,
      with total non-performing assets (NPAs) declining to $897,000, or 0.08% of
      total
      assets as of year-end,


1




compared
      to $1,007,000, or 0.10% at the 2004 year-end. For the year, we reserved $1.5
      million in provisions for  loan
      losses, more than double our actual net charge-offs of $732,000. Consequently,
      our reserve for loan losses  grew
      to
      nearly $10.1 million, up from $9.3 million at the end of the prior year. The
      allowance for loan losses represented 1.13% of gross loans at year-end, compared to 1.14% at December
      2004. For additional information regarding our credit quality please refer
      to
      the “Asset Quality” section.




**Results
      of Operations**




**Net
      Interest Income**




Our
      net
      interest income accounts for the majority of our revenues each year. For 2005,
      our net interest income
      totaled $40.2 million, an increase of $4.1 million, or nearly 12%, over the
      level earned in the prior year,  and
      our
      net interest margin rose seven basis points to 4.08%. This followed improvement
      in net interest income  of
      $5.3
      million, or 17%, in 2004 relative to 2003. The changes in our net interest
      income are influenced by the levels
      of growth in, and mix of, our various earning assets and funding sources, along
      with the repricing characteristics
      of those assets and liabilities. The repricing of our assets and liabilities
      is,
      in turn, influenced by the
      levels of and changes in interest rates.




As
      was
      the case in 2003 and 2004, the increase in our net interest income for 2005
      was
      primarily attributable
      to a higher level of earning assets compared to the prior year, though asset
      and
      liability repricing also
      contributed to the improvement. However, in contrast to previous years, when
      the
      pricing-related improvement
      resulted from greater declines in interest expense than in interest income,
      2005
      saw both interest  income
      and expense increase as a result of pricing, with interest income rising at
      a
      greater pace than interest  expense.
      Although the net impact of the rate-related changes in interest income and
      expense was significantly  less
      than
      that of the volume-related changes, the rate-related improvement in net interest
      income amounted to  $766,000
      in 2005. The following table illustrates the effects of both variables on net
      interest income, with the results
      related to the level of earning assets referred to as “volume,” and the effects
      of asset and liability repricing labeled “rate.”




**Rate/Volume
                Analysis****2005
                vs. 2004**
              **Increase/(Decrease)
                due to**
            
            **2004
                vs. 2003**
              **Increase/(Decrease)
                due to**
            
            **2003
                vs. 2002**
              **Increase/(Decrease)
                due to****Volume**
            
            **Rate**
            
            **Total**
              **Change**
            
            **Volume**
            
            **Rate**
            
            **Total**
              **Change**
            
            **Volume**
            
            **Rate**
            
            **Total**
              **Change****INTEREST
                INCOME**Investments:Available
                for sale securities
            
            $
            601
            
            $
            318
            
            $
            919
            
            $
            1,335
            
            $
            (129
            )
            $
            1,206
            
            $
            540
            
            $
            (1,126
            )
            $
            (586
            )Held
                to maturity securities
            
            
            (37
            )
            
            11
            
            
            (26
            )
            
            (203
            )
            
            (8
            )
            
            (211
            )
            
            (551
            )
            
            (52
            )
            
            (603
            )Other
                equity investments
            
            
            102
            
            
            (188
            )
            
            (86
            )
            
            50
            
            
            (285
            )
            
            (235
            )
            
            (48
            )
            
            8
            
            
            (40
            )Total
                investments
            
            
            666
            
            
            141
            
            
            807
            
            
            1,182
            
            
            (422
            )
            
            760
            
            
            (59
            )
            
            (1,170
            )
            
            (1,229
            )Loans:Residential
            
            
            2,476
            
            
            1,068
            
            
            3,544
            
            
            2,754
            
            
            (551
            )
            
            2,203
            
            
            1,664
            
            
            (745
            )
            
            919Residential
                construction
            
            
            967
            
            
            1,802
            
            
            2,769
            
            
            1,877
            
            
            104
            
            
            1,981
            
            
            1,359
            
            
            104
            
            
            1,463Multifamily
            
            
            (565
            )
            
            1,107
            
            
            542
            
            
            438
            
            
            (1,336
            )
            
            (898
            )
            
            709
            
            
            (1,636
            )
            
            (927
            )Multifamily
                construction
            
            
            (133
            )
            
            216
            
            
            83
            
            
            109
            
            
            (61
            )
            
            48
            
            
            (85
            )
            
            45
            
            
            (40
            )Commercial
                real estate and business
            
            
            586
            
            
            2,218
            
            
            2,804
            
            
            (19
            )
            
            (917
            )
            
            (936
            )
            
            1,397
            
            
            (2,310
            )
            
            (913
            )Commercial
                real estate construction
            
            
            224
            
            
            254
            
            
            478
            
            
            56
            
            
            146
            
            
            202
            
            
            (36
            )
            
            (64
            )
            
            (100
            )Consumer
                & other
            
            
            954
            
            
            256
            
            
            1,210
            
            
            1,569
            
            
            536
            
            
            2,105
            
            
            1,806
            
            
            354
            
            
            2,160Total
                loans
            
            
            4,509
            
            
            6,921
            
            
            11,430
            
            
            6,784
            
            
            (2,079
            )
            
            4,705
            
            
            6,814
            
            
            (4,252
            )
            
            2,562Total
                interest income
            
            
            5,175
            
            
            7,062
            
            
            12,237
            
            
            7,966
            
            
            (2,501
            )
            
            5,465
            
            
            6,755
            
            
            (5,422
            )
            
            1,333




2




**2005
                vs. 2004**
              **Increase/(Decrease)
                due to**
            
            **2004
                vs. 2003**
              **Increase/(Decrease)
                due to**
            
            **2003
                vs. 2002**
              **Increase/(Decrease)
                due to****Volume**
            
            **Rate**
            
            **Total**
              **Change**
            
            **Volume**
            
            **Rate**
            
            **Total**
              **Change**
            
            **Volume**
            
            **Rate**
            
            **Total**
              **Change****(Dollars
                in thousands)****INTEREST
                EXPENSE**Deposits:Money
                market deposit and
              checking
            
            367
            
            1,090
            
            1,457
            
            708
            
            (15
            )
            693
            
            616
            
            (391
            )
            225Savings
            
            (2
            )
            4
            
            2
            
            (1
            )
            (1
            )
            (2
            )
            8
            
            (31
            )
            (23
            )Time
                deposits
            
            1,225
            
            3,217
            
            4,442
            
            1,288
            
            (1,671
            )
            (383
            )
            814
            
            (3,029
            )
            (2,215
            )Total
                deposits
            
            1,590
            
            4,311
            
            5,901
            
            1,995
            
            (1,687
            )
            308
            
            1,438
            
            (3,451
            )
            (2,013
            )FHLB
                and other advances
            
            202
            
            1,985
            
            2,187
            
            1,083
            
            (1,222
            )
            (139
            )
            1,511
            
            (2,263
            )
            (752
            )Total
                interestexpense
            
            1,792
            
            6,296
            
            8,088
            
            3,078
            
            (2,909
            )
            169
            
            2,949
            
            (5,714
            )
            (2,765
            )Net
                interest income
            
            $
            3,383
            
            $
            766
            
            $
            4,149
            
            $
            4,888
            
            $
            408
            
            $
            5,296
            
            $
            3,806
            
            $
            292
            
            $
            4,098




***Earning
      Asset Growth (Volume)***




In
      each
      of the last three years, the majority of the improvement in our net interest
      income has been attributable to growth in our earning assets. For 2005, our
      earning assets averaged nearly $987 million, representing an 11% increase over
      the prior year. Similarly, for 2004, our average earning assets totaled $889
      million, a 15% increase over the 2003 level.




As
      illustrated in the Rate/Volume Analysis table, our loan portfolio has accounted
      for most of the volume-related
      growth in interest income each year. Our average loans, including loans held
      for
      sale, increased  in
      2005
      by more than 10% over the prior year, following growth of approximately 13%
      in
      both 2003 and 2004.  It
      was
      this growth in our average loan balances that largely accounted for the $6.8
      million, $8.0 million, and  $5.2
      million volume-related increases in interest income for 2003, 2004, and 2005,
      respectively. While growth  in
      the
      loan portfolio has been a recurring theme over the last few years, the
      categories driving the growth have changed
      over that timeframe.




In
      2003,
      the increase in interest income attributable to additional volume was driven
      by
      the combination  of
      consumer, residential, residential construction, commercial real estate and
      business, as well as multifamily loans,
      while in 2004, residential mortgages, construction loans, and consumer loans
      were the primary contributors to volume-based interest income growth. This
      continued into 2005, with residential, residential construction,
      and consumer loans again driving the improvement, though the contribution of
      consumer loans  continued
      to decline. The reduction in the contribution of consumer loans was largely
      attributable to a lower  volume
      of
      sales finance loan originations in 2005 compared to 2004, as well as some large
      sales of these loans  in
      early
      2005. Additionally, a contraction in the multifamily loan portfolio led to
      a
      reduction in interest income  relative
      to the prior year. Based on our current observations of loan production and
      expectation of future loan sales,
      we expect that residential lending will continue to be the most significant
      factor in the volume-based growth
      of
      interest income. The role of commercial real estate, business banking, and
      multifamily loans is more difficult to predict, as these credits tend to be larger, and consequently
      more
      capable of a significant impact. The
      production and potential sales of these loans are also more difficult to predict
      with any reasonable degree  of
      accuracy. Finally, we expect additional consumer loan balances to continue
      contributing to interest income  growth,
      though likely at more recent levels, as opposed to those of prior years, based
      on last year’s decline in originations and the lower rate of portfolio growth.




By
      comparison, the growth in our securities holdings made less meaningful
      contributions to the overall net interest income improvement in 2004 and 2005,
      and had virtually no impact in 2003. The additional volume-based
      interest income from securities in 2004 and 2005 was attributable to our
      decision in mid-2004 to increase
      the size of our securities portfolio.




We
      generally rely on growth in our deposit balances, which include certificates
      issued in institutional markets through deposit brokerage services, to support
      our asset growth. As of 2005 year-end, our total




3




deposits
      were up approximately $85 million, or nearly 13% from the end of the prior
      year,
      representing only a  modest
      slowdown from the $91 million, or 16%, deposit growth observed in 2004 and
      $87
      million, or 17%, in  2003.
      More significantly, however, checking and money market balances accounted for
      only $9 million, or 11%  of
      the
      year 2005 growth, after accounting for approximately $62 million, or 68% of
      the
      2004 deposit growth,  and
      approximately two-thirds of the increase in 2003. We experienced declines in
      checking and money market balances
      in the first and third quarters of 2005 when we aggressively promoted time
      deposits through promotional interest rates.




Throughout
      2003 and 2004, rates paid on retail deposits tended to be very low relative
      to
      historical norms, with
      highly-liquid money market accounts paying nearly identical rates to the much
      less-liquid short- and intermediate- term time deposits. With time deposits
      offering very little rate incentive over money market accounts,
      more depositors opted for the additional liquidity of the money market accounts.
      This was a major contributing factor to the growth in our money market balances in 2003 and
      2004.




In
      early
      2005, however, the increases in short-term market interest rates that began
      in
      the second quarter of 2004
      started affecting the yields on retail deposits, with the rates paid on time
      deposits increasing more significantly
      than those paid on money market accounts. This made it difficult to retain
      or
      grow checking and  money
      market balances without incurring excessive marginal costs, as any rate
      increases would apply not only to any
      newly opened accounts, but existing balances as well. Consequently, we observed
      declines in our checking
      and money market balances in the first quarter of 2005. By the end of the second
      quarter, however, the
      trend appeared to have changed, as we saw our checking and money market balances
      rising to $253
      million, approximately $1 million below the 2004 year-end level. In the third
      quarter, however, some of  our
      competitors began offering deposit rates that threatened our ability to retain
      deposit balances. As a result, we were
      forced to offer a promotional time deposit rate and increase our non-maturity
      deposit rates. Despite the increased rates on our money market accounts and
      the
      greater liquidity offered by these deposits, many customers found the
      promotional time deposit rate more attractive than money market
      products.




The
      growth of checking and money market accounts typically helps us reduce our
      overall cost of funds. Consequently, we consider the growth of these account
      types to be an important part of our funding strategy for the future. To
      encourage this growth, we actively monitor the products and rates offered by
      our competition
      in the local market and develop new products and/or offer attractive rates
      to
      acquire new balances in the
      most cost-effective manner possible.




When
      we
      find ourselves unable to fully support our asset growth with new deposits,
      we
      typically utilize advances
      from the Federal Home Loan Bank of Seattle (FHLB) as a supplemental funding
      mechanism. Based on the combination of asset and deposit growth in 2005, we
      did
      not have to rely as significantly on additional
      borrowings as we have in prior years. Consequently, the incremental interest
      expense incurred as a  result
      of
      additional advances totaled only $202,000 for 2005. This represented a
      significant reduction relative to prior
      years, when we increased our utilization of FHLB advances to accommodate asset
      growth. In 2004, volume-based interest expense was $1.1 million over the
      previous year, which was in turn an additional $1.5 million over the 2002
      level.




***Asset
      Yields, Funding Costs, and Net Interest Margin (Rate)***




As
      noted
      above, our net interest margin for 2005 totaled 4.08%, up from 4.01% for 2004,
      and represented  the
      fourth consecutive year for improvement in the margin. However, in contrast
      to
      2003 and 2004, when the  pricing-related
      improvement in net interest income could be attributed to a greater decline
      in
      interest expense than in
      interest income, 2005 saw both interest income and expense increase as a result
      of repricing, with interest income rising more significantly than interest
      expense.




The
      pricing-related increases in interest income and expense for 2005, as well
      as
      the declines in prior years,
      were largely attributable to the interest rate environment over that period.
      Between 2001 and 2003, most  major
      interest rate indexes were falling and the Federal Reserve Bank cut rates a
      total of thirteen times, eleven in 2001
      and once each in 2002 and 2003. By mid-2004, however, short-term market interest
      rates changed direction, with major market indexes moving upward and the Federal
      Reserve Bank commencing a series of increases of its target Fed Funds rate.
      Rising short-term interest rates continued throughout 2005.




4




In
      2001
      through 2003, the yield on our loan portfolio, which consists primarily of
      adjustable rate loans tied to short-term market indexes and subject to
      contractually-defined repricing terms, began falling in response
      to the interest rate movements. Despite the reversal and upward movement in
      market interest rates in 2004,
      our portfolio yield continued to decline, as favorable repricing on
      construction, consumer, and other loans failed to offset the negative repricing
      impacts of single and multifamily residential mortgages and commercial
      real estate loans. The negative repricing effects were largely attributable
      to
      loans repricing prior to  the
      time
      most interest rate indexes began to move upwards. Also contributing to the
      continued decline in yield were
      higher-rate loans paying off and being refinanced with new loans originated
      at
      the lower interest rates available at that time. For 2005, all major loan
      categories showed pricing-related improvement in interest income as existing
      adjustable rate loans repriced, and new loans were originated at higher interest
      rates. If rates
      were to remain at current levels, we would expect to see continued rate-related
      interest income growth in  2006,
      as
      our existing adjustable rate loans continue to reprice based on current
      underlying index levels and new loans
      are originated at rates higher than those acquired last year. However, as the
      future of interest rates is highly uncertain and difficult to estimate with
      any
      degree of accuracy, any number of economic or non-economic factors or events
      could result in actual results varying significantly from this
      expectation.




The
      interest rate movements described earlier affected the yield earned on our
      investment portfolio in a similar
      manner, though to a lesser degree, as fixed-rate instruments represent a much
      greater percentage of the securities portfolio than the loan portfolio. The portfolio’s performance over
      the last two years was also significantly impacted by our holdings of FHLB
      stock. As a member of the FHLB, and to utilize FHLB advances
      as a funding source for our lending and investment activities, we maintain
      a
      position in FHLB stock.  Our
      position in this stock, which totaled nearly $13 million at the years ended
      December 31, 2004 and 2005,  had
      historically paid dividends on a quarterly basis. With restructuring at the
      FHLB, however, these dividends were
      reduced in the first quarter of 2004, with a further reduction occurring in
      the
      third quarter of that year, and no dividend paid in the fourth quarter. For
      2005, the first quarter dividend was a fraction of that paid in prior
      years, and no dividends were paid for the remainder of the year. The reduction
      of these dividends resulted  in
      a
      significant decline in investment income relative to prior years, which is
      represented in the “Other Equity Investments” line in the Rate/Volume Analysis table.




In
      contrast, the pricing of our deposit accounts is not tied directly to short-term
      market index rates, but is  instead
      driven principally by competition in our local market. As a result, in an
      environment where rates move  rapidly,
      the pricing of our deposits will typically lag the market index rates, moving
      in
      a more gradual fashion  and
      continuing to move for some time after market rates have leveled off or changed
      direction. Largely due to this
      lagging effect, our liability costs declined more significantly than asset
      yields in 2003, and resulted in a greater
      rate-related decrease in interest expense than in interest income for that
      year.
      In 2004, we continued to see
      pricing-related reductions in our deposit expense, despite the start of an
      upward trend in short-term interest rates beginning in the second quarter.
      Reflecting the lagging nature of deposit rates, these increases did not impact
      our deposit pricing until late in the year, by which time the vast majority
      of
      our deposit base had
      already repriced and new deposits had been acquired at relatively low interest
      rate levels. By the end of the  2004,
      however, these increases in short-term interest rates had begun to influence
      the
      deposit rates offered by our
      competitors in our local market. The lagged effects of rate increases in 2004
      and 2005, combined with intense competition for deposits in our local
      marketplace, particularly during the first and third quarters of 2005, resulted
      in the rate-related increase in interest expense illustrated in the Rate/Volume
      Analysis table.




**Noninterest
      Income**




Growth
      of
      our noninterest income has been a focus of management in recent years and
      remains a priority going
      forward. In both 2003 and 2004, we succeeded in growing our noninterest income
      over the prior year level, with increases of 13% in 2003 and 16% in 2004. In
      2003, the increase was primarily attributable to growth in rental income
      following our purchase of the First Mutual Center in the first quarter of that
      year, while the additional income in 2004 resulted largely from higher gains
      on
      loan sales and, to a lesser extent, growth in service fee income. For 2005,
      our
      noninterest income exceeded the 2004 level by $1.1 million, or 26%, as
      additional service fee income and higher loan prepayment fees offset significant
      reductions in loan sales and gains thereon.





5




***Gain
      on Sales of Loans***




Following
      a substantial increase in 2004, gains on loan sales declined by approximately
      18% in 2005. Both  the
      growth in 2004 and the decline in 2005 were largely attributable to the sale
      of
      our consumer loans. In 2003, gains on
      loan sales fell relative to the prior year due largely to decreasing volumes
      of
      both residential and consumer loan sales, which were partially offset by an
      increase in commercial loan sale gains.




**Gains
                on Loan Sales**
            
            **2005**
            
            **2004**
            
            **2003**Consumer
                Loan Sale Gains
            
            $
            820,000
            
            $
            1,435,000
            
            $
            411,000Commercial
                Loan SaleGains
            
            
            271,000
            
            
            175,000
            
            
            105,000Residential
                Loan Sale Gains
            
            
            350,000
            
            
            147,000
            
            
            468,000Total
                Gains on Loan Sales
            
            $
            1,441,000
            
            $
            1,757,000
            
            $
            984,000**Loans
                Sold**Consumer
                Loans Sold
            
            $
            17,883,000
            
            $
            35,572,000
            
            $
            12,859,000Commercial
                Loans Sold
            
            
            11,310,000
            
            
            32,606,000
            
            
            24,530,000Residential
                Loans Sold
            
            
            38,019,000
            
            
            35,787,000
            
            
            58,439,000Total
                Loans Sold
            
            $
            67,212,000
            
            $
            103,965,000
            
            $
            95,828,000




*Consumer
      Loan Sales.* The
      year-to-year fluctuations in gains on consumer loan sales have typically followed
      changes in strategy regarding the amount of loans we sell. In 2002, we decided
      to scale back our loan  sales,
      leading to a $111,000 decline in loan sale gains from 2002 to 2003. In late
      summer of 2003, we revised our
      strategy and began to sell more loans as originations increased and our
      portfolio grew. This led to the substantial increase in loan sale gains in
      2004.




In
      our
      second-quarter 2005 press release, we noted another significant change in our
      strategy regarding the
      sales
      of consumer loans. Prior to that time, our plan had been to sell approximately
      $6-$8 million in loans each
      quarter, though actual sales in a given quarter could fall above or below this
      range depending on loan production, market conditions, and other factors. Our
      change in strategy included reducing the sale of these loans, selling only
      sufficient volumes to ensure the continuity of the market. Accordingly, our
      third-quarter 2005
      loan
      sales were well below those for the same period last year and no sales occurred
      in the fourth quarter. While
      the reduction in gains on sales negatively impacted our noninterest income
      in
      the third and fourth quarters,
      the decline in loans sold allowed us to retain a greater volume of these
      higher-yielding assets within our
      portfolio. Additionally, despite the decrease in loans sold, our gains on
      consumer loan sales totaled $820,000 for 2005, and accounted for the majority
      of
      all loan sale gains for the year.




At
      the
      present time, we are experiencing an increased level of interest in, and
      favorable opportunities to market,
      our consumer loans to other institutional investors. Consequently, our
      expectation is that sales of these  loans
      will likely increase in 2006. In the first quarter, we anticipate selling $9-$10
      million of consumer loans, and
      $7-$9 million in the second quarter. However, given the unpredictability of
      the
      level of interest among potential
      investors, we do not know if the higher sales volumes are likely to extend
      beyond the first half of the year.




*Commercial
      Loan Sales.* Gains
      on
      commercial loan sales have increased noticeably over the last three years,
      including an increase of approximately 55% for 2005. In 2004, gains on
      commercial sales increased 67% over
      2003, which was in turn roughly double the 2002 level.




Historically,
      we have typically utilized commercial loan sales to limit our credit exposure
      to
      any one borrower.
      However, in our second-quarter press release, we noted that we had experienced
      increased interest  in,
      and
      opportunities for, sales of participations in our commercial real estate loans.
      Consequently, we added that we
      were considering the merits of expanding our commercial real estate loan sales
      and potentially originating credits with the intent to sell, rather than retain
      the loans in our portfolio. While the volume of commercial real estate loans
      sold in the third quarter was modest and fourth quarter sales were down considerably
      relative to the same period last year, we would note that these volumes do
      not
      reflect a decision




6




against
      expanding our commercial real estate loan sales. Instead, we still regard an
      increase in such sales as likely in 2006. Commercial real estate loan
      transactions, particularly those that are candidates for sales of participations
      to other institutions, tend to be larger-dollar credits and unpredictable in
      their timing and frequency
      of occurrence. As a result, the amount of commercial real estate loans sold,
      and
      gains thereon, can be
      expected to vary considerably from one quarter to the next depending on the
      timing of the loan and sales transactions.




*Residential
      Loan Sales.* Our
      gains
      on residential loan sales increased 139% in 2005, compared to declines of 69%
      in
      2004 and 15% in 2003, which followed a return to a more normalized residential
      lending environment after a high level of refinancing activity in 2001 and
      2002.
      The additional gains for 2005 were largely attributable to a fourth-quarter
      sale
      of approximately $5.4 million in “interest only” (IO) residential mortgages. A
      similar sale of low-documentation (low-doc) residential loans had been planned
      for the first quarter
      of 2006. While we do not, at the present time, anticipate that a sale of these
      loans will be completed in  the
      first
      quarter of 2006, it is still our intention to sell these loans in 2006. We
      consider these IO and low-doc  sales
      to
      be unique events rather than indicative of any future trend in loan sales,
      and
      it is our expectation that  gains
      on
      residential loan sales will, with the potential exception of the quarter in
      which the low-doc loans are sold
      decline from their 2005 level in future quarters.




***Service
      Fee Income***




**2005**
            
            **2004**
            
            **2003**Consumer
                Loan Service Fees
            
            $
            1,228,000
            
            $
            244,000
            
            $
            5,000Commercial
                Loan Service Fees
            
            
            69,000
            
            
            71,000
            
            
            59,000Residential
                Loan Service Fees
            
            
            3,000
            
            
            (1,000
            )
            
            6,000Total
                Service Fee Income
            
            $
            1,300,000
            
            $
            314,000
            
            $
            70,000




Our
      service fee income rose 314% for 2005, following an increase of 349% in 2004,
      as
      a result of substantial
      increases in fees earned on consumer loans sold to, and serviced for, other
      institutions. For 2005, the
      growth in consumer loan service fees was largely attributable to a change in
      the
      amortization period assumed for the underlying servicing asset made in early
      2005. Additional loan sales, particularly the larger sales
      in
      late 2004 and the first quarter of 2005, and corresponding growth in our
      portfolio of consumer loans serviced
      for others also contributed to the increase in servicing income. In 2004, the
      increase in service fees was attributable to greater loan sales and the
      resulting growth in our servicing portfolio.




Servicing
      assets are recorded when we sell loans to other investors and continue to
      service those loans following the sale. To determine the fair value of the
      servicing assets, we utilize a valuation model that calculates the present
      value
      of future cash flows for the loans sold, based on assumptions including market
      discount rates, anticipated prepayment speeds, estimated servicing cost per
      loan, and other relevant factors. These
      factors are subject to significant fluctuations, and the estimates used in
      the
      models are subject to review  and
      revision based on actual experience and changes in expectations for the future.
      The calculated value of the  servicing
      rights is then capitalized and amortized in proportion to, and over the period
      of, estimated future net servicing income.




Based
      on
      a review of our assumptions in the first quarter of 2005, we determined that
      the
      amortization period
      for the servicing rights on our consumer loan servicing portfolio was
      significantly shorter than the term over
      which these loans would be expected to provide net servicing income.
      Consequently, we revised the amortization
      period such that the average life of the amortization schedule would correspond
      with the average  life
      we
      are currently observing for the underlying loan portfolio. This resulted in
      a
      significant increase in our net
      servicing income. Note that any projection of servicing asset amortization
      in
      future periods is limited by the conditions that exist at the time the
      calculations are performed.




The
      income received for servicing consumer loans has also grown as a result of
      our
      sales finance loan sales,
      particularly the larger sales in 2004 and in the first quarter of 2005, and
      the
      corresponding growth in our




7




portfolio
      of consumer loans serviced for others. Based on our anticipated consumer loan
      sales in 2006, we do not
      expect continued rapid growth in service fee income.




Fee
      income earned on our commercial loans serviced for others was not a major
      contributor to the growth in our
      total service fee income. In the event we expand our sales of commercial real
      estate loans in 2006, however,
      we would expect this income to grow and potentially become a significant
      percentage of total service fee
      income. In contrast, residential loans are typically sold servicing released,
      which means we no longer service those loans once they are sold. Consequently,
      we do not view these loans as a significant source of servicing fee
      income.




***Deposit
      Fee Income***




Deposit
      fee income continued the trend established over the last few years, growing
      to
      $630,000 this year, up from
      $571,000 in 2004 and $516,000 in 2003, largely as a result of additional
      checking account service charges, which were partially offset in 2005 by a
      decline in savings account service charges. Deposit fee income
      has risen steadily over the last three years as a result of growth in the number
      of checking accounts as well as
      the balances maintained in those accounts. Business checking balances, in
      particular, grew substantially,
      climbing 47% in 2005, 52% in 2004, and 37% in 2003, while the number of accounts
      increased 15% from
      1,968 to 2,262.




***Other
      Noninterest Income***




For
      2005,
      our noninterest income from sources other than those described earlier rose
      $446,000, or 29%,  with
      the
      largest contributor being an increase in loan fees, specifically prepayment
      fees. These fees had also been a
      major contributor to the prior year’s growth, though the improvements from these
      fees and other sources were partially offset by a decline in rental
      income.




**2005**
            
            **2004**
            
            **2003**Rental
                Income
            
            $
            627,000
            
            $
            627,000
            
            $
            713,000Loan
                Fees
            
            
            647,000
            
            
            384,000
            
            
            281,000ATM/Wires/Safe
                Deposit
            
            
            258,000
            
            
            189,000
            
            
            131,000Late
                Charges
            
            
            207,000
            
            
            167,000
            
            
            120,000Miscellaneous
            
            
            246,000
            
            
            172,000
            
            
            186,000Total
                Other Noninterest Income
            
            $
            1,985,000
            
            $
            1,539,000
            
            $
            1,431,000




Loan
      fees
      increased substantially in 2005, totaling $647,000 and reflecting an increase
      of
      approximately 68%. A
      large portion of the loan fee income for the last three years has been derived
      from loan prepayment fees,
      which have steadily increased over the last several years, totaling $557,000
      in
      2005, $319,000 in 2004, and  $118,000
      in 2003. We believe that a flattening of the yield curve, which resulted from
      rising short-term interest rates
      and relatively static longer-term interest rates, and increased competition
      from
      other lenders have contributed
      to the higher level of loan payoffs and prepayment fees. The flattening of
      the
      yield curve reduced the rate
      differential between short- and long-term financing costs and provided a
      financial incentive for borrowers with short-term or adjustable-rate loans
      to
      refinance with long-term fixed rates. Increased competition
      among lenders in our local market further accelerated loan payoffs, as this
      competition frequently resulted
      in lenders offering borrowers the opportunity to refinance at unusually low
      margins. Given the uncertainties
      regarding interest rates and the behaviors of borrowers and other lenders in
      the
      marketplace, we do not
      believe we can predict the level of prepayment fees in future quarters with
      any
      reasonable degree of accuracy.




We
      observed continued growth in our Visa/ATM fee income, which grew by $61,000
      or
      46% to total $194,000 for 2005, following a 2004 increase of 65% compared to
      2003 levels. The additional fee income earned from these sources is largely
      a
      function of the growth in our checking accounts. Consequently, we expect
      to
      see further increases in this source of income as checking accounts become
      a
      greater percentage of our
      overall deposit mix.




8




Additionally,
      revenues received from late charges on our loan portfolio increased 24% for
      2005, after growing
      39% in 2004. While the growth of sales finance loans, including both the loans
      in our portfolio as well  as
      those
      serviced for other investor institutions, accounted for the majority of the
      2005
      increase, late charges collected on our portfolio of residential loans also contributed to the
      additional income collected in 2005, particularly in the fourth
      quarter.




Rental
      income for 2005 held steady relative to the level received in the prior year
      after falling $86,000, or  approximately
      12% in 2004 as compared to 2003. In 2003, rental income increased substantially,
      to $713,000  compared
      to $99,000 in 2002, following our purchase of the First Mutual Center. In the
      third quarter of 2003, two
      large tenants at First Mutual Center vacated the building and were not replaced
      at that time due to our own expansion needs and remodeling constraints. At
      the
      end of 2005, 88% of First Mutual Center was occupied or leased and we are
      actively working to lease the remaining 12% in 2006.




**Noninterest
      Expense**




Our
      noninterest expense totaled $28.3 million in 2005, an increase of $3.7 million,
      or 15%, over the prior  year.
      In
      2004, noninterest expense had increased 20%, or $4.1 million, which followed
      a
      similar 20% increase  in
      2003.
      Major contributors to these increases include growth in compensation and
      benefits expense, including expenses
      related to additional staff, the 2003 purchase of our corporate headquarters
      building and 2005 remodels
      of that building as well as several banking centers, and rising credit insurance
      premiums attributable to the
      growth of insured balances in our sales finance loan portfolio.




***Salaries
      and Employee Benefits***




Total
      salary and benefit expenses climbed nearly 14%, to $16.2 million for 2005,
      and
      accounted for approximately
      52% of the total increase in noninterest expense for the year. The increase
      represented a slight  improvement
      from 2004, when salary and benefit expenses rose 15%, or $1.8 million over
      the
      previous year,  and
      continued improvement relative to 2003, when personnel related expenses
      increased $2.2 million, or 22%, over the
      2002 level.




**2005**
            
            **2004**
            
            **2003**Salaries
            
            $
            10,407,000
            
            $
            9,191,000
            
            $
            7,965,000Commissions
                and Incentive Bonuses
            
            
            2,525,000
            
            
            2,170,000
            
            
            1,966,000Employment
                Taxes & Insurance
            
            
            949,000
            
            
            873,000
            
            
            741,000Temporary
                Office Help
            
            
            277,000
            
            
            189,000
            
            
            278,000Benefits
            
            
            2,042,000
            
            
            1,838,000
            
            
            1,505,000Total
                Salary & Benefit Expenses
            
            $
            16,200,000
            
            $
            14,261,000
            
            $
            12,455,000




Salary
      expense is the largest component of our personnel related costs, and
      consequently will typically be  the
      most
      significant contributor to year-over-year expense growth. Over the course of
      2005, we experienced a  net
      increase of six full-time equivalent (FTE) employees. This represented FTE
      growth of approximately 3% over the
      prior year-end, and a significant decline from the 9% and 23% FTE growth
      observed in 2004 and 2003,
      respectively. FTE data reflects year-end levels, so when new employees are
      added
      late in the year, the impact
      of the additional salary expense may not be apparent until the following
      year.




The
      business areas that saw the most staff growth over the course of 2005 were
      our
      consumer loan administration
      and residential lending groups, reflecting an increase in residential loan
      volume, as well as the need for
      additional staff to service the loan portfolio. We also added staff in our
      Accounting department to support
      general operations. For 2003 and 2004, the additional positions consisted
      primarily of personnel to help  build
      and
      support the growth of our loan and deposit portfolios. Additionally, significant
      numbers of staff were  added
      in
      2003 for areas related to sales finance lending and consumer loan servicing.
      Also contributing to the




9




2003
      FTE
      growth were staffing requirements related to the openings of our Woodinville
      and
      Sammamish banking centers.




**December
                31,**
            **FTE**2002
            1642003
            2012004
            2202005
            226




In
      addition to the increase in FTE, merit-based pay raises for employees awarded
      in
      April of each year  contribute
      to each year-over-year increase in salary expense. While the rate of increase
      will vary from year to  year,
      merit raises will typically result in an increase in salary expense of
      approximately 3% to 5% each year.




Commissions
      and incentive bonuses rose 16% over the prior year level, totaling $2.5 million
      for 2005. While
      this exceeded the 10% increase observed between 2003 and 2004, it remained
      well
      below the 78% increase
      from 2002 to 2003, at which time commission expense rose dramatically in
      response to new loan and  deposit
      incentive plans. By comparison, the additional commission and incentive expense
      in 2004 and 2005 has  been
      largely driven by higher loan originations, which totaled $526 million in 2005,
      up from $470 million in 2004 and
      $424 million in 2003.




While
      employee benefit costs continued to rise, increasing 11% over the prior year
      level in 2005, this  represented
      a significant reduction from the 24% and 22% rates of increase observed in
      2003
      and 2004. In  those
      years, annual increases of nearly 27% in our expenditures on employee medical
      plans accounted for a large
      portion of the increase in total benefits costs each year. In 2005, however,
      we
      were able to reduce employee
      medical insurance costs by changing the plans offered to staff members. As
      a
      result, our employee medical
      plan expenses for the year actually declined by 2% relative to 2004, despite
      an
      acceleration of insurance
      premium charges from our insurers. Excluding medical insurance related expenses,
      the growth in benefit
      expenses for 2005 was primarily attributable to increasing costs associated
      with
      the funding of retirement plans offered to our employees.




Retirement
      plan expenses continue to rise each year, though at a lower rate of increase
      than in recent years.
      Costs related to employee retirement plans increased 17% in 2004 and 18% in
      2005, which represented a  reduction
      relative to the 25% rate of increase observed in 2003. The most significant
      portion of the retirement plan
      expenses was the matching of employees’ 401 (k) contributions. We would expect
      these expenses to continue
      to grow as our aggregate staffing level continues to rise and more FTE become
      eligible to receive matching
      funds on their 401 (k) contributions.




An
      issue
      that complicates the reporting of our compensation expense is the deferral
      of
      certain costs directly associated with loan originations. In accordance with
      current accounting literature, certain loan origination costs are deferred
      and
      amortized over the life of each loan rather than expensed in the current period.
      These costs include, among other items, the expense related to the personnel
      involved in originating the
      loan. The net figures are then reported in the financial statements.
      Consequently, our compensation expense
      can vary from one period to the next based upon loan origination volumes, the
      mix of different loan  types
      and
      the year-to-year changes in standard loan costs. The table below shows the
      impact of deferred loan origination costs on salary and employee benefit expenses.




**Effect
                of Deferred Loan Origination Costs**
            
            **2005**
            
            **2004**
            
            **2003**Salaries
                and Employee Benefits
            
            $
            18,794,000
            
            $
            16,638,000
            
            $
            14,688,000Deferred
                Loan Origination Costs
            
            
            (2,594,000
            )
            
            (2,377,000
            )
            
            (2,233,000
            )Net
                Salaries and Employee Benefits
            
            $
            16,200,000
            
            $
            14,261,000
            
            $
            12,455,000Loan
                Volume
            
            $
            525,981,000
            
            $
            469,717,000
            
            $
            424,364,000




As
      indicated in the above table, the impact of deferred loan origination costs
      on
      our salary and benefits expense
      has gradually increased over the last two years as changes in loan originations,
      mix, and the standard




10




loan
      costs for each loan type impacted our total deferred costs each year. Between
      2004 and 2005, significant increases in the standard loan costs for both income property and custom
      construction loans, along with an increase in the number of custom construction
      loans originated, offset reductions in deferred costs for other areas,
      most notably Sales Finance, which declined due to a decrease in both its
      standard loan costs as well as  the
      number of loans originated relative to the prior year. In contrast, between
      2003
      and 2004 it was the Sales  Finance
      and Business Banking divisions that posted significant increases, based on
      the
      growth in the number  of
      business banking loans originated and a substantially higher standard cost
      for
      Sales Finance as compared to the
      prior year. We generally expect that growth in loan originations on a bank-wide
      basis will translate to a year-over-year increase in deferred loan costs. This
      is due to the number of variables involved in estimating deferred
      costs, as well as the volatility of some of those variables. As a result, we
      cannot state with a great deal of
      certainty that these deferrals will continue to increase in future
      periods.




An
      additional item that did not factor into our compensation expense in 2005,
      but
      that will significantly impact
      2006, is the expense related to the stock options granted to our employees.
      On
      December 16, 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123(R), *Accounting
      for Stock-Based Compensation.* Statement
      123 (R) requires all share-based payments to employees, including grants of
      employee stock options, to be recognized in the income statement based on their
      fair values. Pro forma disclosure
      is no longer an alternative. We adopted Statement 123(R), effective as of the
      first quarter of 2006.




We
      have
      implemented Statement 123 (R) using the modified retrospective method, which
      allows us to restate all prior periods. Based on our current estimates, we
      believe that the adoption of Statement 123(R) will result in expense of $545,000
      and impact our 2006 earnings per share by approximately $0.11. For comparison,
      we expect that once results are restated following adoption, Statement 123(R)
      will result in options-related expense of $570,000 for 2005, affecting earnings
      per share by an estimated $0.09.




***Occupancy***




Occupancy
      expense continued its upward trend, rising 26% in 2005, following increases
      of
      14% and 4% in 2004 and
      2003, respectively. As was the case in both 2003 and 2004, additional
      depreciation expense was a major
      contributor to the year-over-year increase. Also contributing significantly
      to
      the higher level of costs in 2005
      were other occupancy costs associated with our First Mutual Center and banking
      center remodeling projects.




**2005**
            
            **2004**
            
            **2003**Rent
                Expense
            
            $
            322,000
            
            $
            313,000
            
            $
            323,000Utilities
                and Maintenance
            
            
            685,000
            
            
            639,000
            
            
            543,000Depreciation
                Expense
            
            
            1,651,000
            
            
            1,321,000
            
            
            1,078,000Other
                OccupancyCosts
            
            
            855,000
            
            
            514,000
            
            
            499,000Total
                Occupancy Expenses
            
            $
            3,513,000
            
            $
            2,787,000
            
            $
            2,443,000




Depreciation
      expense has increased considerably in each of the last three years,
      corresponding with our acquisition of the First Mutual Center building in the
      first quarter of 2003. With this acquisition, 2003 depreciation expense
      increased to nearly $1.1 million from $862,000 in 2002. Despite the additional
      depreciation expense that year, as well as increases in utilities and
      maintenance expenses associated with ownership of the building, total occupancy
      expense rose only 4% in 2003. These additional expenses were largely
      offset by a substantial reduction in rent expense, as we no longer leased the
      space we occupied in the building. In 2004, capital expenditures for the enhancement of our information
      systems infrastructure, investment in enterprise software, the remodel of one
      banking center, and an increase in the amortization of leasehold improvements
      led to the growth in deprecation expenses as compared to the previous
      year.




For
      2005,
      the additional depreciation expense largely resulted from remodeling projects
      and improvements at First Mutual Center, our corporate headquarters, and several
      of our banking centers. Since these
      remodeling projects were completed over the course of 2005, the total
      depreciation expense for the year  reflects
      only a partial year of depreciation for most projects. Since the 2006 financial
      results will include a full




11




twelve
      months of depreciation expense, and because we still have some remaining
      improvement projects yet to complete, we expect depreciation expense will continue to increase in
      2006.




In
      addition to the growth in depreciation expense, other costs played a significant
      role in the overall increase
      in occupancy expenses for the year. The primary components contributing to
      the
      increase over the prior
      year were purchases of non-capitalized assets and equipment that were primarily
      related to the remodeling
      projects carried out this year, as well as increases in software licensing
      fees
      and higher servicing  costs
      for
      information systems related equipment. Software licensing fees rose nearly
      $107,000 for the year as a  result
      of
      a new licensing agreement we signed with Microsoft and the procurement of new
      banking-specific software
      programs.




***Other
      Noninterest Expenses***




Other
      noninterest expense increased $1.1 million, or 14% in 2005, representing a
      significant deceleration  in
      the
      rate of increase relative to the 23% and 35% increases in 2003 and 2004,
      respectively. The bulk of the  2005
      increase in other noninterest expenses was attributable to higher credit
      insurance premiums, the growth in the
      use of outside services, and increased loan processing expenses. In contrast,
      for 2003 and 2004, the additional
      other noninterest expense was largely attributed to costs related to our sales
      finance loan portfolio as well as
      additional information systems and marketing costs.




**2005**
            
            **2004**
            
            **2003**Marketing
                & Public Relations
            
            $
            1,389,000
            
            $
            1,243,000
            
            $
            1,087,000CreditInsurance
            
            
            1,506,000
            
            
            1,102,000
            
            
            258,000Outside
                Services
            
            
            763,000
            
            
            600,000
            
            
            482,000Taxes
            
            
            490,000
            
            
            483,000
            
            
            471,000Information
                Systems
            
            
            931,000
            
            
            1,001,000
            
            
            649,000Legal
                Fees
            
            
            501,000
            
            
            421,000
            
            
            404,000Other
            
            
            3,045,000
            
            
            2,716,000
            
            
            2,269,000Total
                Other Noninterest Expenses
            
            $
            8,625,000
            
            $
            7,566,000
            
            $
            5,620,000




The
      most
      substantial increase in noninterest expenses occurred in credit insurance
      premiums, which rose  $404,000
      in 2005, following increases of $844,000 in 2004 and $249,000 in 2003. While
      the
      vast majority of  credit
      insurance expense is attributable to insured balances of Sales Finance loans,
      a
      small percentage of the  2005
      expense reflects coverage of other consumer and real estate loans, which we
      insure depending on various fi nancial
      or non-financial factors relating to the loans and/or borrowers. At the 2003
      year-end, insured sales f inance
      loan balances totaled $27 million, growing substantially to $48 million at
      the
      2004 year-end, then more  modestly
      in 2005, ending the year at $55 million. Also contributing to the additional
      credit insurance expense in 2005
      was a supplemental insurance policy we purchased from a new insurer. This
      supplemental policy provides
      an additional $1.1 million in coverage on a seasoned pool of loans already
      covered by our previous  insurer.
      Per the terms of this supplemental policy, in the event that our previous
      insurer’s maximum exposure  limit
      on
      the pool of loans is reached, our new insurer will provide coverage on the
      remaining loans in the pool, subject
      to a policy limit of 10% of the balance insured in each policy
      year.




The
      amount spent on outside services in 2005 increased $163,000, or 27%, while
      the
      same category of expense
      increased $118,000, or 25%, in 2004 and $172,000, or 55%, in 2003. The majority
      of this year’s increase
      occurred in the fourth quarter, when we contracted outside labor to assist
      with
      moving and set-up  work
      associated with the remodeling of several banking centers and relocations of
      various departments within the
      remodeled First Mutual Center. In addition to these services, we spent
      approximately $76,000 on consulting
      services in the fourth quarter, with approximately half of that amount dedicated
      to a project for  testing
      internal data controls related to the Sarbanes/Oxley Act. Increased expenditures
      for Sarbanes/Oxley compliance issues are a trend that continues from 2004, when accounting and
      auditing fees increased significantly.




12




Following
      increases of 34% and 54% in 2003 and 2004, respectively, information systems
      costs declined $70,000
      or 7% in 2005 to a total of $931,000. This decline was primarily attributable
      to
      a substantial rate reduction
      for 2005 following negotiations with our core service provider in late 2004.
      Higher charges from this same
      provider, along with the development of new products and greater utilization
      of
      our online banking features,
      had contributed significantly to the increase in 2004, while the increase in
      2003 was largely related to improving systems to accommodate asset growth and the opening of our Woodinville
      and Sammamish banking centers.




Other
      noninterest expenses not elsewhere classified increased 12%, or $329,000, over
      2004 levels. The majority of the increase in these expenses for 2005 was
      attributable to loan processing costs, which rose $183,000 compared to 2004.
      In
      accordance with current accounting standards, certain expenses tied to loan origination,
      including some of these loan processing costs, are deferred and amortized over
      the life of each loan  originated,
      rather than expensed in the current period. Expenses are then reported in the
      financial statements  net
      of
      these deferrals. The amount of expense subject to deferral and amortization
      can
      vary from one period to the next
      based upon the number of loans originated, the mix of loan types, and
      year-to-year changes in “standard
      loan costs.” The increase in processing costs observed in 2005 is largely the
      result of the reduction in  deferred
      costs compared to 2004. The amount of processing expense eligible for deferral
      for several loan types, particularly custom construction loans, declined compared to last year. Based
      on
      the current level to which expenses are deferred, and specifically how far
      that
      level was reduced in 2005 relative to prior years, it is unlikely that the
      upward trend in loan processing expense will continue based on future changes
      in
      standard loan costs.




For
      2004,
      growth in accounting and audit service expenses related to Sarbanes/Oxley
      compliance, as previously mentioned in the discussion of outside services
      expenditures, contributed significantly to the increase in this category. In
      2003, greater expenditures on office supplies relative to the prior year
      factored heavily
      in the increase in this category, as our staff levels, loan volumes, and number
      of banking centers grew that
      year.




**Reserve
      and Provision for Loan Losses**




The
      provision for loan losses reflects the amount deemed appropriate to produce
      an
      adequate reserve for possible
      loan losses inherent in the risk characteristics of the loan portfolio. In
      determining the appropriate reserve
      balance, we consider the current and historical performance of the loan
      portfolio, the amount and type  of
      new
      loans added to the portfolio, our level of non-performing loans, the amount
      of
      loans charged-off, and the
      economic conditions in which we currently operate.




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 credit 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, which further evaluates national and international
      trends and makes a recommendation as to the loan loss provision to the Audit
      Committee of the Board of
      Directors. The Audit Committee considers the input of the Asset Management
      Department and the recommendation of the Loan Policy Committee and determines
      the appropriate level of reserves. The Board of Directors reviews and ratifies
      the actions of the Audit Committee.




After
      increasing from $1,150,000 in 2003 to $1,565,000 in 2004, our provision for
      loan
      losses declined modestly for 2005, totaling $1,500,000. A number of
      considerations contributed to the 2005 provision, including the magnitude and
      nature of growth in the loan portfolio, an ongoing assessment of the local
      and
      national economies, the amount of charged-off loans, and the level of
      non-performing assets.




Our
      net
      loan portfolio (excluding loans held-for-sale) grew $69 million over the twelve
      months ended December
      31, 2005, a significant reduction from the $84 million increase in 2004 and
      $101
      million in 2003. Additionally, our loan growth over the last two years has been increasingly
      attributable to our residential




13




lending
      segment, which is generally considered lower risk than commercial real estate
      or
      business banking loans, although the local economy can have a significant effect
      on the performance of all loan types.




The
      national economy, as measured by Gross Domestic Product, remained strong in
      2005, despite slowing
      compared to the prior year. Real GDP increased 3.5% in 2005 (from the 2004
      annual level to the 2005  annual
      level), compared with an increase of 4.2% in 2004. During 2005 (measured from
      the fourth quarter of 2004 to
      the fourth quarter of 2005), real GDP increased 3.1% compared to an increase
      of
      3.8% during 2004. Note
      that
      the 2005 figures utilize “advance” estimates of fourth quarter data, which was
      the data available at the time
      the provision was determined.




Economic
      conditions in the Puget Sound metropolitan area remained favorable as well,
      with
      solid, though not
      dramatic growth. The local housing market remained strong, with prices
      continuing to increase despite signs
      of
      the market beginning to slow, and commercial office vacancy rates declining
      significantly from those of one
      or two years prior.




In
      2005,
      we charged-off loan balances totaling $732,000, net of recoveries, up from
      $670,000 in 2004 and $498,000
      in 2003. The upward trend has been largely attributable to our sales finance
      loan portfolio (home improvement
      loans), which constituted 66%, or $480,000, of net charge-offs in 2005, compared
      to 54% of the  losses
      in
      2004 and 65% in 2003. Due to their unique characteristics, our consumer loans
      comprise the bulk of  our
      loan
      write-offs, though they only constitute approximately 12% of the total loan
      portfolio. Small business loans
      were responsible for $247,000 of the losses, with the remainder being the result
      of losses in the other lending areas.




Another
      factor that has influenced the size of the loan loss provision for the last
      three years has been the level of
      non-performing assets as a percentage of total assets. That ratio was 0.08%
      as
      of the 2005 year-end, compared to 0.10% a year earlier, and 0.06% at the end
      of
      2003. The comparative ratio for all FDIC-insured institutions
      was 0.50% at September 30, 2005, and 0.53% at the 2004 year-end. For a number
      of
      years we have  experienced
      better than average ratios for non-performing assets and we are hopeful that
      our
      credit culture will allow us
      to continue that trend in the future.




**Adoption
      of New Accounting Principle**




On
      December 16, 2004, the Financial Accounting Standards Board (FASB) issued SFAS
      No. 123 (revised 2004), *Share-Based
      Payment,* which
      is
      a revision of SFAS No. 123, *Accounting
      for Stock-Based Compensation.* Statement
      123 (R) supersedes APB Opinion No. 25, *Accounting
      for Stock Issued to Employees,* and
      amends SFAS No. 95, *Statement
      of Cash Flows.* Generally,
      the approach in Statement 123 (R) is similar to the approach described in
      Statement 123. However, Statement 123 (R) requires
      all share-based payments to employees, including grants of employee stock
      options, to be recognized in the
      income statement based on their fair values. Pro forma disclosure is no longer
      an alternative. Statement 123 (R) must be adopted no later than January 1,
      2006.
      Statement 123 (R) permits public companies to adopt its requirements using
      one
      of two methods:




1.
            A
                “modified prospective” method in which compensation cost is recognized
                beginning with the effective date (a) based on the requirements of
                Statement 123 (R) for all share-based payments granted after the
                effective
                date and (b) based on the requirements of Statement 123 for all awards
                granted to employees prior to the effective date of Statement 123(R)
                that
                remain unvested on the effective
                date.




2.
            A
                “modified retrospective” method which includes the requirements of the
                modified prospective method described above, but also permits entities
                to
                restate based on the amounts previously recognized under Statement
                123 for
                purposes of pro forma disclosures for either (a) all prior periods
                presented or (b) prior interim periods of the year of
                adoption.




We
      intend
      to adopt Statement 123 (R) using the modified retrospective method, restating
      all prior periods.




14




As
      permitted by Statement 123, we currently account for share-based payments to
      employees using the  intrinsic
      value method allowed under Opinion No. 25 and, as such, generally recognize
      no
      compensation cost  for
      employee stock options. Accordingly, the adoption of Statement 123 (R)’s fair
      value method will have an impact
      on our results of operations, although it will have no impact on our overall
      financial position. The impact
      of
      adoption of Statement 123 (R) is expected to be similar to the pro forma expense
      amount for 2005 but it
      will depend on levels of share-based payments granted in the
      future.




At
      December 31, 2005, we had four stock-based employee/director compensation plans,
      which are described
      more fully in Note 18 of the financial statements. The plans are accounted
      for
      under the recognition  and
      measurement principles of APB Opinion No. 25,  *Accounting
      for Stock Issued to Employees,* and
      related interpretations. No stock-based employee or director compensation cost is
      reflected in net income, as all options
      granted under those plans had an exercise price equal to the market value of
      the
      underlying common  stock
      on
      the date of grant. The following table illustrates the effect on net income
      and
      earnings per share if the fair
      value recognition provisions of SFAS No. 123, *Accounting
      for Stock-Based Compensation,* had
      been
      adopted.




**Years
                Ended December 31,****2005**
            
            **2004**
            
            **2003**Net
                income, as reported
            
            $
            10,318,649
            
            $
            9,287,813
            
            $
            8,395,738Deduct:
                Total stock-based employee/director
              compensation
                expense determined under fair value
              based
                method for all awards, net of related tax
              effects
            
            
            (569,555
            )
            
            (445,047
            )
            
            (327,461
            )Pro
                forma net income
            
            $
            9,749,094
            
            $
            8,842,766
            
            $
            8,068,277Earnings
                per share:
              Basic
                — as reported
            
            $
            1.94
            
            $
            1.76
            
            $
            1.62Basic
                — pro forma
            
            $
            1.83
            
            $
            1.68
            
            $
            1.56Diluted
                — as reported
            
            $
            1.86
            
            $
            1.68
            
            $
            1.57Diluted
                — pro forma
            
            $
            1.77
            
            $
            1.60
            
            $
            1.51Weighted
                average shares outstanding:
              Basic
            
            
            5,314,616
            
            
            5,264,412
            
            
            5,179,627Diluted
            
            
            5,542,779
            
            
            5,513,658
            
            
            5,352,960




**Critical
      Accounting Policies and Estimates**




The
      preparation of the Consolidated Financial Statements in conformity with
      accounting principles generally
      accepted in the United States requires management to make estimates and
      assumptions that affect  amounts
      reported in the Consolidated Financial Statements. Changes in these estimates
      and assumptions are  considered
      reasonably possible and may have a material impact on the Consolidated Financial
      Statements and  thus
      actual results could differ from the amounts reported and disclosed herein.
      We
      consider the assumptions  and
      estimates underlying the allowance for loan losses, servicing assets, credit
      insurance premiums, and loan origination fees and costs critical accounting policies subject to
      estimates.




For
      additional information regarding the allowance for loan losses, see “Reserve and
      Provision for Loan  Losses”
      in this Management’s Discussion and Analysis (MD&A) and “Allowance for Loan
      Losses” in Note 1 to the
      Consolidated Financial Statements. For additional information regarding
      servicing assets, see “Servicing
      Assets” under the heading “Review of Financial Condition” in this MD&A and
“Servicing Assets”  in
      Note 1
      as well as Note 7 “Servicing Assets and Servicing Fees” in the Consolidated
      Financial Statements.  Additional
      information regarding credit insurance premiums can be found under “Other
      Expenses” within the  “Noninterest
      Expense” section of the MD&A. For additional information regarding loan
      origination fees and  costs,
      see “Loans” in Note 1 to the Consolidated Financial Statements. These critical
      accounting policies are also
      discussed in the “Critical Accounting Policies” section of the Form
      10-K.




15




**Review
      of Financial Condition**




***Assets***




As
      of
      December 31, 2005, our assets increased 8% from the prior year-end level,
      totaling $1 .086 billion,  based
      primarily on growth in our loan portfolio. This represented a significant
      slowdown from the 17% asset  growth
      observed in 2004. One factor that contributed significantly to the 2004
      increase, and was not repeated in 2005,
      was growth in our securities portfolio.




***Securities***




Security
      investments (available-for-sale and held-to-maturity) declined from 2004
      year-end by $10.5
      million, to approximately $121.4 million as of December 31, 2005. We anticipate
      securities purchases to  occur
      periodically throughout the year to replace part of the run-off. Beyond any
      replacement purchases, we do not
      anticipate increasing the size of our securities portfolio at this
      time.




In
      contrast, security investments increased by more than $45 million, or 52%,
      between December 31, 2003
      and
      2004, as a result of a high volume of purchases in 2004, particularly during
      the
      second quarter. Prior  to
      2001,
      our securities portfolio represented a much larger component of our total asset
      mix. As rates declined in 2001,
      2002 and 2003, prepayments on the securities held in our portfolio accelerated,
      typically due to the underlying mortgages being refinanced at lower rates.
      Additionally, the falling interest rate environment at that time resulted in
      many securities trading at premiums to their par values. Consequently, some
      securities were sold from the portfolio during this timeframe to recognize
      the
      gains on those investments before the securities
      paid off at their par values. The volume of new securities acquired during
      these
      periods was typically well
      below the value of securities paid off and/or sold, as we were reluctant to
      add
      significant volumes of securities
      to the balance sheet with interest rates approaching historic lows. With rates
      finally starting to move upward
      in 2004, we began the process of increasing the size of the portfolio with
      short-term hybrid ARM securities.
      The increased volume of purchases did not continue into 2005, contributing
      to
      the reduction in the portfolio size and reduction in asset growth for the year.




Based
      on
      current accounting literature, any investment security purchased is classified
      in one of the following
      categories: 1) trading, 2) available-for-sale, or 3) held-to-maturity. At the
      present time, the majority  of
      securities in our portfolio are classified as available-for-sale, and none
      are
      classified as trading. Securities classified as available-for-sale are reviewed regularly, and any unrealized
      gains or losses are recorded in comprehensive
      income in the shareholders’ equity account. As of 2005 year-end, the balance of
      the unrealized  loss
      in
      comprehensive income, net of federal income taxes, totaled $1.5 million, up
      from
      unrealized losses of  $510,000
      as of the prior year end and $95,000 as of December 31, 2003. The sequential
      increases were largely attributable to the rising short- and intermediate-term interest rates over
      the
      2003 to 2005 timeframe. Generally, falling interest rates will increase the
      amount recorded as unrealized gain, and rising rates will decrease any
      unrealized gains, as the market value of securities inversely adjusts to the
      change in interest rates. The passage of time partially counteracts these
      interest rate effects, as the unrealized gain or loss on a given
      security will gradually decline to zero as the security approaches its pay-off
      date. As we do not anticipate liquidating any of our securities currently in an unrealized loss position,
      we
      do not expect that any of the current unrealized loss will directly impact
      the
      gain or loss from security sales in future periods.




***Loans***




Loans
      receivable, excluding loans held-for-sale, increased by $69 million from $809
      million at the 2004 year-end, to $878 million at December 31, 2005, as loan
      originations increased to $526 million. This




16




followed
      growth of $85 million between the years ended December 31, 2003 and 2004, as
      2004 loan originations increased 11% over the prior year to $470
      million.




**Portfolio
                Distribution**
            
            **2005**
            
            **2004**
            
            **2003**Single
                Family Residential (incl. Held for Sale)
            
            
            25
            %
            
            22
            %
            
            18
            %Income
                Property
            
            
            34
            %
            
            40
            %
            
            47
            %Business
                Banking
            
            
            13
            %
            
            13
            %
            
            10
            %Commercial
                Construction
            
            
            3
            %
            
            3
            %
            
            3
            %Single
                Family Construction:
              SpecConstruction
            
            
            2
            %
            
            2
            %
            
            1
            %Custom
                Construction
            
            
            10
            %
            
            8
            %
            
            9
            %Consumer
            
            
            13
            %
            
            12
            %
            
            12
            %Total
            
            
            100
            %
            
            100
            %
            
            100
            %




Since
      2003, the most significant growth in our loan portfolio has been attributable
      to
      our one- to four - family
      residential loans. While these are typically non-conforming residential loans,
      which do not meet the  requirements
      for sale into the secondary market, they generally offer higher yields than
      conforming residential mortgages and are still considered eligible collateral for borrowing from the
      FHLB.




In
      contrast, our income property loans, which consist of investor-owned commercial
      real estate and multifamily
      mortgages, have steadily fallen as a percentage of our total portfolio in recent
      years. The decline  has
      been
      largely the result of lower originations of permanent multifamily and commercial
      real estate loans, along
      with a high level of prepayments on the loan portfolio, which we attribute
      to a
      combination of a fl attening
      of the yield curve and increased competition from other lenders. The flattening
      of the yield curve,  which
      resulted from rising short-term interest rates and relatively static longer-term
      interest rates, reduced the  rate
      differential between short- and long-term financing costs and provided a
      financial incentive for borrowers to
      select longer-term, fixed-rate loans as opposed to short-term or adjustable-rate
      financing. As we have historically
      been an originator of short-term and adjustable-rate loans, this impacted us
      in
      two ways. First, as prospective borrowers sought loans with terms that fell outside of our typical
      underwriting structure, our originations
      of permanent multifamily and commercial real estate loans declined. Secondly,
      with the yield  curve
      providing borrowers with a financial incentive to refinance adjustable-rate
      loans, which make up the  majority
      of our loan portfolio, with longer-term, fixed-rate debt, the prepayment rates
      on our income property  portfolio
      remained at relatively high levels over the 2003 to 2005 timeframe. Increased
      competition among  lenders
      in our local market accelerated both the decline in new volumes as well as
      portfolio payoffs, as the  competition
      frequently resulted in lenders offering prospective borrowers new loan
      commitments or existing borrowers the opportunity to refinance, at unusually low margins.




Following
      significant growth in 2004, business banking loans exhibited growth in line
      with
      that of the  aggregate
      portfolio in 2005, remaining unchanged at 13% of the total loan portfolio.
      Consumer loans, on the other
      hand, edged up from 12% of the total loan portfolio as of the 2004 year-end,
      to
      13% in 2005. Contributing to this growth was a substantial reduction in consumer
      loan sales, which declined to approximately $18 million in 2005, down from
      almost $36 million in the prior year.




When
      taking into account our expected production volumes, payoffs, and loan sales
      for
      all business segments,
      including an estimated $8 million to $10 million in consumer loan sales, we
      anticipate loan growth in the
      range of $1 2-$ 17 million for the first quarter of 2006.




***Servicing
      Assets***




During
      2005, our servicing assets grew by $341,000 or 22%, a significant reduction
      from
      the $1.1 million, or 226%
      growth observed in 2004. The reduction in servicing asset growth between the
      two
      years was attributable
      to substantial declines in both commercial and consumer loan sales relative
      to
      the prior year, as  total
      loans sold in 2005 amounted to $67 million, down from nearly $104 million in
      2004. In addition to the




17




previously
      mentioned reduction in sales of consumer loans, commercial loan sales fell
      to
      $11 million in 2005, down
      from nearly $33 million in 2004.




In
      the
      first quarter of 2005, most of the growth in our servicing assets was
      attributable to large sales of consumer
      loans originated by our Sales Finance lending area. In the remainder of the
      year, however, sales of  these
      loans and the related servicing asset growth fell significantly after we revised
      our loan sales strategy to substantially reduce our consumer loan sales. At the present time, we are
      experiencing an increased level of interest in, and favorable opportunities
      to
      market, our consumer loans to other institutional investors. Consequently,
      our
      expectation is that sales of these loans will likely increase in 2006, and
      with
      them the servicing asset balances related to our consumer loan portfolio
      serviced for other institutional investors. We currently
      anticipate selling $9 million to $10 million of consumer loans in the first
      quarter and an additional $7
      million to $9 million in the second quarter. Given the unpredictability of
      the
      level of interest among potential
      investors, we do not know if the higher sales volumes are likely to extend
      beyond the second quarter.




**2005**
            
            **2004**
            
            **2003**Commercial
            
            $
            292,000
            
            $
            173,000
            
            $
            94,000Residential
            
            
            114,000
            
            
            13,000
            
            
            36,000Consumer
            
            
            1,460,000
            
            
            1,339,000
            
            
            338,000Total
            
            $
            1,866,000
            
            $
            1,525,000
            
            $
            468,000Loan
                Balances Serviced for Others
            
            $
            105,850,000
            
            $
            117,852,000
            
            $
            76,424,000




Commercial
      loan sales accounted for most of the second-quarter servicing asset growth,
      while residential  loan
      sales were responsible for the increase in the fourth quarter. Given the unique
      nature of commercial loan  transactions,
      we cannot predict when similar loan sales will occur in the future.
      Additionally, we consider the residential sales in the fourth quarter to be a unique transaction, rather
      than
      indicative of any future trend in loan sales.




Historically,
      the commercial real estate loans we originate have been retained in our
      portfolio, and sales  of
      participations in these loans have been utilized to limit our aggregate credit
      exposure to specific borrowers.  In
      our
      second-quarter 2005 press release, however, we noted that we had experienced
      increased interest in, and  opportunities
      for, sales of participations in our commercial real estate loans. Consequently,
      we added that we were
      considering the merits of expanding our commercial real estate loan sales and
      potentially originating credits with the intent to sell, rather than retain
      the
      loans in our portfolio. While the volume of commercial real
      estate loans sold in the second half of 2005 was modest, we would note that
      the
      volume does not reflect a  decision
      against expanding our commercial real estate loan sales. Instead, we still
      regard an increase in such  sales
      as
      likely in 2006. Commercial real estate loan transactions, particularly those
      that are candidates for sales of
      participations to other institutions, tend to be larger-dollar credits and
      unpredictable in their timing and frequency
      of occurrence. As a result, the volumes of commercial real estate loans sold,
      and gains thereon, can be
      expected to vary considerably from one quarter to the next depending on the
      timing of the loan and sales transactions.




Servicing
      assets represent the deferred servicing rights generated from sales of loans
      that are sold servicing retained, offset by the amortization and prepayments
      of
      loans serviced, as well as any impairment charges
      that may occur. Although the increases in servicing assets have not been a
      major
      factor in our overall  asset
      growth, this area is expected to continue increasing with the anticipated future
      sales of commercial and consumer
      loans.




***Liabilities***




Our
      total
      deposit balances rose nearly 13% from their 2004 year-end levels, totaling
      $761
      million at December
      31, 2005, representing a modest slowdown from the $91 million, or 16%, deposit
      growth observed in 2004 and
      $87 million, or 17%, in 2003. More significantly, however, checking and money
      market balances accounted
      for only $9 million, or 11% of the year 2005 growth, after having accounted
      for
      $62 million, or 68% of the
      2004 deposit growth, and approximately two-thirds of the increase in
      2003.


18




Throughout
      2003 and 2004, rates paid on retail deposits tended to be very low relative
      to
      historical norms,  with
      highly-liquid money market accounts paying nearly identical rates to less-liquid
      short- and intermediate -term
      time deposits. With time deposits offering very little rate incentive over
      money
      market accounts, more depositors opted for the additional liquidity of the
      money
      market accounts. This was a major contributing factor to the growth in our
      money
      market balances in 2003 and 2004.




In
      early
      2005, however, the increases in short-term market interest rates that began
      in
      the second quarter of 2004
      started affecting the yields on retail deposits, with the rates paid on time
      deposits increasing more significantly
      than those paid on money market accounts. Consequently, in the first quarter
      of
      2005 we observed  a
      migration of balances from these accounts to time deposits, as rates on time
      deposits had risen while money market
      rates had remained relatively stable. This resulted in time deposits becoming
      more attractive, and made it more difficult to retain or grow checking and
      money
      market balances without incurring exorbitant marginal expense to do so, as
      any
      rate increases would apply not only to any newly opened accounts, but all existing
      balances as well. Consequently, we observed declines in our checking and money
      market balances in  the
      first
      quarter of 2005. By the end of the second quarter, however, the trend appeared
      to have changed, as we saw our
      checking and money market balances recover to just below the 2004 year-end
      level. In the third quarter, however, some of our competitors began offering
      deposit rates that threatened our ability to retain deposit balances. As a
      result, we were forced to offer a promotional time deposit rate and increase
      our
      non-maturity deposit rates. Despite the increased rates on our money market
      accounts and the greater liquidity offered by these deposits, many customers
      found the promotional time deposit rate more attractive than money market
      products.




The
      growth of checking and money market accounts typically helps us reduce our
      overall cost of funds. Consequently, we consider the growth of these account
      types to be an important part of our funding strategy for the future. To
      encourage this growth, we actively monitor the products and rates offered by
      our competition
      in the local market and develop new products and/or offer aggressive rates
      to
      attract new balances in the
      most cost-effective manner possible.




Utilization
      of FHLB advances, our preferred supplemental funding mechanism, remained little
      changed from the 2004 year-end, declining to $226 million at the 2005 year-end,
      as the additional deposits described above supported our asset growth. As of
      December 31, 2005, we had the authority to borrow up to a total of approximately
      $434 million in FHLB advances, subject to sufficient collateral to support
      those
      advances. In the prior year, our deposit growth was insufficient to fully
      support the year’s asset growth. As a result, we increased
      our utilization of FHLB advances to $234 million as of December 31, 2004, an
      increase of 21% over the 2003
      year-end.




**Market
      Risk Sensitive Instruments**




Market
      risk is defined as the sensitivity of income and capital to changes in interest
      rates, and other relevant
      market rates or prices. Our profitability is largely dependent on our net
      interest income. Consequently, our
      primary exposure to market risk arises from the interest rate risk inherent
      in
      our lending, mortgage banking, deposit, and borrowing activities. Interest
      rate
      risk is the risk to earnings and capital resulting from adverse
      movements in interest rates. To that end, we actively monitor and manage our
      exposure to interest rate risk.




A
      number
      of measures are utilized to monitor and manage interest rate risk, including
      net
      interest income  and
      economic value of equity simulation models, as well as traditional “gap” models.
      We prepare these models on a
      monthly basis for review by our Asset Liability Committee (ALCO), senior
      management, and Board of Directors. The use of these models requires us to
      formulate and apply assumptions to various balance sheet items.
      Assumptions regarding interest rate risk are inherent in all financial
      institutions, and may include, but  are
      not
      limited to, prepayment speeds on loans and mortgage-backed securities, cash
      flows and maturities of financial instruments held for purposes other than trading, changes in market
      conditions, loan volumes and pricing,
      deposit sensitivities, consumer preferences, and management’s capital leverage
      plans. We believe that the data
      and assumptions used for our models are reasonable representations of our
      portfolio and possible outcomes under the various interest rate scenarios.
      Nonetheless, these assumptions are inherently uncertain;




19




therefore,
      the models cannot precisely estimate net interest income or predict the impact
      of higher or lower interest rates on net interest income. Actual results may
      differ significantly from simulated results due to timing, magnitude, and
      frequency of interest rate changes, and changes in market conditions and
      specific strategies, among other factors.




***Asset
      and Liability Management***




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




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




***Hedging
      Techniques***




We
      review
      interest rate trends on a monthly basis and employ hedging techniques where
      appropriate. These techniques may include financial futures, options on
      financial futures, interest rate caps and floors, interest rate swaps, and
      extended commitments on future lending activities. Typically, the extent of
      our
      off- balance-sheet
      derivative agreements has been the use of forward loan commitments, which are
      used to hedge our
      loans held-for-sale. Additionally, in 2002 we entered into an interest rate
      swap
      with the FHLB. The purpose of the swap is to protect against potential adverse
      interest rate volatility that could be realized from the Trust Preferred
      Securities (TPS) issued in June 2002. The swap accomplished this by fixing
      the
      interest rate payable for the first five years of the TPS’ life.




***Net
      Interest Income (NII) and Economic Value of Equity (EVE) Simulation Model
      Results***




**December
                31, 2005**
              **Percentage
                Change**
            
            **December
                31, 2004**
              **Percentage
                Change****Change
                in Interest Rates (in basis points)**
            
            **Net
                Interest**
              **Income**
            
            **Economic
                Value**
              **of
                Equity**
            
            **Net
                Interest**
              **Income**
            
            **Economic
                Value**
              **of
                Equity**+200
            
            
            0.06%
            
            
            (2.72)%
            
            
            0.89%
            
            
            (2.51)%+100
            
            
            n/a
            
            
            (0.55)%
            
            
            n/a
            
            
            (0.40)%(100)
            
            
            n/a
            
            
            (1.94)%
            
            
            (1.26)%
            
            
            (1.26)%(200)
            
            
            (1.32)%
            
            
            (6.54)%
            
            
            *
            
            
            *





*
      Because
      a large percentage of our loan portfolio is tied to indexes that were at very
      low levels as of December 31, 2004, the downward 200 bps scenario was not
      computed at that time.




***Net
      Interest Income Simulation***




Our
      income simulation model, constructed using data as of December 31, 2005,
      indicated results consistent
      with an asset sensitive balance sheet, as our net interest income was projected
      to increase from its “base
      case” level in a scenario in which interest rates are assumed to gradually
      increase by 200 bps over a twelve-month period, and decline in a comparable
      falling rate environment. The magnitudes of the changes, however,
      suggest that there is little sensitivity in net interest income from the “base
      case” level over a twelve - month
      horizon in either scenario, as an increase in net interest income of only 0.06%
      was observed in the rising rate
      environment, while a decline of 1.32% was indicated in the falling rate
      scenario.




20




The
      changes indicated by the simulation model represent variances from a “base case”
scenario, which is  a
      projection of net interest income assuming interest rates remain unchanged
      from
      their current levels over the  life
      of
      the forecast, and that the size of the balance sheet remains stable over the
      forecast timeframe, with no growth
      or contraction regardless of interest rate movements. The base model will,
      however, illustrate the future
      effects of rate changes that have already occurred but have not yet flowed
      through to all the assets and  liabilities
      on our balance sheet. These changes can either increase or decrease net interest
      income, depending on the
      timing and magnitudes of those changes. Additionally, the tendencies for loan
      and investment prepayments to accelerate in falling interest rate scenarios
      and
      slow when interest rates rise have been incorporated into the model assumptions.
      Implicit in these assumptions are additional assumptions for increased security
      purchases and loan originations at lower interest rate levels to offset
      accelerated prepayments, and conversely, reduced security purchases and loan
      production when rates increase and prepayments slow.




The
      rising and falling rate ramp scenarios then indicate that if the slope of the
      yield curve remains the same,
      and
      customer loan and deposit preferences do not change in response to further
      movements of the yield curve,
      then a parallel 200 basis point increase or decrease in rates will not
      significantly degrade net interest income
      from what is presently expected in the “base case.” In the event the simulation
      model indicated that the
      increase or decrease in interest rates over the following twelve months would
      adversely affect our net interest income over the same period by more than
      10%
      relative to the “base case” scenario, we would consider the indicated risk to
      have exceeded our internal policy limit.




***Economic
      Value of Equity (EVE) Simulation***




The
      EVE
      analysis goes beyond simulating net interest income for a specified period
      to
      estimating the present value of all financial instruments in our portfolio
      and
      then analyzing how the economic value of the portfolio would be affected by
      various alternative interest rate scenarios. The portfolio’s economic value is
      calculated by generating principal and interest cash flows for the entire life
      of all assets and liabilities, then discounting
      these cash flows back to their present values. The assumed discount rate used
      for each projected  cash
      flow
      is based on a current market rate, such as a LIBOR, FHLB, or swap curve rate,
      and from alternative  instruments
      of comparable risk and duration. In the event the simulation model demonstrates
      that a 200 basis point
      increase or decrease in rates would adversely affect our EVE by more than 25%,
      we consider the indicated risk to have exceeded our internal policy limit.
      Again, as illustrated in the above results, we are operating within the 25%
      internal policy limit in all scenarios.




In
      the
      simulated 200 bps upward shift of the yield curve, the discount rates used
      to
      calculate the present values
      of
      assets and liabilities will increase, causing the present values of both assets
      and liabilities to fall, with  more
      prominent effects on longer-term, fixed-rate instruments. Additionally, when
      interest rates rise, the cash flows on
      our assets are typically expected to decelerate as borrowers are assumed to
      become less likely to prepay
      their loans. As the cash flows on these assets are shifted further into the
      future, their present values are further
      reduced. Our EVE simulation model results as of December 31, 2005 indicated
      that
      our assets and liabilities
      would be expected to exhibit similar levels of sensitivity to rising rates,
      with
      the economic value of  assets
      declining by 2.44%, compared to a decline of 2.40% for our liabilities. Given
      the comparable sensitivities and
      greater asset balance than liabilities balance, the reduction in the economic
      value of assets exceeded the impact
      on
      liabilities. Consequently, the economic value of our equity was negatively
      impacted in this scenario, declining 2.72%.




The
      opposite occurs when rates decline, as the discount rates used to calculate
      the
      present values of assets  and
      liabilities will decrease, causing the present values of both assets and
      liabilities to rise. Counteracting this  effect
      for assets, however, is the tendency for cash flows from assets to accelerate
      in
      a falling rate scenario, as borrowers refinance their existing loans at lower interest rates. These loan
      prepayments prevent the present values
      of
      these assets from increasing in a declining rate scenario, illustrating an
      effect referred to as negative  convexity.
      Taking this negative convexity into account, the simulation results indicated
      a
      negative impact to EVE in
      the falling rate scenario. In this case, the economic values of both assets
      and
      liabilities at December
      31, 2005 were positively impacted when rates were assumed to fall by 200 bps,
      assets by 1.75% and




21




liabilities
      by 2.64%.  As a result, with the value of liabilities rising more than
      asset values, our economic value of
      equity was negatively impacted in this scenario, declining 6.54%.




The
      Net
      Interest Income and Economic Value of Equity sensitivity analyses do not
      necessarily represent  forecasts.
      As previously noted, there are numerous assumptions inherent in the simulation
      models as well as in  the
      gap
      report, including the nature and timing of interest levels, the shape of the
      yield curve, loan and deposit growth,
      prepayments on loans and securities, deposit decay rates, pricing decisions
      on
      loans and deposits, reinvestment/replacement of asset and liability cash flows,
      customer preferences, and competitor and economic influences.




***Gap
      Model***




In
      addition to the above simulation models, an interest “gap” analysis is used to
      measure the matching of  our
      assets and liabilities and exposure to changes in interest rates. This model,
      which represents a traditional view of
      interest rate sensitivity, quantities the mismatch between assets maturing,
      repricing, or prepaying within
      a
      period, and liabilities maturing or repricing within the same period. A gap
      is
      considered positive when the
      amount of interest-rate-sensitive assets exceeds the amount of
      interest-rate-sensitive liabilities within a given period. A gap is considered
      negative in the reverse situation.




Certain
      shortcomings are inherent in gap analysis, including the failure to recognize
      differences in the frequencies
      and magnitudes of repricing for different balance sheet instruments.
      Additionally, some assets and  liabilities
      may have similar maturities or repricing characteristics, but they may react
      differently to changes in interest
      rates. This illustrates a facet of interest rate exposure referred to as “basis
      risk.” Assets, such as adjustable-rate
      mortgage loans, may also have features that limit the effect that changes in
      interest rates have  on
      the
      asset in the short-term and/or over the life of the loan, for example a limit
      on
      the amount by which the interest
      rate on the loan is allowed to adjust each year. This illustrates another area
      of interest rate exposure referred to as “option risk.” Due to the limitations
      of the gap analysis, these features are not taken into consideration.
      Additionally, in the event of a change in interest rates, prepayment and early
      withdrawal penalties
      could deviate significantly from those assumed in the gap calculation. As a
      result, we utilize the gap report
      as a complement to our income simulation and economic value of equity
      models.




Our
      twelve-month interest rate sensitivity gap, expressed as a percentage of assets,
      fell from a positive, or  asset
      sensitive 2.6% at December 31, 2004 to a negative, or liability sensitive 5.3%
      at the 2005 year-end. These  results
      indicated that more liabilities than assets were expected to mature, reprice,
      or
      prepay within the twelve months,
      whereas the opposite was true at the previous year-end.




**One
      Year Interest Rate Sensitivity Gap**


**December
                31,**
              **2005**
            
            **December
                31,**
              **2004****(Dollars
                in thousands)**One-Year
                Repricing/Maturing Assets
            
            $
            715,543
            
            $
            665,665One-Year
                Repricing/Maturing Liabilities
            
            
            773,093
            
            
            639,430One-Year
                Gap
            
            $
            (57,550
            )
            $
            26,235Total
                Assets(1)
            
            $
            1,086,165
            
            $
            1,012,783One-Year
                Interest Rate Gap as a Percentage of Assets
            
            
            (5.3
            )%
            
            2.6
            %





(1)
      Dec.
      31, 2004 figure includes a $9 million off-balance-sheet item




The
      decline in our gap ratio since December 2004 has been primarily attributable
      to
      developments on the  liabilities
      side of the balance sheet, as the percentage of total assets subject to mature,
      reprice, or estimated to prepay
      within a one-year timeframe changed little since the 2004 year-end. In
      particular, a reduction in the use of longer-term funding instruments to replace
      maturing liabilities and the rolling of existing long-term FHLB
      advances to within the twelve-month timeframe have both contributed
      significantly to the reduction in our gap
      ratio.




22




The
      balance of outstanding time deposits scheduled to mature within the next twelve
      months increased  by
      $100
      million relative to the 2004 year-end levels, based largely on high originations
      of eleven-, thirteen-,  and
      fifteen-month “bump” certificates promoted in 2005. Based on the terms of these
      certificates, all balances  will
      appear within the gap report’s twelve-month horizon at the certificate’s
      origination or very shortly thereafter. While our fifteen-month “bump” time
      deposits are issued with a fifteen-month term to maturity,  the
      depositor is granted an option to reprice the certificate to the prevailing
      fifteen-month certificate rate on  one
      occasion at any time during those fifteen months. For the purposes of the gap
      report, we assume that the  majority
      of depositors will reprice their certificates within one year of issue.
      Consequently, for gap purposes,  the
      majority of these certificates are considered to be less than one-year
      instruments at the time of origination.




Additionally,
      while our total outstanding FHLB advances showed little change relative to
      the
      prior year  end,
      the
      volume of advances scheduled to mature or reprice within the following twelve
      months increased by  nearly
      $38 million. In the first half of 2004, we increased our utilization of
      longer-term FHLB advances in  order
      to
      extend liability durations as well as match fund purchases of hybrid ARM
      securities. Over the course  of
      2005,
      many of these longer-term advances rolled to within the gap ratio’s twelve-month
      timeframe. Given  our
      asset/liability position over the course of 2005, we elected to replace maturing
      advances with new short - term
      advances rather than extend those liabilities. This combination of the prior
      year’s advances moving closer to
      maturity and the use of shorter-term replacement advances contributed to the
      reduction in our one-year interest rate gap.




A
      change
      in modeling procedure impacted the total asset base used for the gap ratio
      calculation by $9
      million. As previously noted, in 2002 we entered into an interest rate swap
      agreement to fix the interest rate  on
      our
      first trust preferred security issue for a period of Five years. As of the
      December 2004 year-end, we classified the TPS as a variable rate liability, offset by the asset side of
      the
      swap, under which the bank receives payments tied to the same quarterly
      adjustable rate as the TPS issue. The other side of the swap, under
      which the bank makes payments based on a fixed interest rate, was applied to
      the
      liability side of the gap  report
      based on the remaining life of the swap. Beginning in the second quarter of
      2005, the fixed-payment  side
      of
      the swap, formerly a $9 million liability, was moved to the asset side as a
      $9
      million contra-asset. As a  result
      of
      this modification, our asset base for gap purposes now corresponds to the level
      of total assets reflected on our
      financial statements, rather than exceeding that amount by the $9 million
      notional principal of the swap.




The
      greater increase of liabilities maturing or repricing in the next twelve months
      versus assets resulted in  a
      net $84
      million reduction in our dollar gap, which led to the decline in the one-year
      gap ratio from 2.6% to (5.3%)
      of total assets.




**Asset
      Quality**




Non-performing
      assets totaled $897,000 or 0.08% of assets at December 31, 2005, down from
      $1,007,000,  or
      0.10%
      at the 2004 year-end. The following table details the types of property held
      as
      collateral and our estimates as to any anticipated loss of principal.




***Non-Performing
      Assets***




Ninety-five
                  consumer loans. Full recovery anticipated from insurance
                claims
              
              $
              412,000Two
                  single-family residential loans in Western WA. No anticipated
                  loss
              
              
              294,000Seventeen
                  consumer loans. Possible loss of $96,000
              
              
              96,000Nine
                  consumer loans. No anticipated loss
              
              
              66,000One
                  land loan in Eastern Washington. No anticipated loss
              
              
              29,000
 TOTAL
                  NON-PERFORMING ASSETS
              
              
              
              
              
              $
              897,000OTHER
                  REAL ESTATE OWNED AND REPOSSESSED ASSETS
              
              
              
              
              
              
              0TOTAL
                  NON-PERFORMING ASSETS
              
              
              
              
              
              $
              897,000




23




Since
      the
      2005 year-end, we have recovered $340,000 on an impaired residential loan that
      was previously partially charged-off in the third quarter of 2004. The remaining balance on
      that loan was approximately $125,000.
      This recovery followed extensive negotiation and litigation with the borrower
      and other involved parties
      that contributed significantly to the increase in our legal fees in the fourth
      quarter of 2005. Additionally, in January 2006 we charged-off 15 consumer loans
      with balances totaling $86,000, and experienced recoveries of nearly $7,000
      on
      several other consumer loans.




**Liquidity**




Our
      primary sources of liquidity are loan and security sales and repayments,
      deposits, and wholesale funds. A secondary source of liquidity is cash from
      operations, which, though not a significant source of liquidity,
      is a consistent source based upon the quality of our earnings. Our principal
      uses of liquidity are the  origination
      and acquisition of loans and securities, and to a lesser extent, to purchase
      facilities and equipment.




**2005**
            
            **2004**
            
            **2003****(Dollars
                in thousands)**Loan
                Originations (Disbursed)
            
            $
            526,000
            
            $
            470,000
            
            $
            424,000Increase
                in Undisbursed LoanProceeds
            
            
            (36,000
            )
            
            (9,000
            )
            
            (30,000
            )Security
                Purchases
            
            
            11,000
            
            
            74,000
            
            
            77,000Total
                Originations and Purchases
            
            
            501,000
            
            
            535,000
            
            
            471,000Loan
                and SecurityRepayments
            
            $
            370,000
            
            $
            297,000
            
            $
            240,000Sales
                of Securities
            
            
            —
            
            
            2,000
            
            
            25,000Sales
                of Loans
            
            
            67,000
            
            
            104,000
            
            
            96,000Total
                Repayments and Sales
            
            
            437,000
            
            
            403,000
            
            
            361,000NetDifference
            
            $
            64,000
            
            $
            132,000
            
            $
            110,000




Loan
      and
      security sales and repayments, our primary sources of funding, are heavily
      influenced by trends in
      mortgage rates. When rates trend downward, our prepayment speeds typically
      increase as borrowers refinance
      their loans at lower interest rates. Conversely, as rates move upwards,
      prepayments will generally  tend
      to
      slow, as fewer borrowers will have a financial incentive to refinance their
      loans. The loan portfolio, excluding loans sold into the secondary market and spec construction loans,
      experienced an annualized prepayment rate of 35% in 2005, compared to 32% in
      2004 and 27% in 2003.




Movements
      in rates and the resulting shape of the yield curve have likely contributed
      to
      the sustained  high
      prepayment levels. As short-term rates continued to rise in 2005, longer-term
      rates tended to move within  a
      range,
      with no discernible upward or downward tendency. This increase in short-term
      rates and decline in  longer-term
      rates has resulted in a flattening of the yield curve, which continued through
      the end of 2005. As a  result,
      the rate differential between short- and long-term financing diminished, thus
      reducing the financial  incentive
      for borrowers to use shorter-term, adjustable-rate financing rather than
      longer-term, fixed-rate loans.  This,
      in
      turn, provides borrowers holding short-term or adjustable-rate loans with an
      incentive to refinance  with
      long-term fixed rates. We believe this situation contributed to the higher
      prepayment rates observed in 2005.




Our
      preferred method of funding the net difference between originations/purchases
      and repayments/sales
      is with deposits. To the extent that deposit growth is insufficient to fully
      fund the difference,  we
      may
      rely on wholesale funding sources including, but not limited to FHLB advances,
      brokered certificates




24




of
      deposit, and reverse repurchase agreements. During the years 2003, 2004 and
      2005, changes in funds from deposits
      and borrowings were as follows:




**2005**
            
            **2004**
            
            **2003****(Dollars
                in thousands)**Deposits
            
            $
            68,000
            
            $
            80,000
            
            $
            75,000Borrowings
            
            
            (6,000
            )
            
            42,000
            
            
            10,000Total
            
            $
            62,000
            
            $
            122,000
            
            $
            85,000




The
      inflow of deposits varies from period to period, and our ability to raise
      liquidity from this source is dependent on our effectiveness in competing with
      other financial institutions in our local market. That competition
      tends to focus on rate and service. Although we control the quality of service
      that we provide, we have no
      control over the rates offered by our competitors




Our
      other
      major source of liquidity is wholesale funds, which include borrowings from
      the
      FHLB, brokered
      deposits, reverse repurchase agreements, and a revolving line of credit at
      the
      Holding Company level. The most
      utilized wholesale funding source is FHLB advances, which totaled $226 million
      at December 31, 2005. Our credit line with the FHLB is reviewed annually, and
      our maximum allowable borrowing level is currently
      set at 40% of assets, or $434 million. As a percentage of 2005 year-end assets,
      our FHLB borrowings totaled
      21%, compared to 23% at December 31, 2004, and 22% at year-end 2003. Potential
      risks associated with this funding source include the reduction or non-renewal
      of the line and insufficient collateral to utilize the
      line.
      We try to mitigate the risk of non-renewal by maintaining the credit quality
      of
      our loans and securities and
      attending to the quality and consistency of our earnings.




The
      potential risk of not holding enough collateral to fully utilize our available
      FHLB advances is monitored to ensure that ample collateral is available to
      meet
      our funding needs. Collateral to secure our FHLB
      line
      totaled $422 million as of our most recent assessment, representing 38% of
      year-end 2005 assets.  Our
      two
      principal sources of preferred collateral are single-family residential and
      multifamily loans. Over the last
      three years we have seen an increase in single-family loans, while the level
      of
      multifamily loans has declined. In 2005, single-family loans accounted for
      25%
      of our loan portfolio, an increase over the levels observed
      in 2004 and 2003, which were 22% and 18%, respectively. The percentage of
      multifamily loans in the  loan
      portfolio, on the other hand, has fallen from 25% in 2003 to 22% the following
      year, and then to 17% in  2005.
      The
      decrease in multifamily loans has largely been offset by the increase in
      single-family loans. Taken  together,
      the two loan types accounted for 44% of the loan portfolio in 2003 and 2004
      then
      dropped modestly  to
      43% in
      2005. Because single-family lending is our most profitable business segment
      and
      has exhibited the most
      growth in the last few years, we are encouraged that the business line will
      be
      able to provide sufficient collateral to meet our FHLB borrowing
      requirements.




Brokered
      deposits, which are included in the deposit totals, amounted to $42 million
      as
      of December 31, 2005,
      compared to $40 million at year-end 2004. In the fourth quarter of 2005,
      interest rates on brokered deposits fell below those of FHLB advances.
      Consequently, we increased our use of this funding source to $42
      million in October, which represented 5.6% of total deposits. We may continue
      to
      increase our use in the  future,
      depending on the costs of various wholesale funding sources. Internal policies
      limit our total usage of these
      deposits to no more than 10% of all deposits or $76 million.




Reverse
      repurchase lines are lines of credit collateralized by securities. We have
      lines
      totaling $60 million,  of
      which
      the full amount is currently available. There has been no usage of these lines
      in the past three years. The
      risks associated with these lines are the withdrawal of the line based on the
      credit standing of the Bank, and the potential lack of sufficient collateral
      to
      support the lines.




An
      additional source of liquidity has been our cash from operations, which, though
      not a significant source
      of
      liquidity, is a consistent source based upon the quality of our earnings. On
      a
      very limited basis it can  be
      viewed
      as cash from operations, adjusted for items such as provision for loan losses
      and depreciation. See  the
      “Consolidated Statements of Cash Flows” in the financial statements section of
      this filing for a calculation of net
      cash provided by operating activities.




25




In
      addition to using liquidity to fund loans and securities, we routinely invest
      in
      facilities and equipment.  In
      2005
      we invested $7.2 million in these assets, up from $5.1 million in 2004. The
      increased investment in  2005
      stemmed from the remodeling projects completed in several of our banking centers
      and our corporate  headquarters,
      as well as the equipment purchases that coincided with these remodeling
      projects. We intend to invest
      $3.5 million in facilities and equipment in 2006. Planned projects include:
      the
      completion of the remodeling
      projects in First Mutual Center, the $1.1 million construction of the West
      Seattle banking center,  and
      the
      $1.2 million completion of our Canyon Park banking center, which is anticipated
      to open in the fourth quarter
      of 2006.




**Contractual
      Obligations and Commitments**




The
        following table sets forth the Company’s long-term obligations:


**Payments
                Due****Total**
            
            **Less
                Than**
              **1
                Year**
            
            **1
                - 3 Years**
            
            **3-
                5 Years**
            
            **Thereafter****(Dollars
                in thousands)**Debt
            
            $
            736,527
            
            $
            590,883
            
            $
            106,527
            
            $
            21,374
            
            $
            17,743Fixed
                Interest on Debt(1)
            
            
            2,578
            
            
            1,307
            
            
            1,241
            
            
            30
            
            
            —Operating
                Leases
            
            
            2,158
            
            
            323
            
            
            574
            
            
            579
            
            
            682Total
            
            $
            741,263
            
            $
            592,513
            
            $
            108,342
            
            $
            21,983
            
            $
            18,425





(1)
      Amount excludes interest expense on adjustable-rate debt.




At
      December 31, 2005, the Company’s obligations related to debt totaled $737
      million to be paid over the next 30
      years. Included in this amount are time deposits and FHLB borrowings totaling
      $489 million and $226 million, respectively, a note for $600,000 and the debt
      related to the three trust preferred security issuances totaling $17 million.
      In
      addition, the Holding Company has a line of credit with an outstanding balance
      of $4 million which is renewable annually.




We
      also
      have operating leases for office space, equipment and an equipment maintenance
      agreement.




**OFF-Balance
      Sheet Commitments**




At
      December 31, 2005, the Bank’s commitments consisted of commitments to extend
      credit to borrowers  in
      which
      the borrower has not formally accepted the financing arrangement or where the
      borrower has not  drawn
      upon some portion of the credit that was extended to them. Standby letters
      of
      credit are conditional  commitments
      issued by the Bank to guarantee the performance of a customer to a third party
      or payment by a  customer
      to a third party. The credit risk involved in issuing letters of credit is
      essentially the same as that  involved
      in extending loan facilities to customers. We routinely charge a fee for these
      credit facilities. We have not been
      required to perform on any financial guarantees. The Holding Company does not
      issue financial guarantees.




The
        following table sets forth the Bank’s off-balance
        sheet commitments:




**Amount
                of Commitment****Total**
            
            **Less
                than**
              **1
                Year**
            
            **1
                - 3 Years**
            
            **3-
                5 Years**
            
            **Thereafter****(Dollars
                in thousands)**Commitments
                to Extend Credit
            
            $
            315,308
            
            $
            261,388
            
            $
            4,171
            
            $
            1,247
            
            $
            48,502Standby
                Letters of Credit
            
            
            160
            
            
            160
            
            
            —
            
            
            —
            
            
            —Total
            
            $
            315,468
            
            $
            261,548
            
            $
            4,171
            
            $
            1,247
            
            $
            48,502




26




**Capital**




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




**Capital
                Ratios**
            
            **Company**
            
            **Bank**
            
            **Well-Capitalized**
              **Minimum**Total
                Capital to Risk-Weighted Assets
            
            
            11.21%
            
            
            11.10%
            
            
            10.0%Tier
                1 Capital to Risk-Weighted Assets
            
            
            9.96%
            
            
            9.85%
            
            
            6.0%Tier
                1 Leverage Capital to Average Assets
            
            
            7.11%
            
            
            7.16%
            
            
            5.0%




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




**Business
      Segments**




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




The
      reportable segments include the following:




*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 others loans to borrowers to purchase, refinance, or build homes
      secured by one-to-four-unit family dwellings. They also finance the purchase
      or
      refinance of buildable residential lots.




*Business
      Banking Lending* —
      Business Banking lending others a full range of banking services to small and
      medium size businesses including deposit and cash management products, loans
      for
      Financing receivables, inventory, 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 others permanent and interim construction loans for multifamily
      housing (over four units), manufactured housing communities, commercial real
      estate properties,
      and spec single-family 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.




27




***Consumer
      Lending***


**Year**
            
            **Net**
              **Income/(Loss)**
            
            **Return
                on**
              **Equity**
            
            **Average
                Earning**
              **Assets**2003
            
            $
            333,000
            
            
            5.4%
            
            $
            86,189,0002004
            
            
            1,292,000
            
            
            15.4%
            
            
            107,637,0002005
            
            
            921,000
            
            
            9.7%
            
            
            120,997,000




Following
      two years of dramatic year-over-year improvement, the Consumer Lending segment’s
      net income declined significantly relative to the prior year, totaling $921,000
      for 2005. Whereas the previous improvement
      was achieved through a combination of earning asset growth and related
      incremental net interest income,
      along with additional gains on loan sales compared to the prior year, the
      decline in 2005 was attributable to a substantial increase in noninterest
      expense which more than offset modest growth in net interest income and rising
      noninterest income.




The
      Consumer segment’s earning assets averaged nearly $121 million over the course
      of 2005, an increase of over
      12% over the prior year level. This represented a significant reduction from
      the
      nearly 25% growth achieved during 2004. The decline in asset growth can be
      largely attributed to a reduction in originations of our sales finance (home
      improvement) loans compared to the prior year. With the decline in earning
      asset growth
      relative to the prior year, and the primarily fixed-rate nature of the loans
      in
      the portfolio, the Consumer Lending
      segment’s interest income increased approximately 16% as compared to the prior
      year. While the segment’s interest income continued to increase, it did so at a
      lesser rate, as the improvement in 2005 was down significantly from the 34%
      and
      49% growth observed in 2004 and 2003, respectively.




In
      contrast to interest income, interest expense rose nearly 41% relative to the
      prior year, based on increases in retail deposit and wholesale funding rates,
      as
      well as the cost of the additional funds required to support the growth in
      earning assets. In 2004, interest expense rose only 4% over 2003, as the impact
      of reductions in funding rates largely offset the cost of the additional funds
      required to support the growth in earning assets. The rates on our
      interest-bearing liabilities declined over the 2002 to 2004 timeframe as our time
      deposits gradually repriced at lower levels after interest rates fell between
      2001 and 2003. However, by  the
      end
      of the 2004, increases in short-term interest rates had begun to influence
      the
      deposit rates offered by our
      competitors in our local market. The lagged effects of rate increases in 2004
      and 2005, combined with intense competition for deposits in our local
      marketplace, drove the increase in interest expense in 2005. Movements
      of retail deposit rates tend to lag major interest-rate indices, with deposit
      rates remaining static as  the
      market indices begin moving, and then continuing to move for some time after
      the
      market rates stabilize. Consequently, if short-term rates were to stabilize now after rising for several
      quarters, we could potentially see
      deposit rates continue to trend upward in subsequent quarters based on the
      lagging nature of retail deposit rate
      movements.




Overall,
      the Consumer segment’s net interest income rose approximately $411,000, or 7%,
      from its 2004 level.
      The segment’s net interest income after provision increased $367,000 relative to
      2004.




The
      segment’s noninterest income exceeded the prior year level by $405,000, an
      increase of approximately 21%, as growth in service fee income offset a
      reduction in loan sales relative to prior years.




In
      our
      second-quarter 2005 press release, we noted a significant change in our strategy
      regarding sales of  consumer
      loans. Previously, our plan had been to sell approximately $6 million to $8
      million in sales finance loans
      each quarter, though actual sales in a given quarter could fall above or below
      this range depending on loan
      production, market conditions, and other factors. In the second quarter, we
      elected to change this strategy  and
      substantially reduce our sales of these loans, selling only sufficient volumes
      to ensure the continuity of the  market.
      Accordingly, our loan sales in the second half of 2005 were well below those
      for
      the same period in the prior
      year. While the reduction in gains on sales negatively impacted our noninterest
      income, reducing our sales of consumer loans allowed us to retain a greater
      volume of these higher-yielding assets within our portfolio.
      At the present time, we are experiencing an increased level of interest in,
      and
      favorable opportunities to
      market, our consumer loans to other institutional investors. Consequently,
      our
      expectation is that sales of these
      loans will likely increase in 2006. We currently anticipate selling $9-$10
      million of consumer loans in the




28




first
      quarter and an additional $7-$9 million in the second quarter. However, given
      the unpredictability of the level of
      interest among potential investors, we do not know if the higher sales volumes
      are likely to extend beyond the second quarter.




Despite
      the reduction in sales volume, consumer loan sales remained the largest
      contributor to our loan sale gains, with gains of $820,000 in 2005. While this
      represented a 43% decline from the gains realized in 2004, our pricing and
      execution improved relative to last year, as the volume of loans sold declined
      50% to $17.9 million.




Offsetting
      the reduction in gains on loan sales, our servicing fee income earned on the
      consumer loans serviced
      for other institutional investors totaled $1,227,000 for 2005, nearly Five
      times
      the $250,000 earned in  2004.
      This increase in consumer loan service fees was attributable in large part
      to a
      change in the amortization period
      assumed for the underlying servicing assets.




Servicing
      assets are recorded when we sell loans from our portfolio to other investors,
      and continue to service
      those loans for the investors following the sale. To determine the fair value
      of
      the servicing assets, we utilize
      a valuation model that calculates the present value of future cash flows for
      the
      loans sold based on assumptions
      which include market discount rates, anticipated prepayment speeds, estimated
      servicing cost per  loan,
      and
      other relevant factors. These factors are subject to significant fluctuations,
      and the estimates used in  the
      models are frequently reviewed and revised based on actual experience and
      changes in expectations for the  future.
      The calculated value of the servicing rights is then capitalized and amortized
      in proportion to, and over the
      period of, estimated future net servicing income.




Based
      on
      a review of our assumptions in the first quarter of 2005, we determined that
      the
      amortization period
      for the servicing rights on our consumer loan servicing portfolio was
      significantly shorter than the term over
      which these loans would be expected to provide net servicing income.
      Consequently, we revised the amortization
      period such that the average life of the amortization schedule would correspond
      with the average life we
      were currently observing for the underlying loan portfolio.




More
      than
      offsetting the additional net interest and noninterest income, however, was
      growth in the Consumer
      segment’s noninterest expenses, which increased $1.3 million, or 23% compared to
      the prior year,  with
      the
      most significant growth observed in our credit insurance expense. This
      additional insurance cost was  attributable
      to growth in insured sales finance loan balances, including both the loans
      in
      our portfolio and those  serviced
      for other institutions, as well as a supplemental insurance policy taken out
      in
      late 2005 on a seasoned pool of
      previously insured loans. We expect this expense to continue to increase in
      the
      future based on continued growth of insured sales finance loan
      balances.




Also
      contributing to the increase in costs relative to the prior year was a decline
      in the Consumer segment’s
      FAS 91 benefit. In accordance with current accounting standards, certain costs
      associated with loan origination are deferred and amortized over the life of each loan, rather than
      expensed in the current period. Expenses
      are then reported in the financial statements net of these deferrals. The amount
      of expense subject to  deferral
      and amortization can vary from one period to the next based upon the number
      of
      loans originated, the  mix
      of
      loan types, and year-to-year changes in “standard loan costs.” In this instance,
      fewer sales finance loans were
      originated this year compared to last, and the standard cost associated with
      each sales finance loan originated in 2005 was lower than the comparable figure
      for 2004. Consequently, the amount of noninterest expense to be deferred and
      amortized this year declined relative to 2004, resulting in a higher level
      of
      noninterest expense in 2005.




In
      addition to the increased credit insurance premium expense and reduced FAS
      91
      benefits, administrative and support costs allocated to this segment contributed
      to the additional expense. Included in these allocated costs are expenses
      related to our Consumer Loan Administration and Asset Management departments.
      The Consumer Loan Administration and Asset Management expenses allocated to
      this
      segment have
      risen based on the increased efforts required to manage the growing sales
      finance portfolio, including those loans serviced for others.




29




***Residential
      Lending***




**Year**
            
            **Net
                Income/**
              **(Loss)**
            
            **Return
                on**
              **Equity**
            
            **Average
                Earning**
              **Assets**2003
            
            $
            2,014,000
            
            
            27.4%
            
            $
            192,578,0002004
            
            
            2,700,000
            
            
            25.2%
            
            
            271,665,0002005
            
            
            3,641,000
            
            
            26.6%
            
            
            332,247,000




Net
      income for the Residential Lending segment totaled $3,641,000 in 2005,
      representing a 35% increase over the
      prior year, which in turn represented a 34% improvement over the segment’s 2003
      net income. The increase in net income resulted from growth in net interest
      and
      noninterest income, as well as a reduction in the provision for loan loss.
      These
      improvements were, however, partly offset by rising operating
      expenses.




The
      Residential segment has been the largest contributor to our earning asset growth
      in recent years, with  its
      average level of earning assets growing 41% and 22% over prior year levels
      for
      2004 and 2005, respectively. With
      these additional assets and the rise in interest-rate indexes to which the
      loan
      rates are tied, interest income earned on the portfolio increased 34% from
      2003
      to 2004, and 37% from 2004 to 2005.




Following
      a year-over-year increase of 26% in 2004, the Residential segment’s interest
      expense rose nearly 57% relative to the prior year due to the rising retail
      deposit and wholesale funding rates mentioned earlier,
      as well as the cost of the additional funds required to support the earning
      asset growth. The increase in funding
      costs, combined with the segment’s provision for loan loss, reduced the overall
      increase in the segment’s
      net interest income after provision to approximately 26% over the prior year
      level, down from a 38% year-over-year increase in 2004.




The
      Residential Lending segment’s noninterest income rose $470,000, or nearly 55%,
      based largely on higher
      loan fees, particularly prepayment fees, as well as a high level of loan sale
      gains in the fourth quarter of the
      year. We believe that a flattening of the yield curve, which resulted from
      rising short-term interest rates and
      relatively static longer-term interest rates, and increased competition from
      other lenders contributed to the higher
      level of loan payoffs and prepayment fees in 2005. The flattening of the yield
      curve reduced the rate differential
      between short- and long-term financing costs and provided a financial incentive
      for borrowers with short-term or adjustable-rate loans to refinance with long-term fixed rates.
      Increased competition among lenders
      in our local market further accelerated loan payoffs, as this competition
      frequently resulted in lenders offering
      borrowers the opportunity to refinance at unusually low margins. Given the
      uncertainties regarding interest rates and the behaviors of borrowers and other
      lenders in the marketplace, we do not believe we can predict the level of
      prepayment fees in future quarters with any reasonable degree of
      accuracy.




Gains
      on
      residential loan sales rose 139% relative to 2004, increasing $203,000, due
      in
      large part to a sale  of
      approximately $5.4 million in “interest only” (IO) residential mortgages. As we
      consider this IO sale to be  a
      unique
      transaction, rather than indicative of any future trend in loan sales, it is
      our
      expectation that gains on residential loan sales will return to historical levels in future
      quarters.




Partially
      offsetting this year’s income growth was a $1.4 million, or 24% increase in the
      Residential segment’s
      noninterest expense. Among the segment’s direct expenses, the most significant
      contribution to the  increase
      was additional compensation expense, including higher loan officer commissions
      driven by increased loan
      production volumes. Also contributing to the additional expense in 2005 were
      rising allocations of administrative
      and other costs. The administrative costs include expenses for both general
      corporate activities,  which
      are
      allocated to all the business segments, as well as loan servicing and
      administration costs attributable to the
      Residential Lending segment’s originations and portfolio management. Other
      allocated expenses included expenses incurred at the banking centers and
      allocated to the Residential Lending segment. These allocations have increased
      with the growth of the Residential segment.




30




***Business
      Banking Lending***




**Year**
            
            **Net
                Income/**
              **(Loss)**
            
            **Return
                on**
              **Equity**
            
            **Average
                Earning**
              **Assets**2003
            
            $
            99,000
            
            
            1.5%
            
            $
            87,423,0002004
            
            
            (424,000
            )
            
            (5.1)
            %
            
            108,138,0002005
            
            
            77,000
            
            
            0.74%
            
            
            131,702,000




Our
      Business Banking segment is one of the newer business lines in which we have
      invested, and will continue to invest our resources with the eventual goal
      of
      achieving our targeted 15% return on equity and consistent year-over-year
      earnings growth. At this time, these results have not yet been achieved, nor
      do
      we anticipate
      reaching these goals in 2006. However, Business Banking attracts low-cost core
      deposits, which help  reduce
      our overall cost of funds, brings diversification to our portfolio of earning
      assets, and will potentially generate
      long-term relationship-banking opportunities and additional sources of
      noninterest income.




The
      Business Banking segment’s net interest income after provision for loan losses
      rose $1.7 million, or  41%,
      over
      2004, a significant improvement over the 11% year-over-year growth observed
      from
      2003 to 2004.  Business
      Banking’s 41% improvement was also the highest percentage net interest income
      increase among our  four
      business lines, and the second highest dollar increase behind the Residential
      Lending segment. Like the  Consumer
      and Residential segments, the Business Banking segment succeeded in building
      incremental assets  over
      the
      prior year, with earning assets averaging nearly $132 million in 2005, an
      increase of nearly 22% over  the
      prior
      year. This level of asset growth was consistent with the nearly 24%
      year-over-year growth observed in 2004.




In
      addition to the earning asset growth, the prevalence of prime-based loans in
      the
      business banking portfolio
      also contributed to the improvement in interest income. The majority of the
      adjustable-rate loans in  our
      portfolio reprice according to contractually defined schedules, typically on
      an
      annual basis. The rates on prime-based loans, on the other hand, typically adjust in response to any change
      in the prime rate. Consequently,
      these loans reprice within days of any change to the index, rather than at
      a
      specified reset date  potentially
      months into the future, and may reprice on several occasions over the course
      of
      the year, as was the case for
      both 2004 and 2005.




The
      Business Banking segment’s noninterest income rose $148,000, or 31%, over the
      2004 level, driven by a gain
      on the sale of a commercial real estate credit that included both the
      construction financing as well as the permanent mortgage to refinance that
      loan
      following the completion of construction. Given the unique nature
      of
      this transaction, we cannot predict the probability that similar deals could
      occur in the future. Also contributing to the segment’s noninterest income growth has been the expansion
      of the Business Banking segment’s
      deposit base, measured by both total deposit balances as well as the number
      of
      open accounts. Fee  income
      earned on these additional deposits has contributed to the improvement in
      noninterest income, and is expected
      to generate additional noninterest income for the segment in the
      future.




Partially
      offsetting the growth in net interest and noninterest income was an additional
      $1.1 million in noninterest
      expense relative to the prior year. The primary drivers of the additional
      noninterest expense were increases in expenses from our retail banking centers and other administrative
      departments allocated to the Business Banking segment, as well as compensation
      and marketing expenses. The expenses from our retail banking centers allocated
      to the Business Banking segment have increased largely as a result of the strong growth
      of
      our business checking and other commercial deposit accounts. The additional
      compensation expense  was
      due,
      in large part, to a return to a more normal level of loan officer commissions
      this year, compared to a below
      average level of expense in 2004.




31




***Income
      Property Lending***




**Year**
            
            **Net
                Income/**
              **(Loss)**
            
            **Return
                on**
              **Equity**
            
            **Average
                Earning**
              **Assets**2003
            
            $
            5,949,000
            
            
            21.0%
            
            $
            431,924,0002004
            
            
            5,721,000
            
            
            19.6%
            
            
            438,968,0002005
            
            
            5,680,000
            
            
            19.3%
            
            
            414,804,000




The
      Income Property segment’s 2005 net income continued the gradual downward trend
      of recent years, with relatively modest changes impacting net interest income,
      noninterest income, and noninterest expense.




The
      segment’s net interest income after provision for loan loss declined $266,000,
      or 2%, based on interest  income
      growth of 9% and a 28% increase in interest expense. Unlike our other business
      segments, the Income  Property
      segment did not benefit from year-over-year earning asset growth, and instead
      saw its average earning  assets
      for the year fall to $415 million, a decline of nearly 6% relative to the prior
      year. The decline was largely  attributable
      to a high level of prepayments on the loan portfolio, likely motivated by the
      same factors described earlier
      in the Residential segment section.




Noninterest
      income for the Income Property segment rose $79,000, or 8%, relative to 2004,
      based on substantially higher levels of prepayment penalties and brokered loan
      fees compared to the prior year. We believe the increase in prepayment fees
      can
      be attributed to the same interest rate environment and competitive
      factors previously described in the review of the Residential Lending segment,
      while the increase in
      brokered loan fees was the result of returning to a more normal level of loan
      brokerage activity in 2005 following an absence of such in 2004.




In
      several of our 2005 press releases, we noted that we had experienced increased
      interest in, and opportunities
      for, sales of participations in our commercial real estate loans. Consequently,
      we added that we were
      considering the merits of expanding our commercial real estate loan sales and
      potentially originating credits with the intent to sell, rather than retain
      the
      loans in our portfolio. While the volume of commercial real estate loans sold
      in
      2005 represented a significant decline from the prior year’s sales activity, we
      would note
      that
      the 2005 sales volume does not reflect a decision against expanding our
      commercial real estate loan sales.
      Instead, we still regard an increase in such sales as likely in 2006. Commercial
      real estate loan transactions, particularly those that are candidates for sales
      of participations to other institutions, tend to be larger-dollar
      credits and unpredictable in their timing and frequency of occurrence. As a
      result, the volumes of  commercial
      real estate loans sold, and gains thereon, can be expected to vary considerably
      from one quarter to the next
      depending on the timing of the loan and sales transactions.




In
      contrast to the other business segments, noninterest expense for the Income
      Property segment exhibited
      modest reductions compared to the prior year, declining $139,000, or 2% for
      2005. This followed a  decline
      of $51,000, or 1%, from 2003 to 2004. As noted above, the asset growth exhibited
      by the other business  lines
      was
      not observed with the Income Property segment, which instead saw its balances
      decline as the other  business
      lines grew their operations and became larger components of our overall asset
      mix. Consequently, for a number
      of different expenses that we allocate out to the business segments, such as
      banking center and administrative
      costs, the percentages allocated to other business lines increased over the
      prior year with their growing
      activity and asset balances, thus reducing the percentage allocated to the
      Income Property segment.




32


**REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**




To
      the
      Board of Directors and Stockholders


First
      Mutual Bancshares, Inc. and Subsidiary




We
      have
      audited the accompanying consolidated statement of financial condition of First
      Mutual Bancshares, Inc. and Subsidiaries (Company) as of December 31, 2005
      and
      2004, and the related consolidated
      statements of operations, stockholders’ equity and comprehensive income, and
      cash flows for the  three
      years in the period ended December 31, 2005. We also have audited management’s
      assessment included in the
      accompanying Management’s Annual Report on Internal Control over Financial
      Reporting that the Company maintained effective internal control over financial
      reporting as of December 31, 2005, based on criteria established in the Internal
      Control — Integrated Framework issued by the Committee of Sponsoring
      Organizations of the Treadway Commission (COSO). The Company’s management is
      responsible for these f inancial
      statements, for maintaining effective internal control over financial reporting,
      and for its assessment  of
      the
      effectiveness of internal control over financial reporting. Our responsibility
      is to express an opinion on  these
      financial statements, an opinion on management’s assessment, and an opinion on
      the effectiveness of the Company’s internal control over financial reporting based on our
      audits.




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




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




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





33




In
      our
      opinion, the consolidated financial statements referred to above present fairly,
      in all material respects, the consolidated financial position of First Mutual
      Bancshares, Inc. and Subsidiaries as of December 31, 2005 and 2004, and the
      results of their operations and cash flows for each of the three years ended
      December 31, 2005, in conformity with accounting principles generally accepted
      in the United States of America.
      Also in our opinion, management’s assessment that First Mutual Bancshares, Inc.
      and Subsidiaries maintained
      effective internal control over financial reporting as of December 31, 2005,
      is
      fairly stated, in all material
      respects, based on criteria established in Internal Control — Integrated
      Framework issued by the Committee of Sponsoring Organizations of the Treadway
      Commission. Furthermore, in our opinion, First Mutual Bancshares, Inc. and
      Subsidiaries maintained, in all material respects, effective internal control
      over financial reporting as of December 31, 2005, based on criteria established
      in Internal Control — Integrated Framework issued by the Committee of Sponsoring
      Organizations of the Treadway Commission.









Everett,
      Washington


March
      10,
      2006





34


**FIRST
      MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**




**CONSOLIDATED
      STATEMENTS OF FINANCIAL CONDITION**




**ASSETS**




**December
                31,****2005**
            
            **2004**Cash
                and cash equivalents:
              Interest-earning
                deposits
            
            $
            1,229,176
            
            $
            309,125Noninterest-earning
                demand deposits and cash onhand
            
            
            24,551,436
            
            
            13,536,31625,780,612
            
            
            13,845,441Mortgage-backed
                and other securities available-for-sale (AFS)
            
            
            114,450,342
            
            
            124,224,683Loans
                receivable, held-for-sale
            
            
            14,683,507
            
            
            10,064,155Mortgage-backed
                and other securities held-to-maturity (HTM), fair
              value
                of $6,970,890 and $7,826,994
            
            
            6,966,295
            
            
            7,719,542Loansreceivable
            
            
            878,066,241
            
            
            808,642,531Reserve
                for loan losses
            
            
            (10,069,020
            )
            
            (9,300,854
            )Loans
                Receivable, net
            
            
            867,997,221
            
            
            799,341,677Accrued
                interest receivable
            
            
            5,350,493
            
            
            4,300,131Servicing
                assets
            
            
            1,865,698
            
            
            1,525,085Land,
                buildings, and equipment, net
            
            
            33,483,998
            
            
            27,994,532Federal
                Home Loan Bank (FHLB) stock, at cost
            
            
            13,122,300
            
            
            12,918,700Other
                assets
            
            
            2,464,369
            
            
            1,849,401Total
                assets
            
            $
            1,086,164,835
            
            $
            1,003,783,347










See
      accompanying notes.


35


**FIRST
      MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**




**CONSOLIDATED
      STATEMENTS OF FINANCIAL CONDITION (Continued)**




**LIABILITIES
      AND STOCKHOLDERS’ EQUITY**




**December
                31,****2005**
            
            **2004**Liabilities:
              Deposits:
              Money
                market deposit and checking accounts
            
            $
            263,444,641
            
            $
            254,435,583Savings
            
            
            8,053,510
            
            
            8,434,423Time
                deposits
            
            
            489,222,486
            
            
            412,498,902Total
                deposits
            
            
            760,720,637
            
            
            675,368,908Drafts
                payable
            
            
            733,773
            
            
            377,814Accounts
                payable and other liabilities
            
            
            15,706,624
            
            
            14,106,402Advance
                payments by borrowers for taxes and insurance
            
            
            1,671,496
            
            
            1,676,175Federal
                Home Loan Bank (FHLB) advances
            
            
            225,705,005
            
            
            234,206,775Other
                advances
            
            
            4,600,000
            
            
            1,600,000Junior
                subordinated long-term debentures
            
            
            17,000,000
            
            
            17,000,000Total
                liabilities
            
            
            1,026,137,535
            
            
            944,336,074Stockholders’
                equity:
              Common
                stock, $1 par value; authorized, 30,000,000 shares; issued
              and
                outstanding, 5,296,810 and 5,288,489 shares, respectively
            
            
            5,296,810
            
            
            5,288,489Additional
                paid-in capital
            
            
            45,288,791
            
            
            45,595,319Retained
                earnings
            
            
            10,877,529
            
            
            9,220,450Accumulated
                other comprehensive income/ (loss):
              Unrealized
                (loss) on securities available-for-sale and interest rate
              swap,
                net of federal income tax
            
            
            (1,435,830
            )
            
            (656,985
            )Total
                stockholders’ equity
            
            
            60,027,300
            
            
            59,447,273$
            1,086,164,835
            
            $
            1,003,783,347










See
      accompanying notes.


36


**FIRST
      MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**




**CONSOLIDATED
      STATEMENTS OF INCOME**




**Years
                Ended December 31,****2005**
            
            **2004**
            
            **2003**INTEREST
                INCOME:
              Loansreceivable
            
            $
            61,623,627
            
            $
            50,195,027
            
            $
            45,487,357Interest
                on AFS securities
            
            
            4,949,968
            
            
            4,030,836
            
            
            2,824,565Interest
                on HTMsecurities
            
            
            391,925
            
            
            418,054
            
            
            631,236Interest
                other
            
            
            397,105
            
            
            482,774
            
            
            718,37567,362,625
            
            
            55,126,691
            
            
            49,661,533INTEREST
                EXPENSE:
              Deposits
            
            
            18,191,383
            
            
            12,292,125
            
            
            11,984,052FHLB
                and other advances
            
            
            8,987,941
            
            
            6,800,388
            
            
            6,939,66027,179,324
            
            
            19,092,513
            
            
            18,923,712Net
                interest income
            
            
            40,183,301
            
            
            36,034,178
            
            
            30,737,821PROVISION
                FOR LOAN LOSSES:
            
            
            1,500,000
            
            
            1,565,000
            
            
            1,150,000Net
                interest income after provision for loan losses
            
            
            38,683,301
            
            
            34,469,178
            
            
            29,587,821NONINTEREST
                INCOME:
              Servicing
                fees, net of amortization
            
            
            1,299,620
            
            
            313,988
            
            
            69,431Gain
                on sales of loans
            
            
            1,440,571
            
            
            1,757,032
            
            
            984,063Gain
                on sales of investments
            
            
            —
            
            
            70,870
            
            
            662,564Fees
                on deposit services
            
            
            629,854
            
            
            571,216
            
            
            516,107Other
            
            
            1,984,916
            
            
            1,538,770
            
            
            1,430,788Total
                noninterestincome
            
            
            5,354,961
            
            
            4,251,876
            
            
            3,662,953NONINTEREST
                EXPENSE:
              Salaries
                and employee benefits
            
            
            16,200,309
            
            
            14,261,840
            
            
            12,454,918Occupancy
            
            
            3,512,255
            
            
            2,786,407
            
            
            2,443,363Other
            
            
            8,624,826
            
            
            7,566,223
            
            
            5,619,620Total
                noninterest expense
            
            
            28,337,390
            
            
            24,614,470
            
            
            20,517,901Income
                before provision for federal income taxes
            
            
            15,700,872
            
            
            14,106,584
            
            
            12,732,873PROVISION
                FOR FEDERAL INCOME TAXES:
              Current
            
            
            5,383,223
            
            
            4,270,771
            
            
            3,523,860Deferred
            
            
            (1,000
            )
            
            548,000
            
            
            813,2755,382,223
            
            
            4,818,771
            
            
            4,337,135NET
                INCOME
            
            $
            10,318,649
            
            $
            9,287,813
            
            $
            8,395,738







See
      accompanying notes.





37


**FIRST
      MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**




**CONSOLIDATED
      STATEMENTS OF INCOME (Continued)**




**Years
                Ended December 31,****2005**
            
            **2004**
            
            **2003**PER
                SHARE DATA
              Basic
                earnings per common share
            
            $
            1.94
            
            $
            1.76
            
            $
            1.62Earnings
                per common share assuming dilution
            
            $
            1.86
            
            $
            1.68
            
            $
            1.57WEIGHTED
                AVERAGE SHARES OUTSTANDING
            
            
            5,314,616
            
            
            5,264,412
            
            
            5,179,627WEIGHTED
                AVERAGE SHARES OUTSTANDING
              INCLUDING
                DILUTIVE STOCKOPTIONS
            
            
            5,542,779
            
            
            5,513,658
            
            
            5,352,960




















See
        accompanying notes.


38


**FIRST
      MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**




**CONSOLIDATED
      STATEMENTS OF STOCKHOLDERS’ EQUITY
      AND
      COMPREHENSIVE INCOME**




**Accumulated****Other****Additional**
            
            
            
            **Comprehensive****Common
                Stock**
            
            **Paid-In**
            
            **Retained**
            
            **Income****Shares**
            
            **Amount**
            
            **Capital**
            
            **Earnings**
            
            **(Loss)**
            
            **Total**BALANCE,
                December 31, 2002
            
            
            4,247,166
            
            $
            4,247,166
            
            $
            24,028,610
            
            $
            15,214,220
            
            $
            793,841
            
            $
            44,283,837Comprehensive
                income:Net
                income
            
            
            
            
            
            
            
            
            
            
            
            8,395,738
            
            
            
            
            
            8,395,738Other
                comprehensive income/(loss), net of tax:Unrealized
                (loss) on securities available-for-sale
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (1,294,797
            )
            
            (1,294,797
            )Unrealized
                gain on interest rate swap
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            87,186
            
            
            87,186Total
                comprehensive income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            7,188,127Options
                exercised, including tax benefit of $219,124
            
            
            53,040
            
            
            53,040
            
            
            571,618
            
            
            
            
            
            
            
            
            624,658Issuance
                of stock through employees’
                stock
                plans
            
            
            1,386
            
            
            1,386
            
            
            23,617
            
            
            
            
            
            
            
            
            25,00310%
                stock dividend
            
            
            428,101
            
            
            428,101
            
            
            9,054,336
            
            
            (9,482,437
            )
            
            
            
            
            —Cash
                dividend declared ($0.28 per share)
            
            
            
            
            
            
            
            
            
            
            
            (1,294,869
            )
            
            
            
            
            (1,294,869
            )BALANCE,
                December 31, 2003
            
            
            4,729,693
            
            
            4,729,693
            
            
            33,678,181
            
            
            12,832,652
            
            
            (413,770
            )
            
            50,826,756Comprehensive
                income:Net
                income
            
            
            
            
            
            
            
            
            
            
            
            9,287,813
            
            
            
            
            
            9,287,813Other
                comprehensive income/(loss), net of tax:Unrealized
                (loss) on securities available-for-sale
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (414,879
            )
            
            (414,879
            )Unrealized
                gain on interest rate swap
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            171,664
            
            
            171,664Total
                comprehensive income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            9,044,598Options
                exercised, including tax benefit of $337,052
            
            
            80,697
            
            
            80,697
            
            
            1,138,303
            
            
            
            
            
            
            
            
            1,219,000Issuance
                of stock through employees’ stock plans
            
            
            2,019
            
            
            2,019
            
            
            47,992
            
            
            
            
            
            
            
            
            50,01110%
                stock dividend
            
            
            476,080
            
            
            476,080
            
            
            10,730,843
            
            
            (11,206,923
            )
            
            
            
            
            —Cash
                dividend declared ($0.32 per share)
            
            
            
            
            
            
            
            
            
            
            
            (1,693,092
            )
            
            
            
            
            (1,693,092
            )BALANCE,
                December 31, 2004
            
            
            5,288,489
            
            
            5,288,489
            
            
            45,595,319
            
            
            9,220,450
            
            
            (656,985
            )
            
            59,447,273Comprehensive
                income:Net
                income
            
            
            
            
            
            
            
            
            
            
            
            10,318,649
            
            
            
            
            
            10,318,649Other
                comprehensive income/(loss), net of tax:Unrealized
                (loss) on securities available-for-sale
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (945,014
            )
            
            (945,014
            )Unrealized
                gain on interest rate swap
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            166,169
            
            
            166,169Total
                comprehensive income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            9,539,804Options
                exercised, including tax benefit of $478,492
            
            
            148,511
            
            
            148,511
            
            
            1,763,597
            
            
            
            
            
            
            
            
            1,912,108Retirement
                of shares repurchased
            
            
            (144,036
            )
            
            (144,036
            )
            
            (2,166,275
            )
            
            (1,343,882
            )
            
            
            
            
            (3,654,193
            )Issuance
                of stock through employees’ stock plans
            
            
            3,846
            
            
            3,846
            
            
            96,150
            
            
            
            
            
            
            
            
            99,996Cash
                dividend declared ($1.38 per share)
            
            
            
            
            
            
            
            
            
            
            
            (7,317,688
            )
            
            
            
            
            (7,317,688
            )BALANCE,
                December 31, 2005
            
            
            5,296,810
            
            $
            5,296,810
            
            $
            45,288,791
            
            $
            10,877,529
            
            $
            (1,435,830
            )
            $
            60,027,300




See
      accompanying notes.




39


**FIRST
      MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**




**CONSOLIDATED
      STATEMENTS OF CASH FLOWS**




**Years
                Ended December 31,****2005**
            
            **2004**
            
            **2003**OPERATING
                ACTIVITIES:
              Net
                income
            
            $
            10,318,649
            
            $
            9,287,813
            
            $
            8,395,738Adjustments
                to reconcile net income to net cash
              from
                operating activities:
              Provision
                for loan losses
            
            
            1,500,000
            
            
            1,565,000
            
            
            1,150,000Depreciation
                and amortization
            
            
            1,732,576
            
            
            1,385,604
            
            
            1,109,746Deferred
                loan origination fees, net of accretion
            
            
            (121,537
            )
            
            68,237
            
            
            (1,375,998
            )Amortization
                of servicing assets
            
            
            952,704
            
            
            871,725
            
            
            98,277Gain
                on sales of loans
            
            
            (1,440,571
            )
            
            (1,757,032
            )
            
            (984,063
            )Gain
                on sale of repossessed real estate and other
              assets
            
            
            —
            
            
            (5,452
            )
            
            (23,515
            )Gain
                on sale of securities available-for-sale
            
            
            —
            
            
            (70,870
            )
            
            (662,564
            )FHLB
                stock dividends
            
            
            (52,900
            )
            
            (338,800
            )
            
            (592,300
            )Deferred
                federal income taxes
            
            
            1,000
            
            
            (548,000
            )
            
            (813,275
            )Changes
                in operating assets and liabilities:
              Loans
                receivable held-for-sale
            
            
            (4,619,352
            )
            
            79,164
            
            
            2,555,685Accrued
                interest receivable
            
            
            (1,050,362
            )
            
            (651,099
            )
            
            (213,689
            )Other
                assets
            
            
            (83,249
            )
            
            259,171
            
            
            (1,051,794
            )Drafts
                payable
            
            
            355,959
            
            
            20,558
            
            
            (11,778
            )Accounts
                payable and other liabilities
            
            
            (3,835,999
            )
            
            378,278
            
            
            6,839,874Advance
                payments by borrowers for taxes and
              insurance
            
            
            (4,679
            )
            
            (51,170
            )
            
            (70,888
            )Federal
                income taxes
            
            
            (444,660
            )
            
            1,232,044
            
            
            1,074,577Net
                cash provided by operating activities
            
            
            3,207,579
            
            
            11,725,171
            
            
            15,424,033INVESTING
                ACTIVITIES:
              Loan
                originations
            
            
            (454,150,263
            )
            
            (365,831,641
            )
            
            (331,091,827
            )Loan
                principal repayments
            
            
            349,147,077
            
            
            271,246,047
            
            
            203,551,451Increase
                in undisbursed loan proceeds
            
            
            36,145,078
            
            
            9,282,872
            
            
            29,612,514Principal
                repayments and redemptions on mortgage-
              backed
                and other securities
            
            
            20,406,369
            
            
            25,840,035
            
            
            36,931,131Purchase
                of securities held-to-maturity
            
            
            (1,015,435
            )
            
            (1,126,983
            )
            
            (1,098,881
            )Purchase
                of securities available-for-sale
            
            
            (10,235,677
            )
            
            (72,897,074
            )
            
            (75,710,656
            )Purchase
                of premises andequipment
            
            
            (7,178,708
            )
            
            (5,146,784
            )
            
            (14,326,118
            )Purchase
                of FHLBstock
            
            
            (150,700
            )
            
            (1,544,400
            )
            
            —Proceeds
                from sale of securities
            
            
            —
            
            
            2,228,958
            
            
            25,442,072Proceeds
                from sale of real estate held-for-sale
            
            
            —
            
            
            116,275
            
            
            282,354Net
                cash (used) by investing activities
            
            
            (67,032,259
            )
            
            (137,832,695
            )
            
            (126,407,960
            )







See
      accompanying notes.





40


**FIRST
      MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**




**CONSOLIDATED
      STATEMENTS OF CASH FLOWS (Continued)**




**Years
                Ended December 31,****2005**
            
            **2004**
            
            **2003**FINANCING
                ACTIVITIES:
              Net
                increase in deposit accounts
            
            
            68,322,366
            
            
            80,056,903
            
            
            75,175,800Interest
                credited to deposit accounts
            
            
            17,029,363
            
            
            11,421,357
            
            
            11,345,229Proceeds
                from junior subordinated long-term
              debentures
                (trust preferred securities)
            
            
            
            
            
            
            
            
            8,000,000Issuance
                of stock through employees’ stock plan
            
            
            99,996
            
            
            50,011
            
            
            25,003Proceeds
                from advances
            
            
            960,624,500
            
            
            983,802,196
            
            
            490,921,754Repayment
                of advances
            
            
            (966,126,270
            )
            
            (942,138,299
            )
            
            (481,172,773
            )Dividends
                paid
            
            
            (1,969,527
            )
            
            (1,548,206
            )
            
            (1,261,092
            )Proceeds
                from exercise of stock options
            
            
            1,433,616
            
            
            881,948
            
            
            405,534Repurchase/retirement
                of common stock
            
            
            (3,654,193
            )
            
            —
            
            
            —Net
                cash provided by financing activities
            
            
            75,759,851
            
            
            132,525,910
            
            
            103,439,455NET
                INCREASE/ (DECREASE) IN CASH AND
              CASH
                EQUIVALENTS
            
            
            11,935,171
            
            
            6,418,386
            
            
            (7,544,472
            )CASH
                AND CASH EQUIVALENTS
              Beginning
                of year
            
            
            13,845,441
            
            
            7,427,055
            
            
            14,971,527End
                of year
            
            $
            25,780,612
            
            $
            13,845,441
            
            $
            7,427,055SUPPLEMENTAL
                DISCLOSURES OF CASH
              FLOW
                INFORMATION
              Loans
                originated for sale in the secondary market
            
            $
            71,831,162
            
            $
            103,885,786
            
            $
            93,272,670Loans
                originated for investment activities
            
            $
            454,150,263
            
            $
            365,831,641
            
            $
            331,091,827Proceeds
                from sale of loans held-for-sale
            
            $
            67,211,810
            
            $
            103,964,950
            
            $
            95,828,355Cash
                paid during the year for:
              Interest
            
            $
            26,823,867
            
            $
            18,778,254
            
            $
            19,121,039Income
                taxes
            
            $
            4,928,013
            
            $
            3,931,000
            
            $
            3,849,000










See
      accompanying notes.


41


**FIRST
      MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**




**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**




**Note
      1 — Summary of Significant Accounting Policies**





*Principles
      of Consolidation and Basis of Presentation* —
The
      consolidated financial statements include the
      accounts of First Mutual Bancshares, Inc. and its wholly-owned subsidiaries,
      First Mutual Bank and First Mutual
      Services, Inc. (collectively, the Company). All significant intercompany
      transactions have been eliminated.
      Certain reclassifications have been made to the 2004 and 2003 financial
      statements to conform to the 2005
      presentation.





*Nature
      of Operations* —
First
      Mutual Bancshares, Inc. and Subsidiaries (the Company), a Washington
      corporation, is a financial holding company primarily engaged in the business
      of
      planning, directing, and coordinating
      the activities of its wholly-owned banking subsidiary, First Mutual Bank
      (formerly First Mutual  Savings
      Bank). On October 26, 1999, First Mutual Savings Bank converted into the holding
      company form of  ownership
      in a tax-free reorganization. In the reorganization, First Mutual Savings Bank
      changed its name to First
      Mutual Bank and became the wholly-owned banking subsidiary of the Company.
      Subsequently, on June
      11,
      2000, the Federal Reserve Bank of San Francisco approved the election for First
      Mutual Bancshares,  Inc.
      to
      become a financial holding company. First Mutual Bank is also referred to as
      the
“Bank” in this report.




First
      Mutual Capital Trust I was formed in June 2002 for the exclusive purpose of
      issuing trust preferred  securities
      and common securities and using the $9.0 million in proceeds from the issuance
      to repurchase and retire
      common stock of the Company.




First
      Mutual Capital Trust II was formed in January 2003 for the exclusive purpose
      of
      issuing trust preferred securities and common securities and using the $4.0
      million in proceeds from the issuance to partially fund the purchase of First
      Mutual Center and to fund future asset growth.




First
      Mutual Statutory Trust III was formed in December 2003 for the exclusive purpose
      of issuing trust preferred securities and common securities and using the $4.0 million in
      proceeds from the issuance to fund future growth.




The
      Bank
      is a community-oriented bank offering a variety of products to retail customers
      while concentrating
      its lending activities on residential, consumer, commercial real estate, and
      business loans. The  Bank
      conducts business from its corporate office in Bellevue, Washington, its 12
      banking centers in the greater Puget
      Sound area, and a multi-state sales finance division with an office in
      Jacksonville, Florida. The Bank accepts deposits from the general public,
      provides lending services to citizens of Washington, Oregon, and Idaho and
      others consumer home improvement loans to borrowers in 42 states.




*Use
      of Estimates* —
The
      preparation of financial statements in conformity with accounting principles generally
      accepted in the United States of America requires management to make estimates
      and assumptions  that
      affect the reported amounts of assets and liabilities at the balance sheet
      date.
      Changes in these estimates and
      assumptions are considered reasonably possible and may have a material impact
      on
      the financial statements.




Material
      estimates that are particularly susceptible to significant changes relate to
      the
      determination of the
      allowance for loan losses, the value of servicing assets, credit insurance
      premiums payable, amortization of deferred
      loan fees/costs, deferred taxes, and the valuation of real estate acquired
      in
      connection with foreclosures
      or in satisfaction of loans. In connection with the determination of the
      allowance for loan losses  and
      the
      valuation of foreclosed assets held-for-sale, management obtains independent
      appraisals for significant properties when needed.




*Cash
      and Cash Equivalents* —
For
      purposes of the consolidated statements of cash flows, all deposits and
      investment securities with an original term to maturity of three months or
      less
      are considered to be cash equivalents.
      We place our cash with high-credit-quality institutions. The amount on deposit
      fluctuates and at  times
      exceeds the insured limit by the U.S. Federal Deposit Insurance Corporation,
      which potentially subjects the Bank
      to credit risk.




42


**FIRST
      MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**




**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**




*Securities* —
      Securities are classified at acquisition into one of three categories:
      held-to-maturity, available-for-sale or held-for-trading. Debt securities that
      management has the positive intent and ability to hold
      to
      maturity are classified as “held-to-maturity” and recorded at amortized cost.
      Securities not classified  as
      held-to-maturity or trading, including equity securities with readily
      determinable fair values, are classified  as
      “available-for-sale” and recorded at fair value, with unrealized gains and
      losses excluded from earnings and  reported
      in other comprehensive income. There were no securities classified as
      held-for-trading during 2005, 2004,
      and 2003.




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




*Federal
      Home Loan Bank (FHLB) Stock* —
Our
      investment in FHLB stock is carried at par value ($100 per share), which
      reasonably approximates its fair value. During 2002, the FHLB revised its
      capital structure
      from the issuance of one class of stock to two, B (1) and B (2) stock. B (1)
      stock can be sold back to the FHLB
      at cost, but is restricted as to purchase, sale, and redemption. Class B (2)
      is
      not a required investment
      for institutions and is not restricted to purchase and sale, but has the same
      redemption restrictions  as
      class
      B (1) stock. Included in the balance sheet as of December 31, 2005 and 2004,
      we
      have $13.1 million and
      $12.9 million of class B (1) stock, respectively. We held no class B (2) stock
      in either year.




*Loans
      Held-For-Sale* —
Loans
      originated and held-for-sale are carried at the lower of aggregate cost or
      estimated fair value.
      Net unrealized losses on loans receivable held-for-sale are recognized in a
      valuation allowance by charges to operations. Gains and losses on the sale
      of
      loans are based on the specific identification method.




*Loans* —
The
      Bank grants mortgage, commercial, and consumer loans to customers. A substantial
      portion of the loan portfolio is represented by real estate loans throughout
      Washington, Oregon, and Idaho. The ability of our debtors to honor their
      contracts is dependent upon the real estate and general economic conditions
      in
      this area.




Loans
      that management has the intent and ability to hold for the foreseeable future
      or
      until maturity or pay-off generally are reported at their outstanding unpaid
      principal balances adjusted for charge-offs, the allowance
      for loan losses, and any deferred fees or costs on originated loans. Interest
      income is accrued on the unpaid
      principal balance. 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.




The
      accrual of interest on mortgage and commercial loans is discontinued at the
      time
      the loan is 90 days  past
      due
      unless the credit is well-secured and in process of collection. Consumer loans
      are typically charged-off no later than 120 days past due. Past due status
      is
      based on the contractual terms of the loan. In all cases, loans
      are placed on non-accrual or charged-off at an earlier date if collection of
      principal or interest is considered doubtful.




All
      interest accrued but not collected for loans that are placed on non-accrual
      or
      charged-off is reversed against
      interest income. The interest on these loans is accounted for on the cash-basis
      or cost-recovery method until
      qualifying for return to accrual. Loans are returned to accrual status when
      all
      the principal and interest amounts contractually due are brought current and
      future payments are reasonably assured.




43


**FIRST
      MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**




**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**




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




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




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




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




Large
      groups of smaller balance, homogeneous loans are collectively evaluated for
      impairment. Accordingly,
      we do not separately identify individual consumer loans for impairment
      disclosures, unless such loans
      are the subject of a restructuring agreement.




*Foreclosed
      Assets* —
Assets
      acquired through, or in lieu of, loan foreclosures are held-for-sale and are recorded
      at the lower of cost or fair value at the date of foreclosure. 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.




*Servicing
      Assets* —
      Originated servicing assets are recorded when loans are originated and
      subsequently sold or securitized (and held as available-for-sale securities)
      with the servicing rights retained. A portion of the cost of originating the
      loan is allocated to the servicing asset based on relative fair value. Fair
      value is based on market prices for comparable servicing contracts, when
      available, or alternatively, is based on a valuation model that calculates
      the
      present value of future cash flows. Assumptions used in the valuation model
      include market discounts rates and anticipated prepayment speeds. The prepayment
      speeds are based




44


**FIRST
      MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**




**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**




on
      loan
      prepayment forecasts derived from the consensus of investment banking firms
      as
      reported by online, fixed-income quotation systems.




The
      one
      exception to this practice is for servicing assets that result from a sale
      of
      sales finance loans of  which
      we
      use actual prepayment experience due to the fact that no online quotation system
      is available for  these
      types of loans. In addition, estimates of the cost of servicing per loan, an
      inflation rate, ancillary income  per
      loan,
      and default rates are used. The cost relating to the servicing rights is
      capitalized and amortized into  noninterest
      income in proportion to, and over the period of, estimated future net servicing
      income. Amounts capitalized are recorded at cost, net of accumulated amortization and valuation
      allowance.




Management
      assesses impairment of the capitalized servicing assets based on recalculations
      of the present value of remaining future cash flows using updated market
      discount rates and prepayment speeds. Subsequent loan prepayments and changes
      in
      prepayment assumptions in excess of those forecasted can adversely
      impact the carrying value of the servicing assets. Impairment is assessed on
      a
      stratum-by-stratum  basis
      with any impairment recognized through a valuation allowance for each impaired
      stratum. The servicing assets
      are stratified based on the types of loans and the underlying
      collateral.




*Land,
      Buildings, and Equipment* — Premises
      and equipment are stated at cost, less accumulated depreciation.
      Depreciation is computed on the straight-line method over the estimated useful
      lives as follows:




Buildings
                and improvements
            10
                to 40 yearsLeasehold
                improvements
            5
                to 20 yearsFurniture,
                fixtures and equipment
            1
                to 5 years




We
      follow
      the policy of capitalizing expenditures for betterments and major renewals
      and
      expensing ordinary maintenance and repairs as incurred.




*Stock-Based
      Compensation Plans* — Statement of Financial Accounting Standards (SFAS) No. 148, *Accounting
      for Stock-Based Compensation* — *Transition and Disclosure,* became
      effective for financial statements
      for fiscal years ending after December 15, 2002. The accounting standard amends
      APB Opinion No. 28, *Interim
      Financial Reporting* and
      SFAS
      No. 123, *Accounting
      for Stock-Based Compensation,* to
      require prominent disclosure about the effects on reported net income of an
      entity’s accounting policy decisions
      with respect to stock-based compensation and to require disclosures about those
      effects in interim f inancial
      information. Management has elected to continue to use the intrinsic value
      method of accounting until
      January 2006 when SFAS No. 123 (R) goes into effect.




On
      December 16, 2004, the Financial Accounting Standards Board (FASB) issued SFAS
      No. 123 (revised 2004), *Share-Based
      Payment,* which
      is
      a revision of SFAS No. 123, *Accounting
      for Stock-Based Compensation.* Statement
      123 (R) supersedes APB Opinion No. 25, *Accounting
      for Stock Issued to Employees,* and
      amends SFAS No. 95, *Statement
      of Cash Flows.* Generally,
      the approach in Statement 123 (R) is similar to the approach described in
      Statement 123. However, Statement 123 (R) requires
      all share-based payments to employees, including grants of employee stock
      options, to be recognized in the
      income statement based on their fair values. Pro forma disclosure is no longer
      an alternative. We adopted Statement 123(R) on January 1, 2006 using the
      modified retrospective method, restating all prior periods.




As
      permitted by Statement 123, we currently account for share-based payments to
      employees using the  intrinsic
      value method allowed under Opinion No. 25 and, as such, generally recognize
      no
      compensation cost  for
      employee stock options. Accordingly, the adoption of Statement 123 (R)’s fair
      value method will have an  impact
      on
      our results of operations, although it will have no impact on our overall
      financial position. The impact of adoption of Statement 123 (R) is expected
      to
      be similar to the pro forma expense amount for 2005,  but
      it
      will depend on levels of share-based payments granted in the future. Statement
      123 (R) also requires the  benefits
      of tax deductions in excess of recognized compensation cost to be reported
      as a
      financing cash flow,




45


**FIRST
      MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**




**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**




rather
      than as an operating cash flow. This requirement will reduce net operating
      cash
      flows and increase net f inancing
      cash flows in periods after adoption. While we cannot estimate what those
      amounts will be in the  future
      (because they depend on, among other things, when employees exercise stock
      options), the amount of  operating
      cash flows recognized in prior periods for such excess tax deductions were
      $92,000, $87,000, and $13,000
      in 2005, 2004, and 2003, respectively.




At
      December 31, 2005, we had four stock-based employee/director compensation plans,
      which are described more fully in Note 18. The plans are accounted for under
      the
      recognition and measurement principles
      of APB Opinion No. 25,  *Accounting
      for Stock Issued to Employees,* and
      related interpretations. No  stock-based
      employee or director compensation cost is reflected in net income, as all
      options granted under  those
      plans had an exercise price equal to the market value of the underlying common
      stock on the date of grant.
      The following table illustrates the effect on net income and earnings per share
      if the fair value recognition provisions of SFAS No. 123, *Accounting
      for Stock-Based Compensation,* had
      been
      adopted.




**Years
                Ended December 31,****2005**
            
            **2004**
            
            **2003**Net
                income, as reported
            
            $
            10,318,649
            
            $
            9,287,813
            
            $
            8,395,738Deduct:
                Total stock-based employee/director compensation
              expense
                determined under fair value based method for all
              awards,
                net of related tax effects
            
            
            (569,555
            )
            
            (445,047
            )
            
            (327,461
            )Pro
                forma net income
            
            $
            9,749,094
            
            $
            8,842,766
            
            $
            8,068,277Earnings
                per share:
              Basic
                — as reported
            
            $
            1.94
            
            $
            1.76
            
            $
            1.62Basic
                — pro forma
            
            $
            1.83
            
            $
            1.68
            
            $
            1.56Diluted
                — as reported
            
            $
            1.86
            
            $
            1.68
            
            $
            1.57Diluted—pro forma
            
            $
            1.77
            
            $
            1.60
            
            $
            1.51Weighted
                average shares outstanding:
              Basic
            
            
            5,314,616
            
            
            5,264,412
            
            
            5,179,627Diluted
            
            
            5,542,779
            
            
            5,513,658
            
            
            5,352,960




*Income
      taxes* —
We
      file
      a consolidated tax return which includes income earned by our subsidiaries.
      We  account
      for income taxes on the liability method. The liability method recognizes the
      amount of tax currently  payable
      and deferred at the date of the financial statements as a result of all events
      that have been recognized in the
      financial statements, as measured by the provisions of current enacted tax
      laws
      and rates.




*Advertising
      costs* —
      Advertising costs were expensed as incurred. Advertising expenses were $1.2
      million, $1.1
      million, and $918,000 for the years ended December 31, 2005, 2004, and 2003,
      respectively.




*Interest
      Rate Risk Management* —
      Management may hedge certain transactions with purchased option contracts and forward sales commitments.
      Net gains or
      losses on these options are considered in the calculation of the lower of cost
      or fair value for loans receivable held-for-sale.




We
      utilized an interest rate swap agreement in order to fix the interest rate
      on
      the trust preferred securities.
      In June 2002, we entered into a swap agreement with the FHLB in connection
      with
      the $9 million  of
      trust
      preferred securities that was issued. Under the terms of the agreement, we
      receive the equivalent of  three-month
      LIBOR (London Interbank Offering Rate) and pay the FHLB a fixed rate of interest
      equal to  the
      Five-year swap curve. This arrangement is considered an effective cash flow
      hedge under SFAS No. 133,  *Accounting
      for Derivative Instruments and Hedging Activities.* As
      a
      result, the interest paid and received is  reflected
      in earnings while the changes in fair value of the swap are reported in
      comprehensive income.




46


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      MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**




**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**




Interest
      rate swaps are contracts in which a series of interest rate flows are exchanged
      over a prescribed period. The notional amount on which the interest payments
      are
      based is not exchanged.




Under
      SFAS No. 133 the effective portion of the gain or loss on a derivative
      designated and qualifying as a cash
      flow hedging instrument is initially reported as a component of other
      comprehensive income and subsequently reclassified into earnings in the same
      period or periods during which the hedged transaction affects
      earnings. The ineffective portion of the gain or loss on the derivative
      instruments, if any, is recognized currently in earnings.




Interest
      rate derivative financial instruments receive hedge accounting treatment only
      if
      they are designated as a hedge and are expected to be, and are, effective in
      substantially reducing interest rate risk arising from the assets and
      liabilities identified as exposing the Bank to risk. Those derivative financial
      instruments that do not meet the hedging criteria would be classified as trading
      activities and would be recorded at fair value with changes in fair value
      recorded in income. Derivative hedge contracts must meet specific
      effectiveness tests (i.e., over time the change in their fair values due to
      the
      designated hedge risk must be
      within 80 to 125 percent of the opposite change in the fair values of the hedged
      assets or liabilities). Changes
      in fair value of the derivative financial instruments must be effective at
      offsetting changes in the fair value of
      the hedged items due to the designated hedge risk during the term of the hedge.
      Further, if the underlying financial instrument differs from the hedged asset
      or
      liability, there must be a clear economic relationship
      between the prices of the two financial instruments. If periodic assessment
      indicates derivatives no  longer
      provide an effective hedge, the derivatives contracts would be closed out and
      settled or classified as a trading
      activity.




In
      accordance with SFAS 133, as amended, hedges of variable-rate debt are accounted
      for as cash flow hedges,
      with changes in fair value recorded in derivative assets or liabilities and
      other comprehensive income. The net
      settlement (upon close out or termination) that offsets changes in the value
      of
      the hedged debt is deferred
      and amortized into net interest income over the life of the hedged debt. The
      portion, if any, of the net settlement amount that did not offset changes in the value of the hedged asset
      or liability is recognized immediately in noninterest income.




Cash
      flows resulting from the derivative financial instruments that are accounted
      for
      as hedges of assets  and
      liabilities are classified in the cash flow statement in the same category
      as
      the cash flows of the items being hedged.




*Rate
      Lock Commitments* —
We
      enter into commitments to originate loans whereby the interest rate on the
      loan
      is determined prior to funding (rate lock commitments). Rate lock commitments
      on
      mortgage loans that
      are
      intended to be sold are considered to be derivatives. Accordingly, such
      commitments, along with any related
      fees received from potential borrowers, are recorded at fair value with the
      changes in fair value recorded in the net gain or loss on sale of mortgage
      loans.




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




*Comprehensive
      Income* —
      Comprehensive income is comprised of net income and other comprehensive income.
      Other comprehensive income includes items previously recorded directly to
      equity, such as unrealized  gains
      and
      losses on securities available-for-sale and unrealized gains and losses on
      the
      interest rate swap, net of tax.
      Comprehensive income is presented in the consolidated statement of shareholders’
equity.





47


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      MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**




**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**




*Off-Balance
      Sheet Credit Related Financial Instruments* —
In
      the
      ordinary course of business, we enter into commitments to extend credit,
      including commitments under commercial letters of credit and standby letters
      of
      credit. These financial instruments are not recorded until they are
      funded.




*Earnings
      per share (EPS) data* —
Basic
      and diluted EPS are presented in the income statement. Basic EPS is computed
      by
      dividing net income by the weighted average number of shares outstanding during
      the year.
      Diluted EPS reflects the potential dilutive effect of stock options and is
      computed by dividing net income  by
      the
      weighted average number of shares outstanding during the year, plus the dilutive
      common shares that would
      have been outstanding had the stock options been exercised. A reconciliation
      of
      the numerator and denominator
      used for the basic EPS to the numerator and denominator used for the diluted
      EPS
      is provided in Note
      14.




**Note** **2—** **Reserve Balances**




Included
      in Cash and Cash Equivalents are legally reserved amounts which are required
      to
      be maintained on an
      average basis in the form of cash and balances due from the Federal Reserve
      Bank. Average reserve balances were $4.5 million, $2.4 million, and $472,000
      for
      the years ended December 31, 2005, 2004, and, 2003, respectively.




**Note** **3—** **Mortgage-Backed and Other Securities Available-for-Sale**




The
      amortized cost and estimated fair value of securities available-for-sale at
      December 31, 2005 and 2004 are summarized as follows:




**Amortized**
              **Cost**
            
            **Gross**
              **Unrealized**
              **Gains**
            
            **Gross**
              **Unrealized**
              **Losses**
              <**1
                Year**
            
            **Gross**
              **Unrealized**
              **Losses**
              >**1
                Year**
            
            **Estimated**
              **Fair
                Value**December
                31, 2005:Freddie
                Mac securities
            
            $
            16,639,949
            
            $
            15,285
            
            $
            60,164
            
            $
            485,345
            
            $
            16,109,725Fannie
                Mae securities
            
            
            38,209,406
            
            
            28,119
            
            
            334,933
            
            
            672,624
            
            
            37,229,968Ginnie
                Mae securities
            
            
            43,632,279
            
            
            2,673
            
            
            340,680
            
            
            172,152
            
            
            43,122,120US
                treasury and agency securities
            
            
            18,207,150
            
            
            —
            
            
            123,328
            
            
            95,293
            
            
            17,988,529$
            116,688,784
            
            $
            46,077
            
            $
            859,105
            
            $
            1,425,414
            
            $
            114,450,342December
                31, 2004:Freddie
                  Mac securities
            
            $
            19,127,613
            
            $
            48,719
            
            $
            173,913
            
            $
            115,062
            
            $
            18,887,357Fannie
                Mae securities
            
            
            39,095,463
            
            
            75,726
            
            
            87,354
            
            
            308,837
            
            
            38,774,998Ginnie
                Mae securities
            
            
            48,839,639
            
            
            38,712
            
            
            270,022
            
            
            —
            
            
            48,608,329US
                treasury and agency securities
            
            
            17,946,544
            
            
            57,76
                1
            
            
            50,306
            
            
            —
            
            
            17,953,999$
            125,009,259
            
            $
            220,918
            
            $
            581,595
            
            $
            423,899
            
            $
            124,224,683




Certain
      investment securities shown above currently have fair values less than amortized
      cost and therefore
      contain unrealized losses. We have evaluated these securities and have
      determined that the decline  in
      value
      is temporary and is related to the change in market interest rates since
      purchase. The decline in value is not
      related to any company or industry specific event. We evaluate the securities
      portfolio for other-than-temporary impairment on a quarterly basis and more
      frequently when economic or market concerns warrant such evaluations.
      Consideration is given to (1) the length of time and the extent to which the
      fair value has been less than cost, (2) the financial condition and near-term
      prospects of the issuer, and (3) our intent and ability
      to retain our investment in the issuer for a period of time sufficient to allow
      for any anticipated recovery




48


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      MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**




**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**




in
      fair
      value. There are 34 investment securities with unrealized losses. We anticipate
      full recovery of amortized
      cost with respect to these securities at maturity or sooner in the event of
      a
      more favorable market interest
      rate environment.




Proceeds
      from the sale of securities during 2005, 2004, and 2003 were $0, $2,228,958,
      and
      $25,442,072,  respectively.
      Gross gains on those sales were $0, $70,870, and $662,564, respectively. No
      gross losses were realized
      on sales during 2005, 2004, and 2003.




The
      amortized cost and estimated fair value of mortgage-backed and other securities
      available-for-sale at December
      31, 2005, by contractual maturity, are shown below. Expected maturities will
      differ from contractual maturities because issuers may have the right to call
      or
      prepay obligations with or without prepayment penalties.




**Amortized**
              **Cost**
            
            **Estimated**
              **Fair
                Value**Due
                less than one year
            
            $
            7,219,784
            
            $
            7,213,289Due
                after one year through five years
            
            
            10,295,807
            
            
            10,017,553Due
                after five years through ten years
            
            
            —
            
            
            —Due
                after ten years
            
            
            99,173,193
            
            
            97,219,500$
            116,688,784
            
            $
            114,450,342




**Note
      4 — Mortgage-Backed and Other Securities Held-to-Maturity**




The
      amortized cost and estimated fair value of securities held-to-maturity at
      December 31, 2005 and 2004 are summarized as follows:




**Amortized**
              **Cost**
            
            **Gross**
              **Unrealized**
              **Gains**
            
            **Gross**
              **Unrealized**
              **Losses**
              <**1
                Year**
            
            **Gross**
              **Unrealized**
              **Losses**
              >**1
                Year**
            
            **Estimated**
              **Fair
                Value**December
                31, 2005:Fannie
                Mae securities
            
            $
            5,345,378
            
            $
            68,712
            
            $
            56,460
            
            $
            17,175
            
            $
            5,340,455Freddie
                Mac securities
            
            
            432,808
            
            
            9,659
            
            
            —
            
            
            —
            
            
            442,467Municipal
                bonds
            
            
            1,188,109
            
            
            649
            
            
            —
            
            
            790
            
            
            1,187,968$
            6,966,295
            
            $
            79,020
            
            $
            56,460
            
            $
            17,965
            
            $
            6,970,890December
                31, 2004:Fannie
                Mae securities
            
            $
            6,010,318
            
            $
            125,722
            
            $
            —
            
            $
            30,472
            
            $
            6,105,568Freddie
                Mac securities
            
            
            492,607
            
            
            13,408
            
            
            —
            
            
            —
            
            
            506,015Municipal
                bonds
            
            
            1,216,617
            
            
            2,622
            
            
            3,828
            
            
            —
            
            
            1,215,411$
            7,719,542
            
            $
            141,752
            
            $
            3,828
            
            $
            30,472
            
            $
            7,826,994




Certain
      investment securities shown above currently have fair values less than amortized
      cost and therefore
      contain unrealized losses. The Company has evaluated these securities and has
      determined that the  decline
      in value is temporary and is related to the change in market interest rates
      since purchase. The decline  in
      value
      is not related to any company or industry specific event. We evaluate the
      securities portfolio for other- than-temporary
      impairment on a quarterly basis and more frequently when economic or market
      concerns warrant
      such evaluation. Consideration is given to (1) the length of time and the extent
      to which the fair value  has
      been
      less than cost, (2) the financial condition and near-term prospects of the
      issuer, and (3) our intent and
      ability to retain our investment in the issuer for a period of time sufficient
      to allow for any anticipated




49


**FIRST
      MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**




**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**




recovery
      in fair value. There are four investment securities with unrealized losses.
      We
      anticipate full recovery  of
      amortized cost with respect to these securities at maturity or sooner in the
      event of a more favorable market interest
      rate environment.




The
      amortized cost and estimated fair value of mortgage-backed and other securities
      held-to-maturity at  December
      31, 2005, by contractual maturity, are shown below. There were no sales from
      the
      held-to-maturity portfolio during 2005, 2004, or 2003.




**Amortized**
              **Cost**
            
            **Estimated**
              **Fair
                Value**Due
                less than one year
            
            $
            300,295
            
            $
            303,943Due
                after one year through five years
            
            
            408,673
            
            
            416,460Due
                after five years through ten years
            
            
            —
            
            
            —Due
                after ten years
            
            
            6,257,327
            
            
            6,250,487$
            6,966,295
            
            $
            6,970,890







At
      December 31, 2005, the fair value and amortized cost of pledged securities
      for
      public deposits totaled  $954,000
      and $935,000, respectively. At December 31, 2004, both the fair value and
      amortized cost of securities pledged to secure public deposits totaled $1.2 million.




**Note
      5 — Loans Receivable, Net and Loans Receivable
      Held-for-Sale**




Loans
      receivable consisted of the following as of
      December 31:




**2005**
            
            **2004**Real
                estate:
              Single-family
                residential
            
            $
            223,927,585
            
            $
            177,321,664Single-family
                construction
            
            
            188,148,362
            
            
            151,735,247Income
                property:
              Commercial
                construction
            
            
            35,153,390
            
            
            25,773,413Commercial
                realestate
            
            
            191,719,514
            
            
            205,417,180Multifamily
                construction
            
            
            24,980,916
            
            
            6,555,794Multifamily
                residential
            
            
            153,987,722
            
            
            176,429,163Consumer
                and other loans
            
            
            115,940,966
            
            
            94,776,138Business
                loans
            
            
            67,223,270
            
            
            52,963,3261,001,081,725
            
            
            890,971,925Less:
              Net
                deferred loan origination costs
            
            
            1,280,027
            
            
            1,157,969Undisbursed
                loanproceeds
            
            
            (109,568,286
            )
            
            (73,423,208
            )Reserve
                for loan losses
            
            
            (10,069,020
            )
            
            (9,300,854
            )Unearned
                discount on purchased leases
            
            
            (43,718
            )
            
            —882,680,728
            
            
            809,405,832Loans
                receivable held-for-sale
            
            
            (14,683,507
            )
            
            (10,064,155
            )Loans
                receivable, net
            
            $
            867,997,221
            
            $
            799,341,677




A
      substantial portion of revenue is derived from the origination of loans in
      the
      Puget Sound region of  Washington
      State. The customers’ ability to honor their commitments to repay such loans is
      dependent upon





50


**FIRST
      MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**




**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**




the
      region’s real estate values, economy and, to a certain extent, the dominant
      industries in that region such as aerospace, international trade, and high technology.




Single-family
      residential permanent and construction loans are primarily secured by collateral
      located in  Western
      Washington. Income property loans, by county or state in which the property
      resides, are as follows at December
      31, 2005:




**King
                County**
            
            **Snohomish**
              **County**
            
            **Pierce**
              **County**
            
            **Thurston**
              **County**
            
            **Oregon**
            
            **Other**
            
            **Total**Income
                property:
              Commercial
              construction
            
            $
            2,889,000
            
            $
            2,920,000
            
            $
            3,762,500
            
            $
            10,500,000
            
            $
            11,202,500
            
            $
            3,879,390
            
            $
            35,153,390Commercial
              real
                estate
            
            
            100,161,670
            
            
            26,102,785
            
            
            33,003,629
            
            
            484,096
            
            
            12,507,752
            
            
            19,459,582
            
            
            191,719,514Multifamily
              construction
            
            
            16,489,800
            
            
            2,164,100
            
            
            —
            
            
            —
            
            
            6,327,016
            
            
            —
            
            
            24,980,916Multifamily
              residential
            
            
            42,385,975
            
            
            5,893,804
            
            
            39,045,493
            
            
            3,646,583
            
            
            37,100,631
            
            
            25,915,236
            
            
            153,987,722$
            161,926,445
            
            $
            37,080,689
            
            $
            75,811,622
            
            $
            14,630,679
            
            $
            67,137,899
            
            $
            49,254,208
            
            $
            405,841,542




The
      loan
      portfolio includes both adjustable and fixed interest rate loans. At December
      31, 2005, the composition of those loans was as follows:




**Fixed
                Rate**
            
            **Adjustable**
              **Rate**
            
            **Total**Term
                to maturity or rate adjustment:
              Due
                within one year
            
            $
            7,592,504
            
            $
            527,154,122
            
            $
            534,746,626After
                one but within three years
            
            
            12,602,229
            
            
            101,692,104
            
            
            114,294,333After
                three but within five years
            
            
            22,316,188
            
            
            64,594,798
            
            
            86,910,986After
                five but within ten years
            
            
            47,866,718
            
            
            52,853,618
            
            
            100,720,336After
                ten years
            
            
            45,041,289
            
            
            967,158
            
            
            46,008,447$
            135,418,928
            
            $
            747,261,800
            
            $
            882,680,728




Single-family,
      adjustable-rate loans typically have both periodic and lifetime adjustment
      limitations.  Permanent,
      income property, adjustable-rate loans generally only have lifetime adjustment
      limitations. Both  types
      of
      adjustable-rate loans are generally indexed to either the one-, three-, or
      Five-year Constant Maturity Treasury
      (CMT), the FHLB’s cost of funds, or the one-year London Interbank Offering Rate (LIBOR)
      indices. Future market factors may affect the correlation of the interest rate
      adjustment with the rates
      the Bank pays on the short-term deposits that have been primarily utilized
      to
      fund these loans.




An
      analysis of the changes in the reserve for loan losses is as follows for the
      years ended December 31:




**2005**
            
            **2004**
            
            **2003**Balance,
                beginning of year
            
            $
            9,300,854
            
            $
            8,406,198
            
            $
            7,754,106Provision
                for loan losses
            
            
            1,500,000
            
            
            1,565,000
            
            
            1,150,000Charge-offs
            
            
            (1,045,962
            )
            
            (913,645
            )
            
            (639,573
            )Recoveries
            
            
            314,128
            
            
            243,301
            
            
            141,665Balance,
                end of year
            
            $
            10,069,020
            
            $
            9,300,854
            
            $
            8,406,198


51




**FIRST
      MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**




**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**




The
      following is a summary of information pertaining to impaired and non-accrual
      loans as of December 31:




**2005**
            
            **2004**
            
            **2003**Impaired
                loans
            
            $
            308,645
            
            $
            317,023
            
            $
            21,045Valuation
                allowance related to impaired loans
            
            
            (172,475
            )
            
            (177,190
            )
            
            (4,600
            )Net
                impaired loans
            
            
            136,170
            
            
            139,833
            
            
            16,445Non-accrual
                loans
            
            
            761,020
            
            
            864,464
            
            
            510,424Total
                non-accrual loans
            
            $
            897,190
            
            $
            1,004,297
            
            $
            526,869Total
                loans past due 90-days or more and still accruinginterest
            
            $
            —
            
            $
            34,000
            
            $
            —Average
                balance of impaired loans
            
            $
            173,445
            
            $
            49,204
            
            $
            4,582Interest
                income recognized on impaired loans
            
            $
            793
            
            $
            1,108
            
            $
            1,177




The
      Bank
      serviced loans owned by other investors with aggregate principal balances of
      $105,850,000, $117,852,000, and $76,424,000 as of December 31, 2005, 2004, and 2003
      respectively.




Outstanding
      commitments to borrowers for loans totaled $315,468,000, $239,329,000, and
      $230,374,000  at
      December 31, 2005, 2004, and 2003 respectively. Outstanding commitments to
      sell
      loans to investors, which  totaled
      $9,452,000, $3,763,000, and $6,773,000 at December 31, 2005, 2004, and 2003
      respectively, hedge  against
      interest rate fluctuations from the time of the loan commitment until the date
      at which loans are sold, which is
      generally within 60 days.




Commitments
      to extend credit generally have fixed expiration dates. Since portions of the
      commitments  are
      expected to expire without being drawn upon, the total commitment amounts do
      not
      necessarily represent  future
      cash requirements. Prior to extending commitments, each customer’s
      creditworthiness is evaluated on a  case-by-case
      basis. The amount of collateral obtained upon extension of credit is based
      on
      management’s  credit
      evaluation of the borrower. Collateral held varies but may include accounts
      receivable, inventory, property, plant and equipment, and residential or income-producing commercial
      properties.




**Note
      6 — Accrued Interest Receivable**




Accrued
      interest receivable at December 31 is
      summarized as follows:




**2005**
            
            **2004**Loansreceivable
            
            $
            4,806,129
            
            $
            3,763,370Securitiesavailable-for-sale
            
            
            493,880
            
            
            492,012Securities
                held-to-maturity
            
            
            50,484
            
            
            44,749$
            5,350,493
            
            $
            4,300,131




52


**FIRST
      MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**




**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**




**Note** **7—** **Servicing Assets and Servicing Fees**




Changes
      in the servicing assets balance for the years ended December 31 are as
      follows:




**2005**
            
            **2004**
            
            **2003**Balance,
                beginning of year
            
            $
            1,525,085
            
            $
            468,413
            
            $
            49,914Additions
            
            
            1,293,317
            
            
            1,928,397
            
            
            516,776Amortization
            
            
            (952,704
            )
            
            (871,725
            )
            
            (98,277
            )Balance,
                end of year
            
            $
            1,865,698
            
            $
            1,525,085
            
            $
            468,413




There
      were no changes in the valuation for impairment of servicing assets for each
      impaired loan for the years
      ended December 31, 2005, 2004, and 2003.




Servicing
      fee income, net of amortization, consisted of the following for the years ended
      December 31:




**2005**
            
            **2004**
            
            **2003**Servicingfees
            
            $
            2,252,324
            
            $
            1,185,714
            
            $
            167,708Amortization
            
            
            (952,704
            )
            
            (871,726
            )
            
            (98,277
            )Loan
                servicing fees, net
            
            $
            1,299,620
            
            $
            313,988
            
            $
            69,431




At
      December 31, 2005, the expected weighted average life of the Bank’s servicing
      assets was four years.  Projected
      amortization expense for the gross carrying value of servicing assets at
      December 31, 2005 is estimated to be as follows:




2006
            
            $
            820,1912007
            
            
            592,2262008
            
            
            381,0662009
            
            
            72,215Gross
                carrying value of servicing assets
            
            $
            1,865,698




The
      projected amortization expense of the servicing asset is an estimate and should
      be used with caution.  The
      amortization expense for future periods was calculated by applying the same
      quantitative factors, such as  estimated
      prepayment assumptions that were used to determine the amortization expense
      for
      the fourth  quarter
      of 2005. These factors are subject to significant fluctuations. Any projection
      of servicing asset  amortization
      in future periods is limited by the conditions that existed at the time the
      calculations were  performed,
      and may not be indicative of actual amortization expense that will be recorded
      in future periods.




53


**FIRST
      MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**




**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**




**Note
      8 — Land, Buildings, and Equipment**




The
        following is a summary of land, buildings, and equipment at December
        31:


**2005**
            
            **2004**Land
            
            $
            13,731,369
            
            $
            13,686,172Buildings
            
            
            20,863,538
            
            
            15,217,038Furniture,
                fixtures, and equipment
            
            
            5,629,939
            
            
            4,379,703Leasehold
                improvements
            
            
            1,052,251
            
            
            1,032,54641,277,097
            
            
            34,315,459Less
                accumulated depreciation and amortization
            
            
            (7,793,099
            )
            
            (6,320,927
            )$
            33,483,998
            
            $
            27,994,532




Depreciation
      expense for the years ended December 31, 2005, 2004, and 2003 amounted to
      $1,651,000, $1,321,000, and $1,078,000, respectively.




Five
      office locations are leased under operating leases. Total lease obligations
      for
      the next five years are as follows:




**Year
                Ending December 31,**2006
            
            $
            280,9002007
            
            
            244,6552008
            
            
            245,7502009
            
            
            247,9412010
            
            
            247,941$
            1,267,187




Total
      lease expenses were $322,000, $313,000, and $323,000 for the years ended
      December 31, 2005, 2004,
      and 2003, respectively.




Lease
      income totaled $627,000, $627,000, and $713,000 for the years ended December
      31,
      2005, 2004, and
      2003, respectively.




Future
      minimum lease receipts from lessees for the next
      five years are as follows:




**Year
                Ending December 31,**2006
            
            $
            510,2282007
            
            
            335,8002008
            
            
            306,7442009
            
            
            173,1712010
            
            
            19,752$
            1,345,695




During
      2005 three banking centers were under construction. In accordance with SFAS
      34,  *Capitalization* *of
      Interest Cost,* we
      capitalize any interest expense associated with construction costs. Interest
      costs are  calculated
      monthly by multiplying the expenditures related to each asset being constructed
      by the weighted  average
      rate of outstanding FHLB borrowings. The interest capitalized for the new West
      Seattle banking center
      also includes a $600,000 note at 6%.





54


**FIRST
      MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**




**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**




During
      the year ended December 31, 2005, interest related to the construction of three
      new banking centers
      was as follows:




**Canyon********Park**
            
            **West
                Seattle**
            
            **Crossroads**Interest
                capitalized during 2005
            
            $
            46,000
            
            $
            74,000
            
            $
            13,000




The
      total
      interest capitalized in 2005 totaled $133,000. The Crossroads banking center
      was
      completed in  June
      2005
      and the interest costs were transferred to the basis of the asset. There was
      no
      interest capitalized in 2004 or
      2003.




**Note** **9—** **Deposits**




Deposits
      consisted of the following at December 31:




**Weighted****Average
                Rate at****December
                31,**
            
            **2005**
            
            **2004****2005**
            
            **Amount**
            
            **Percent**
            
            **Amount**
            
            **Percent**TermsMoney
                market deposit and checkingaccounts,
                including noninterest-bearingdeposits
                of $30,914,000(2005)
                and $26,961,000 (2004)
            
            
            1.8
            %
            $
            263,444,641
            
            
            34.6
            %
            $
            254,435,583
            
            
            37.7
            %Savings
            
            
            1.0
            %
            
            8,053,510
            
            
            1.1
            %
            
            8,434,423
            
            
            1.2
            %Time
                deposits:1
                to 6 months
            
            
            3.0
            %
            
            25,325,763
            
            
            3.3
            %
            
            54,744,788
            
            
            8.1
            %7
                to 12 months
            
            
            3.6
            %
            
            166,316,334
            
            
            21.9
            %
            
            136,786,209
            
            
            20.2
            %13
                to 23 months
            
            
            3.5
            %
            
            199,509,548
            
            
            26.2
            %
            
            102,408,465
            
            
            15.2
            %2
                to 10 years
            
            
            3.7
            %
            
            98,070,841
            
            
            12.9
            %
            
            118,559,440
            
            
            17.6
            %Total
                time deposits
            
            
            3.6
            %
            
            489,222,486
            
            
            64.3
            %
            
            412,498,902
            
            
            61.1
            %Total
                deposits
            
            
            2.9
            %
            $
            760,720,637
            
            
            100
            %
            $
            675,368,908
            
            
            100
            %




Deposits
      at December 31, 2005 and 2004, included public funds of $5,628,000 and
      $10,865,000,  respectively.
      Mortgage-backed securities with a book value of $935,000 and $1,197,000 and
      fair
      values of  $954,000
      and $1,239,000 were pledged as collateral on these deposits at December 31,
      2005
      and 2004,  respectively,
      which exceeds the minimum collateral requirement established by the Washington
      Public Deposit
      Protection Commission.




As
      of December 31, 2005, scheduled maturities of time
      deposits were as follows:




**Year
                Ending December 31,**2006
            
            $
            383,455,1272007
            
            
            77,150,0352008
            
            
            12,062,5912009
            
            
            12,336,4602010
            
            
            4,187,172Thereafter
            
            
            31,101$
            489,222,486


55




**FIRST
      MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**




**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**




Included
      in deposits are time deposits greater than or equal to $100,000 of $216,507,000
      and $166,366,000
      at December 31, 2005 and 2004, respectively. Interest on time deposits greater
      than or equal to  $100,000
      totaled $5,916,000, $4,733,000, and $4,225,000 for the years ended December
      31,
      2005, 2004, and  2003,
      respectively. Also included in deposits are accounts of approximately $7,712,000
      and $3,455,000 at  December
      31, 2005 and 2004, respectively, which are controlled by members of the Board
      of
      Directors and management.




Deposit
      interest expense by type for the years ended December 31 was as
      follows:




**2005**
            
            **2004**
            
            **2003**Time
                deposits
            
            $
            14,152,631
            
            $
            9,712,012
            
            $
            10,095,366Money
                market deposit and checking
            
            
            3,967,963
            
            
            2,512,022
            
            
            1,818,163Savings
            
            
            70,789
            
            
            68,091
            
            
            70,523$
            18,191,383
            
            $
            12,292,125
            
            $
            11,984,052




**Note
      10 — FHLB and Other Advances**




Borrowings
      consisted of the following at December
      31:




**2005**
            
            **2004**FHLB
                advances
            
            $
            225,705,005
            
            $
            234,206,775FHLB
                advances:
              Maximum
                outstanding at any month end
            
            $
            265,215,985
            
            $
            246,666,680Average
                outstanding
            
            
            235,113,503
            
            
            227,936,570Weighted
                average interest rates:
              Annual
            
            
            3.080
            %
            
            2.330
            %End
                of year
            
            
            3.777
            %
            
            2.394
            %Other
                advances
            
            $
            4,600,000
            
            $
            1,600,000




Under
      the
      terms of the FHLB advances, in addition to FHLB stock held, the Bank must
      maintain unencumbered collateral of agency MBS/CMOs/REMICS, subject to the discounted
      market value determined
      by the FHLB, 83% of one-to-four-unit family permanent mortgages, and 80% of
      multifamily  permanent
      loans. At December 31, 2005, the minimum book value of eligible collateral
      pledged for these  borrowings
      was $476.6 million. The Bank has an available line of credit with the FHLB
      in
      the amount equal to 40% of
      total assets.




FHLB
      advances at December 31, 2005 mature as
      follows:




**Interest
                Rates**
            
            **Amount**2006
            
            
            1.81%
                —
                6.25%
            
            $
            203,427,9582007
            
            
            2.52%
                — 3.66%
            
            
            15,814,5472008
            
            
            3.13%
                — 3.23%
            
            
            1,500,0002009
            
            
            3.65%
            
            
            250,0002010
            
            
            4.93%
            
            
            4,000,0002011
            
            
            5.19%
            
            
            712,500$
            225,705,005


56




**FIRST
      MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**




**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**




The
      other
      advances are comprised of: a $4,000,000 line of credit which matures on February
      28, 2006, with
      an
      interest rate of 6.05% and a $600,000 note that matures on November 1, 2009
      with
      an interest rate of 6.00%.
      The payment terms on the note consist of monthly interest payments with the
      full
      principal due at maturity.




**Note
      11 — Long-Term Debentures (Trust Preferred Securities)**




First
      Mutual Capital Trust I is a statutory business trust created for the exclusive
      purpose of issuing and selling capital securities and utilizing sale proceeds
      to
      acquire junior subordinated debt issued by the Company. In June 2002, the Trust
      issued $9.0 million of trust preferred securities with a 30-year maturity,
      callable after the fifth year by the Company. The rate adjusts quarterly based
      on LIBOR plus 3.65%. We entered
      into a swap with the FHLB to fix the interest rate at 8.18% for a period of
      five
      years (Note 23). These securities are considered capital for the purposes of regulatory capital
      requirements, subject to regulatory limitations. Accordingly, the junior
      subordinated debentures are the sole assets of the Trust, and payments under
      the
      junior subordinated debentures will be the sole revenues of the Trust. We own
      all of the common securities of the Trust.




First
      Mutual Capital Trust II was formed in January 2003 for the exclusive purpose
      of
      issuing and selling trust
      preferred securities and utilizing the $4.0 million in proceeds from the
      issuance to partially fund the purchase
      of First Mutual Center, the building in which our corporate office resides,
      and
      to fund asset growth. In
      January 2003, the Trust issued $4.0 million of trust preferred securities with
      a
      30-year maturity, callable after
      the
      fifth year by the Company. The securities have a fixed rate of 6.87% in the
      first five years, and will  reset
      quarterly thereafter at the three-month LIBOR rate, plus 3.30%. These securities
      are considered capital  for
      the
      purposes of regulatory capital requirements, subject to regulatory limitations.
      Accordingly, the junior subordinated debentures are the sole assets of the Trust, and payments under
      the
      junior subordinated debentures will be the sole revenues of the Trust. We own
      all of the common securities of the Trust.




First
      Mutual Statutory Trust III was formed in December 2003 for the exclusive purpose
      of issuing trust  preferred
      securities and utilizing the $4.0 million in proceeds from the issuance to
      fund
      future asset growth. In December
      2003, the Trust issued $4.0 million of trust preferred securities with a 30-year
      maturity, callable after
      the
      fifth year by the Company. The securities have a fixed rate of 6.51% in the
      first five years, and will  reset
      quarterly thereafter at the three-month LIBOR rate, plus 2.85%. These securities
      are considered capital  for
      the
      purposes of regulatory capital requirements, subject to regulatory limitations.
      Accordingly, the junior subordinated debentures are the sole assets of the Trust, and payments under
      the
      junior subordinated debentures will be the sole revenues of the Trust. We own
      all of the common securities of the Trust.




During
      the fourth quarter of 2003, we adopted SFAS Interpretation Number 46, *Consolidation
      of* *Variable
      Interest Entities,* and
      in
      accordance with the Interpretation, do not consolidate First Mutual
      Capital Trust I
      or II or First Mutual Statutory Trust III.





57


**FIRST
      MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**




**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**




**Note
      12 — Federal Taxes on Income**




Deferred
      federal income taxes constitute the differences in the reporting of income
      and
      expense for f inancial
      statement and income tax purposes. The components of deferred income tax
      provision (benefit) are as
      follows for the years ended December 31:




**2005**
            
            **2004**
            
            **2003**Loan
                origination fees and costs
            
            $
            374,537
            
            $
            530,819
            
            $
            350,212FHLB
                stock dividends
            
            
            18,515
            
            
            118,580
            
            
            201,382Reserve
                for loan losses
            
            
            (268,858
            )
            
            (313,130
            )
            
            (221,711
            )Other,net
            
            
            (125,194
            )
            
            211,731
            
            
            483,392$
            (1,000
            )
            $
            548,000
            
            $
            813,275




At
      December 31, the significant components of the net deferred tax liability were
      as follows:




**2005**
            
            **2004**Deferred
                tax assets:
              Reserve
                for loan losses
            
            $
            3,300,000
            
            $
            3,031,000Unrealized
                loss on available-for-sale securities
            
            
            773,000
            
            
            354,000Other,
                net
            
            
            353,000
            
            
            311,0004,426,000
            
            
            3,696,000Deferred
                tax liabilities:
              Loan
                origination fees and costs
            
            
            2,554,000
            
            
            2,179,000FHLB
                stock dividends
            
            
            1,936,000
            
            
            1,918,000Servicing
                assets
            
            
            17,000
            
            
            8,000Other,
                net
            
            
            498,000
            
            
            590,0005,005,000
            
            
            4,695,000Net
                deferred tax (liability)
            
            $
            (579,000
            )
            $
            (999,000
            )




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




**2005**
            
            **2004**
            
            **2003****Amount**
            
            **Rate**
            
            **Amount**
            
            **Rate**
            
            **Amount**
            
            **Rate**Federal
                income tax at statutory
              rates
            
            $
            5,393,951
            
            
            34
            %
            $
            4,831,665
            
            
            34
            %
            $
            4,340,185
            
            
            34
            %Effect
                of tax-exempt interest
              income
            
            
            (23,304
            )
            
            0
            %
            
            (22,520
            )
            
            0
            %
            
            (15,554
            )
            
            0
            %Other
            
            
            11,576
            
            
            0
            %
            
            9,626
            
            
            0
            %
            
            12,504
            
            
            0
            %$
            5,382,223
            
            
            34
            %
            $
            4,818,771
            
            
            34
            %
            $
            4,337,135
            
            
            34
            %




**Note
      13 — Stockholders’ Equity and Regulatory Capital
      Requirements**




*Restricted
      Retained Earnings* —
Under
      Washington State law, pre-conversion retained earnings are  restricted
      for the protection of pre-conversion depositors. Restricted retained earnings
      at
      December 31, 2005, totaled
      $81,000.


58




**FIRST
      MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**




**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**




*Regulatory
      Capital Requirements* —
The
      Company, which includes the Bank, is subject to various regulatory capital
      requirements administered by the Federal Deposit Insurance Corporation (FDIC),
      the Washington State Department of Financial Institutions, and the Federal
      Reserve Board. Failure to meet minimum
      capital requirements can initiate certain mandatory and possibly additional
      discretionary action by regulators that, if undertaken, could have a direct material effect on the
      Company’s financial statements. Under
      capital adequacy guidelines and the regulatory framework for prompt corrective
      action, we must meet  specific
      capital guidelines that involve quantitative measures of assets, liabilities,
      and certain off-balance-sheet items as
      calculated under regulatory accounting practices. The capital amounts and
      classifications also are subject to qualitative judgments by the regulators
      about components, risk-weightings, and other factors.




Quantitative
      measures established by regulators to ensure capital adequacy require us to
      maintain minimum amounts and ratios (set forth in the table below) of total
      and
      Tier I capital to risk-weighted assets, and
      of
      Tier I capital to average assets. Management believes, as of December 31, 2005,
      that the Company met all
      capital adequacy requirements to which it is subject.




As
      of
      December 31, 2005, the most recent notification from the FDIC categorized the
      Bank as well capitalized
      under the regulatory framework for prompt corrective action. To be categorized
      as well capitalized,  the
      Bank
      must maintain minimum total risk-based, Tier I risk-based, and Tier I leverage
      ratios as set forth in  the
      table. There are no conditions or events since that notification that management
      believes have changed the Bank’s
      category.




Actual
      capital amounts and ratios for First Mutual Bancshares, Inc. (consolidated)
      and
      First Mutual Bank are presented in the table below:




**Actual**
            
            
            **For
                  Capital Adequacy**Purposes
            
            
            To
                  Be Well Capitalized
                Under
                  Prompt CorrectiveAction
                Provisions**Amount**
            
            
            **Ratio**
            
            
            **Amount**
            
            
            **Ratio**
            
            
            **Amount**
            
            
            **Ratio**As
                of December 31, 2005:
              Total
                capital (to risk-weighted assets):
              First
                Mutual Bancshares,Inc.
            
            $
            88,311,571
            
            
            11.21
            %
            $
            63,030,029
            
            
            ≥ 8.00
            %
            
            N/A
            
            
            N/AFirst
                Mutual Bank
            
            
            87,282,028
            
            
            11.10
            %
            
            62,906,506
            
            
            ≥ 8.00
            %
            $
            78,633,133
            
            
            ≥ 10.00
            %Tier
                I capital (to risk-weighted assets):
              First
                Mutual Bancshares,Inc.
            
            
            78,463,129
            
            
            9.96
            %
            
            31,515,014
            
            
            ≥ 4.00
            %
            
            N/A
            
            
            N/AFirst
                Mutual Bank
            
            
            77,452,887
            
            
            9.85
            %
            
            31,453,253
            
            
            ≥ 4.00
            %
            
            47,179,880
            
            
            ≥ 6.00
            %Tier
                I capital (to average assets):
              First
                Mutual Bancshares,Inc.
            
            
            78,463,129
            
            
            7.11
            %
            
            44,168,694
            
            
            ≥ 4.00
            %
            
            N/A
            
            
            N/AFirst
                Mutual Bank
            
            
            77,452,887
            
            
            7.16
            %
            
            43,299,079
            
            
            ≥ 4.00
            %
            
            54,123,849
            
            
            ≥ 5.00
            %As
                of December 31, 2004:Total
                  capital (to risk-weighted assets):
                First
                  Mutual Bancshares,Inc.
            
            $
            86,170,400
            
            
            11.88
            %
            $
            58,023,309
            
            
            ≥ 8.00
            %
            
            N/A
            
            
            N/AFirst
                Mutual Bank
            
            
            84,076,375
            
            
            11.61
            %
            
            57,941,043
            
            
            ≥ 8.00
            %
            $
            72,426,304
            
            
            ≥ 10.00
            %Tier
                I capital (to risk-weighted assets):
              First
                Mutual Bancshares,Inc.
            
            
            77,104,258
            
            
            10.63
            %
            
            29,011,655
            
            
            ≥ 4.00
            %
            
            N/A
            
            
            N/AFirst
                Mutual Bank
            
            
            75,023,087
            
            
            10.36
            %
            
            28,970,521
            
            
            ≥ 4.00
            %
            
            43,455,782
            
            
            ≥ 6.00
            %Tier
                I capital (to average assets):
              First
                Mutual Bancshares,Inc.
            
            
            77,104,258
            
            
            7.48
            %
            
            41,254,099
            
            
            ≥ 4.00
            %
            
            N/A
            
            
            N/AFirst
                Mutual Bank
            
            
            75,023,087
            
            
            7.42
            %
            
            40,451,785
            
            
            ≥ 4.00
            %
            
            50,564,732
            
            
            ≥ 5.00
            %





59


**FIRST
      MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**




**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**




The
      banking subsidiary is not subject to any written agreement, order, capital
      directive, or prompt corrective
      action directive issued by the FDIC to meet and maintain a specific capital
      level nor is the holding company
      under any directive by the Federal Reserve Bank.




Under
      Washington State banking regulations, the Bank is limited as to the ability
      to
      declare or pay dividends to the Company up to the amount of the Bank’s retained
      earnings then on hand.




**Note
      14 — Earnings Per Share**




The
      following is a reconciliation of the numerators and denominators of the basic
      and diluted earnings per share
      computations:




**Income**
              **(Numerator)**
            
            **Shares(1)**
              **(Denominator)**
            
            **Per
                Share(1)**
              **Amount**Year
                ended December 31, 2005:
              Basic
                EPS:
              Income
                available to common shareholders
            
            $
            10,318,649
            
            
            5,314,616
            
            $
            1.94Effect
                of dilutive stock options
            
            
            
            
            
            228,163Diluted
                EPS:
              Income
                available to common shareholders plus
              assumed
                stock options exercised
            
            $
            10,318,649
            
            
            5,542,779
            
            $
            1.86Year
                ended December 31, 2004:
              Basic
                EPS:
              Income
                available to common shareholders
            
            $
            9,287,813
            
            
            5,264,412
            
            $
            1.76Effect
                of dilutive stock options
            
            
            
            
            
            249,246Diluted
                EPS:
              Income
                available to common shareholders plus
              assumed
                stock options exercised
            
            $
            9,287,813
            
            
            5,513,658
            
            $
            1.68Year
                ended December 31, 2003:
              Basic
                EPS:
              Income
                available to common shareholders
            
            $
            8,395,738
            
            
            5,179,627
            
            $
            1.62Effect
                of dilutive stock options
            
            
            
            
            
            173,333Diluted
                EPS:
              Income
                available to common shareholders plus
              assumed
                stock options exercised
            
            $
            8,395,738
            
            
            5,352,960
            
            $
            1.57








(1)
      Shares and EPS have been adjusted for 10% stock dividends paid April 7, 2004
      and
      July 2, 2003.





60


**FIRST
      MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**




**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**




**Note
      15 — Noninterest Expenses**




Salaries
      and employee benefits consisted of the following for the years ended December
      31:




**2005**
            
            **2004**
            
            **2003**Salaries
                and employee benefits expense
            
            $
            18,793,850
            
            $
            16,638,703
            
            $
            14,687,438Amounts
                deferred with loan origination fees
            
            
            (2,593,541
            )
            
            (2,376,863
            )
            
            (2,232,520
            )$
            16,200,309
            
            $
            14,261,840
            
            $
            12,454,918




Direct
      costs of originating loans are deferred and capitalized with the related loan
      origination fees collected. Deferral of costs varies directly with the volume
      of
      loan originations.




**Note
      16 — Retirement Plan and Trust**




The
      Bank
      has a 401 (k) retirement plan and trust for employees. All employees who have
      completed 90
      days
      of service are eligible to contribute to the plan. Additionally, after meeting
      the one-year-of-service and  the
      minimum-hours-worked requirements employees are eligible to receive
      employer-matching contributions.  The
      Bank
      funds the annual cost of the plan as accrued. Employees may contribute up to
      50%
      of their salaries  to
      the
      plan up to the annual Internal Revenue Service (IRS) limit. The Bank matches
      75%
      of the employees’ contributions up to 6% of the employees’ compensation. At plan year-end, the
      Bank contributed a profit sharing
      contribution representing an additional 3% of all eligible employees’
compensation. Participants are fully
      vested in employer contributions to the plan upon six years of
      employment.




The
      Bank’s contributions to the 401 (k) retirement plan and trust were $744,000,
      $629,000, and $509,000  for
      the
      years ended December 31, 2005, 2004, and 2003, respectively. There were no
      significant changes in the rate of
      contributions to the plan between those years.




**Note
      17 — Employee Stock Ownership Plan**




In
      1985,
      the Bank established an ESOP to provide benefits to all employees who have
      completed one year  of
      service and meet the minimum-hours-worked requirement. The plan is
      noncontributory on the part of the  participants
      and provides for full vesting upon completion of Five years of service. The
      plan
      provides for the distribution of accumulated benefits to the employees or their beneficiaries
      upon death, termination, or retirement.
      Upon formation of the holding company, First Mutual Bank stock was converted
      to
      First Mutual Bancshares, Inc. stock.




Shares
      held by the ESOP at December 31, 2005, were as follows:




**Number
                of**
            
            **Average
                Cost****Shares**
            
            **Per
                Share**AllocatedVested
            
            
            373,631Non-vested
            
            
            3,325376,956
            
            
            $2.87




Contributions
      to the ESOP for the years ended December 31, 2005, 2004, and 2003 were $99,986, $99,996,
      and $50,011, respectively. The contribution for 2005 was approved by the Board
      of Directors at its December
      2005 meeting; the shares contributed are reflected in the total shown
      above.




61


**FIRST
      MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**




**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**




**Note
      18 — Stock Option Plan**




We
      have
      stock option plans for directors and employees. Options have a term of six,
      seven or ten years and are granted at fair market value on the grant date.
      The
      Compensation and Stock Option Committees determine vesting of the options.
      Options generally become exercisable in one or more installments during their
      term, and the right to exercise may be cumulative. At December 31, 2005, 614,435
      shares of common stock, adjusted for stock dividends, were available for grant
      under the plan. A total of 259,651 shares are currently exercisable at December
      31, 2005. All schedules presented in this footnote are adjusted for stock
      dividends and stock splits.




A
      summary
      of the stock option plans at December 31, 2005, 2004, and 2003, and changes
      during the years ended on those dates are presented below:




**Shares**
            
            **Range
                of**
              **Exercise
                Price(1)**
            
            **Weighted**
              **Average**
              **Exercise
                Price(1)**
            
            **Weighted**
              **Average**
              **Fair
                Value(1)**BALANCE,
                December 31, 2002
            
            
            539,319
            
            
            $3.29
                  - $13.02
            
            
            $10.00Exercisable
                at year end: 282,026 shares
              Options
                granted
            
            
            116,804
            
            
            14.62
                - 17.07
            
            
            16.68
            
            
            $9.23Options
                exercised
            
            
            (62,142
            )
            
            3.29
                - 11.95
            
            
            6.53Options
                terminated
            
            
            (3,779
            )
            
            5.38
                - 13.02
            
            
            9.36BALANCE,
                December 31, 2003
            
            
            590,202
            
            
            3.33
                - 17.07
            
            
            11.69Exercisable
                at year end: 313,910 shares
              Options
                granted
            
            
            93,550
            
            
            23.55
                - 25.25
            
            
            24.21
            
            
            $10.26Options
                exercised
            
            
            (83,834
            )
            
            3.33
                - 13.02
            
            
            10.52Options
                terminated
            
            
            (787
            )
            
            13.02
                - 17.07
            
            
            15.82BALANCE,
                December 31, 2004
            
            
            599,131
            
            
            5.38
                - 25.25
            
            
            13.81Exercisable
                at year end: 329,885 shares
              Options
                granted
            
            
            117,450
            
            
            25.25
                - 25.45
            
            
            25.28
            
            
            $5.53Options
                exercised
            
            
            (148,511
            )
            
            5.38
                - 17.07
            
            
            9.65Options
                terminated
            
            
            (9,493
            )
            
            13.02
                - 25.25
            
            
            19.73BALANCE,
                December 31, 2005
            
            
            558,577
            
            
            $3.33
                  - $25.45
            
            
            $17.22




Exercisable
      at year end: 259,651 shares (1) Per
      share


62




**FIRST
      MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**




**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**




**Note
      18 — Stock Option Plan (continued)**




The
      following table summarizes information about stock options outstanding at
      December 31, 2005:




**Options
                Outstanding**
            
            **Options
                Exercisable****Range
                of Exercise**
              **Price(1)**
            
            **Number**
              **of
                Shares**
              **Outstanding**
            
            **Weighted**
              **Average**
              **Exercise**
              **Price(1)**
            
            **Weighted**
              **Average**
              **Remaining**
              **Life**
            
            **Number**
              **of
                Shares**
              **Exercisable**
            
            **Weighted**
              **Average**
              **Exercise**
              **Price(1)**$
                3.00 - $ 6.00
            
            
            3,625
            
            
            $ 
                  5.38
            
            
            0.5
                years
            
            
            3,625
            
            
            $ 
                  5.386.01
                - 9.00
            
            
            34,501
            
            
            7.43
            
            
            4.1
                years
            
            
            34,501
            
            
            7.439.01
                - 12.00
            
            
            85,966
            
            
            10.27
            
            
            4.0
                years
            
            
            85,966
            
            
            10.2712.01
                - 15.00
            
            
            129,705
            
            
            12.90
            
            
            4.8
                years
            
            
            98,748
            
            
            12.7415.01
                - 18.00
            
            
            98,230
            
            
            16.91
            
            
            7.1
                years
            
            
            36,811
            
            
            16.6518.01
                - 21.00
            
            
            —
            
            
            —
            
            
            0
                years
            
            
            —
            
            
            —21.01
                - 24.00
            
            
            3,300
            
            
            23.55
            
            
            8.2
                years
            
            
            —
            
            
            —24.01
                - 27.00
            
            
            203,250
            
            
            24.84
            
            
            7.2
                years
            
            
            —
            
            
            —558,577
            
            
            
            
            
            
            
            
            259,651





(1)
      Per
      share




We
      apply
      Accounting Principles Board Opinion No. 25,  *Accounting
      for Stock Issued to Employees,* and  related
      Interpretations in accounting for our stock option plans. Accordingly, no
      compensation cost has been recognized for our stock option plans for the years ended December 31, 2005,
      2004, and 2003.




The
      fair
      value of options granted under the stock option plans was estimated on the
      date
      of grant using the Black-Scholes option-pricing model with the following
      weighted-average assumptions used: Annual dividend
      yield of 1.43% for 2005, 1.19% - 1.49% for 2004, and 1.49% - 1.65% for 2003;
      expected volatility of 22% for
      2005, 40% - 43% for 2004, and 38% - 48% for 2003; and expected lives of 4 -
      5
      years for 2005, 7 - 8 years for 2004, and 6 - 10 years for 2003. The risk-free
      interest rate assumptions were 3.72% for 2005, 4.02% - 4.26% for 2004, and
      2.80%
      - 3.69% for 2003.




**Note
      19 — Commitments and Contingencies**




We
      are a
      party to financial instruments with off-balance-sheet risk in the normal course
      of business to meet
      the
      Financing needs of our customers. These financial instruments may include
      commitments to extend credit,
      standby letters of credit, and financial guarantees. Those instruments involve,
      to varying degrees, elements
      of credit and interest-rate risk in excess of the amount recognized in the
      balance sheet. The contract amount
      of those instruments reflects the extent of our involvement in particular
      classes of financial instruments.




Our
      exposure to credit loss in the event of nonperformance by the other party to
      the
      instrument for commitments
      to extend credit, standby letters of credit, and written financial guarantees
      is
      represented by the contractual amount of those instruments. We use the same credit policies in
      making commitments and conditional obligations as we do for on-balance-sheet
      instruments.




Commitments
      to extend credit are agreements to lend to a customer as long as there is no
      violation of any  condition
      established in the contract. Commitments generally have fixed expiration dates
      or other termination clauses
      and may require payment of a fee. Since some of the commitments are expected
      to
      expire without being drawn upon, the total commitment amounts do not necessarily
      represent future cash requirements. At December 31, 2005, approximately 41%
      of
      loan commitments were drawn upon by customers. We evaluate each customer’s
      creditworthiness on a case-by-case basis. The amount of collateral obtained,
      if
      it is deemed





63


**FIRST
      MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**




**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**




necessary
      upon extension of credit, is based on management’s credit evaluation of the
      borrower. Collateral held
      varies but may include accounts receivable, inventory, property, plant, and
      equipment, and residential or  income-producing
      commercial properties. We have not incurred any significant losses on our
      commitments in 2005,
      2004, or 2003.




Unfunded
      commitments related to overdraft protection agreements are commitments for
      possible future extensions
      of credit to existing customers. These agreements are uncollateralized and
      usually do not contain a specified maturity date and may not necessarily be drawn upon to the total
      extent to which we have committed.
      Additionally, we have unfunded commitments under commercial lines of credit
      for
      possible future  extensions
      of credit to existing customers. These lines of credit may or may not be
      collateralized and contain specified maturity dates.




Standby
      letters of credit and written financial guarantees are conditional commitments
      issued to guarantee the performance of a customer to a third party. Those
      guarantees are primarily issued to support public and private borrowing
      arrangements, bond financing, and similar transactions. We underwrite our
      standby letters of credit using our policies and procedures applicable to loans
      in general. Standby letters of credit are made on an unsecured and secured
      basis. We have not been required to perform on any financial guarantees during
      the past three years.




In
      the
      normal course of business, the Company has various legal claims and other
      contingent matters outstanding. Management believes that any ultimate liability
      arising from these actions will not have a material adverse effect on the
      financial condition or results of operations.




A
      summary
      of the notional amount of our financial instruments with off-balance-sheet
      risk
      at December 31, 2005 follows (in thousands):




**Amount**Commitments
                to extend credit
            
            $
            315,308Standby
                letters of credit
            
            $
            160







The
      Company also has a number of employment agreements with certain key employees.
      These agreements provide for payment of the recipient’s base salary for a term
      of 35 months upon termination (whether voluntary or otherwise) and expire in
      December 2006, February 2007 and December 2008 depending upon the
      agreement.




**Note
      20 — Fair Value of Financial Instruments**




The
      following disclosure of the estimated fair value of financial instruments is
      made in accordance with the
      requirements of SFAS No. 107, *Disclosures
      About Fair Value of Financial Instruments.* The
      estimated fair value amounts have been determined using available market
      information and appropriate valuation methodologies. However, considerable
      judgment is necessary to interpret market data in the development of the
      estimates of fair value. Accordingly, the estimates presented herein are not
      necessarily indicative of the amounts that may be realized in a current market
      exchange. The use of different market assumptions and/or





64


**FIRST
      MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**




**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**




estimation
      methodologies may have a material effect on the estimated fair value amounts.
      The estimated fair value of
      financial instruments is as follows at December 31, 2005 and 2004 (in
      thousands):




**2005**
            
            **2004****Carrying**
              **Value**
            
            **Estimated**
              **Fair**
              **Value**
            
            **Carrying**
              **Value**
            
            **Estimated**
              **Fair**
              **Value**Assets:
              Cash
                and cash equivalents
            
            $
            25,781
            
            $
            25,781
            
            $
            13,845
            
            $
            13,845Securitiesavailable-for-sale
            
            
            114,450
            
            
            114,450
            
            
            124,225
            
            
            124,225Loans
                held-for-sale
            
            
            14,684
            
            
            14,684
            
            
            10,064
            
            
            10,064Mortgage-backed
                and other securities held-to-maturity
            
            
            6,966
            
            
            6,971
            
            
            7,720
            
            
            7,827Loansreceivable
            
            
            867,997
            
            
            862,231
            
            
            799,342
            
            
            794,024Accrued
                interest receivable
            
            
            5,350
            
            
            5,350
            
            
            4,300
            
            
            4,300Servicing
                assets
            
            
            1,866
            
            
            2,639
            
            
            1,525
            
            
            2,310FHLB
                stock
            
            
            13,122
            
            
            13,122
            
            
            12,919
            
            
            12,919Liabilities:
              Demand,
                savings, and money market deposits
            
            
            271,498
            
            
            271,498
            
            
            262,870
            
            
            262,870Time
                deposits
            
            
            489,222
            
            
            488,378
            
            
            412,499
            
            
            411,566Drafts
                payable
            
            
            734
            
            
            734
            
            
            378
            
            
            378Advance
                payments by borrowers for taxes and insurance
            
            
            1,671
            
            
            1,671
            
            
            1,676
            
            
            1,676Short-term
                FHLB advances
            
            
            203,428
            
            
            203,096
            
            
            165,158
            
            
            168,053Long-term
                FHLB advances
            
            
            22,277
            
            
            22,241
            
            
            69,049
            
            
            68,642Other
                advances
            
            
            4,600
            
            
            4,485
            
            
            1,600
            
            
            1,598Long-term
                debentures
            
            
            17,000
            
            
            16,750
            
            
            17,000
            
            
            16,888Derivatives:
              Interest
                rateswap
            
            
            29
            
            
            29
            
            
            (226
            )
            
            (226
            )Rate
                lock commitments
            
            $
            27
            
            $
            27
            
            $
            28
            
            $
            28







Fair
      value estimates, methods, and assumptions are set forth below for financial
      and
      off-balance-sheet instruments.




*Cash
      and Cash Equivalents* —
The
      carrying amount of these items is a reasonable estimate of their
      fair value.




*Securities
      and Loans Held-For-Sale* —
The
      fair value of securities and loans receivable held-for-sale are based on
      quoted market rates and dealer quotes.




*Loans
      Receivable* —
For
      variable-rate loans that reprice frequently and with no significant change
      in  credit
      risk, fair values are based on carrying values. The fair value of the loans
      that
      have fixed interest rates or  variable
      rates which do not reprice frequently are estimated using discounted cash flow
      analysis, based on  interest
      rates currently being offered for loans with similar terms to borrowers of
      similar credit quality. The fair  value
      of
      non-performing loans is estimated using discounted cash flow analysis, based
      on
      applicable risk - adjusted
      spreads to the contractual interest rates applicable to each category of
      loan.




No
      adjustment was made to the market interest rates for changes in credit of
      performing loans for which  there
      are
      no known credit concerns. Management believes that the risk factor embedded
      in
      the market interest  rates,
      along with the general reserves applicable to the loan portfolio for which
      there
      are no known credit concerns, results in a fair valuation of such loans.




65


**FIRST
      MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**




**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**




*FHLB
      Stock* —
The
      fair value is based upon the redemption value of the stock which equates to
      its
      carrying value.




*Servicing
      Assets* —
The
      carrying value of the servicing assets are as defined by SFAS No. 140, *Accounting
      for Transfers and Servicing of Financial Assets and Extinguishment of
      Liabilities.* The
      fair
      value  of
      the
      servicing assets is based upon a valuation model that calculates the present
      value of future cash flows.




*Deposit
      Liabilities* —
Under
      SFAS No. 107, the fair value of deposits with no stated maturity, such as
      noninterest-bearing demand deposits, savings, money market and checking
      accounts, is equal to the amount payable
      on demand. The fair value of time deposits is based on the discounted value
      of
      contractual cash flows. The
      discount rate is estimated using market rates for deposits of similar maturity
      of other local financial institutions.




*FHLB
      and Other Advances* —
The
      fair value of FHLB advances and other borrowings is estimated based on
      discounting the estimated future cash flows using rates currently available
      for
      debt with similar remaining maturities.




*Long-term
      Debentures* —
The
      carrying amount of the long-term debentures (associated with the trust preferred
      securities issuances) is estimated using discounted cash flow analyses based
      on
      our current incremental borrowing rates of similar types of borrowing
      arrangements.




*Other* —
The
      carrying value of other financial instruments has been determined to be a
      reasonable estimate of their fair value.




*Commitments
      to Originate Loans* —
Based
      on the short terms of these instruments, the unrealized gains or losses are
      expected to be insignificant.




*Limitations* —
The
      fair value estimates presented herein are based on pertinent information
      available to management
      as of December 31, 2005 and 2004. Although management is not aware of any
      factors that would  significantly
      affect the estimated fair value amounts, such amounts have not been
      comprehensively revalued for
      purposes of these financial statements since that date and therefore, current
      estimates of fair value may differ significantly from the amounts presented
      herein.





66


**FIRST
      MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**




**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**




**Note
      21 — Selected Quarterly Financial Data (Unaudited)**




**First**
              **Quarter**
            
            **Second**
              **Quarter**
            
            **Third**
              **Quarter**
            
            **Fourth**
              **Quarter**
            
            **Total****Year
                Ended**
              **December
                31, 2005**
              Interestincome
            
            $
            15,399,196
            
            $
            16,286,447
            
            $
            17,163,916
            
            $
            18,513,066
            
            $
            67,362,625Interest
                expense
            
            
            5,598,950
            
            
            6,459,708
            
            
            7,147,319
            
            
            7,973,347
            
            
            27,179,324Net
                interest income
            
            $
            9,800,246
            
            $
            9,826,739
            
            $
            10,016,597
            
            $
            10,539,719
            
            $
            40,183,301Provision
                for loan losses
            
            $
            400,000
            
            $
            450,000
            
            $
            325,000
            
            $
            325,000
            
            $
            1,500,000Noninterest
                income and
              noninterest
                expenses,net
            
            $
            (5,493,145
            )
            $
            (5,570,996
            )
            $
            (5,522,034
            )
            $
            (6,396,254
            )
            $
            (22,982,429
            )Net
                income
            
            $
            2,584,260
            
            $
            2,517,345
            
            $
            2,729,361
            
            $
            2,487,683
            
            $
            10,318,649Basic
                earnings per share
            
            $
            0.49
            
            $
            0.47
            
            $
            0.51
            
            $
            0.47
            
            $
            1.94Earnings
                per share assuming
              dilution
            
            $
            0.47
            
            $
            0.45
            
            $
            0.49
            
            $
            0.45
            
            $
            1.86Weighted
                average shares
              outstanding
            
            
            5,301,235
            
            
            5,319,017
            
            
            5,350,733
            
            
            5,287,234
            
            
            5,314,616Weighted
                average shares
              outstanding
                including effect
              of
                dilutive stock options
            
            
            5,552,302
            
            
            5,554,215
            
            
            5,573,837
            
            
            5,490,516
            
            
            5,542,779**Year
                Ended**
              **December
                31, 2004**
              Interestincome
            
            $
            12,903,640
            
            $
            13,462,024
            
            $
            14,185,538
            
            $
            14,575,489
            
            $
            55,126,691Interest
                expense
            
            
            4,413,575
            
            
            4,605,237
            
            
            4,926,223
            
            
            5,147,478
            
            
            19,092,513Net
                interest income
            
            $
            8,490,065
            
            $
            8,856,787
            
            $
            9,259,315
            
            $
            9,428,011
            
            $
            36,034,178Provision
                for loan losses
            
            $
            250,000
            
            $
            440,000
            
            $
            525,000
            
            $
            350,000
            
            $
            1,565,000Noninterest
                income and
              noninterest
                expenses, net
            
            $
            (4,742,339
            )
            $
            (5,111,922
            )
            $
            (4,899,958
            )
            $
            (5,608,375
            )
            $
            (20,362,594
            )Net
                income
            
            $
            2,314,140
            
            $
            2,186,851
            
            $
            2,525,804
            
            $
            2,261,018
            
            $
            9,287,813Basic
                earnings per share
            
            $
            0.44
            
            $
            0.42
            
            $
            0.48
            
            $
            0.42
            
            $
            1.76Earnings
                per share assuming
              dilution
            
            $
            0.42
            
            $
            0.40
            
            $
            0.46
            
            $
            0.40
            
            $
            1.68Weighted
                average shares
              outstanding
            
            
            5,222,639
            
            
            5,268,108
            
            
            5,279,971
            
            
            5,286,517
            
            
            5,264,412Weighted
                average shares
              outstanding
                including effect
              of
                dilutive stock options
            
            
            5,476,474
            
            
            5,511,304
            
            
            5,529,531
            
            
            5,536,908
            
            
            5,513,658





67


**FIRST
      MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**




**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**




**Note
      22 — Segments**




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




The
      reportable segments include the following:




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




·
            *Business
                Banking Lending*—
                Business Banking lending others a full range of banking services
                to small
                and medium size businesses including deposit and cash management
                products,
                loans for Financing receivables, inventory, 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 others permanent and interim construction
                loans
                for multifamily housing (over four units), manufactured housing
                communities, commercial real estate properties, and spec single-family
                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
      revenues.





68


**FIRST
      MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**




**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**


Financial
        information for our segments is shown below for the:


**Years
                Ended December 31,****Consumer**
              **Lending**
            
            **Residential**
              **Lending**
            
            **Business
                Banking**
              **Lending**
            
            **Income
                Property**
              **Lending**
            
            **Total**Interest
                income
            
            
            2003
            
            $
            6,544,949
            
            $
            11,737,159
            
            $
            5,423,497
            
            $
            25,955,928
            
            $
            49,661,5332004
            
            
            8,739,904
            
            
            15,755,202
            
            
            5,882,066
            
            
            24,749,519
            
            
            55,126,6912005
            
            
            10,133,526
            
            
            21,546,890
            
            
            8,745,985
            
            
            26,936,224
            
            
            67,362,625Interest
                expense
            
            
            2003
            
            
            2,309,346
            
            
            4,935,692
            
            
            1,527,975
            
            
            10,150,699
            
            
            18,923,7122004
            
            
            2,412,316
            
            
            6,239,174
            
            
            1,532,865
            
            
            8,908,158
            
            
            19,092,5132005
            
            
            3,395,087
            
            
            9,768,959
            
            
            2,639,453
            
            
            11,375,825
            
            
            27,179,324Net
                interest income
            
            
            2003
            
            
            4,235,603
            
            
            6,801,467
            
            
            3,895,522
            
            
            15,805,229
            
            
            30,737,8212004
            
            
            6,327,588
            
            
            9,516,028
            
            
            4,349,201
            
            
            15,841,361
            
            
            36,034,1782005
            
            
            6,738,439
            
            
            11,777,931
            
            
            6,106,532
            
            
            15,560,399
            
            
            40,183,301Provision
                for loan losses
            
            
            2003
            
            
            326,769
            
            
            112,111
            
            
            150,365
            
            
            560,755
            
            
            1,150,0002004
            
            
            502,314
            
            
            318,689
            
            
            177,479
            
            
            566,518
            
            
            1,565,0002005
            
            
            545,690
            
            
            181,740
            
            
            221,200
            
            
            551,370
            
            
            1,500,000Net
                interest income,
              after
                provision for
              loan
                losses
            
            
            2003
            
            
            3,908,834
            
            
            6,689,356
            
            
            3,745,157
            
            
            15,244,474
            
            
            29,587,8212004
            
            
            5,825,274
            
            
            9,197,339
            
            
            4,171,722
            
            
            15,274,843
            
            
            34,469,1782005
            
            
            6,192,749
            
            
            11,596,191
            
            
            5,885,332
            
            
            15,009,029
            
            
            38,683,301Noninterest
                income
            
            
            2003
            
            
            677,520
            
            
            1,212,054
            
            
            376,547
            
            
            1,396,832
            
            
            3,662,9532004
            
            
            1,932,676
            
            
            859,507
            
            
            478,842
            
            
            980,851
            
            
            4,251,8762005
            
            
            2,338,032
            
            
            1,329,644
            
            
            626,976
            
            
            1,060,309
            
            
            5,354,961Noninterest
                expense
            
            
            2003
            
            
            4,083,526
            
            
            4,848,032
            
            
            3,974,644
            
            
            7,611,699
            
            
            20,517,9012004
            
            
            5,795,514
            
            
            5,957,050
            
            
            5,301,467
            
            
            7,560,439
            
            
            24,614,4702005
            
            
            7,131,519
            
            
            7,385,523
            
            
            6,399,183
            
            
            7,421,165
            
            
            28,337,390Income
                before provision
              for
                federal income
              taxes
            
            
            2003
            
            
            502,828
            
            
            3,053,378
            
            
            147,060
            
            
            9,029,607
            
            
            12,732,8732004
            
            
            1,962,436
            
            
            4,099,796
            
            
            (650,903
            )
            
            8,695,255
            
            
            14,106,5842005
            
            
            1,399,262
            
            
            5,540,312
            
            
            113,125
            
            
            8,648,173
            
            
            15,700,872Provision
                for federal
              income
                taxes
            
            
            2003
            
            
            169,402
            
            
            1,039,557
            
            
            47,984
            
            
            3,080,192
            
            
            4,337,1352004
            
            
            670,856
            
            
            1,400,288
            
            
            (226,474
            )
            
            2,974,101
            
            
            4,818,7712005
            
            
            478,725
            
            
            1,899,377
            
            
            35,805
            
            
            2,968,316
            
            
            5,382,223Netincome
            
            
            2003
            
            
            333,426
            
            
            2,013,821
            
            
            99,076
            
            
            5,949,415
            
            
            8,395,7382004
            
            
            1,291,580
            
            
            2,699,508
            
            
            (424,429
            )
            
            5,721,154
            
            
            9,287,8132005
            
            
            920,537
            
            
            3,640,935
            
            
            77,320
            
            
            5,679,857
            
            
            10,318,649Total
                interest earning
              assets
                (averages)
            
            
            2003
            
            
            86,189,438
            
            
            192,578,216
            
            
            87,423,263
            
            
            431,923,949
            
            
            798,114,8662004
            
            
            107,636,948
            
            
            271,665,283
            
            
            108,137,835
            
            
            438,968,174
            
            
            926,408,2402005
            
            
            120,997,279
            
            
            332,247,041
            
            
            131,702,143
            
            
            414,804,128
            
            
            999,750,591


69




**FIRST
      MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**




**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**




**Note
      23 — Derivative Activities and Market Risk**




We
      are
      exposed to market risk on residential mortgage loans held-for-sale and
      interest-rate-lock commitments.
      Under certain circumstances, we undertake to limit this market risk (risk of
      fluctuating interest rates
      affecting the market value of an asset) through the use of derivative
      instruments.





We
      have a
      stand alone derivative financial instrument in the form of an interest rate
      swap
      agreement,  which
      derives its value from underlying interest rates. This transaction involves
      both
      credit and market risk.  The
      notional amount is the amount on which calculations, payments, and the value
      of
      the derivative are based.  The
      notional amount does not represent direct credit exposure. Direct credit
      exposure is limited to the net  difference
      between the calculated amount to be received and paid. This difference
      represents the fair value of the
      derivative instrument.




We
      are
      exposed to credit-related losses in the event of nonperformance by the
      counterparty to this agreement. Credit risk of the financial contract is
      controlled through the credit approval, limits, and monitoring procedures and
      we
      do not expect the counterparty to fail their obligation.




At
      December 31, 2005, the fair value of financial instruments defined as
      derivatives consisted of:




**Notional**
              **Amount**
            
            **Fair**
              **Value**Interest-rate-lock
                loan commitments
            
            $
            3,189,470
            
            $
            27,348Interest
                rate swap
            
            $
            9,000,000
            
            $
            29,473




We
      entered into a swap agreement with the FHLB to hedge the variability of cash
      flows to be paid related  to
      the $9
      million of securities issued under First Mutual Capital Trust I. The hedge
      is a
      qualifying cash flow hedge
      with changes in the fair value recorded in other comprehensive
      income.




**Note
      24 — Other Comprehensive Income/(Loss)**




Other
      comprehensive income/ (loss) components and related taxes were as
      follows:





**Years
                Ended December 31,****2005**
            
            **2004**Beginning
                balance:
              Accumulated
                other comprehensive (loss)
            
            $
            (656,985
            )
            $
            (413,770
            )Net
                unrealized (loss) on securities available-for-sale
            
            
            (1,453,868
            )
            
            (638,275
            )Tax
                effect
            
            
            508,854
            
            
            223,396Net
                of tax amount
            
            
            (945,014
            )
            
            (414,879
            )Net
                unrealized gain on derivative used for cash flow hedge
            
            
            255,645
            
            
            264,098Tax
                effect
            
            
            (89,476
            )
            
            (92,434
            )Net
                of tax amount
            
            
            166,169
            
            
            171,664Accumulated
                other comprehensive (loss)
            
            $
            (1,435,830
            )
            $
            (656,985
            )


70




**FIRST
      MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**




**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**




**Note
      25 — Parent Company Only Financial Statements**




Summary
      of condensed parent company financial information for First Mutual Bancshares,
      Inc. for December
      31, 2005 and 2004 (in thousands):




**Statement
      of Financial Condition**




**December
                31,****2005**
            
            **2004**ASSETS
              Cash
            
            $
            6,722
            
            $
            572Investments
                in subsidiaries
            
            
            76,544
            
            
            74,893Other
                assets
            
            
            3,725
            
            
            2,598Total
                assets
            
            $
            86,991
            
            $
            78,063LIABILITIES
                AND STOCKHOLDERS’ EQUITY
              Liabilities
              Borrowings
            
            $
            4,000
            
            $
            1,000Otherliabilities
            
            
            22,964
            
            
            17,61626,964
            
            
            18,616Stockholders’equity
            
            
            60,027
            
            
            59,447Total
                liabilities and stockholders’ equity
            
            $
            86,991
            
            $
            78,063




**Statement
      of Income**




**Years
                Ended December 31,****2005**
            
            **2004**
            
            **2003**INCOME
              Equity
                in undistributed net income from subsidiaries
            
            $
            11,585
            
            $
            10,314
            
            $
            9,161NONINTEREST
                EXPENSE
              Compensation
                and employee benefits
            
            
            310
            
            
            205
            
            
            107Other
            
            
            1,621
            
            
            1,358
            
            
            1,057Total
                noninterest expense
            
            
            1,931
            
            
            1,563
            
            
            1,164Income
                before federal income taxes
            
            
            9,654
            
            
            8,751
            
            
            7,997FEDERAL
                INCOME TAX BENEFIT
            
            
            665
            
            
            537
            
            
            399NET
                INCOME
            
            $
            10,319
            
            $
            9,288
            
            $
            8,396





71


**FIRST
      MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**




**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**




**Statement
      of Cash Flows**




**Years
                Ended December 31,****2005**
            
            **2004**
            
            **2003**OPERATING
                ACTIVITIES
              Net
                income
            
            $
            10,319
            
            $
            9,288
            
            $
            8,396Adjustments
                to reconcile net cash from operating activities
              Equity
                in undistributed earnings of subsidiaries
            
            
            (11,585
            )
            
            (10,314
            )
            
            (9,161
            )Federal
                income tax refund
            
            
            —
            
            
            264
            
            
            —Other
                assets
            
            
            (1,127
            )
            
            (592
            )
            
            (843
            )Accounts
                payable and other liabilities
            
            
            478
            
            
            83
            
            
            22Net
                cash (used) by operating activities
            
            
            (1,915
            )
            
            (1,271
            )
            
            (1,586
            )INVESTING
                ACTIVITIES
              Dividends
                (to) /from subsidiaries
            
            
            9,155
            
            
            1,350
            
            
            (5,900
            )FINANCING
                ACTIVITIES
              Dividendspaid
            
            
            (1,970
            )
            
            (1,548
            )
            
            (1,261
            )Proceeds
                from exercise of stock options
            
            
            1,434
            
            
            882
            
            
            406Repurchase
                and retirement of common stock
            
            
            (3,654
            )
            
            —
            
            
            —Proceeds
                from issuance of long-term debt
            
            
            —
            
            
            —
            
            
            8,000Proceeds
                from borrowings
            
            
            3,000
            
            
            500
            
            
            500Repayment
                ofborrowings
            
            
            —
            
            
            —
            
            
            (250
            )Contribution
                to employee stock ownership plan
            
            
            100
            
            
            50
            
            
            25Net
                cash provided (used) by Financing activities
            
            
            (1,090
            )
            
            (116
            )
            
            7,420NET
                INCREASE/ (DECREASE) IN CASH AND CASH
              EQUIVALENTS
            
            
            6,150
            
            
            (37
            )
            
            (66
            )Beginning
                of year
            
            
            572
            
            
            609
            
            
            675End
                of year
            
            $
            6,722
            
            $
            572
            
            $
            609





72







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              **Mutual**
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First
        Mutual Bancshares, Inc. t 400
        108th
        Avenue NE t Bellevue,
        WA 98004 t (425)
        453-7300