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







**First** **Mutual** **Bancshares, Inc.**






2006


Annual
      Report










**Board
                  of Directors**
                
                **F.
                  Kemper Freeman, Jr.,*****Chairman***
                Chairman
                  and Chief Executive Officer of
                Kemper
                  Development Co., and President of
                Bellevue
                  Square Managers, Inc.
                
                **James
                  J. Doud, Jr.,*****Vice
                  Chairman***
                Business
                  Consultant
                
                **Mary
                  Case Dunnam**
                Active
                  volunteer in various community
                groups
                  and homemaker
                
                **Janine
                  Florence**
                Chairman
                  and President of Property
                Development
                  Corporation and owner of
                Cambridge
                  Management
                
                **Robert
                  J. Herbold**
                Managing
                  Director of The Herbold Group LLC
              
              **Victor
                  E. Parker**
                Retired
                  Chairman and Chief Executive Officer
                of
                  Parker Smith & Feek, Inc.
                
                **George
                  W. Rowley, Jr.**
                Chairman
                  and Chief Executive Officer of
                Rowley
                  Enterprises, Inc.
                
                **Richard
                  S. Sprague**
                Vice
                  President and Secretary of Bellevue
                Square
                  Managers, Inc.
                
                **John
                  R. Valaas**
                President
                  and Chief Executive Officer of First
                Mutual
                  Bancshares, Inc. and First Mutual Bank
                
                **Robert
                  C. Wallace**
                Managing
                  Partner of Wallace Properties
                Group
                  and Chairman of Wallace
                Properties,
                  Inc.






**Bank
                  Executive Officers**
                
                **John
                  R. Valaas**
                President
                  and Chief Executive Officer
                
                **Robin
                  R. Carey**
                Executive
                  Vice President
                Operations
                  and Administration
                
                **Richard
                  J. Collette**
                Executive
                  Vice President
                Commercial
                  Banking Group
                
                **Scott
                  B. Harlan**
                Executive
                  Vice President
                Consumer
                  and Residential Lending
              
              **Roger
                  A. Mandery, CPA**
                Executive
                  Vice President and
                Chief
                  Financial Officer
                
                **George
                  D. Smeby**
                Executive
                  Vice President
                ChiefCredit
                  Risk Officer
                
                **Joseph
                  P. Zavaglia**
                Executive
                  Vice President
                Retail
                  Banking Group








**Selected
      Financial Data**




December
                31,
            
            **2006**
            
            2005
            
            2004
            
            2003
            
            2002Total
                assets
            
            **$**
            **1,079,263,072**
            
            $
            1,086,164,835
            
            $
            1,003,783,347
            
            $
            860,844,077
            
            $
            745,295,252Loans
                outstanding,
              net,
                including loans
              held-for-sale
            
            
            **897,435,974**
            
            
            882,680,728
            
            
            809,405,832
            
            
            725,447,766
            
            
            627,319,413Cash
                & Investments
            
            
            **120,709,624**
            
            
            147,197,249
            
            
            145,789,666
            
            
            93,954,285
            
            
            89,709,773Savings
                deposits
            
            
            **492,101,000**
            
            
            497,275,996
            
            
            420,933,325
            
            
            391,942,298
            
            
            363,122,044Other
                deposits
            
            
            **313,693,904**
            
            
            263,444,641
            
            
            254,435,583
            
            
            191,948,350
            
            
            134,247,575Advances
            
            
            **176,532,307**
            
            
            230,305,005
            
            
            235,806,775
            
            
            194,142,878
            
            
            184,393,897Stockholders’equity
            
            
            **70,021,523**
            
            
            60,027,300
            
            
            59,447,273
            
            
            50,826,756
            
            
            44,283,837







**2006**
            
            2005
            
            2004
            
            2003
            
            2002Interest
                income
            
            **$**
            **80,172,243**
            
            $
            67,362,625
            
            $
            55,126,691
            
            $
            49,661,533
            
            $
            48,325,363Interest
                expense
            
            
            **(40,072,365**
            **)**
            
            (27,179,324
            )
            
            (19,092,513
            )
            
            (18,923,712
            )
            
            (21,686,365
            )Net
                interest income
            
            
            **40,099,878**
            
            
            40,183,301
            
            
            36,034,178
            
            
            30,737,821
            
            
            26,638,998Noninterest
                income
            
            
            **8,120,782**
            
            
            5,354,961
            
            
            4,251,876
            
            
            3,662,953
            
            
            3,236,705Non
                interest expense
            
            
            **(30,493,764**
            **)**
            
            (28,337,390
            )
            
            (24,614,470
            )
            
            (20,517,901
            )
            
            (17,155,904
            )Provision
                for loan and lease
              losses
            
            
            **(964,868**
            **)**
            
            (1,500,000
            )
            
            (1,565,000
            )
            
            (1,150,000
            )
            
            (910,000
            )Income
                before provision for
              federal
                income tax
            
            
            **16,762,028**
            
            
            15,700,872
            
            
            14,106,584
            
            
            12,732,873
            
            
            11,809,799Provision
                for federal income
              tax
            
            
            **(5,782,366**
            **)**
            
            (5,382,223
            )
            
            (4,818,771
            )
            
            (4,337,135
            )
            
            (4,012,429
            )Net
                income
            
            
            **10,979,662**
            
            
            10,318,649
            
            
            9,287,813
            
            
            8,395,738
            
            
            7,797,370Return
                on average assets
            
            
            **1.01**
            **%**
            
            0.99
            %
            
            0.98
            %
            
            1.04
            %
            
            1.10
            %Return
                on average equity
            
            
            **16.98**
            **%**
            
            16.56
            %
            
            16.76
            %
            
            17.63
            %
            
            15.71
            %Diluted
                earnings per share*
            
            **$**
            **1.60**
            
            $
            1.49
            
            $
            1.34
            
            $
            1.26
            
            $
            1.06Book
                value per share*
            
            **$**
            **10.49**
            
            $
            9.07
            
            $
            8.99
            
            $
            7.82
            
            $
            6.90Shares
                outstanding*
            
            
            **6,673,528**
            
            
            6,621,013
            
            
            6,610,611
            
            
            6,503,328
            
            
            6,423,839




*Adjusted
      for five-for-four stock split paid on October 4, 2006 and 10% stock dividends
      paid April 7, 2004 andJuly
      2,2003.








2006
                
                2005
                
                2004
                
                2003Net
                  Income (dollars in millions)
                
                $
                10,980
                
                $
                10,319
                
                $
                9,288
                
                $
                8,396Assets
                  (dollars in millions)
                
                $
                1,079
                
                $
                1,086
                
                $
                1,004
                
                $
                861Deposits
                  (dollars in millions)
                
                $
                546
                
                $
                546
                
                $
                546
                
                $
                546Loan
                    Production (dollars in millions)
                
                $
                546
                
                $
                526
                
                $
                470
                
                $
                424ReturnonAverage Equity (percentages)
                
                
                17.0
                %
                
                16.6
                %
                
                16.8
                %
                
                17.6
                %Non-performingAssets (percentage of total assets)
                
                
                0.32
                %
                
                0.08
                %
                
                0.10
                %
                
                0.06
                %





**Stock** **Information**




The
      Company sold 966,000 shares of common stock in its initial public offering
      on December
      23, 1985. As of December 31, 2006, there were 6,673,528 shares outstanding.
      The
      shares are held by approximately 1,400 registered shareholders and persons
      or
      entities who hold their stock in nominee or “street name” through various
      brokerage firms or other depositories.




First
      Mutual Bancshares, Inc.’s common stock trades on The Nasdaq Stock Market under
      the symbol FMSB. The chart (below) is based on the reported sale prices on
      Nasdaq for the quarters indicated,
      as reported by the National Association of Securities Dealers.




Quarter
                ending
            
            High*
            
            Low*March
                31, 2005
            
            $
            20.76
            
            $
            20.76June
                30, 2005
            
            $
            20.98
            
            $
            20.72September
                30, 2005
            
            $
            20.60
            
            $
            20.60December
                31, 2005
            
            $
            20.75
            
            $
            20.17March
                31, 2006
            
            $
            20.80
            
            $
            20.27June
                30, 2006
            
            $
            21.67
            
            $
            21.67September
                30, 2006
            
            $
            21.92
            
            $
            21.92December
                31, 2006
            
            $
            23.20
            
            $
            23.18


**Adjusted
      to reflect five-for-four stock split paid on* *October
      4, 2006.*




The
      Company paid a cash dividend of nine cents (9¢) per share per quarter for the
      first two quarters of 2005. For the third and fourth quarters of 2005, the
      dividend was increased to ten cents (10¢) per share. In addition a special cash
      dividend of one dollar ($1.00) per share was declared in the fourth quarter
      of
      2005. For the first two quarters of 2006 the Company paid cash dividends of
      ten
      cents (10¢) per share. In the third and fourth quarters of 2006 the cash
      dividend was decreased to nine cents (9¢) per share.




The
      graph
      below compares the Company’s five-year cumulative total return, including reinvestment
      of dividends, on its Common Stock to similar returns for (a) all U.S.
      stocks  under
      the
      NASDAQ Index, (b) SNL Western Bank Index, and (c) SNL NASDAQ Bank
      Index.







12/31/01
            
            12/31/02
            
            12/31/03
            
            12/31/04
            
            12/31/05
            
            12/31/06First
                Mutual Bancshares, Inc.
              NASDAQ
                Composite
              SNL
                Western Bank Index
              SNL
                NASDAQ Bank Index
            
            
            100.00
              100.00
              100.00
              100.00
            
            
            149.62
              68.76
              109.41
              102.85
            
            
            226.69
              103.67
              148.21
              132.76
            
            
            264.88
              113.16
              168.43
              152.16
            
            
            281.87
              115.57
              175.36
              147.52
            
            
            319.97
              127.58
              197.86
              165.62




Source:
                SNL Financial LC, Charlottesville, VA
            ©
                2007
            
            www.snl.com
            
            (434)
                977-1600










First
      Mutual Bancshares, Inc. (FMSB)


Stock
      Values


*Closing
      price adjusted for dividends and splits*









1992
            1993
            1994
            1995
            1996
            1997
            1998
            1999
            2000
            2001
            2002
            2003
            2004
            2005
            2006Closing
                price adjusted for dividends and
                splits
            $2.03
            $2.73
            $2.63
            $4.48
            $5.80
            $10.11
            $7.24
            $7.21
            $7.89
            $8.11
            $11.93
            $17.82
            $20.55
            $20.74
            $23.18




**Corporate
      Profile**


First
      Mutual Bancshares, Inc. (the “Company”) is based in Bellevue, Washington,
      immediately east of
      Seattle. It is the holding company for First Mutual Bank, its sole banking
      subsidiary. First Mutual Bank’s primary lending market serves citizens of the
      Eastside, the area east of Lake Washington that includes parts of King and
      Snohomish Counties, and the I-5 corridor, which
      stretches from Bellingham to Tacoma, Washington. The 12 full-service banking
      centers  of
      this
      state-chartered, FDIC-insured bank are located in Bellevue (three), Ballard,
      Issaquah,  Juanita,
      Kirkland, Monroe, Redmond, Sammamish, West Seattle and Woodinville. In
      addition, First
      Mutual has sales finance offices located in Orange Park, Florida and Mt.
      Clemens, Michigan.




Operating
      income is derived from real estate lending activities, business loans and
      consumer loans. First Mutual Bank also sells a range of depository and other
      financial services.




First
      Mutual Bank originally was chartered as a savings and loan association when
      it
      opened in 1953.
      It converted to an FDIC-insured mutual savings bank in 1968. In 1985, the Bank
      converted to a stock FDIC savings bank and completed its initial public offering
      of common stock. The holding company, First Mutual Bancshares, Inc., was formed
      in 1999.




In
      2006,
      the Company’s net income increased 6% to $11 million, or $1.60 per diluted
      share, up from $10.3 million, or $1.49 per diluted share, in 2005.
      Net interest
      income for 2006 was $40.1 million, while deposits totaled $806 million, and
      total assets were $1.1 billion at year-end 2006.




The
      Company’s common stock trades on The Nasdaq Stock Market under the symbol
      FMSB.



























**FIRST
      MUTUAL BANCSHARES, INC.**


**AND
      SUBSIDIARIES**




**INDEPENDENT
      AUDITOR’S REPORT**


**AND**


**CONSOLIDATED
      FINANCIAL STATEMENTS**


**DECEMBER
      31, 2006 AND 2005**










**FIRST
      MUTUAL BANCSHARES, INC.**




**TABLE
      OF CONTENTS**




**2006
      FINANCIAL INFORMATION**








**PAGE**Forward-Looking Statements
            1Management’s Discussion and Analysis of
              Financial Condition and Results of Operations
            2Report of Independent Registered Public
              Accounting Firm
            35Consolidated Statements of Financial
              Condition
            37Consolidated Statements of
              Income
            39Consolidated Statements of Stockholders’
              Equity and Comprehensive Income
            41Consolidated Statements of Cash
              Flows
            42Notes to Consolidated Financial
              Statements
            44







**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
“anticipate”, “believe”, “estimate”,
      “expect”, “expectation”, “indicate” and “likely” generally constitute
      forward-looking statements. Such
      forward-looking statements include statements referring to our expectations
      regarding future net interest margins
      and the anticipated effects of changes in interest rates on the Company and
      rate
      related income growth; our loan originations from residential lending and other
      segments and our volume of sales of such loans, particularly consumer loans,
      and
      the related servicing business; an anticipated reduction in charge-offs from
      our
      community banking business; the reduction in expenses for credit insurance
      in
      the sales finance business
      and the effect of that reduction on charge-offs; and expectations regarding
      our
      relatively low ratio of  non-performing
      loans. Information regarding our net interest and economic value of equity
      (EVE)
      simulations 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, assumed 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.





1


**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**




Year
      2006
      marked our fourteenth consecutive year of earnings growth, as net income
      increased 6% over the prior year, to $11.0 million, or $1.60 per diluted share,
      compared to $10.3 million, or $1.49 per diluted share in 2005 and $9.3 million,
      or $1.34 per diluted share in 2004. A significant increase in our noninterest
      income and a reduction in our provision for loan losses offset a 16 basis point
      compression of our net interest margin
      and a higher level of operating expenses. Our return on average equity (ROE)
      was
      17.0%, compared to 16.6% in
      the prior year and 16.8% in 2004. We were able to meet one of our corporate
      goals, which consisted of obtaining an ROE of at least 15%; however, we fell
      short of the goal of year-over-year net income growth in the range of 10% to
      12%. We consider these targets to be our corporate goals, and not indicative
      of
      current forecasts or expected future operating results.




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 2006, our
      net interest income totaled $40.1 million, down $84,000 from the level earned
      in
      the prior year, as our net interest margin fell 16 basis points from 4.08%
      to
      3.92% due to an increase in our funding costs that exceeded our interest income.
      This ended a trend of year-over-year
      improvements in net interest income, including growth of over $4.1 million,
      or
      nearly 12%, in 2005 and
      $5.3 million, or 17% in 2004. We consider controlling the interest expense
      paid
      on our liabilities to be
      a
      critical element in maintaining a consistent net interest margin in the current
      economic environment, and continue
      to direct our efforts to improving the percentage of lower-cost non-maturity
      deposit products in our funding mix. We are focusing our attention on reducing,
      as significantly as is prudent, the occurrence of promotional deposit rates,
      and
      utilizing wholesale funding sources when estimates of marginal funding costs
      indicate that it may be advantageous to do so.




Another
      key driver of net interest income is the growth of the business lines’ earning
      assets. While 2006 was consistent with prior years in that growth in our earning
      assets continued to result in additional net interest income, the level of
      earning asset growth was well below that experienced in prior years. For 2006,
      our earning assets averaged nearly $1,016 million, representing an increase
      of
      $29 million, or 3% over the prior year. This was a substantial reduction from
      the rates of growth observed for 2005 and 2004, when our earning assets
      increased 11% and 15% over prior year levels. Additionally, our earning assets
      ended the year at $1,013 million, or nearly $6 million below the level at which
      they ended 2005, with sequential quarter growth occurring only in the second
      quarter of this year and a significant reduction in balances occurring in the
      fourth quarter. A substantially higher level of loan sales than in prior years
      as well as continued runoff of our securities portfolio were significant factors
      in the lack of growth this year.




A
      36%
      reduction in our provision for loan loss relative to prior years helped to
      offset the lack of growth in net interest income. Following a modest decline
      from $1,565,000 in 2004 to $1,500,000 in 2005, our provision for loan losses
      decreased significantly for 2006, totaling $965,000. A number of considerations
      contributed to the reduction in the 2006 provision, including the high volume
      of
      consumer loan sales, the absence of growth in our loan portfolio, and an ongoing
      assessment of the local economy.




A
      secondary source of revenue is our noninterest income, the growth of which
      has
      been a focus of management in recent years and remains a priority going forward.
      For 2006, noninterest income increased nearly $2.8 million, or 52% relative
      to
      2005, with a higher level of gains on loan sales making the most significant
      contribution to income. Proceeds received from an insurance policy in the second
      quarter of this





2


year
      also
      added to the increase, as did gains recognized from the marking-to-market of
      hedging instruments, though income earned from this source was counteracted
      by
      nearly identical losses on corresponding instruments.




A
      reduced
      rate of increase in our operating expenses also contributed to our incremental
      profitability in 2006. Following increases of 20% in both 2003 and 2004 and
      15%
      in 2005, our noninterest expense grew less than 8% in 2006, totaling $30.5
      million for the year.




**Results
      of Operations**




**Net
      Interest Income**




Our
      net
      interest income, or the difference between the income generated by our earning
      assets and the expense incurred from our interest bearing liabilities, accounts
      for the majority of our revenues each year. For 2006, our net interest income
      totaled $40.1 million, down $84,000 from the level earned in the prior year,
      as
      our net interest margin fell 16 basis points from 4.08% to 3.92%. This ended
      a
      trend of year-over-year improvements in net interest income, including growth
      of
      over $4.1 million, or nearly 12%, in 2005 and $5.3 million, or 17% in 2004.
      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 2004 and 2005, a higher level of earning assets compared to the
      prior year resulted in additional net interest income, approximately $4.2
      million in 2006. However, in contrast to those previous years, when asset and
      liability repricing also contributed to the improvement, the effects of
      repricing negatively impacted our 2006 net interest income by $4.3 million
      and
      more than offset the improvement from the additional earning assets. 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**


**2006
                  vs. 2005**Increase/(Decrease)
                due to
            
            **2005
                  vs. 2004**Increase/(Decrease)
                due to
            
            **2004
                vs. 2003**
              Increase/(Decrease)
                due to**Volume**
            
            **Rate**
            
            **Total**
              **Change**
            
            **Volume**
            
            **Rate**
            
            **Total**
              **Change**
            
            **Volume**
            
            **Rate**
            
            **Total**
              **Change****(Dollars
                in thousands)****INTEREST
                INCOME**
              Investments:Available-for-Sale
                Securities
            
            $
            (794
            )
            $
            150
            
            $
            (644
            )
            $
            601
            
            $
            318
            
            $
            919
            
            $
            1,335
            
            $
            (129
            )
            $
            1,206Held-to-Maturity
                Securities
            
            
            (78
            )
            
            40
            
            
            (38
            )
            
            (37
            )
            
            11
            
            
            (26
            )
            
            (203
            )
            
            (8
            )
            
            (211
            )Other
                Equity Investments
            
            
            799
            
            
            (532
            )
            
            267
            
            
            102
            
            
            (188
            )
            
            (86
            )
            
            50
            
            
            (285
            )
            
            (235
            )Total
                Investments
            
            
            (73
            )
            
            (342
            )
            
            (415
            )
            
            666
            
            
            141
            
            
            807
            
            
            1,182
            
            
            (422
            )
            
            760Loans:
              Residential
            
            
            2,444
            
            
            2,451
            
            
            4,895
            
            
            2,476
            
            
            1,068
            
            
            3,544
            
            
            2,754
            
            
            (551
            )
            
            2,203Residential
                Construction
            
            
            1,875
            
            
            1,296
            
            
            3,171
            
            
            967
            
            
            1,802
            
            
            2,769
            
            
            1,877
            
            
            104
            
            
            1,981Multifamily
            
            
            (2,182
            )
            
            1,505
            
            
            (677
            )
            
            (565
            )
            
            1,107
            
            
            542
            
            
            438
            
            
            (1,336
            )
            
            (898
            )Multifamily
                Construction
            
            
            1,117
            
            
            185
            
            
            1,302
            
            
            (133
            )
            
            216
            
            
            83
            
            
            109
            
            
            (61
            )
            
            48Commercial
                Real Estate and
              Business
            
            
            617
            
            
            1,741
            
            
            2,358
            
            
            586
            
            
            2,218
            
            
            2,804
            
            
            (19
            )
            
            (917
            )
            
            (936
            )Commercial
                Real Estate
              Construction
            
            
            624
            
            
            511
            
            
            1,135
            
            
            224
            
            
            254
            
            
            478
            
            
            56
            
            
            146
            
            
            202Consumer
                & Other
            
            
            579
            
            
            460
            
            
            1,039
            
            
            954
            
            
            256
            
            
            1,210
            
            
            1,569
            
            
            536
            
            
            2,105Total
                Loans
            
            
            5,074
            
            
            8,149
            
            
            13,223
            
            
            4,509
            
            
            6,921
            
            
            11,430
            
            
            6,784
            
            
            (2,079
            )
            
            4,705**Total
                Interest Income**
            
            
            5,001
            
            
            7,807
            
            
            12,808
            
            
            5,175
            
            
            7,062
            
            
            12,237
            
            
            7,966
            
            
            (2,501
            )
            
            5,465





3




**2006
                  vs. 2005**Increase/(Decrease)
                due to
            
            **2005
                  vs. 2004**Increase/(Decrease)
                due to
            
            **2004
                vs. 2003**
              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
            
            
            444
            
            
            2,279
            
            
            2,723
            
            
            367
            
            
            1,090
            
            
            1,457
            
            
            708
            
            
            (15
            )
            
            693Savings
            
            
            (9
            )
            
            12
            
            
            3
            
            
            (2
            )
            
            4
            
            
            2
            
            
            (1
            )
            
            (1
            )
            
            (2
            )Time
                Deposits
            
            
            717
            
            
            5,276
            
            
            5,993
            
            
            1,225
            
            
            3,217
            
            
            4,442
            
            
            1,288
            
            
            (1,671
            )
            
            (383
            )Total
                Deposits
            
            
            1,152
            
            
            7,567
            
            
            8,719
            
            
            1,590
            
            
            4,311
            
            
            5,901
            
            
            1,995
            
            
            (1,687
            )
            
            308FHLB
                and Other Advances
            
            
            (360
            )
            
            4,533
            
            
            4,173
            
            
            202
            
            
            1,985
            
            
            2,187
            
            
            1,083
            
            
            (1,222
            )
            
            (139
            )**Total
                Interest Expense**
            
            
            792
            
            
            12,100
            
            
            12,892
            
            
            1,792
            
            
            6,296
            
            
            8,088
            
            
            3,078
            
            
            (2,909
            )
            
            169**Net
                Interest Income**
            
            $
            4,209
            
            $
            (4,293
            )
            $
            (84
            )
            $
            3,383
            
            $
            766
            
            $
            4,149
            
            $
            4,888
            
            $
            408
            
            $
            5,296




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




While
      2006 was consistent with prior years in that growth in our earning assets
      continued to result in improvement in our level of net interest income, the
      level of earning asset growth observed during the year was well below that
      experienced in prior years. For 2006, our earning assets averaged nearly $1,016
      million, representing an increase of $29 million, or 3% over the prior year.
      This was a significant reduction from the rates of growth observed for 2005
      and
      2004, when our earning assets averaged nearly $987 million and $889 million,
      respectively, representing increases of 11% and 15% over prior year levels.
      Additionally, our earning assets ended the year at $1,013 million, or nearly
      $6
      million below the level at which they ended 2005, with sequential quarter growth
      occurring only in the second quarter of this year and a significant reduction
      in
      balances occurring in the fourth quarter. A substantially higher level of loan
      sales than in prior years
      as
      well as continued runoff of our securities portfolio were significant factors
      in
      the lack of growth this year.




As
      illustrated in the Rate/Volume Analysis table, our loan portfolio has accounted
      for the majority of the volume-related growth in interest income each year.
      Our
      average loans, including loans held-for-sale and net of provision for loan
      loss,
      increased by more than $44 million, or 5% over the prior year in 2006, following
      growth of approximately 10% and 13% in 2005 and 2004, respectively. It was
      primarily this growth in our average loan balances that accounted for the $8.0
      million, $5.2 million, and $5.0 million in volume-related increases in interest
      income for 2004, 2005, and 2006 respectively.




Over
      the
      last three years, residential and residential construction loans have been
      the
      most significant contributors to our year-over-year income growth. In contrast,
      the growth in our consumer and other loan balances has gradually declined,
      as
      increased sales of our consumer loans impeded portfolio growth. Reductions
      in
      the size of our multifamily real estate portfolio have led to volume-based
      declines in interest income in each of the last two years, though the 2006
      decline was partially offset by a volume-based increase from multifamily
      construction loans.




Based
      on
      our current observations of loan production and anticipated future loan sales,
      we expect that residential lending will continue to be the most significant
      factor in the volume-based growth of interest income and that improvement
      attributable to consumer loans will likely continue to decline based on the
      high
      levels of anticipated loan sales. The roles of commercial real estate, business
      banking, and multifamily loans are more difficult to predict, as these credits
      tend to be larger, and consequently more capable of significant impacts.
      Additionally the timing of originations and potential sales of these loans
      are
      very difficult to forecast with any
      reasonable degree of accuracy.




By
      comparison, our securities holdings have fallen since mid-2004 and the
      contribution to interest income from those holdings has declined accordingly.
      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.





4




Over
      the
      past several quarters, however, we have typically found the yields available
      on
      investment securities to be significantly less attractive than those on loans,
      particularly when the funding costs to support the additional assets were taken
      into account. Consequently, as the securities in our portfolio have been called
      or matured, we have generally not replaced the paid-off securities, but instead
      redirected those cash flows to support loan growth. This resulted in the balance
      of our securities portfolio contracting by more than $26 million during the
      12
      months ended December 31, 2006. In the event that yields on securities and/or
      the cost
      of
      funding purchases should become more conducive to holding investment securities,
      we would consider increasing the size of our securities portfolio at that time.




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 the December 2006 year-end, our total deposit balances
      had increased $45 million, or approximately 6% from the 2005 year-end level.
      Our
      non-maturity deposit balances increased nearly $49 million, while time deposits
      declined approximately $4 million. The 6% growth observed in 2006 represented
      a
      significant reduction from the 13% increase in deposit balances between the
      2004
      and 2005 year-end levels, 16% growth observed in 2004, and 17% increase in
      2003.
      Growth in checking and money market balances, however, returned to a more
      desirable level in 2006 after accounting for only $9 million of the 2005 deposit
      growth. By comparison, checking and money market accounts had increased by
      approximately $62 million between the years ended December 2003 and 2004. 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.




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 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 to affect the yields on retail deposits,
      with
      the rates paid on time deposits increasing more significantly than those paid
      on
      money market accounts. Consequently, we observed a migration of balances from
      non-maturity 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.




In
      the
      first quarter of this year a substantial increase in non-maturity deposit
      balances, particularly in our money market products, allowed us to take steps
      to
      improve our funding mix by reducing balances borrowed from the Federal Home
      Loan
      Bank of Seattle (FHLB). Unfortunately, this trend did not continue in the second
      and third quarters. Following impressive growth in the first quarter, our
      non-maturity deposit balances peaked in mid-April, then steadily declined for
      the next month as a result of outflows for federal income tax and state property
      tax payments, as well as a substantial reduction in balances maintained by
      a
      large commercial customer. The decline continued in the third quarter, as our
      non-maturity balances fell in July, then recovered modestly over the remainder
      of the quarter. In the fourth quarter, however, we once again experienced a
      substantial increase in non-maturity balances, particularly in our
      higher-balance, higher-rate money market product,
      as a result of large depositors, many of them commercial customers, bringing
      significant balances into both new
      and existing accounts.




Our
      time
      deposit balances fell modestly in the first quarter and substantially in the
      second as we priced our
      certificates less aggressively, resulting in a lower retention of maturing
      balances. In the third quarter, time deposit
      balances increased significantly, rising nearly $23 million from their level
      as
      of the June 30, 2006 quarter end, including an $8 million net increase during
      the quarter in certificates issued through deposit brokerage services. For
      the
      final quarter of the year, time deposit balances declined nearly $5 million
      from
      their September 30 level based on a $10 million net reduction in outstanding
      brokered certificate balances





5


during
      the quarter. For the year, our retail time deposit balances fell $9 million
      compared to December 31, 2005,
      while brokered certificate balances increased $5 million from the 2005 year-end
      level.




In
      the
      event we find ourselves unable to fully support our asset growth with new
      deposits, we typically utilize
      advances from the FHLB as a supplemental funding mechanism. However, because
      of
      a combination of slower
      asset growth than deposit growth in 2005 and 2006, we did not have to rely
      as
      significantly on FHLB borrowings as we have in prior years. Consequently, the
      interest expense incurred as a result of additional advances to fund asset
      growth totaled only $202,000 for 2005 and declined $360,000 for 2006 as our
      FHLB
      borrowings fell to $172 million as of the 2006 year-end, compared to $226
      million as of December 31, 2005. This represented a significant reduction
      relative to prior years, when the increased utilization of FHLB advances to
      accommodate asset growth resulted in an additional $1.1 million (2004) and
      $1.5
      million (2003) in volume-based interest expense relative to the corresponding
      prior years.




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




As
      noted
      above, following four years of improvement, our net interest margin declined
      16
      basis points in 2006, totaling 3.92% for the year compared to 4.08% in 2005
      and
      4.01% in 2004. In each of those prior years, the effects of asset and liability
      repricing resulted in improvements to our net interest income, with an
      additional $408,000 contributed in 2004 and a $766,000 increase in 2005. By
      comparison, while the effects of asset repricing contributed an additional
      $7.8
      million in interest income in 2006 relative to the prior year, the repricing
      of
      our funding sources increased our interest expense by $12.1 million, resulting
      in a $4.3 million reduction in our net interest income compared to
      2005.




The
      pricing-related increases in interest income and expense for 2005 and 2006,
      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 13 times, 11 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 remained the
      theme throughout 2005 and into
      mid-2006.




In
      response to these interest rate movements, 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
      2001, with the decline continuing through 2003. 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. Early in 2004, negative
      repricing effects were largely attributable to loans repricing before most
      interest rate indexes had 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 and 2006, 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.




The
      interest rate movements described above affected the yield earned on our
      investment portfolio in a similar manner, though less significantly, as
      fixed-rate instruments represent a much greater percentage of the securities
      portfolio than the loan portfolio. The portfolio’s performance over the last
      three 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 approximately $13 million in each of
      the
      last three years, had historically
      paid dividends on a quarterly basis. Because of financial 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 or absence of these
      dividends resulted in a significant decline in investment income for 2004 and
      2005 relative to prior years (represented in the “Other Equity Investments” line in the Rate/Volume Analysis
      table). While a modest





6


dividend
      was paid in the fourth quarter of 2006, this was not substantially different
      than the situation in 2005 and consequently, not a significant factor in the
      $532,000 rate-related reduction for the year. The majority of that figure
      represents the difference in interest payments paid and received on our interest
      rate swaps, which are
      discussed in the Noninterest Income, Noninterest Expense, Financial Condition,
      and Market Risk sections. Under
      the terms of these swaps, we make interest payments to our counterparty at
      a
      fixed rate of interest and receive payments based on a variable rate, typically
      a short-term LIBOR rate. In the event that the variable rate received exceeds
      the fixed rate paid, we would expect to see a positive rate-related impact
      in
      this category. At the present time, however, the fixed rates paid on these
      instruments exceed the variable rates received,
      thus the negative impact. In either case, however, it should be pointed out
      that
      these instruments are utilized
      for the purpose of hedging interest rate risk and never for speculative
      purposes, and that objective would be achieved regardless of the impact
      presented above.




In
      contrast to the assets described above, the pricing of our deposit accounts
      is
      not tied directly to short-term market index rates, but is instead driven
      principally by competitive factors 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.
      Due
      largely to this lagging effect, our liability costs declined more significantly
      than asset yields in 2003, and resulted in a greater rate-related reduction
      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. Again, based on 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 acquired, at 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. The lagged effects of rate increases in 2004,
      2005, and the first half of 2006, combined with intense competition for deposits
      in our local marketplace, resulted in the rate-related increases in 2005 and
      2006 interest expense illustrated in the Rate/Volume Analysis table. Given
      that
      market rates did not level off until mid-2006 and that movements in deposit
      rates can lag market rate movements by as much as several quarters, it is
      possible that we may continue to experience upward pressure on our deposit
      pricing in future quarters, even as asset yields plateau or decline in response
      to market rate indexes. In this event, we would expect to experience continued
      compression of our net interest margin.




**Noninterest
      Income**




Growth
      of
      our noninterest income has been a focus of management in recent years and
      remains a priority going forward. In both 2004 and 2005, we succeeded in growing
      our noninterest income over the prior year levels, with an increase of 16%
      in
      2004 resulting primarily from higher gains on loan sales, and an increase of
      $1.1 million, or 26%, in 2005 attributable to service fee income and higher
      loan
      prepayment fees.




For
      2006,
      noninterest income increased nearly $2.8 million, or 52% relative to 2005,
      with
      a higher level of gains on loan sales making the most significant contribution
      to income. Proceeds received from an insurance policy in the second quarter
      of
      this year also contributed to the increase, as did gains recognized from the
      marking-to-market of hedging instruments.




***Gain
      on Sales of Loans***




Gains
      on
      loan sales rose nearly $1.7 million in 2006, to more than double the prior
      year’s level, based on a significant increase in the volume of consumer loans
      sold. In the prior year, gains on loan sales had declined from 2004 levels
      as a
      result of a substantial reduction in consumer loan sales.





7


**Gains
                on Loan Sales**
            
            **2006**
            
            **2005**
            
            **2004**Consumer
            
            $
            2,698,000
            
            $
            820,000
            
            $
            1,435,000Commercial
            
            
            303,000
            
            
            271,000
            
            
            175,000Residential
            
            
            92,000
            
            
            350,000
            
            
            147,000Total
                Gains on Loan Sales
            
            $
            3,093,000
            
            $
            1,441,000
            
            $
            1,757,000**Loans
                Sold**Consumer
            
            $
            58,755,000
            
            $
            17,883,000
            
            $
            35,572,000Commercial
            
            
            29,973,000
            
            
            11,310,000
            
            
            32,606,000Residential
            
            
            49,373,000
            
            
            38,019,000
            
            
            35,787,000Total
                Loans Sold
            
            $
            138,101,000
            
            $
            67,212,000
            
            $
            103,965,000




*Consumer
      Loan Sales*




The
      year-to-year fluctuations in gains on consumer loan sales have typically
      followed changes in our practices regarding the volumes of loans to be sold.
      Our
      practice with regard to sales is, in turn, largely based on a combination of
      loan production and market demand. Prior to the second quarter of 2005, based
      on
      loan production and market demand, our plan had been to sell approximately
      $6
      million to $8 million in sales finance loans each quarter. In the second quarter
      of 2005, we elected to change this practice and substantially reduced our sales
      of these loans, selling only sufficient volumes to ensure the continuity of
      the
      market. As a result, our loan sales in the second half of 2005 were well below
      those for the same period in 2004. At the end of 2005, however, we noted that
      we
      were experiencing an increased level of interest in our consumer loans
      from institutional investors, and consequently expected that sales of these
      loans would increase in 2006. This
      materialized and, combined with a higher level of loan production than in 2005,
      which provided us with more inventory to sell, resulted in a substantial
      increase in sales over the prior year.




Based
      on
      our current levels of loan production and market demand, our expectation is
      for
      our first quarter 2007 consumer loan sales to total in the $12 million to $18
      million range, which should equal or exceed the level sold in the first quarter
      of 2006. Note that these expectations may be subject to change based on changes
      in loan production, market conditions, and other factors.




*Commercial
      Loan Sales*




Following
      increases of approximately 67% in 2004 and 55% in 2005, we continued to
      experience growth in our gains on commercial loan sales for 2006, though at
      a
      reduced rate. While our current expectation is that we will continue our
      commercial real-estate loan sales in future quarters, we reiterate that
      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,
      will vary considerably from one quarter to the next depending on the timing
      of
      the loan and sales transactions.




*Residential
      Loan Sales*




While
      gains on residential loan sales declined significantly relative to the prior
      year, the reduction was largely attributable to an unusual event in the fourth
      quarter of 2005, the sale of approximately $5.4 million in “interest only”
residential mortgages. The 2006 results are more in line with our expectations
      for loan sales and gains thereon.




As
      compared to the markets for our consumer and commercial loan sales, the market
      for residential loan sales is significantly larger and more efficient. As a
      result, residential loan sales are typically sold for very modest gains or
      potentially even at slight losses when interest rates are rising quickly. We
      believe the construction phase to be the most profitable facet of residential
      lending and the primary objective in a residential lending relationship.
      Following the construction process, our practice is to retain in our
      portfolio





8


those
      residential mortgages that we consider to be beneficial to the Bank, but to
      sell
      those that we consider less
      attractive assets. Included in these less attractive assets would be those
      mortgages with fixed rates, which  we
      offer
      for competitive reasons. Additionally, as residential loans are typically sold
      servicing released, sales do not
      result in the recognition of servicing assets or future servicing
      income.




***Service
      Fee Income/(Loss)***


**2006**
            
            **2005**
            
            **2004**Consumer
            
            $
            1,345,000
            
            $
            1,228,000
            
            $
            244,000Commercial
            
            
            (62,000
            )
            
            69,000
            
            
            71,000Residential
            
            
            (5,000
            )
            
            3,000
            
            
            (1,000
            )Total
                Service Fee Income
            
            $
            1,278,000
            
            $
            1,300,000
            
            $
            314,000




Servicing
      fee income represents the net of actual servicing income received less the
      amortization of servicing assets. Servicing assets are recorded when we sell
      loans from our portfolio to investors and continue to service those loans
      following the sale. The value of these servicing assets is determined at the
      time of the sale using a valuation model that calculates the present value
      of
      future cash flows for the loans sold, including cash flows related to the
      servicing of the loans. The servicing asset is recorded at allocated cost based
      on fair value. The servicing rights are then amortized in proportion to, and
      over the period of, the estimated future servicing income.




Following
      an increase of 314% in 2005, our servicing income declined by nearly 2% in
      2006.
      The high rate of growth in service fee income, and specifically consumer loan
      service fees, in 2005 was largely attributable to a change in the amortization
      period assumed for the underlying servicing asset.




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. This resulted in
      a
      significant increase in our net
      servicing income. To a lesser extent, 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.




For
      2006,
      service fee income earned on consumer loans serviced for investors exceeded
      that
      earned in the prior year based on a significant increase in the balances of
      consumer loans serviced, which was in turn a product of the increased volume
      of
      loan sales in 2006. Partially offsetting the additional service fee income
      from
      these higher balances was an increase in servicing asset amortization expense
      relative to the level of gross
      service fee income received. The amortization of servicing assets is reviewed
      on
      a quarterly basis, taking into
      account anticipated prepayment speeds, estimated servicing cost per loan, and
      other relevant factors. These factors are subject to significant fluctuations,
      and 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.




In
      the
      case of commercial loans serviced, two large pools were paid off in the fourth
      quarter of 2006. This required us to immediately write off the remaining $75,000
      in servicing assets associated with these credits, which resulted in the
      year-to-date losses presented above.




In
      contrast to consumer and commercial loans, 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 service fee income.




***Deposit
      Fee Income***




Continuing
      the trend observed over the last few years, fee income earned on our deposit
      accounts increased 19%, to $748,000, up from $630,000 in 2005 and $571,000
      in
      2004. As was the case last year, the





9


improvement
      over the prior year level was largely attributable to increased non-sufficient
      funds (NSF) fees and checking
      account service charges, which have grown as we have continued our efforts
      to
      expand our base of business and consumer checking accounts.




***Other
      Noninterest Income***




For
      2006,
      our noninterest income from sources other than those described earlier rose
      by
      $1.0 million, or 51%, relative to the prior year, with gains on instruments
      used
      to hedge interest rate risks and insurance proceeds received from a key-man
      life
      insurance policy each contributing significantly to the year-over-year result.
      This followed growth of $446,000, or 29%, in 2005 driven by an increase in
      loan
      fees, more specifically loan prepayment fees.




**2006**
            
            **2005**
            
            **2004**Rental
                Income
            
            $
            726,000
            
            $
            627,000
            
            $
            627,000Loan
                Fees
            
            
            766,000
            
            
            647,000
            
            
            384,000Debit
                Card/Wires/Safe Deposit
            
            
            328,000
            
            
            258,000
            
            
            189,000Late
                Charges
            
            
            268,000
            
            
            207,000
            
            
            167,000Miscellaneous
            
            
            914,000
            
            
            246,000
            
            
            172,000Total
                Other Noninterest Income
            
            $
            3,002,000
            
            $
            1,985,000
            
            $
            1,539,000




Additional
      income earned from miscellaneous sources made the most significant contribution
      to the increased level of other noninterest income for the year, rising
      $668,000, or 272% over the 2005 level. Included
      in the 2006 total were insurance proceeds of $400,000 received from a key-man
      life insurance policy. The
      receipt of these proceeds was the result of the unexpected passing of our
      Eastern Regional Sales Finance Manager.




Gains
      on
      hedging instruments for our commercial real estate loan portfolio, which
      represent the change in fair value of interest-rate derivatives, contributed
      $182,000 in miscellaneous income for the year. While these are, in fact,
      unrealized gains on the positions, the changes in the fair value of these
      instruments are reflected in the current period income. Losses on related
      instruments counteracted, and are expected to counteract, any income earned
      from
      this source. The unrealized fair value losses on these additional instruments
      are reflected in
      our
      noninterest expense. These derivatives, which are evaluated each quarter, were
      utilized to hedge interest rate
      risk associated with extending longer-term, fixed-rate periods on commercial
      real-estate loans, and structured such that a gain on any given derivative
      is
      matched against a nearly identical loss on an offsetting derivative, resulting
      in essentially no net impact to the bank’s earnings. To the extent that we
      continue to offer similar
      longer-term, fixed-rate periods on commercial real-estate loans in the future,
      and use similar derivative structures to manage interest rate risk, this income, as well as the offsetting
      expense, would be expected to increase in future periods. As these instruments
      were new to our operations in 2006, no similar income was recognized in prior
      years.




Loan
      fee
      income increased relative to 2005 based on a higher level of non-deferred loan
      fees, particularly in our Business Banking and Residential Lending areas. These
      typically include fees collected in connection with loan modifications or
      extensions. Loan prepayment fees, which had contributed significantly to the
      growth observed in 2004 and 2005, fell $11,000, or 2%, compared to the 2005
      level.




Rental
      income also increased substantially relative to the prior year, as the second
      quarter of 2006 brought the arrival of a new tenant in the First Mutual Center
      building, as well as a recovery of some 2005 operating expenses from other
      tenants in the building.




We
      continued to observe significant growth in our Debit Card/Wires/Safe Deposit
      Fees, which totaled $328,000 for the year, representing an increase of 27%
      over
      the 2005 level. This followed growth of 46% in 2005 and an increase of 65%
      in
      2004. Most of this growth is attributable to debit card fee income, which we
      expect to continue rising as checking accounts become a greater piece of our
      overall deposit mix.




Additionally,
      revenues received from late charges on our loan portfolio increased nearly
      30%
      for 2006 after growing 24% in 2005 and 39% in 2004 based on growth of our sales
      finance and residential loan





10


portfolios,
      combined with improved collection efforts and, in the case of some states,
      stricter payment deadlines on the sales finance loans.




**Noninterest
      Expense**




Following
      increases of 20% in both 2003 and 2004 and 15% in 2005, our noninterest expense
      increased less than 8% in 2006, totaling $30.5 million for the year. While
      personnel related expenses represented the most significant increase among
      operating costs for 2006, accounting for 55% of the total increase in noninterest
      expense, occupancy and other noninterest expenses also increased substantially
      relative to 2005. In previous
      years, the major contributors to increased operating costs included growth
      in
      compensation and benefits
      expense, 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***




Even
      though we incurred $633,000 in stock option expense, as required by the new
      accounting guidelines,
      our 2006 salary and benefit expense rose only $1.2 million, or 7%, over the
      prior year level, compared
      to increases of nearly 14%, or $1.9 million for 2005, and 15%, or $1.8 million
      in 2004.




**2006**
            
            **2005**
            
            **2004**Salaries
            
            $
            13,246,000
            
            $
            12,577,000
            
            $
            11,186,000Deferred
                Origination Expenses (SFAS 91)
            
            
            (1,658,000
            )
            
            (2,169,000
            )
            
            (1,995,000
            )Stock
                Option Expense
            
            
            633,000
            
            
            —
            
            
            —Net
                Salaries
            
            $
            12,221,000
            
            $
            10,408,000
            
            $
            9,191,000Commissions
                and Incentive Bonuses
            
            
            2,218,000
            
            
            2,525,000
            
            
            2,170,000Employment
                Taxes & Insurance
            
            
            989,000
            
            
            949,000
            
            
            873,000Temporary
                Office Help
            
            
            219,000
            
            
            277,000
            
            
            189,000Benefits
            
            
            1,749,000
            
            
            2,041,000
            
            
            1,838,000Total
                Salaries & Benefit Expenses
            
            $
            17,396,000
            
            $
            16,200,000
            
            $
            14,261,000




Salary
      expense is the largest component of our personnel related costs, and
      consequently will typically be the most significant component of year-over-year
      expense growth. Relative to the prior year, net salaries expense grew $1.8
      million, or 17%, for 2006 with a large part of the increase attributable to
      the
      expensing of stock option compensation in accordance with Statement of Financial
      Accounting Standard 123(R) (SFAS 123(R)). As SFAS 123(R) was adopted in January
      2006, no comparable expense was recognized in prior years.




Further
      contributing to the growth in salary expense was a significant reduction in
      the
      deferral of salary costs related to loan originations. In accordance with
      current accounting standards, certain loan origination costs, including some
      salary expenses tied to loan origination, are deferred and amortized over the
      life of each loan originated, rather than expensed in the current period.
      Operating costs 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.”




For
      the
      year, the amount of salary expense deferred by our Income Property and
      Residential Lending areas ran below the levels deferred in 2005, resulting
      in
      higher current period expenses. In the case of our Residential
      lending area, both the number of loans originated in 2006, as well as the
      deferred costs associated with
      originations, declined relative to the prior year. In contrast, while our Income
      Property department’s originations through the first nine months of 2006 were
      comparable to last year, the mix of loans changed substantially, with a greater
      volume of construction loans, which resulted in a much lower level of expense
      deferral. In the fourth quarter of 2006, expense deferrals for the Income
      Property area returned to a level





11


comparable
      to the prior year, while deferrals for the Residential Lending area remained
      well below those of 2005.




By
      comparison, for 2005, the impact of deferred loan origination costs on our
      salary expense increased over the prior year as changes in loan originations,
      mix, and the standard loan costs for each loan type impacted
      our total deferred costs. 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.




Also
      contributing to the escalation in regular compensation expense were the annual
      increases in staff salaries, which take effect in April of each year and
      generally fall within the 3% to 4% range.




Commissions
      and incentive compensation declined relative to the 2005 levels, based in large
      part on the elimination of the general staff bonus for 2006. For those personnel
      not participating in a specified commission or incentive compensation plan,
      we
      maintain a separate bonus pool, with accruals made to the pool at the end of
      each quarter based on our year-to-date performance. Based on our results in
      2005, expenses related to this bonus totaled $249,000 for the year. By
      comparison, based on our results for 2006, we have elected to forego the staff
      bonus for the year, resulting in a substantial reduction relative to the prior
      year’s total incentive compensation expense.




Among
      the
      other categories of incentive compensation, loan officer commissions were little
      changed compared to their 2005 level, while a decline of $53,000, or 10%, was
      observed in other incentive compensation for the year. The incentive
      compensation plans for loan production staff tend to vary directly with
      the
      production of the business lines. Other incentive compensation includes payments
      to all areas of the bank,
      but consists primarily of bonuses paid to banking center personnel.




In
      contrast, commissions and incentive bonuses had shown increases of 16% for
      2005
      and 10% in 2004 based on
      rising loan originations. Loan originations totaled $526 million in 2005 and
      $470 million in 2004. Loan originations for 2006 totaled $546
      million.




Expenditures
      on temporary office help declined significantly relative to the prior year
      level
      based on reductions
      in usage by our executive, accounting, consumer loan administration, and
      customer service areas. Temporary office help is frequently used to staff positions left vacant as
      a
      result of employee turnover. As permanent employees were placed in these
      positions, reliance upon temporary staff was reduced.




Following
      increases of 22% in 2004 and 11% in 2005, employee benefit expense declined
      significantly relative
      to the prior year, falling $292,000, or 14%. This reduction was primarily
      attributable to a decision in the
      fourth quarter of 2006 to forego an annual 3% profit sharing contribution to
      our
      401K plan. As this represents an unusual occurrence, the benefits expense
      incurred for the fourth quarter of 2006 should not be considered indicative
      of
      an expected future run rate for our benefits expense.




Prior
      to
      2005, annual increases in our expenditures on employee medical plans accounted
      for a large portion of the increase in total benefits costs each year. Beginning
      in 2005, however, we were able to reduce employee
      medical insurance costs by changing the insurance plans offered to staff
      members. As a result, our employee
      medical plan expenses for 2005 actually declined by 2% relative to the prior
      year. We continue to evaluate
      the plans offered to our employees each year as a means of controlling our
      overall benefits expense.




***Occupancy***




Occupancy
      expense continued its upward trend, rising 15% for the year, following increases
      of 26% and 14% in 2005 and 2004, respectively. As was the case in both 2004
      and
      2005, additional depreciation expense was
      a
      major contributor to the year-over-year increase. The additional depreciation
      expense in 2005 and 2006





12


resulted
      from remodeling projects at several of our banking centers and sections of
      our
      First Mutual Center building. We also relocated the West Seattle Banking Center to a new facility
      in
      2006.




**2006**
            
            **2005**
            
            **2004**Rent
                Expense
            
            $
            288,000
            
            $
            322,000
            
            $
            313,000Utilities
                and Maintenance
            
            
            763,000
            
            
            685,000
            
            
            639,000Depreciation
                Expense
            
            
            2,060,000
            
            
            1,651,000
            
            
            1,321,000Other
                Occupancy Costs
            
            
            939,000
            
            
            855,000
            
            
            514,000Total
                Occupancy Expenses
            
            $
            4,050,000
            
            $
            3,513,000
            
            $
            2,787,000




Depreciation
      expense has increased considerably in each of the last four years, starting
      with
      our acquisition
      of the First Mutual Center building in the first quarter of 2003. 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
      as
      the 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
      and several of our banking centers. Since these remodeling projects were
      completed over the course of 2005,
      the depreciation expense for the year reflected only a partial year of
      depreciation for most of these projects.




Finally,
      in 2006, depreciation expense rose $409,000, or 25%, relative to the prior
      year,
      as a result of recognizing
      a full year of depreciation expense on the new buildings and improvements,
      as
      well as items such as
      furniture, fixtures, and computer networking equipment, as the construction
      and
      renovation projects were typically accompanied by new furnishings and
      equipment.




Utilities
      and maintenance expenses increased $78,000, or 11%, over their prior year level
      after increasing approximately 7% in 2005. In addition to higher utilities rates this year,
      several projects completed in the banking centers and at our corporate
      headquarters contributed to the increased costs. These projects included, among
      other things, new signage, removing old signage at the previous West Seattle
      Banking Center location, landscaping, and HVAC and window film repairs at First Mutual
      Center.




The
      10%
      increase in other occupancy costs over the 2005 level was attributable to
      additional expenditures for real
      estate taxes, equipment maintenance, security systems, and software licensing.
      Real estate taxes rose $36,000 compared to 2005 because of annual increases
      in
      taxes paid on bank properties, as well as property taxes on the land purchased
      for our new Canyon Park banking center. Maintenance costs for computers and
      equipment rose by $26,000 for the year based in part on a change in the
      management of, and contract for, office equipment such as printers and copy
      machines.




The
      10%
      increase observed in other occupancy costs for 2006 represented a significant
      improvement from
      the
      prior year, when these expenses rose by nearly 66% based on purchases of
      non-capitalized assets and equipment that were primarily related to the remodeling projects carried out
      that 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.




In
      contrast to the other categories of occupancy expense, rent expense declined
      in
      2006 based on the closings
      of Income Property lending offices as well as the relocation of the West Seattle
      Banking Center from a leased
      space to a new building that we own.





13


***Other
      Noninterest Expenses***




The
      rate
      of increase for our other noninterest expense continued to decline in 2006,
      as
      expenses grew $423,000, or 5%, compared to the prior year, after increases
      of
      14% in 2005 and 35% in 2004. The additional expense in 2006 was attributable
      to
      increased expenditures for credit insurance, taxes, and miscellaneous noninterest
      expenses including losses on hedging instruments. These additional costs were
      partially offset by a substantial decline in marketing and public relations expense.




**2006**
            
            **2005**
            
            **2004**Marketing
                & Investor Relations
            
            $
            983,000
            
            $
            1,389,000
            
            $
            1,243,000Credit
                Insurance
            
            
            1,782,000
            
            
            1,506,000
            
            
            1,102,000Outside
                Services
            
            
            832,000
            
            
            763,000
            
            
            600,000Taxes
            
            
            670,000
            
            
            490,000
            
            
            483,000Information
                Systems
            
            
            906,000
            
            
            931,000
            
            
            1,001,000Legal
                Fees
            
            
            520,000
            
            
            501,000
            
            
            421,000Other
            
            
            3,355,000
            
            
            3,045,000
            
            
            2,716,000Total
                Other Noninterest Expenses
            
            $
            9,048,000
            
            $
            8,625,000
            
            $
            7,566,000




While
      our
      credit insurance expense continued to increase in 2006, rising $276,000, or
      18%,
      over the prior year, it is our expectation that expenditures for credit
      insurance will decline in future quarters. In the fourth quarter of 2006, our
      premium costs fell nearly 4% compared to the same period in 2005.




The
      majority of credit insurance premiums are attributable to our sales finance
      loans, including both those loans retained in our portfolio as well as those
      loans serviced for other institutions. After evaluating our use of credit
      insurance, we concluded that the benefits of the insurance on sales finance
      loans no longer outweighed the costs and chose to forego the insurance and
      assume the credit risk on future sales finance loan production. Loans insured
      prior to August 1, 2006 will remain insured under previous policies. Some sales
      finance loans originated on or after August 1, 2006 were sold to institutional
      investors with insurance placed prior to sale. These loans will be insured
      under
      the new policy effective August 1, 2006. All other sales finance loans
      originated on or after August 1 will not be insured. To a much lesser extent,
      residential land loans and a small percentage of the consumer and income
      property loan portfolios are also insured. While these insured balances may
      continue to increase in future quarters, the premiums paid on these balances
      are
      sufficiently small relative to those paid on sales finance loans such that
      total
      premiums paid would still be expected to decline.




Relative
      to the prior year level, our 2006 tax expense rose 37% due to increased business
      and occupation taxes.
      The increase in these taxes was largely attributable to the year’s higher level
      of consumer loan sales and gains
      thereon. As we currently expect loan sales in future quarters to approximately
      equal or exceed the levels of sales in 2006, it is our expectation that these
      taxes will likely remain at or above their current levels. Also reflected in
      the
      2006 total was a $35,000 settlement with the Washington State Department of
      Revenue on our B&O tax audit.




Losses
      on
      hedging instruments, which represent the change in fair value of interest-rate
      derivative instruments for our commercial real-estate loan portfolio, resulted
      in $184,000 in noninterest expense for the year. As was the case with the
      previously mentioned gains on hedging instruments, accounting rules require
      any
      change in the fair value of such instruments to be reflected in the current
      period income. Additionally, as was previously noted, the losses incurred on
      these derivatives were essentially negated by gains on corresponding
      instruments. These derivatives are associated with longer-term, fixed-rate
      commercial real-estate loans,
      and are evaluated each quarter. The derivatives were utilized to hedge interest
      rate risk associated with these loans and structured such that a gain on any
      given derivative is matched against a nearly identical loss on a corresponding
      derivative, resulting in essentially no net impact to the bank’s earnings. To
      the extent that we continue to offer similar longer-term, fixed-rate maturities
      on commercial real-estate loans in the future and
      use
      similar derivative structures to manage interest rate risk, this income, as
      well
      as the offsetting expense,





14


would
      be
      expected to increase in future periods. As these instruments were a new
      development in 2006, no comparable expense was recognized in 2004 or
      2005.




Partially
      offsetting the above increases, marketing expense totaled $983,000, or 29%
      less
      than the prior year, as we reduced marketing expenditures across all departments
      throughout most of the year.




**Reserve
      and Provision for Loan and Lease Losses**




The
      provision for loan and lease losses reflects the amount deemed appropriate
      to
      produce an adequate reserve for probable 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 and
      environmental 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
      loss perspective and a composition and geographic concentration viewpoint.
      The
      Asset Management Department then prepares an economic analysis of the Puget Sound region that
      includes, when appropriate, employment forecasts, housing sales, vacancy rates,
      and commercial real estate analysis. That information is then
      reviewed by our Loan Policy Committee, and Chief Risk Officer who makes a
      recommendation as to the loan and
      lease loss provision to the Audit Committee of the Board of Directors. The
      Audit
      Committee considers the input and recommendations of the Asset Management
      Department, the Loan Policy Committee, and the Chief Risk Officer, and
      determines the appropriate level of reserves. The Board of Directors reviews
      the
      actions of the Audit Committee.




Following
      a modest decline from $1,565,000 in 2004 to $1,500,000 in 2005, our provision
      for loan and lease
      losses declined significantly for 2006, totaling $965,000. A number of
      considerations contributed to the reduction in the 2006 provision, including the high volume of consumer loan
      sales, the absence of growth in our loan portfolio, and an ongoing assessment
      of
      the local economy.




While
      our
      provisions taken through the first three quarters of 2006 would have implied
      an
      even more significant decline in the provision this year, an increase in the
      in
      fourth quarter provision was prompted by growth in net charge-offs from $170,000
      in the first nine months of 2006 to $810,000 in the fourth quarter. Also
      contributing to the need for a larger provision in the fourth quarter was an
      increase in nonperforming assets from $1.5 million as of September 30, to $3.5
      million at the year-end. Partially offsetting the effects of the growth in
      charge-offs and nonperforming assets was a $22 million decline in the loan
      portfolio during the fourth quarter.




Our
      2006
      charge-offs, net of recoveries, are presented in the following table along
      with
      the size of each business line’s portfolio as of December 31, 2006. For the
      year, over 90% of the net charge-offs occurred in two of the smaller portfolios,
      Community Business Banking and Sales Finance.




**Business
                Line**
            
            **Net**
              **Charge-Offs**
              **2006**
            
            **Loan
                Portfolio**
              **as
                of**
              **December
                31,**
              **2006**Community
                Business Banking
            
            $
            309,000
            
            $
            13,583,000Sales
                Finance
            
            
            575,000
            
            
            70,786,000Consumer
            
            
            2,000
            
            
            26,392,000Residential
            
            
            93,000
            
            
            356,231,000Income
                Property
            
            
            —
            
            
            295,251,000Business
                Banking
            
            
            —
            
            
            131,188,000Total
            
            $
            979,000
            
            $
            893,431,000




Community
      Business Banking (CBB) represents less than 2% of the portfolio, yet accounted
      for $309,000, or 32% of all net charge-offs for 2006. By comparison, this
      segment accounted for $247,000, or 34% of all net charge-offs in 2005. We have
      taken actions to correct this problem, including a review of our underwriting
      procedures and greater oversight of the underwriting of these loans. We don’t
      anticipate





15


continued
      net charge-offs at the levels experienced in the last two quarters, in part
      because the loss experienced in 2006 was largely attributable to a single
      borrower.




While
      the
      majority of all charge-offs were observed in our Sales Finance business line,
      this result was within our expectations for that area.
      Net charge-offs for the year totaled $575,000, or 59% of all net charge-offs, and
      included gross charge-offs of $880,000 offset by $305,000 in recoveries.
      Similarly, net charge-offs for the segment had totaled $480,000 in 2005, or
      66%
      of all net charge-offs for the year. We anticipate that we will see increased
      net charge-offs in this area in 2007 as we have changed our policy of purchasing
      credit insurance on loans with low FICO scores. Prior to last fall, we placed
      credit coverage on many loans with FICO
      scores below the 720 level, however, since that time we have not insured those
      loans, which reduces our insurance costs, but increases the level of net charge-offs. Loans with FICO
      scores of 720 and below typically account
      for 20-30% of loans originated. The insurance cost for those loans had
      previously ranged from 2-2.5% a year,
      and we expect net charge-offs to be commensurate with that level of insurance
      expense.




The
      charge-off experience with the Residential business line was unusual. The
      Residential portfolio has traditionally had an excellent record of credit
      quality and did not incur any charge-offs in 2005. Through the first three
      quarters of 2006, we experienced net recoveries totaling $141,000. In the fourth
      quarter, however, we incurred $235,000 in charge-offs related to custom
      construction loans in the Oregon market. We have subsequently
      carefully scrutinized the portfolio in the Oregon market, reviewed our
      underwriting procedures for that
      area, and changed the oversight of our Underwriting Department. We are hopeful
      that the steps we have taken will restore the credit quality that has
      characterized this portfolio in the past.




Partially
      offsetting the effects of the charge-offs on our 2006 provision, was the modest
      growth of our net loan portfolio (excluding loans held-for-sale), which
      increased by less than $16 million, or 2%, over the 12 months ended December
      31,
      2006, a sharp decline relative to the growth of $69 million observed in 2005
      and
      $84 million in 2004. Additionally, economic conditions in the Puget Sound
      metropolitan area remained favorable as well, with solid, though not dramatic
      growth. The local housing market continues to be strong, and commercial office
      vacancy rates remain low relative to recent years.




**Asset
      Quality**




Non-performing
      assets as a percentage of total assets increased from 0.08% at December 31,
      2005
      to 0.32%
      at
      year-end 2006. Although that level of nonperforming assets is well within
      industry standards, it is at the
      upper range of our historical experience. Noted below are the ratios from 1998
      through 2006 and the comparative industry ratios.




**Year**
            
            **First
                Mutual Bank**
            
            **All
                FDIC-Insured**
              **Commercial
                Banks**1998
            
            
            0.07%
            
            
            0.65%1999
            
            
            0.06%
            
            
            0.63%2000
            
            
            0.38%
            
            
            0.74%2001
            
            
            0.08%
            
            
            0.92%2002
            
            
            0.28%
            
            
            0.94%2003
            
            
            0.06%
            
            
            0.77%2004
            
            
            0.10%
            
            
            0.55%2005
            
            
            0.08%
            
            
            0.48%2006
            
            
            0.32%
            
            
            n/a




At
      year-end 2006 our nonperforming assets totaled $3.5 million. Subsequent to
      the
      year-end, two multifamily
      loans and one custom construction loan in Oregon totaling $1.2 million were
      paid
      in full, bringing our
      nonperforming assets down to $2.2 million, or 0.21% as of February 22, 2007.
      We
      have two custom construction loans in the Oregon market totaling $660,000 for
      which we have already taken impairment charges of $198,000. We don’t anticipate
      any further significant losses on those loans. A third residential loan also
      in
      that market, with a loan balance of $825,000, appears to be fully collectable.
      We have one other residential loan in the Puget Sound area with a loan balance
      of $167,000, on which we do not expect any loss.





16


The
      remaining loans are one equipment lease and sales finance loans, most of which
      are covered by credit insurance.




Listed
      below is a compilation of the loans that comprised our non-performing assets
      as
      of the 2006 year-end:




Two
                multi-family loans in Oregon. No anticipated loss. Paid in full January
                2007
            
            $
            865,000One
                single-family residential loan in Oregon. No anticipated
                loss
            
            
            825,000Two
                custom construction loans in Oregon market. Impairment charges taken
                in
                2006.
              No
                further losses anticipated
            
            
            660,000Sixty-seven
                consumer loans. Full recovery expected from insurance
                claims
            
            
            421,000Custom
                construction loan in Oregon. Impairment charges taken in 2006. No
                further
              loss
                anticipated. Paid in full February 2007
            
            
            376,000One
                single-family residential loan in the Puget Sound market. No anticipated
                loss
            
            
            167,000One
                equipment lease. No anticipated loss
            
            
            62,000Six
                consumer loans. No anticipated loss
            
            
            34,000Three
                insured consumer loans from insured pools that have exceeded the
                credit
              insurance
                limit. Possible loss of $29,000
            
            
            29,000Four
                consumer loans. Possible loss of $23,000
            
            
            23,000Total
                Non-Performing Assets
            
            $
            3,462,000




**Adoption
      of New Accounting Principle**




In
      December 2004, the Financial Accounting Standards Board (FASB) issued Statement
      of Financial Accounting
      Standards No. 123(R) (SFAS 123(R)),  *Share-Based
      Payment,* which
      is
      a revision of Statement of Financial Accounting Standards No. 123 (SFAS 123), *Accounting
      for Stock-Based Compensation.*




SFAS
      123(R) eliminates accounting for share-based compensation transactions using
      the
      intrinsic value method prescribed in Accounting Principles Board Opinion No.
      25
      (APB 25), *Accounting
      for Stock Issued to Employees,* and
      requires instead that such transactions be accounted for using a
      fair-value-based method. We elected to adopt the provisions of SFAS 123(R)
      effective January 1, 2006, under the modified prospective transition
      method, in which compensation cost is recognized beginning with the effective
      date (a) based on the requirements of SFAS 123(R) for all share-based payments granted after the
      effective date and (b) based on the requirements of SFAS 123(R) for all awards
      granted to employees prior to the effective date of SFAS 123(R) that remain
      unvested on the effective date.




As
      was
      permitted under SFAS 123, we chose to follow Accounting APB 25, and related
      interpretations in accounting for stock-based awards to employees through
      December 31, 2005. Accordingly, no compensation cost for stock options was
      recorded at the date of grant.




With
      the
      adoption of SFAS 123(R), we elected to amortize stock-based compensation for
      awards granted on or after the adoption of SFAS 123(R) on January 1, 2006,
      on a
      straight-line basis over the requisite service (vesting) period for the entire
      award. For awards granted prior to January 1, 2006, compensation costs are
      amortized in a manner consistent with APB 25.




At
      December 31, 2006, we had four stock-based employee/director compensation plans.
      The plans are accounted for under the recognition and measurement principles
      of
      SFAS 123(R), and related interpretations. Stock-based employee or director
      compensation cost is reflected in net income for 2006. All options granted
      under
      those plans had an exercise price equal to the market value of the underlying
      common stock on the date





17


of
      grant.
      The following table illustrates the effect on net income and earnings per share
      if the fair value recognition provisions of SFAS 123(R) had been adopted in
      2004
      and 2005.




**2005**
            
            **2004**Net
                income, as reported
            
            $
            10,318,649
            
            $
            9,287,813Deduct:
                Total stock-based employee/director compensation expensedetermined
                under fair value based method for all awards, net ofrelated
                tax effects(1)
            
            
            (569,555
            )
            
            (445,047
            )Pro
                forma net income
            
            $
            9,749,094
            
            $
            8,842,766Earnings
                per share:
              Basic
                — as reported
            
            $
            1.55
            
            $
            1.41Basic
                — pro forma
            
            $
            1.46
            
            $
            1.34Diluted
                — as reported
            
            $
            1.49
            
            $
            1.34Diluted
                — pro forma
            
            $
            1.42
            
            $
            1.28Weighted
                average shares outstanding:
              Basic
            
            
            6,643,270
            
            
            6,580,515Diluted
            
            
            6,928,474
            
            
            6,892,073







(1)
      A
      Black-Scholes option pricing model was used to determine the fair value of
      the
      options granted




**Critical
      Accounting Policies and Estimates**




The
      preparation of the Consolidated Financial Statements in conformity with
      accounting principles generally accepted in the United States of America
      requires that we 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 and lease losses, the value
      of
      servicing assets, the value of
      loans held-for-sale, the useful lives of fixed assets, credit insurance premiums
      payable, amortization of
      deferred loan fees/costs, the value of derivative instruments, the calculations
      to determine the value of stock option
      expense, deferred taxes, and the valuation of real estate acquired in connection
      with foreclosures or in satisfaction of loans critical accounting policies
      subject to estimates.




For
      additional information regarding the allowance for loan and lease losses, see
      “Reserve and Provision for
      Loan
      and Lease Losses” in the Management’s Discussion and Analysis (MD&A) and
“Allowance for Loan and
      Lease 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 the MD&A and “Servicing
      Assets” in Note 1 as well as Note 6 “Servicing Assets and Servicing Fees” in the
      Consolidated Financial
      Statements. Additional information regarding the value of loans held-for-sale
      can be found under the heading
“Loans Held-For-Sale” in Note 1 to the Consolidated Financial Statements.
      Additional information related to the useful lives of fixed assets can be found
      under the heading “Land, Buildings, and Equipment” in Note 1 to the Consolidated
      Financial Statements. Additional information related to credit insurance
      premiums payable can be found under the “Other Noninterest Expense” section of
      the MD&A. For additional information regarding amortization of deferred loan
      fees/costs, see “Loans” in Note 1 to the Consolidated Financial Statements. For
      additional information related to the value of derivative instruments see the
      sections titled “Interest Rate Risk Management” and “Derivative Loan Commitments
      (Rate Lock Commitments)” in Note 1 as well as Note 21 “Derivative Activities and
      Market Risk” in the Consolidated Financial Statements. For additional
      information regarding the calculations to determine the value of stock option
      expense see “Stock-Based Compensation Plans” in Note 1 and also Note 16 “Stock
      Option Plans” in the Consolidated Financial Statements. For additional
      information regarding deferred taxes see Note 11 “Federal Taxes on Income” in
      the Consolidated Financial Statements. For additional information regarding
      the
      valuation of real estate acquired in connection with foreclosures or in
      satisfaction of loans see “Foreclosed Assets” in Note 1 to





18


the
      Consolidated Financial Statements. These critical accounting policies are also
      discussed in the “Critical Accounting Policies” section of the Form 10-K.




**Review
      of Financial Condition** ***Assets***




As
      of the
      December 31, 2006 year-end, our assets totaled $1.079 billion, representing
      a
      decline of less than
      1%
      from the $1.086 billion 2005 year-end level. A substantially higher level of
      loan sales relative to prior years
      and the continued runoff of our securities portfolio compromised asset growth
      in
      2006, with sequential quarter growth occurring only in the second quarter of
      the
      year.




***Cash
      and Equivalents***




While
      our
      total balances of cash and equivalents were little changed relative to the
      2005
      year-end level, the
      noninterest earning balances declined significantly, totaling $18 million
      compared to nearly $25 million as of the
      2005 year-end. Contributing to the decline in balances was the introduction
      of a
      new program which reduced our reserve requirement at the Federal Reserve Bank,
      as well as a change in our correspondent banking relationship that decreased
      the
      balances in transit.




We
      view
      the reduction in cash balances as a positive event, as reducing a noninterest
      earning asset balance does not result in the loss of any interest income, but
      does allow us to retire a corresponding level of funding sources and avoid
      the
      related interest expense.




***Securities***




The
      balance of our securities portfolio (including both available-for-sale and
      held-to-maturity securities) fell $26
      million from its 2005 year-end level, ending 2006 at approximately $95 million.
      This followed a reduction of nearly $11 million from the 2004 year-end level
      over the course of 2005.




Over
      the
      past year we have found the yields available on investment securities to be
      significantly less attractive than those on loans, particularly when the funding
      costs to support the additional assets were taken into
      account. Consequently, as the securities in our portfolio have amortized or
      matured, we have generally not  replaced
      the paid-off balances, but instead redirected those cash flows to support loan
      growth. Our expectation for 2007
      is that, while we may consider executing a purchase of securities to replace
      part of the run-off in the portfolio, we do not anticipate a material increase
      in the size of our securities portfolio. However, in the event that yields
      on
      securities and/or the cost of funding purchases should become more conducive
      to
      holding investment securities, we would consider increasing the size of our
      securities portfolio at that time.




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. The majority of the securities in our present portfolio are
      of
      the second type, available-for-sale. None of the securities in our portfolio
      are classified
      in the trading category. Available-for-sale securities are reviewed regularly,
      and any unrealized gains or
      losses are recorded in comprehensive income in the shareholders’ equity account.
      As of December 31, 2006, the balance of the unrealized loss in comprehensive
      income, net of federal income taxes, totaled $1.4 million, compared to a balance
      of $1.5 million as of the 2005 year-end. Generally, falling interest rates
      will
      enhance the amount recorded as unrealized gain, and rising rates will erode
      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 maturity date. As
      we do
      not anticipate liquidating any of our securities that are currently in an
      unrealized loss position, we do not expect that any of the unrealized loss
      will
      directly impact the gain or loss from security sales in future
      periods.




***Loans***




Loans
      receivable, excluding loans held-for-sale, increased $15 million, or
      approximately 2%, from $878
      million at the close of 2005 to $893 million at December 31, 2006 as loan
      originations increased from




19


$526
      million to $546 million. The growth rate in loans represented a significant
      reduction from that observed in
      recent
      years, when loans receivable increased by $69 million (2005) and $85 million
      (2004). The slowdown in loan
      portfolio growth this year was largely attributable to a combination of high
      prepayment speeds and a significant increase in loan sales relative to prior
      years.




**Portfolio
                Distribution**
            
            **2006**
            
            **2005**
            
            **2004**Single
                Family (includes held-for-sale)
            
            
            28%
            
            
            25%
            
            
            22%Income
                Property
            
            
            28%
            
            
            34%
            
            
            40%Business
                Banking
            
            
            16%
            
            
            13%
            
            
            13%Commercial
                Construction
            
            
            5%
            
            
            3%
            
            
            3%Single
                Family Construction
              Spec
                Construction
            
            
            4%
            
            
            2%
            
            
            2%Custom
                Construction
            
            
            8%
            
            
            10%
            
            
            8%Consumer
            
            
            11%
            
            
            13%
            
            
            12%Total
            
            
            100%
            
            
            100%
            
            
            100%




The
      modest increase that occurred in our loan portfolio over the course of this
      year
      was primarily attributable to growth in our Business Banking and Residential
      Lending segments. The single family residential
      loans held in our portfolio are typically non-conforming loans that do not
      meet
      the requirements for resale
      in the secondary market, but generally offer higher yields than conforming
      residential mortgages and are still considered eligible collateral for borrowing
      from the FHLB. Additionally, our consumer lending segment would likely have
      shown significant growth this year if not for the previously mentioned loan
      sales, which totaled nearly $59 million for the year compared to only $18
      million in 2005 and $36 million in 2004.




Income
      property loans, which consist of mortgages on investor-owned commercial real
      estate and multifamily properties, have demonstrated a gradual declining trend
      over the last three years. This gradual decline has been largely attributable
      to
      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 flat
      to inverted yield curve and increased competition from other lenders. The
      flattening of the yield curve 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 has impacted us
      in
      two ways. First, as prospective buyers sought loans with terms that fell outside
      of our typical underwriting structures, 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. Increased competition
      among lenders in our local market
      accelerated both the decline in new loans 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.




Over
      the
      course of 2006, we introduced several initiatives aimed at reducing the high
      prepayment rates in the income property loan portfolio and addressing borrowers’
requests for fixed-rate loans. In an effort to prevent prepayments of certain
      loans this year, we offered rate modifications to some of our borrowers. While
      these modifications effectively reduced asset yields and negatively impacted
      our
      net interest margin, we believe that the benefits of reducing these borrowers’
rates outweighed the costs of losing the borrowing relationships altogether.
      The
      impact to net interest income, and ultimately earnings, as a result of these
      modifications is less than what the reduction in net interest income would
      have
      been had these loans paid-off and refinanced elsewhere, effectively compressing
      our income property portfolio. Additionally, in the second quarter of this
      year,
      we began to utilize interest-rate swaps to hedge interest rate risk associated
      with extending longer-term, fixed-rate loans to certain commercial real-estate
      borrowers. The use of these swaps allows
      us
      to provide loans with the longer terms sought by certain borrowers, and then
      convert the loan’s fixed





20


rate
      to a
      floating rate through an institutional counterparty, thus offsetting any
      potential interest rate risk to the Bank as
      a consequence of offering loans with longer fixed-rate terms.




***Servicing
      Assets***




Servicing
      assets represent the deferred servicing rights generated from sales of loans
      that are sold servicing retained, reduced by the amortization and prepayments
      of
      those loans, as well as any impairment charges that may occur. While our
      servicing assets have not and do not represent a significant percentage of
      our
      total assets, this area has grown and is expected to continue growing with
      future loan sales.




**Servicing
                Assets**
            
            **2006**
            
            **2005**
            
            **2004**Commercial
            
            $
            224,000
            
            $
            292,000
            
            $
            173,000Residential
            
            
            63,000
            
            
            114,000
            
            
            13,000Consumer
            
            
            3,724,000
            
            
            1,460,000
            
            
            1,339,000Total
                Servicing Assets
            
            $
            4,011,000
            
            $
            1,866,000
            
            $
            1,525,000Loan
                Balances Serviced for Others
            
            $
            155,025,000
            
            $
            105,850,000
            
            $
            117,852,000




As
      a
      result of the $59 million in consumer loan sales this year, our servicing assets
      related to consumer loans increased over $2 million, or approximately 155%,
      over
      the 2005 year-end level, far exceeding the $121,000,
      or 9%, increase observed in the prior year when sales of consumer loans totaled
      only $18 million. In 2004,
      when sales of consumer loans totaled nearly $36 million, our related servicing
      assets increased by $1 million for the year.




Servicing
      assets related to commercial loans declined from their 2005 year-end level
      as
      two large commercial loan pools were paid-off in the fourth quarter of 2006.
      This required us to immediately writeoff the remaining $75,000 in servicing
      assets associated with these credits.




Residential
      loans are generally sold servicing released and consequently, no servicing
      assets are recognized.
      In the fourth quarter of 2005, however, we executed a transaction that retained
      servicing rights for a pool
      of residential loans, which resulted in the increase in servicing assets. In
      2006, we did not retain servicing on residential loans sold, consequently the
      related servicing asset declined based on regular amortization of the
      asset.




***Deposits
      and Borrowings***




As
      of the
      December 2006 year-end, our total deposit balances had increased $45 million,
      or approximately
      6% from the 2005 year-end level, with non-maturity deposit balances rising
      in
      the first quarter, losing
      ground over the second and third quarters, and finally increasing significantly
      in the fourth quarter. In contrast, time deposit balances declined modestly
      in
      the first quarter, significantly in the second, and then increased substantially
      in the third quarter before once again declining modestly in the final quarter
      of the year. Overall, our non-maturity deposit balances increased nearly $49
      million, while time deposits declined approximately $4 million.




The
      6%
      growth observed in 2006 represented a significant reduction from the 13%
      increase in deposit balances between the 2004 and 2005 year-end levels, 16%
      growth observed in 2004, and 17% increase in 2003. Growth in checking and money
      market balances, however, returned to a more desirable level in 2006 after
      accounting for only $9 million of the 2005 deposit growth. By comparison,
      checking and money market accounts
      had increased by approximately $62 million between the years ended December
      2003
      and 2004.




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 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.





21


In
      early
      2005, however, the increases in short-term market interest rates that began
      in
      the second quarter of 2004 started to affect the yields on retail deposits,
      with
      the rates paid on time deposits increasing more significantly than those paid
      on
      money market accounts. Consequently, we observed a migration of balances from
      non-maturity 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.




In
      the
      first quarter of this year a substantial increase in non-maturity deposit
      balances, particularly in our money market products, allowed us to take steps
      to
      improve our funding mix by reducing balances borrowed from the FHLB, as well
      as
      rates offered on retail certificates of deposit. Unfortunately, this trend
      did
      not continue in the second and third quarters. Following impressive growth
      in
      the first quarter, our non-maturity deposit balances peaked in mid-April, then
      steadily declined for the next month as a result of outflows for federal income
      tax and state property tax payments, as well as a substantial reduction in
      balances maintained by a large commercial customer. The decline continued in
      the
      third quarter, as our non-maturity balances fell in July, then recovered
      modestly over the remainder of the quarter. In the fourth quarter, however,
      we
      once again experienced a substantial increase in non-maturity balances,
      particularly in our higher-balance, higher-rate money market product, as a
      result of large balance depositors, many of them commercial depositors, making
      significant deposits into both new and existing accounts.




Our
      time
      deposit balances fell modestly in the first quarter and significantly in the
      second as we priced our
      certificates less aggressively, resulting in a lower retention of maturing
      balances. In the third quarter, time deposit
      balances increased significantly, rising nearly $23 million from their level
      as
      of the June 30, 2006 quarter end, including an $8 million net increase during
      the quarter in certificates issued through deposit brokerage services. For
      the
      final quarter of the year, time deposit balances declined nearly $5 million
      from
      their September 30 level based on a $10 million net reduction in outstanding
      brokered certificate balances during the quarter. For the year, our retail
      time
      deposit balances fell $9 million compared to December 31, 2005, while brokered
      certificate balances increased $5 million from the 2005 year-end
      level.




Our
      preferred supplemental funding mechanism is borrowing funds from the FHLB.
      During the first quarter
      of this year, modest asset growth and substantial increases in non-maturity
      deposit balances allowed us to
      reduce the amount of funding borrowed from the FHLB and improve our funding
      mix.
      This trend did not continue into the second quarter, however, as the combination
      of deposit runoff and increased asset growth resulted in an increased use of
      FHLB funding. After declining from $226 million as of December 31, 2005 to
      $207
      million at the end of the first quarter, advances from the FHLB rose to $248
      million at the end of the second quarter. Similar to the first quarter, however,
      the third and fourth quarters saw an absence of asset growth combined with
      rising deposit balances. The combination of these two factors resulted in a
      decrease in our FHLB advances to $172 million at the end of the year. As of
      December 31, 2006, we had the authority to borrow up to approximately $432
      million from the FHLB, subject to maintaining a sufficient level of eligible
      collateral.




**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.




Numerous
      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





22


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; 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 derivative usage 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 was
      to
      protect against potential adverse interest rate volatility that could be realized
      from the $9 million in Trust Preferred Securities (TPS) issued with an
      adjustable interest rate in June 2002.
      The swap accomplished this by fixing the interest rate payable for the first
      five years of the TPS’ life. This swap is set to expire in 2007, coinciding with
      the first call date for the TPS. As the pricing on TPS has improved
      significantly since the time we issued these securities, it is our intention
      to
      refinance the $9 million in
      securities with a new TPS issue in 2007. Based on the current levels of interest
      rates and TPS pricing, we expect the replacement TPS will be issued at a rate
      lower than that of the issue to be retired.




In
      the
      second quarter of 2006, we began to utilize interest rate swaps in connection
      with the underwriting of
      longer-term, fixed-rate commercial real estate loans. This decision was the
      result of prospective borrowers’ demand
      for longer-term, fixed-rate loans, and the preference of depositors for
      instruments of significantly shorter
      terms. Under this program, we originate commercial mortgage loans with
      amortization schedules of up to
      thirty-years, with an initial ten-year fixed rate. To hedge the interest rate
      risk exposure presented by ten- year,
      fixed-rate instruments, we utilize interest rate swaps on a loan-by-loan basis
      to convert each loan’s fixed rate to
      an adjustable rate subject to regular repricing relative to a market index
      rate,
      typically the one-month LIBOR rate. As this is a relatively new program, with
      only a few deals totaling less than $5 million in notional principal on the
      books thus far, we do not yet have an expectation of the number of loans that
      will likely be originated and hedged in such a manner. These interest rate
      swaps
      will be used solely for the purpose of managing the interest rate risk
      associated with longer-term, fixed-rate assets, and will not be used for any
      speculative purposes.





23


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


**December
                31, 2006**
              **Percentage
                Change**
            
            **December
                31, 2005**
              **Percentage
                Change****Change
                in Interest Rates (in basis points)**
            
            **Net
                Interest**
              **Income**
            
            **Economic
                Value**
              **of
                Equity**
            
            **Net
                Interest**
              **Income**
            
            **Economic
                Value**
              **of
                Equity**+200
            
            
            2.40%
            
            
            (1.07)%
            
            
            0.06%
            
            
            (2.72)%+100
            
            
            n/a
            
            
            0.06%
            
            
            n/a
            
            
            (0.55)%-100
            
            
            n/a
            
            
            (0.88)%
            
            
            n/a
            
            
            (1.94)%-200
            
            
            0.23%
            
            
            (3.76)%
            
            
            (1.32)%
            
            
            (6.54)%




***Net
      Interest Income Simulation***




Our
      income simulation model, based on information as of the December 31, 2006
      year-end, indicated that our net interest income over the following 12 months
      was projected to increase from its “base case” level in scenarios in which
      interest rates are assumed to gradually increase or decline by 200 bps over
      a
      12-month period. The magnitudes of the changes, however, suggest that there
      is
      little sensitivity in net interest income from the “base case” level over a
      12-month horizon in either scenario, as an increase in net interest income
      of
      2.40% was observed in the rising rate environment, and a change of only 0.23%
      was indicated in the falling rate scenario.




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 securities
      purchases and loan originations at lower interest rate levels to offset
      accelerated prepayments, and conversely, reduced securities 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 change 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 12 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.





24


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, 2006 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
      2.46%, compared to a decline of 2.62% for our liabilities. Given the greater
      balance of assets than liabilities, 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
      1.07%.




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 on
      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 economic 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
      were positively impacted when rates were assumed to fall by 200 bps, assets
      by
      1.85% and liabilities by
      2.50%. 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
      3.76%.




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, quantifies 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.




One
      Year Interest Rate Sensitivity
      Gap




**December
                31,**
              **2006**
            
            **December
                31,**
              **2005****(Dollars
                in thousands)**One-Year
                Repricing/Maturing Assets
            
            $
            673,514
            
            $
            715,543One-Year
                Repricing/Maturing Liabilities
            
            
            725,636
            
            
            773,093One-Year
                Gap
            
            $
            (52,122
            )
            $
            (57,550
            )Total
                Assets
            
            $
            1,079,263
            
            $
            1,086,165One-Year
                Interest Rate Gap as a Percentage of Assets
            
            
            (4.8
            )%
            
            (5.3
            )%




At
      a
      negative, or liability sensitive, 4.8% of assets, our 12-month interest rate
      sensitivity gap as of December 31, 2006 indicated a degree of liability
      sensitivity similar to the 5.3% observed at the 2005 year-end. 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





25


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.




**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. Liquidity is also used to purchase
      facilities and equipment.




**2006**
            
            **2005**
            
            **2004****(Dollars
                in thousands)**Loan
                Originations (Disbursed)
            
            $
            (546,000
            )
            $
            (526,000
            )
            $
            (470,000
            )Increase/(Decrease)
                in Undisbursed Loan Proceeds
            
            
            (22,000
            )
            
            36,000
            
            
            9,000Security
                Purchases
            
            
            (7,000
            )
            
            (11,000
            )
            
            (74,000
            )Total
                Originations and Purchases
            
            $
            (575,000
            )
            $
            (501,000
            )
            $
            (535,000
            )Loan
                and Security Repayments
            
            $
            446,000
            
            $
            370,000
            
            $
            297,000Sales
                of Securities
            
            
            —
            
            
            —
            
            
            2,000Sales
                of Loans
            
            
            138,000
            
            
            67,000
            
            
            104,000Total
                Repayments and Sales
            
            
            584,000
            
            
            437,000
            
            
            403,000Net
                Difference
            
            $
            9,000
            
            $
            (64,000
            )
            $
            (132,000
            )




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 nearly
      39% in 2006, compared to 35% in 2005 and 32% in 2004.




We
      believe the flat to inverted shape of the yield curve in 2005 and 2006 likely
      contributed to the continued high level of prepayments, as the rate differential
      between short- and long-term financing diminished and reduced the financial
      incentive for borrowers to use shorter-term, adjustable-rate financing rather
      than longer-term fixed rate loans. This, in turn, provided borrowers holding
      short-term or adjustable-rate loans,
      which represent the majority of our loan portfolio, with an incentive to
      refinance with long-term fixed-rate loans.




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 of deposit, and reverse repurchase
      agreements. During the years 2004, 2005 and 2006, changes in funds from deposits
      and borrowings
      were as follows:




**2006**
            
            
            **2005**
            
            
            **2004****(Dollars
                in
                thousands)**Deposits
            
            $
            21,000
            
            $
            68,000
            
            $
            80,000Borrowings
            
            
            (54,000
            )
            
            (6,000
            )
            
            42,000Total
            
            $
            (33,000
            )
            $
            62,000
            
            $
            122,000




26


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 prevailing rates in our marketplace.




Our
      other
      major source of liquidity is wholesale funds, which include borrowing 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 $172 million
      at the 2006 year-end, down from $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 $432 million. As a percentage of
      year-end assets, our FHLB borrowings totaled 16%, down from 21% at December
      31,
      2005, and 23% at December 31, 2004. 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. Our
      two
      principal sources of preferred collateral are single-family residential and multifamily loans.
      Because single-family lending has exhibited significant growth in recent 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 $47 million
      as
      of December 31, 2006, compared to $42 million at year-end 2005. At various
      times
      over the course of 2006, interest rates on brokered
      deposits fell below those of FHLB advances. Consequently, during those times
      we
      elected to increase our use
      of this funding source. 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 total deposits.
      As of December 31, 2006, brokered deposits represented 5.9% of our total
      deposits.




Reverse
      repurchase lines are lines of credit collateralized by securities. We currently
      have lines totaling $35
      million, of which the full amount is currently available. There has been no
      usage of these lines in the previous 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 loss 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.




In
      addition to using liquidity to fund loans and securities, we routinely invest
      in
      facilities and equipment. In 2006, we invested $4.2 million in these assets,
      compared to $7.2 million in 2005 and $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. Among the 2006 expenditures were the completion of various remodeling
      projects in First
      Mutual Center and the construction of our West Seattle banking center’s new
      facility.





27




**Contractual
      Obligations and Commitments**




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




**Payments
                Due Per Period****Total**
            
            **Less
                  than****1
                year**
            
            **1-3
                years**
            
            **3-5
                years**
            
            **Thereafter****(Dollars
                in thousands)**Debt
            
            $
            678,931
            
            $
            533,174
            
            $
            114,702
            
            $
            13,872
            
            $
            17,183Fixed
                Interest on Debt(1)
            
            
            1,271
            
            
            940
            
            
            331
            
            
            —
            
            
            —Operating
                Leases
            
            
            1,418
            
            
            313
            
            
            566
            
            
            313
            
            
            226Total
            
            $
            681,620
            
            $
            534,427
            
            $
            115,599
            
            $
            14,185
            
            $
            17,409





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




At
      December 31, 2006, the Company’s obligations related to debt totaled $679
      million to be paid over the
      next
      30 years. Included in this amount are time deposits and FHLB borrowings totaling
      $485 million and $172
      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, 2006, 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 Expiration Per Period****Total**
            
            **Less
                  than****1
                year**
            
            **1
                - 3 years**
            
            **3
                - 5 years**
            
            **Thereafter****(Dollars
                in thousands)**Commitments
                to Extend Credit
            
            $
            283,083
            
            $
            211,439
            
            $
            5,951
            
            $
            6,598
            
            $
            59,095Standby
                Letters of Credit
            
            
            6,638
            
            
            1,563
            
            
            —
            
            
            5,000
            
            
            75Total
            
            $
            289,721
            
            $
            213,002
            
            $
            5,951
            
            $
            11,598
            
            $
            59,170




**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





28


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
            
            
            12.14%
            
            
            12.39%
            
            
            10.0%Tier
                1 Capital to Risk-Weighted Assets
            
            
            10.90%
            
            
            11.15%
            
            
            6.0%Tier
                1 Leverage Capital to Average Assets
            
            
            7.97%
            
            
            8.30%
            
            
            5.0%




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




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




Income
      Property Lending — Income Property lending offers permanent and interim
      construction loans for multifamily housing (over four units), manufactured
      housing communities, commercial real estate
      properties, and 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.




***Consumer
      Lending***




**Year**
            
            **Net**
              **Income**
            
            **Return
                on**
              **Equity**
            
            **Average
                Earning**
              **Assets**2004
            
            $
            1,292,000
            
            
            15.4
            %
            $
            107,637,0002005
            
            
            921,000
            
            
            9.7
            %
            
            120,997,0002006
            
            
            1,704,000
            
            
            18.7
            %
            
            117,992,000




Following
      a year in which its net income had declined significantly as a result of rising
      noninterest expense, the Consumer Lending segment’s net income increased
      remarkably in 2006, growing more than 85%





29


over
      the
      prior year’s level based on an additional $2.1 million in noninterest income,
      primarily from gains on  loan
      sales. Prior to 2005, the segment had shown two years of dramatic year-over-year
      earnings improvement based on
      a combination of earning asset growth and related incremental net interest
      income, along with increasing gains on loan sales.




Leading
      up to 2006, the Consumer segment’s rate of earning asset growth had been in
      decline, falling from 25% for 2004 to 12% in 2005, despite a reduction in loans
      sales from $36 million to $18 million. This year, with loan sales totaling
      nearly $59 million, the segment’s earning assets contracted approximately 2%.
      Because of the reduction in earning assets relative to the prior year, and
      the
      fixed-rate nature of the majority of the loans in the portfolio, the Consumer
      Lending segment’s interest income only increased 7% compared to growth of 16%
      and 34% observed in 2005 and 2004, respectively. It should be noted that, while
      most of the segment’s loans are fixed rate instruments, these loans typically
      have fairly short average lives and, over the last couple of years, new loans
      have typically been originated at higher rates of interest than the seasoned
      loans they replaced.




In
      contrast to the declining rate of interest income growth, interest expense
      increased 42% relative to the prior year, based on increases in the retail
      deposit and wholesale funding rates. This followed an increase of 41% in 2005.
      By comparison, the segment’s 2004 interest expense had risen only 5%, as the
      impact of a decrease 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 deposits, particularly our certificates, 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. The lagged effects of rate increases in 2004,
      2005, and the first half of 2006, combined with intense competition for deposits
      in our local marketplace, drove the increase in interest expense in 2005 and
      2006. 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,
      even if short-term rates effectively stabilized in mid-2006, 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 2006 net interest income declined more than 10%, or
      $699,000, from its 2005
      level, after increasing $411,000, or 7%, in the prior year. Following a $203,000
      reduction in the provision for loan and lease loss, the segment’s net interest
      income after provision fell $496,000 relative to 2005.
      Significant recoveries on previously charged-off loans combined with this year’s
      high level of loan sales led to
      the significant decrease in the segment’s provision for loan and lease
      losses.




The
      segment’s noninterest income exceeded the prior year level by $2.1 million, an
      increase of 89%, based on a growth in loan sale volumes from $18 million in
      2005
      to $59 million in 2006. The year-to-year fluctuations in gains on consumer
      loan
      sales have typically followed changes in our practice regarding the amount
      of
      loans to be sold, which is in turn, largely based on a combination of loan
      production and market demand.




Prior
      to
      the second quarter of 2005, based on loan production and market demand, our
      plan
      had been to sell approximately $6-$8 million in sales finance loans each
      quarter. In the second quarter of 2005, we elected to change this practice
      and
      substantially reduced our sales of these loans, selling only sufficient volumes
      to ensure the continuity of the market. As a result, our loan sales in the
      second half of 2005 were well below those for the same period in 2004. At the
      end of 2005, however, we noted that we were experiencing an increased level
      of
      interest in our consumer loans from institutional investors, and consequently
      expected that sales of these loans would increase in 2006. This materialized,
      and combined with a higher level of loan production than in 2005, resulted
      in a
      substantially higher level of sales, and gains thereon.




Based
      on
      our current levels of loan production and market demand, our expectation is
      for
      our first quarter 2007 consumer loan sales to total in the $12-$18 million
      range, which should equal or exceed the level sold in





30


the
      first
      quarter of 2006. Note that these expectations may be subject to change based
      on
      changes in loan production, market conditions, and other factors.




In
      2005,
      noninterest income had increased $405,000, or 21%, as a reduction in loan sales
      was offset by a higher level of servicing fee income, which largely resulted
      from a change in the amortization period assumed for the underlying servicing
      asset made in early 2005. For 2006, service fee income earned on consumer loans
      serviced for other investors exceeded that earned in the prior year based on
      a
      significant increase in the balances
      of consumer loans serviced, which was in turn a product of the growth in loan
      sales in 2006.




Partially
      offsetting the additional noninterest income, however, was growth in the
      segment’s noninterest expenses, which increased $382,000, or 5% compared to the
      prior year, with the largest contributors to the increases
      being compensation, credit insurance premiums, legal fees, and taxes.
      Compensation expense rose as a result
      of annual salary increases, additional expenditures for temporary office help,
      and the arrival of new personnel including a new manager for our Sales Finance
      lending area. The 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.
      Note that while we will continue the insurance on loans insured prior to August
      1, 2006, as well as certain loans originated after that date that had already
      been sold to investors with insurance coverage, we have decided not to insure
      newly originated loans going forward. Consequently, our expectation is that
      expenses related to credit insurance will decline in the future as existing
      insured loans are paid off and new production is not insured. Also contributing
      to the additional expense were higher legal costs for our Sales Finance
      operations attributable to the biennial compliance review that evaluates our
      practices in the states in which we do business. State B&O tax expense also
      increased because of this year’s higher gains on loan sales.




During
      2006 we experienced a substantial reduction in the rate of increase in expenses
      compared to the prior year. The segment’s operating expenses in 2005 had grown
      by $1.3 million, or 23%, relative to the 2004 level. The additional expense
      in
      2005 was a result of the combination of additional credit insurance cost
      attributable to the growth in insured sales finance loan balances, a reduction
      in the segment’s deferral of loan origination costs, and an increase in
      administrative and support costs allocated to the segment.




***Residential
      Lending***




**Year**
            
            **Net**
              **Income**
            
            **Return
                on**
              **Equity**
            
            **Average
                Earning**
              **Assets**2004
            
            $
            2,700,000
            
            
            25.2
            %
            $
            271,665,0002005
            
            
            3,641,000
            
            
            26.6
            %
            
            332,247,0002006
            
            
            3,763,000
            
            
            25.0
            %
            
            365,595,000




Following
      net income growth of 34% in 2004 and 35% in 2005, the Residential Lending
      segment saw its rate of increase fall to single digits as 2006 earnings exceeded
      the prior year by only 3%. In each year, the increase
      in net income resulted primarily from growth in earning assets and corresponding
      net interest income. Consequently, as the rate of earning asset growth slowed in 2006, so did the
      segment’s earnings.




Prior
      to
      2006, the Residential segment had been the largest contributor to our earning
      asset growth, with its average level of earning assets increasing 41% and 22%
      over prior year levels for 2004 and 2005, respectively. In 2006, however, in
      response to sustained high prepayment rates and some cooling in the local
      housing market, the rate of asset growth declined to 10%. Partially offsetting
      the slowdown in asset growth was the benefit of the repricing resulting from
      increases in interest rate indexes from which the loan rates are set.
      Interest income in 2006 earned on the portfolio increased 25%, compared to
      increases of 37% in 2005 and 34% for
      2004.




Following
      year-over-year growth of 26% in 2004 and 57% in 2005, the Residential segment’s
      2006 interest expense rose nearly 50% 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 a $52,000 reduction in the
      segment’s provision for





31


loan
      and
      lease loss, reduced the overall increase in the segment’s net interest income
      after provision to approximately
      5% over the prior year level, down from a 26% year-over-year increase in 2005
      and 38% increase
      in 2004.




Noninterest
      income for the Residential segment increased $160,000, or 12% relative to the
      prior year, based in large part on a partial allocation of $400,000 in insurance
      proceeds received from a key-man life insurance policy. These proceeds were
      allocated across the four business segments, with the Residential segment
      receiving one of the larger allocations because of its size relative to the
      other segments. In the previous
      year, the segment’s noninterest income had risen $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.




Partially
      offsetting this year’s income growth was a $477,000, or 7%, increase in
      operating costs. This followed a 2005 increase of $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 this year was in
      compensation expense resulting from a decrease in SFAS 91 deferrals. In
      accordance with SFAS 91, certain loan
      origination costs, including some salary expenses tied to loan origination,
      are
      deferred and amortized over the life
      of each loan originated, rather than expensed in the current period. Operating
      costs 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.” Both the number of loans originated by our
      Residential segment as well
      as the deferred costs associated with originations, declined relative to the
      prior year. As a result, the amount of salary expense eligible for deferral
      ran
      below the level deferred in 2005, resulting in higher current period
      expenses.




Additional
      compensation expense also adversely effected 2005, though in that year the
      increase was primarily observed in incentive compensation driven by increased
      loan production volumes. Further contributing
      to additional expense in 2005 and 2006 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.




***Business
      Banking Lending***




**Year**
            
            **Net**
              **Income/(Loss)**
            
            **Return
                on**
              **Equity**
            
            **Average
                Earning**
              **Assets**2004
            
            $
            (424,000
            )
            
            (5.1
            )%
            $
            108,138,0002005
            
            
            77,000
            
            
            0.7
            %
            
            131,702,0002006
            
            
            (110,000
            )
            
            (0.8
            )%
            
            171,307,000




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. While these results have not yet been achieved, we continue
      to invest
      in
      this segment based upon its ability to attract low-cost core deposits, which
      help reduce our overall cost of
      funds, the diversification it brings to our portfolio of earning assets, and
      the
      potential it offers for generating longer-term relationship-banking
      opportunities and additional sources of noninterest income.




The
      Business Banking segment’s 2006 net interest income after provision for loan
      losses rose $917,000, or 16% over the prior year. While this was substantially
      less than the $1.7 million, or 41% increase in 2005, it remained an impressive
      rate of growth and superior to the 11% year-over-year growth observed in 2004.
      The Business Banking segment’s improvement was, in fact, the highest net
      interest income increase among our four business lines from both dollar and
      percentage perspectives. The segment was also the most successful in building
      incremental assets over the prior year, with its average earning assets
      increasing nearly $40 million,





32


or
      30%
      for the year. This level of asset growth exceeded the 22% year-over-year growth
      observed in 2005 as well as the 24% growth of 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, most commonly 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 2004, 2005, and 2006.




For
      2006,
      the Business Banking segment’s noninterest income rose $280,000, or 45% over the
      level earned in the prior year. This followed an increase of $148,000, or 31%
      in
      2005, driven by a large 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.




Contributing
      to the increase in fee income this year were the mark-to-market entries for
      interest-rate derivatives.
      The income on these instruments, which totaled $207,000 for the year, was
      essentially matched by comparable mark-to-market losses on offsetting derivatives recorded in the
      segment’s noninterest expense. These derivatives are utilized to hedge interest
      rate risk associated with extending longer-term, fixed-rate periods on
      commercial real estate loans, and structured such that a gain on any given
      derivative is matched against
      a
      nearly identical loss on a corresponding instrument, resulting in essentially
      no
      net impact to earnings. To the
      extent that we continue to offer similar longer-term, fixed-rate periods on
      commercial real estate loans in the future and use similar derivative structures
      to manage interest rate risk, this income, as well as the offsetting expense,
      would be expected to increase in future periods.




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.




Offsetting
      the growth in net interest and noninterest income was an additional $1.5 million
      in noninterest expense, representing an increase of 23% compared to 2005. This
      followed an increase in operating expenses of $1.1 million, or 21%, for 2005
      relative the prior year. In both years, growth in compensation expense as well
      as expenses from our retail banking centers and other administrative departments
      allocated to the Business Banking segment contributed to the increase.
      Additionally, for 2006, approximately $207,000 of the increase
      was attributable to unrealized losses on hedging instruments. These were the
      corresponding positions to those
      mentioned above that contributed $207,000 in additional noninterest income
      for
      the year.




The
      increase observed in the segment’s compensation expense this year was
      attributable to higher loan officer commissions in response to this year’s
      production of earning asset and deposit balances, as well as the addition of
      a
      new business banking officer. The additional compensation expense in 2005 was
      due, in large part, to a return to a normal level of loan officer commissions
      that year, compared to a below average level of expense in 2004.




Also
      contributing to the additional noninterest expense were increases in expenses
      from our retail banking centers and other administrative departments allocated
      to the Business Banking segment. The operating costs 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.




***Income
      Property Lending***




**Year**
            
            **Net**
              **Income**
            
            **Return
                on**
              **Equity**
            
            **Average
                Earning**
              **Assets**2004
            
            $
            5,721,000
            
            
            19.6
            %
            $
            438,968,0002005
            
            
            5,680,000
            
            
            19.3
            %
            
            414,804,0002006
            
            
            5,623,000
            
            
            20.2
            %
            
            379,109,000





33


The
      Income Property segment’s 2006 net income continued the gradual downward trend
      of recent years, with
      relatively modest changes impacting net interest income and noninterest
      expense.




The
      segment’s 2006 net interest income after provision for loan loss declined
      $490,000, or 3%, from the prior year’s level based on interest income growth of
      nearly 10% and a more than offsetting 32% increase in interest expense. This
      followed a decline of $266,000, or 2%, in 2005 based on a 28% increase in
      interest expense
      which more than offset a 9% improvement in interest income. Unlike our other
      business segments, the Income
      Property segment has experienced a decline in earning asset growth in the last
      three years. Assets for the year 2006 fell $36 million to $379 million, a
      decline of 9% relative to the prior year. This followed a $24 million, or nearly
      6% reduction in 2005.




Noninterest
      income for the Income Property segment rose $244,000, or 23%, relative to 2005,
      based in large part on the previously mentioned key-man life insurance proceeds.
      The income property segment received the greatest allocation of these proceeds
      as a result of its size relative to the sizes of the other segments. In 2004,
      the segment’s noninterest income had increased $79,000, or 8%, compared to the
      prior year based on higher levels of prepayment penalties and brokered loan
      fees.




As
      has
      been the case in each of the last three years, the Income Property segment’s
      noninterest expense in 2006 exhibited a modest reduction compared to the prior
      year, declining $186,000, or 3%. This followed declines of $139,000, or 2%,
      in
      2005 and $51,000, or 1%, in 2004. As noted earlier, the asset growth exhibited
      by the other business lines was not observed with the Income Property segment,
      which instead saw its
      balances decrease 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.



















34


**REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**




To
      the
      Board of Directors and Stockholders


First
      Mutual Bancshares, Inc. and Subsidiaries




We
      have
      audited the accompanying consolidated statement of financial condition of First
      Mutual Bancshares, Inc. and Subsidiaries (Company) as of December 31, 2006
      and
      2005, and the related consolidated statements of income, stockholders’ equity
      and comprehensive income, and cash flows for the three years in the period
      ended
      December 31, 2006. We also have audited management’s annual assessment included
      in the accompanying
      Management Report on Internal Control over Financial Reporting that the Company
      maintained  effective
      internal control over financial reporting as of December 31, 2006, based on
      the
      criteria established in Internal
      Control — Integrated Framework issued by the Committee of Sponsoring
      Organizations of the Treadway
      Commission (COSO). The Company’s management is responsible for these financial
      statements, for maintaining effective internal control over financial reporting, and for its
      assessment of the effectiveness of internal control over financial reporting.
      Our responsibility is to express an opinion on these financial statements,
      an
      opinion on management’s assessment, and an opinion on the effectiveness of the
      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 financial reporting includes those policies and procedures
      that (1) pertain to the maintenance of records that, in reasonable detail,
      accurately and fairly reflect the transactions and dispositions of the assets
      of
      the Company; (2) provide reasonable assurance that transactions are recorded
      as
      necessary to permit preparation of financial statements in accordance with
      accounting principles generally accepted in the United States of America, 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.





35


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, 2006 and 2005, and the
      results of their operations and cash flows for each of the three years ended
      December 31, 2006, in conformity with accounting principles generally accepted
      in the United States of America.
      Also in our opinion, management’s assessment that First Mutual Bancshares, Inc.
      and Subsidiaries maintained effective internal control over financial reporting
      as of December 31, 2006, is fairly stated, in all material respects, based
      on
      criteria established in Internal Control — Integrated Framework issued by the
      Committee of Sponsoring Organizations of the Treadway Commission. Furthermore,
      in our opinion, First Mutual Bancshares, Inc. and Subsidiaries maintained,
      in
      all material respects, effective internal control over financial reporting
      as of
      December 31, 2006, based on criteria established in Internal Control —
Integrated Framework issued by the Committee of Sponsoring Organizations of
      the
      Treadway Commission.




/s/
      Moss
      Adams LLP




Everett,
      Washington


March
      14,
      2007



























36


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




**CONSOLIDATED
      STATEMENTS OF FINANCIAL CONDITION**




**ASSETS**




**December
                31,****2006**
            
            **2005**Interest-bearing
                deposits
            
            $
            6,990,015
            
            $
            1,229,176Noninterest-bearing
                demand deposits and cash on hand
            
            
            18,371,546
            
            
            24,551,436Cash
                and cash equivalents
            
            
            25,361,561
            
            
            25,780,612Mortgage-backed
                and other securities available-for-sale (AFS)
            
            
            89,727,985
            
            
            114,450,342Loans
                receivable, held-for-sale
            
            
            13,732,932
            
            
            14,683,507Mortgage-backed
                and other securities held-to-maturity (HTM), fair valueof
                $5,585,079 and $6,970,890
            
            
            5,620,078
            
            
            6,966,295Loans
                receivable
            
            
            893,431,488
            
            
            878,066,241Reserve
                for loan and lease losses
            
            
            (9,728,446
            )
            
            (10,069,020
            )Loans
                Receivable, net
            
            
            883,703,042
            
            
            867,997,221Accrued
                interest receivable
            
            
            5,533,751
            
            
            5,350,493Servicing
                assets
            
            
            4,011,334
            
            
            1,865,698Land,
                buildings, and equipment, net
            
            
            35,566,112
            
            
            33,483,998Federal
                Home Loan Bank (FHLB) stock, at cost
            
            
            13,122,300
            
            
            13,122,300Other
                assets
            
            
            2,883,977
            
            
            2,464,369Total
                assets
            
            $
            1,079,263,072
            
            $
            1,086,164,835










See
      accompanying notes.





37


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




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




**LIABILITIES
      AND STOCKHOLDERS’ EQUITY**




**December
                31,****2006**
            
            **2005**Liabilities:
              Deposits:
              Money
                market deposit and checking accounts
            
            $
            313,693,904
            
            $
            263,444,641Savings
            
            
            6,701,770
            
            
            8,053,510Time
                deposits
            
            
            485,399,230
            
            
            489,222,486Total
                deposits
            
            
            805,794,904
            
            
            760,720,637Drafts
                payable
            
            
            1,313,624
            
            
            733,773Accounts
                payable and other liabilities
            
            
            7,017,815
            
            
            15,706,624Advance
                payments by borrowers for taxes and insurance
            
            
            1,582,899
            
            
            1,671,496Federal
                Home Loan Bank (FHLB) advances
            
            
            171,932,307
            
            
            225,705,005Other
                advances
            
            
            4,600,000
            
            
            4,600,000Junior
                subordinated long-term debentures
            
            
            17,000,000
            
            
            17,000,000Total
                liabilities
            
            
            1,009,241,549
            
            
            1,026,137,535Stockholders’
                equity:
              Common
                stock, $1 par value; authorized, 30,000,000 shares; issued andoutstanding,
                6,673,528 and 6,621,013 shares, respectively
            
            
            6,673,528
            
            
            6,621,013Additional
                paid-in capital
            
            
            45,119,428
            
            
            43,964,588Retained
                earnings
            
            
            19,589,048
            
            
            10,877,529Accumulated
                other comprehensive loss:
              Unrealized
                loss on securities available-for-sale and interest rate swap,net
                of federal income tax
            
            
            (1,360,481
            )
            
            (1,435,830
            )Total
                stockholders’ equity
            
            
            70,021,523
            
            
            60,027,300Total
                liabilities and stockholders’ equity
            
            $
            1,079,263,072
            
            $
            1,086,164,835










See
      accompanying notes.





38


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




**CONSOLIDATED
      STATEMENTS OF INCOME**


**Years
                Ended December 31,****2006**
            
            **2005**
            
            **2004**INTEREST
                AND FEE INCOME:
              Loans
                receivable
            
            $
            74,846,926
            
            $
            61,623,627
            
            $
            50,195,027Interest
                on available-for-sale securities
            
            
            4,305,975
            
            
            4,949,968
            
            
            4,030,836Interest
                on held-to-maturity securities
            
            
            341,704
            
            
            391,925
            
            
            418,054Interest
                other
            
            
            677,638
            
            
            397,105
            
            
            482,77480,172,243
            
            
            67,362,625
            
            
            55,126,691INTEREST
                EXPENSE:
              Deposits
            
            
            26,910,374
            
            
            18,191,383
            
            
            12,292,125FHLB
                and other advances
            
            
            13,161,991
            
            
            8,987,941
            
            
            6,800,38840,072,365
            
            
            27,179,324
            
            
            19,092,513Net
                interest income
            
            
            40,099,878
            
            
            40,183,301
            
            
            36,034,178PROVISION
                FOR LOAN AND LEASE LOSSES:
            
            
            964,868
            
            
            1,500,000
            
            
            1,565,000Net
                interest income after provision for loan and leaselosses
            
            
            39,135,010
            
            
            38,683,301
            
            
            34,469,178NONINTEREST
                INCOME:
              Servicing
                fees, net of amortization
            
            
            1,277,791
            
            
            1,299,620
            
            
            313,988Gain
                on sales of loans
            
            
            3,093,174
            
            
            1,440,571
            
            
            1,757,032Gain
                on sales of investments
            
            
            —
            
            
            —
            
            
            70,870Fees
                on deposit services
            
            
            747,544
            
            
            629,854
            
            
            571,216Other
            
            
            3,002,273
            
            
            1,984,916
            
            
            1,538,770Total
                noninterest income
            
            
            8,120,782
            
            
            5,354,961
            
            
            4,251,876NONINTEREST
                EXPENSE:
              Salaries
                and employee benefits
            
            
            17,395,636
            
            
            16,200,309
            
            
            14,261,840Occupancy
            
            
            4,049,867
            
            
            3,512,255
            
            
            2,786,407Credit
                insurance premiums
            
            
            1,782,400
            
            
            1,506,496
            
            
            1,101,802Other
            
            
            7,265,861
            
            
            7,118,330
            
            
            6,464,421Total
                noninterest expense
            
            
            30,493,764
            
            
            28,337,390
            
            
            24,614,470Income
                before provision for federal income taxes
            
            
            16,762,028
            
            
            15,700,872
            
            
            14,106,584PROVISION
                FOR FEDERAL INCOME TAXES:
              Current
            
            
            6,364,366
            
            
            5,383,223
            
            
            4,270,771Deferred
            
            
            (582,000
            )
            
            (1,000
            )
            
            548,0005,782,366
            
            
            5,382,223
            
            
            4,818,771NET
                INCOME
            
            $
            10,979,662
            
            $
            10,318,649
            
            $
            9,287,813




See
      accompanying notes.





39


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




**CONSOLIDATED
      STATEMENTS OF INCOME (Continued)**




**Years
                Ended December 31,****2006**
            
            **2005**
            
            **2004**PER
                SHARE DATA
              Basic
                earnings per common share(1)
            
            $
            1.65
            
            $
            1.55
            
            $
            1.41Earnings
                per common share assuming dilution(1)
            
            $
            $1.60
            
            $
            1.49
            
            $
            1.34WEIGHTED
                AVERAGE SHARES OUTSTANDING(1)
            
            
            6,650,209
            
            
            6,643,270
            
            
            6,580,515WEIGHTED
                AVERAGE SHARES OUTSTANDING INCLUDING
              DILUTIVE
                STOCK OPTIONS(1)
            
            
            6,864,095
            
            
            6,928,474
            
            
            6,892,073








(1)
      Shares and EPS have been adjusted for a 10% stock dividend paid April 7, 2004
      and a five-for-four stock split paid on October 4, 2006.







See
      accompanying notes.




40


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




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




**Additional**
            
            
            
            **Accumulated
                Other****Common
                Stock**
            
            **Paid-in**
            
            **Retained**
            
            **Comprehensive****Shares(1)**
            
            **Amount(1)**
            
            **Capital(1)**
            
            **Earnings(1)**
            
            **Income
                (Loss)**
            
            **Total**BALANCE,
                December 31, 2003
            
            
            5,912,116
            
            $
            5,912,116
            
            $
            32,495,758
            
            $
            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
            
            
            100,871
            
            
            100,871
            
            
            1,118,129
            
            
            
            
            
            
            
            
            1,219,000Issuance
                of stock through employees’ stock plans
            
            
            2,524
            
            
            2,524
            
            
            47,487
            
            
            
            
            
            
            
            
            50,01110%
                stock dividend
            
            
            595,100
            
            
            595,100
            
            
            10,611,823
            
            
            (11,206,923
            )
            
            
            
            
            —Cash
                dividend declared ($0.26 per share)
            
            
            
            
            
            
            
            
            
            
            
            (1,693,092
            )
            
            
            
            
            (1,693,092
            )BALANCE,
                December 31, 2004
            
            
            6,610,611
            
            
            6,610,611
            
            
            44,273,197
            
            
            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
            
            
            185,639
            
            
            185,639
            
            
            1,726,469
            
            
            
            
            
            
            
            
            1,912,108Retirement
                of shares repurchased
            
            
            (180,045
            )
            
            (180,045
            )
            
            (2,130,266
            )
            
            (1,343,882
            )
            
            
            
            
            (3,654,193
            )Issuance
                of stock through employees’ stock plans
            
            
            4,808
            
            
            4,808
            
            
            95,188
            
            
            
            
            
            
            
            
            99,996Cash
                dividend declared ($1.11 per share)
            
            
            
            
            
            
            
            
            
            
            
            (7,317,688
            )
            
            
            
            
            (7,317,688
            )BALANCE,
                December 31, 2005
            
            
            6,621,013
            
            
            6,621,013
            
            
            43,964,588
            
            
            10,877,529
            
            
            (1,435,830
            )
            
            60,027,300Comprehensive
                income:Net
                income
            
            
            
            
            
            
            
            
            
            
            
            10,979,662
            
            
            
            
            
            10,979,662Other
                comprehensive income/(loss), net of tax:Unrealized
                gain on securities available-for-sale
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            75,349
            
            
            75,349Total
                comprehensive income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            11,055,011Compensation
                related to stock options
            
            
            
            
            
            
            
            
            632,579
            
            
            
            
            
            
            
            
            632,579Options
                exercised, including tax benefit of $109,598
            
            
            47,950
            
            
            47,950
            
            
            427,095
            
            
            
            
            
            
            
            
            475,045Cash
                in lieu of shares issued for the five-for-four stock split
            
            
            (255
            )
            
            (255
            )
            
            
            
            
            
            
            
            
            
            
            (255
            )Issuance
                of stock through employees’ stock plans
            
            
            4,820
            
            
            4,820
            
            
            95,166
            
            
            
            
            
            
            
            
            99,986Cash
                dividend declared ($0.32 per share)
            
            
            
            
            
            
            
            
            
            
            
            (2,268,143
            )
            
            
            
            
            (2,268,143
            )BALANCE,
                December 31, 2006
            
            
            6,673,528
            
            $
            6,673,528
            
            $
            45,119,428
            
            $
            19,589,048
            
            $
            (1,360,481
            )
            $
            70,021,523





(1)
            The
                number and amount of common shares have been adjusted for a 10% stock
                dividend paid April 7, 2004 and a five-for-four stock split paid
                onOctober
                4, 2006.




See
      accompanying notes.


41


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




**CONSOLIDATED
      STATEMENTS OF CASH FLOWS**




**2006**
            
            **2005**
            
            **2004**OPERATING
                ACTIVITIES:
              Net
                income
            
            $
            10,979,662
            
            $
            10,318,649
            
            $
            9,287,813Adjustments
                to reconcile net income to net cash fromoperating
                activities:
              Provision
                for loan and lease losses
            
            
            964,868
            
            
            1,500,000
            
            
            1,565,000Depreciation
                and amortization
            
            
            2,060,476
            
            
            1,651,039
            
            
            1,320,965Deferred
                loan origination fees, net of accretion
            
            
            942,140
            
            
            (121,537
            )
            
            68,237Amortization
                of servicing assets
            
            
            1,464,722
            
            
            952,704
            
            
            871,725Gain
                on sales of loans
            
            
            (3,093,174
            )
            
            (1,440,571
            )
            
            (1,757,032
            )(Gain)/loss
                on sale of repossessed real estate andother
                assets
            
            
            329
            
            
            —
            
            
            (5,452
            )Gain
                on sale of securities available-for-sale
            
            
            —
            
            
            —
            
            
            (70,870
            )FHLB
                stock dividends
            
            
            —
            
            
            (52,900
            )
            
            (338,800
            )Stock
                based compensation
            
            
            632,579
            
            
            —
            
            
            —Excess
                tax benefit from stock based compensation
            
            
            (109,598
            )
            
            —
            
            
            —Deferred
                federal income taxes
            
            
            582,000
            
            
            1,000
            
            
            (548,000
            )Changes
                in operating assets and liabilities:
              Loans
                receivable, held-for-sale
            
            
            950,575
            
            
            (4,619,352
            )
            
            79,164Accrued
                interest receivable
            
            
            (183,258
            )
            
            (1,050,362
            )
            
            (651,099
            )Other
                assets
            
            
            (867,592
            )
            
            (1,712
            )
            
            323,810Drafts
                payable
            
            
            579,851
            
            
            355,959
            
            
            20,558Accounts
                payable and other liabilities
            
            
            (2,954,529
            )
            
            (3,835,999
            )
            
            378,278Advance
                payments by borrowers for taxes andinsurance
            
            
            (88,597
            )
            
            (4,679
            )
            
            (51,170
            )Federal
                income taxes
            
            
            (730,249
            )
            
            (444,660
            )
            
            1,232,044Net
                cash provided by operating activities
            
            
            11,130,205
            
            
            3,207,579
            
            
            11,725,171INVESTING
                ACTIVITIES:
              Loan
                originations
            
            
            (409,068,800
            )
            
            (454,150,263
            )
            
            (365,831,641
            )Loan
                principal repayments
            
            
            412,756,638
            
            
            348,668,585
            
            
            270,908,995Increase/(decrease)
                in undisbursed loan proceeds
            
            
            (21,965,826
            )
            
            36,145,078
            
            
            9,282,872Principal
                repayments and redemptions on mortgage-backed
                and other securities
            
            
            33,362,994
            
            
            20,406,369
            
            
            25,840,035Purchase
                of securities held-to-maturity
            
            
            —
            
            
            (1,015,435
            )
            
            (1,126,983
            )Purchase
                of securities available-for-sale
            
            
            (7,170,095
            )
            
            (10,235,677
            )
            
            (72,897,074
            )Purchase
                of premises and equipment
            
            
            (4,194,116
            )
            
            (7,178,708
            )
            
            (5,146,784
            )Purchase
                of FHLB stock
            
            
            —
            
            
            (150,700
            )
            
            (1,544,400
            )Proceeds
                from sale of securities
            
            
            —
            
            
            —
            
            
            2,228,958Proceeds
                from sale of impaired loan
            
            
            340,000
            
            
            —
            
            
            —Proceeds
                from sale of real estate held-for-sale
            
            
            —
            
            
            —
            
            
            116,275Net
                cash provided/(used) by investing activities. . .
            
            
            4,060,795
            
            
            (67,510,751
            )
            
            (138,169,747
            )







See
      accompanying notes.


42


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




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




**Years
                Ended December 31,****2006**
            
            **2005**
            
            **2004**FINANCING
                ACTIVITIES:
              Net
                increase in deposit accounts
            
            
            20,558,306
            
            
            68,322,366
            
            
            80,056,903Interest
                credited to deposit accounts
            
            
            24,515,961
            
            
            17,029,363
            
            
            11,421,357Issuance
                of stock through employees’ stock plan
            
            
            99,986
            
            
            99,996
            
            
            50,011Proceeds
                from advances
            
            
            776,166,000
            
            
            960,624,500
            
            
            983,802,196Repayment
                of advances
            
            
            (829,938,698
            )
            
            (966,126,270
            )
            
            (942,138,299
            )Dividends
                paid
            
            
            (7,486,396
            )
            
            (1,969,527
            )
            
            (1,548,206
            )Cash
                in lieu of shares issued for five-for-four stocksplit
            
            
            (255
            )
            
            —
            
            
            —Proceeds
                  from exercise of stock options and excess tax benefit of $109,598,
                  $478,492, and $337,052, respectively, from stock based compensation
            
            
            475,045
            
            
            1,912,108
            
            
            1,219,000Repurchase/retirement
                of common stock
            
            
            —
            
            
            (3,654,193
            )
            
            —Net
                cash provided/(used) by financing activities
            
            
            (15,610,051
            )
            
            76,238,343
            
            
            132,862,962NET
                INCREASE/(DECREASE) IN CASH AND CASHEQUIVALENTS
            
            
            (419,051
            )
            
            11,935,171
            
            
            6,418,386CASH
                AND CASH EQUIVALENTS
              Beginning
                of year
            
            
            25,780,612
            
            
            13,845,441
            
            
            7,427,055End
                of year
            
            $
            25,361,561
            
            $
            25,780,612
            
            $
            13,845,441SUPPLEMENTAL
                DISCLOSURES OF CASH FLOWINFORMATION
              Loans
                originated for sale in the secondary market
            
            $
            137,150,286
            
            $
            71,831,162
            
            $
            103,885,786Loans
                originated for investment activities
            
            $
            409,068,800
            
            $
            454,150,263
            
            $
            365,831,641Proceeds
                from sale of loans held-for-sale
            
            $
            138,100,861
            
            $
            67,211,810
            
            $
            103,964,950Cash
                paid during the year for:Interest
            
            $
            39,777,692
            
            $
            26,823,867
            
            $
            18,778,254Income
                taxes
            
            $
            5,860,000
            
            $
            4,928,013
            
            $
            3,931,000







See
      accompanying notes.




43


**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 2005 and 2004 financial
        statements to conform to the 2006
        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.
  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 offices in
        Orange Park, Florida and Mt. Clemens,
        Michigan. The Bank accepts deposits from the general public, provides lending
        services to citizens of Washington, Oregon, and Idaho and offers consumer
        home
        improvement loans to borrowers in 45 states.
  *Variable
        Interest Entities —* The
        following Trusts are considered variable interest entities as defined in
        FASB
        Interpretation No. 46R, *Consolidation
        of Variable Interest Entities (revised December 2003),* which
        are: (1) the entity has equity that is insufficient to permit the entity
        to
        finance its activities without additional subordinated financial support
        from
        other parties, or (2) the entity has equity investors that cannot make
        significant decisions about the entity’s operations or that do not absorb the
        expected losses or receive the expected returns of the entity.
  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
        has a significant variable interest in the Trusts, however they are not
        consolidated because the Bank is
        not the primary beneficiary.
  *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 and lease losses, the value of servicing assets, the value
        of
        loans held for sale, the
 
 44
 **FIRST
        MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**
  useful
        lives of fixed assets, credit insurance premiums payable, amortization of
        deferred loan fees/costs, the value
        of
        derivative instruments, the calculations to determine the value of stock
        option
        expense, deferred taxes, and the
        valuation of real estate acquired in connection with foreclosures or in
        satisfaction of loans. In connection with the determination of the allowance
        for
        loan and lease 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.
  *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 2006, 2005, and 2004.
  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 2006, the FHLB revised its
        capital structure from the issuance of two classes of stock, B(1) and B(2),
        to a
        single Class B stock. Class B stock will continue to have a five-year redemption
        period. Our stock purchase requirement to support new or renewing advances
        is 4%
        of advances outstanding. If all of our Class B stock has been used to support
        our outstanding advances, we will have the ability to access the FHLB’s excess
        stock pool for advances with maturities of one year or less, and/or purchase
        the
        newly created Class A stock to support new or renewing advances. Class A
        stock
        will have a six-month redemption period. Included in the balance sheet as
        of
        December 31, 2006, we had $13.1 million of Class B stock and as of December
        31,
        2005, we had $13.1 million of Class B(1) stock. We held no class B(2) stock
        in
        2005.
  *Loans
        Held-For-Sale —* Loans
        originated and intended for sale in the secondary market 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
 
 45
 **FIRST
        MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**
  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.
  *Allowance
        for Loan and Lease Losses —* The
        allowance for loan and lease losses is established as losses are
        estimated to have occurred through a provision for loan and lease losses
        charged
        to earnings. Loan and lease losses are charged against the allowance when
        management believes the uncollectibility of a loan or lease balance is
        confirmed. Subsequent recoveries, if any, are credited to the
        allowance.
  The
        allowance for loan and lease 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 and leases in light of historical experience, the nature and volume
        of the
        loan and lease portfolios, 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 or leases 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 or
        lease 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/lease 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 or leases that experience
        insignificant payment delays and payment shortfalls generally are not classified
        as impaired. Management determines the significance of payment delays and payment
        shortfalls on a case-by-case basis, taking into consideration all of the
        circumstances surrounding the  loan
        and
        the borrower, including the length of delay, the reasons for the delay, the
        borrower’s prior payment  record,
        and the amount of the shortfall in relation to the principal and interest
        owed.
        Impairment is measured on a
        loan-by-loan basis for commercial and construction loans by either the present
        value of 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.
 
 46
 **FIRST
        MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**
  Large
        groups of smaller balance, homogeneous loans or leases are collectively
        evaluated for impairment. Accordingly, we do not separately identify individual
        consumer loans or leases 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
        initially recorded at fair value less cost to sell at the date of foreclosure,
        establishing a new cost basis. Subsequent to foreclosure, valuations are
        periodically performed by management and the assets are carried at the lower
        of
        carrying amount or fair value less cost to sell. Revenue and expenses from
        operations and changes
        in the valuation allowance are included in net expenses from foreclosed assets.
        The amounts that will ultimately be recovered from foreclosed assets may differ substantially from
        the
        carrying value of the assets because of future market factors beyond
        management’s control.
  *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 estimated
        future
        cash flows. Assumptions used in the valuation
        model include market discounts rates and anticipated prepayment speeds. The
        prepayment speeds of the
        servicing asset portfolio are based on the Bank’s prepayment experience. Our
        servicing asset portfolio consists of sales finance loans, construction loan
        participations, lot loans and other income property loans of which there
        is no
        readily available online quotation system 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 —* Land
        is
        carried at cost. Buildings and equipment are carried at cost, less accumulated
        depreciation and amortization computed on the straight-line method over the
        estimated useful lives of the assets or the expected terms of the leases,
        if
        shorter. Expected terms include lease option periods to the extent that the
        exercise of such options is reasonably assured. Following are the ranges
        of
        estimated useful lives:
  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 —* In
        December 2004, the Financial Accounting Standards Board (FASB) issued Statement
        of Financial Accounting Standards No. 123(R) (SFAS 123(R)), *Share-Based
        Payment,* which
        is
        a revision of Statement of Financial Accounting Standards No. 123 (SFAS 123), *Accounting
        for Stock-Based Compensation.*
  SFAS
        123(R) eliminates accounting for share-based compensation transactions using
        the
        intrinsic value method prescribed in Accounting Principles Board Opinion
        No. 25
        (APB 25), *Accounting
        for Stock Issued to*
 
 47
 **FIRST
        MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**
  *Employees,* and
        requires instead that such transactions be accounted for using a
        fair-value-based method. The Company
        has elected to adopt the provisions of SFAS 123(R) effective January 1, 2006,
        under the modified prospective transition method, in which compensation cost
        was
        recognized beginning with the effective date (a) based on the requirements
        of
        SFAS 123(R) for all share-based payments granted after the effective date
        and
        (b) based on the requirements of SFAS 123(R) for all awards granted to employees
        prior to the effective date of SFAS 123(R) that remain unvested on the effective
        date.
  As
        permitted under SFAS 123, we elected to follow Accounting APB 25, and related
        interpretations in accounting
        for stock-based awards to employees through December 31, 2005. Accordingly,
        no
        compensation cost for
        stock options was recorded at the date of grant.
  With
        the
        adoption of SFAS 123(R), we elected to amortize stock-based compensation
        for
        awards granted on or after the adoption of SFAS 123(R) on January 1, 2006,
        on a
        straight-line basis over the requisite service (vesting) period for the entire
        award. For awards granted prior to January 1, 2006, compensation costs are
        amortized in a manner consistent with APB 25. This is the same manner applied
        in
        the pro forma disclosures under SFAS 123.
  At
        December 31, 2006, we had four stock-based employee/director compensation
        plans,
        which are described
        more fully in Note 16 — Stock Option Plans. The plans are accounted for under
        the recognition and measurement principles of SFAS 123(R), and related interpretations. Stock-based
        employee or director compensation cost is reflected in net income for 2006.
        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 123(R) had been adopted in 2004 and
        2005.
  **2005**
              
              **2004**Net
                  income, as reported
              
              $
              10,318,649
              
              $
              9,287,813Deduct:
                  Total stock-based employee/director compensation expensedetermined
                  under fair value based method for all awards, net ofrelated
                  tax effects(1)
              
              
              (569,555
              )
              
              (445,047
              )Pro
                  forma net income
              
              $
              9,749,094
              
              $
              8,842,766Earnings
                  per share:
                Basic
                  — as reported
              
              $
              1.55
              
              $
              1.41Basic
                  — pro forma
              
              $
              1.46
              
              $
              1.34Diluted
                  — as reported
              
              $
              1.49
              
              $
              1.34Diluted
                  — pro forma
              
              $
              1.42
              
              $
              1.28Weighted
                  average shares outstanding:
                Basic
              
              
              6,643,270
              
              
              6,580,515Diluted
              
              
              6,928,474
              
              
              6,892,073
 
 (1)   
        A Black-Scholes option pricing model was used to determine the fair value
        of the
        options granted
  As
        a
        result of adopting SFAS 123(R) on January 1, 2006, income before taxes and
        net
        income for the year ended December 31, 2006 are $632,579 and $408,691 lower,
        respectively, than if we had continued to account for share-based compensation
        under APB No. 25. Basic and diluted earnings per share for year 2006 would
        have been $1.71 and $1.66, respectively, had we not adopted SFAS 123(R),
        compared to reported basic and
        diluted earnings per share of $1.65 and $1.60, respectively. Prior to adopting
        SFAS 123(R), we presented all tax benefits of deductions resulting from the
        exercise of stock options as operating cash flows in the Consolidated Statements
        of Cash Flows. SFAS 123(R) requires the cash flows from the tax benefits
        resulting from tax deductions in excess of the compensation cost recognized
        for
        those options (excess tax benefits) to
 
 48
 **FIRST
        MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**
  be
        classified as financing cash flows. The $109,598 excess tax benefit classified
        as a financing cash flow would
        have been classified as an operating cash inflow if we had not adopted SFAS
        123(R).
  Compensation
        cost is recorded as if each vesting portion of the award is a separate award.
        Share-based compensation
        expense recognized for stock options was $632,579 for the year ended December
        31, 2006. The total
        related to income tax benefits recognized was $99,687 for the year ended
        December 31, 2006.
  *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 $761,000, $1.2
        million, and $1.1 million for the years ended December 31, 2006, 2005, and
        2004,
        respectively.
  *Interest
        Rate Risk Management —* For
        asset/liability management purposes, we use interest rate swap agreements
        to
        hedge various exposures or to modify interest rate characteristics of some
        balance sheet accounts. 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. The swap agreements are derivative instruments and convert variable-rate instruments
        to
        fixed rate or vice versa.
  The
        gain
        or loss on a derivative designated and qualifying as a fair value hedging
        instrument, as well as the
        offsetting gain or loss on the hedged item attributable to the risk being
        hedged, is recognized currently in earnings
        in the same accounting period. 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
        instrument, if any, is recognized currently in earnings.
  For
        cash
        flow hedges, 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. For fair value hedges,
        the net
        settlement (upon close-out or termination) that offsets changes in the value
        of
        the loans adjusts the basis of the loans and is deferred and amortized to
        loan
        interest income over the life of the loans. 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.
  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 Company to risk.
        Those derivative financial instruments that do not meet specified hedging criteria would be recorded
        at
        fair value with changes in fair value
        recorded in income. If periodic assessment indicates derivatives no longer
        provide an effective hedge, the
        derivative contracts would be closed or settled, or classified as a trading
        activity.
  Cash
        flows resulting from the derivative financial instrument 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.
  *Derivative
        Loan Commitments (Rate Lock Commitments) —* Mortgage
        loan commitments are referred to as derivative loan commitments if the loan
        that
        will result from exercise of the commitment will be held-for-sale upon funding.
        Loan commitments that are derivatives are recognized at fair value on the
        consolidated balance sheet in other assets or other liabilities with changes
        in
        their fair values recorded in net gain on sale of loans.
 
 49
 **FIRST
        MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**
  We
        record
        a zero value for the loan commitment at inception at the time the commitment
        is
        issued to a borrower (“the time of rate lock”), consistent with EITF 02-3, *Issues
        Involved in Accounting for Derivative Contracts Held for Trading Purposes
        and
        Contracts Involved in Energy Trading and Risk Management Activities,* and
        SEC
        Staff Accounting Bulletin No. 105, *Application
        of Accounting Principles to Loan Commitments,* and,
        accordingly, do not recognize the value of the expected normal servicing
        rights
        until the underlying loan is sold. Subsequent to inception, changes in the
        fair
        value of the loan commitment are recognized based on changes in the fair
        value
        of the underlying mortgage loan due to interest rate changes, changes in
        the
        probability the derivative loan commitment will be exercised, and the passage
        of
        time. In estimating fair value, we assign a probability to a loan commitment
        based on an expectation that it will be exercised and the loan will be
        funded.
  *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 swaps, net of tax. Comprehensive
        income is presented in the consolidated statement of shareholders’
equity.
  *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 13 — Earnings Per
        Share.
  *Recent
        Accounting Pronouncements -* In
        March
        of 2006, the FASB published SFAS No. 156, *Accounting
        for Servicing of Financial Assets* (SFAS
        156), which amends SFAS No. 140 *Accounting
        for Transfers and Servicing of Financial Assets and Extinguishments of
        Liabilities,* with
        respect to the accounting for servicing of financial assets. SFAS 156 requires
        that all separately recognized servicing rights be initially measured at
        fair
        value, if practicable. For each class of separately recognized servicing
        assets
        and liabilities, SFAS 156 permits an entity to choose either of the following
        subsequent measurement methods: (1) the amortization of servicing assets
        or
        liabilities in proportion to and over the period of estimated net servicing
        income or net servicing loss or (2) the reporting of servicing assets or
        liabilities at fair value at each reporting date and reporting changes in
        fair
        value in earnings in the period in which the changes occur. SFAS 156 also
        requires additional disclosures for all separately recognized servicing rights.
        Early adoption is permitted as of the beginning of an entity’s fiscal year,
        provided the entity has not yet issued financial statements, including interim
        financial statements, for any period of that fiscal year. SFAS 156 is effective
        the earlier of the date an entity adopts the requirements of SFAS 156, or
        as of
        the beginning of its first fiscal year beginning after September 15, 2006.
        An
        entity should apply the requirements for recognition and initial measurement
        of
        servicing assets and servicing liabilities prospectively to all transactions
        after the effective date of SFAS 156. Management has made the decision to
        continue to amortize the servicing assets or liabilities in proportion to
        and
        over the period of estimated net servicing income or net servicing loss
        effective January 1, 2007.
 
 50
 **FIRST
        MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**
  In
        July
        2006, the FASB issued Interpretation No. 48 (FIN 48), *Accounting
        for Uncertainty in Income* *Taxes,* an
        interpretation of FASB Statement No. 109, which seeks to reduce the diversity
        in
        practice associated with the
        accounting and reporting for uncertainty in income tax positions. This
        Interpretation prescribes a comprehensive model for the financial statement
        recognition, measurement, presentation, and disclosure of uncertain tax
        positions taken or expected to be taken in income tax returns. FIN 48 is
        effective for fiscal years beginning after December 15, 2006. We will adopt
        the
        new requirements in the first quarter of 2007. The cumulative effects, if
        any,
        of adopting FIN 48 will be recorded as an adjustment to retained earnings
        as of
        the beginning of 2007. The adoption of FIN 48 is not expected to have a
        significant impact on our consolidated financial statements.
  In
        September 2006, the FASB issued SFAS No. 157, *Fair
        Value Measurements* (SFAS
        157), which defines fair value, establishes a framework for measuring fair
        value
        in GAAP, and expands disclosures about fair
        value measurements. SFAS 157 is effective for financial statements issued
        for
        fiscal years beginning after  November
        15, 2007, and interim periods within those fiscal years. Early adoption is
        permitted. We must adopt these
        new requirements no later than the first quarter of 2008. We have not yet
        determined the effects on our consolidated financial statements, if any,
        upon
        adoption of SFAS 157, or if we will adopt the requirements prior to the first
        quarter of 2008.
  In
        September 2006, the SEC staff issued Staff Accounting Bulletin No. 108, *Considering
        the Effects of Prior Year Misstatements when Quantifying Misstatements in
        Current Year Financial Statements* (SAB
        108). The intent of SAB 108 is to reduce diversity in practice for the method
        companies use to quantify financial statement misstatements, including the
        effect of prior year uncorrected errors. SAB 108 establishes an approach
        that
        requires quantification of financial statement errors using both an income
        statement and cumulative
        balance sheet approach. SAB 108 is effective for fiscal years beginning after
        November 15, 2006. We will
        adopt this new requirement in the first quarter of 2007. The adoption of
        SAB 108
        is not currently expected to have a significant impact on our consolidated
        financial statements.
  **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 $2.1 million and $4.5
        million for the years ended December 31, 2006 and 2005,
        respectively.
     
 51
 **FIRST
        MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**
  **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, 2006 and 2005 are summarized as follows:
  **Amortized**
                **Cost**
              
              **Gross**
                **Unrealized**
                **Gains**
              
              **Gross**
                **Unrealized**
                **Losses**
                <**1
                  Year**
              
              **Gross**
                **Unrealized**
                **Losses**
                >**1
                  Year**
              
              **Estimated**
                **Fair
                  Value**December
                  31, 2006:Freddie
                  Mac securities
              
              $
              14,656,640
              
              $
              9,291
              
              $
              —
              
              $
              565,256
              
              $
              14,100,675Fannie
                  Mae securities
              
              
              32,222,236
              
              
              7,885
              
              
              —
              
              
              1,090,027
              
              
              31,140,094Ginnie
                  Mae securities
              
              
              34,052,801
              
              
              2,416
              
              
              —
              
              
              397,321
              
              
              33,657,896US
                  agency securities
              
              
              10,990,633
              
              
              —
              
              
              —
              
              
              161,313
              
              
              10,829,320$
              91,922,310
              
              $
              19,592
              
              $
              —
              
              $
              2,213,917
              
              $
              89,727,985
 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
              
              $
              114,450,342
  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 in fair value. At December 31, 2006 and 2005
        there
        were 32 and 34 investment securities, respectively, 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 2006, 2005, and 2004 were $0, $0, and
        $2,228,958, respectively.
        Gross gains on those sales were $0, $0, and $70,870, respectively. No gross
        losses were realized on sales
        during 2006, 2005, and 2004.
  The
        amortized cost and estimated fair value of mortgage-backed and other securities
        available-for-sale at December 31, 2006, by contractual maturity, are shown
        below. Expected maturities will differ from
  
 52
 **FIRST
        MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**
  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
              
              $
              —
              
              $
              —Due
                  after one year through five years
              
              
              9,418,845
              
              
              9,157,541Due
                  after five years through ten years
              
              
              —
              
              
              —Due
                  after ten years
              
              
              82,503,465
              
              
              80,570,444$
              91,922,310
              
              $
              89,727,985
  **Note
        4— Mortgage-Backed and Other Securities Held-to-Maturity**
  The
        amortized cost and estimated fair value of mortgage-backed and other securities
        held-to-maturity are summarized as follows:
  **Amortized**
                **Cost**
              
              **Gross**
                **Unrealized**
                **Gains**
              
              **Gross**
                **Unrealized**
                **Losses**
                <**1
                  Year**
              
              **Gross**
                **Unrealized**
                **Losses**
                >**1
                  Year**
              
              **Estimated**
                **Fair
                  Value**December
                  31, 2006:Fannie
                  Mae securities
              
              $
              4,176,674
              
              $
              34,545
              
              
              —
              
              $
              $74,055
              
              $
              4,137,164Freddie
                  Mac securities
              
              
              299,700
              
              
              6,854
              
              
              —
              
              
              —
              
              
              306,554Municipal
                  bonds
              
              
              1,143,704
              
              
              1,443
              
              
              —
              
              
              3,786
              
              
              1,141,361$
              5,620,078
              
              $
              42,842
              
              
              —
              
              $
              $77,841
              
              $
              5,585,079December
                  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
              
              $
              6,970,890
  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 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.
 
 53
 **FIRST
        MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**
  The
        amortized cost and estimated fair value of mortgage-backed and other securities
        held-to-maturity at December
        31, 2006, by contractual maturity, are shown below. There were no sales from
        the
        held-to-maturity portfolio during 2006, 2005, or 2004.
  **Amortized**
                **Cost**
              
              **Estimated**
                **Fair
                  Value**Due
                  less than one year
              
              $
              —
              
              $
              —Due
                  after one year through five years
              
              
              217,984
              
              
              219,743Due
                  after five years through ten years
              
              
              —
              
              
              —Due
                  after ten years
              
              
              5,402,094
              
              
              5,365,336$
              5,620,078
              
              $
              5,585,079
 
  At
        December 31, 2006, the fair value and amortized cost of pledged securities
        for
        public deposits and for other
        purposes required or permitted by law totaled $34,956,000 and $35,863,000,
        respectively. The respective amounts
        of pledged securities as of December 31, 2005 were $45,122,000 and
        $45,905,000.
  **Note
        5— Loans Receivable, Net and Loans Receivable
        Held-for-Sale**
  Loans
        receivable consisted of the following as of
        December 31:
  **2006**
              
              **2005**Real
                  estate:
                Single-family
                  residential
              
              $
              264,332,818
              
              $
              223,927,585Single-family
                  construction
              
              
              159,651,447
              
              
              188,148,362Income
                  property:
                Commercial
                  construction
              
              
              45,550,139
              
              
              35,153,390Commercial
                  real estate
              
              
              163,324,755
              
              
              191,719,514Multifamily
                  construction
              
              
              29,910,570
              
              
              24,980,916Multifamily
                  residential
              
              
              138,351,552
              
              
              153,987,722Consumer
                  and other
              
              
              99,657,623
              
              
              115,940,966Business
                  loans
              
              
              95,954,821
              
              
              67,223,270996,733,725
              
              
              1,001,081,725Less:
                Net
                  deferred loan origination costs and other
              
              
              333,505
              
              
              1,280,027Undisbursed
                  loan proceeds
              
              
              (87,602,460
              )
              
              (109,568,286
              )Reserve
                  for loan and lease losses
              
              
              (9,728,446
              )
              
              (10,069,020
              )Unearned
                  discount on purchased leases
              
              
              (2,300,350
              )
              
              (43,718
              )897,435,974
              
              
              882,680,728Loans
                  receivable held-for-sale
              
              
              (13,732,932
              )
              
              (14,683,507
              )Loans
                  receivable, net
              
              $
              883,703,042
              
              $
              867,997,221
  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 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.
 
 54
 **FIRST
        MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**
  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
        is
        located, are as follows at December 31, 2006:
  **King
                  County**
              
              **Snohomish**
                **County**
              
              **Pierce**
                **County**
              
              **Kitsap**
                **County**
              
              **Oregon**
              
              **Other**
              
              **Total**Income
                  property:
                Commercialconstruction
              
              $
              9,032,335
              
              $
              12,361,469
              
              $
              9,747,500
              
              $
              —
              
              $
              8,779,445
              
              $
              5,629,390
              
              $
              45,550,139Commercial
                  realestate
              
              
              92,252,650
              
              
              18,757,144
              
              
              26,599,998
              
              
              2,189,025
              
              
              9,992,195
              
              
              13,533,743
              
              
              163,324,755Multifamilyconstruction
              
              
              25,839,199
              
              
              —
              
              
              —
              
              
              —
              
              
              4,071,371
              
              
              —
              
              
              29,910,570Multifamilyresidential
              
              
              42,948,213
              
              
              13,363,084
              
              
              34,532,505
              
              
              7,188,966
              
              
              20,843,593
              
              
              19,475,191
              
              
              138,351,552$
              170,072,397
              
              $
              44,481,697
              
              $
              70,880,003
              
              $
              9,377,991
              
              $
              43,686,604
              
              $
              38,638,324
              
              $
              377,137,016
  The
        loan
        portfolio includes both adjustable and fixed interest rate loans. At December
        31, 2006, the composition of those loans was as follows:
  **Fixed
                  Rate**
              
              **Adjustable**
                **Rate**
              
              **Total**Term
                  to maturity or rate adjustment:Due
                  within one year
              
              $
              8,239,777
              
              $
              455,574,471
              
              $
              463,814,248After
                  one but within three years
              
              
              32,986,631
              
              
              90,738,957
              
              
              123,725,588After
                  three but within five years
              
              
              48,618,410
              
              
              100,597,495
              
              
              149,215,905After
                  five but within ten years
              
              
              46,366,688
              
              
              70,277,959
              
              
              116,644,647After
                  ten years
              
              
              43,596,911
              
              
              438,675
              
              
              44,035,586$
              179,808,417
              
              $
              717,627,557
              
              $
              897,435,974
  Single-family,
        adjustable-rate loans typically have both periodic and lifetime adjustment
        limitations. Income property permanent adjustable-rate loans generally only
        have
        lifetime adjustment limitations. Both types of adjustable-rate loans are
        generally indexed to either the FHLB’s cost of funds, the one-year London Interbank
        Offering Rate (LIBOR), or the one-, three-, or five-year Constant Maturity
        Treasury (CMT) 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 and lease losses is as follows
        for the years ended December 31:
  **2006**
              
              **2005**
              
              **2004**Balance,
                  beginning of year
              
              $
              10,069,020
              
              $
              9,300,854
              
              $
              8,406,198Provision
                  for loan and lease losses
              
              
              964,868
              
              
              1,500,000
              
              
              1,565,000Charge-offs
              
              
              (1,582,552
              )
              
              (1,045,962
              )
              
              (913,645
              )Recoveries
              
              
              603,149
              
              
              314,128
              
              
              243,301Balance,
                  end of year
              
              
              10,054,485
              
              
              10,069,020
              
              
              9,300,854Amount
                  reclassified for unfunded commitments
              
              
              (326,039
              )
              
              —
              
              
              —Balance,
                  end of year
              
              $
              9,728,446
              
              $
              10,069,020
              
              $
              9,300,854
 
 55
 **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:
  **2006**
              
              **2005**Impaired
                  loans with a valuation allowance
              
              $
              1,283,170
              
              $
              308,645Valuation
                  allowance related to impaired loans
              
              
              (236,125
              )
              
              (172,475
              )Net
                  impaired loans
              
              
              1,047,045
              
              
              136,170Non-accrual
                  loans
              
              
              2,414,630
              
              
              761,020Total
                  non-accrual loans
              
              $
              3,461,675
              
              $
              897,190
  **2006**
              
              **2005**
              
              **2004**Total
                  loans past due 90-days or more and still accruing interest
              
              $
              —
              
              $
              —
              
              $
              34,000Average
                  investment of impaired loans
              
              $
              591,608
              
              $
              138,002
              
              $
              78,139Interest
                  income recognized on impaired loans
              
              $
              583
              
              $
              793
              
              $
              1,108
  Additional
        funds committed to be advanced in connection with impaired loans totaled
        $161,000.
  The
        Bank
        serviced loans owned by other investors with aggregate principal balances
        of
        $155,025,000, $105,850,000, and $117,852,000 as of December 31, 2006, 2005, and 2004,
        respectively.
  **Note
        6— Servicing Assets and Servicing Fees**
  Changes
        in the servicing assets balance for the years ended December 31 are as
        follows:
  **2006**
              
              **2005**
              
              **2004**Balance,
                  beginning of year
              
              $
              1,865,698
              
              $
              1,525,085
              
              $
              468,413Additions
              
              
              3,610,358
              
              
              1,293,317
              
              
              1,928,398Amortization
              
              
              (1,464,722
              )
              
              (952,704
              )
              
              (871,726
              )Balance,
                  end of year
              
              $
              4,011,334
              
              $
              1,865,698
              
              $
              1,525,085Servicing
                  assets fair value
              
              $
              4,488,079
              
              $
              2,639,052
              
              $
              2,310,233
  There
        were no changes in the valuation for impairment of servicing assets for the
        years ended December 31, 2006, 2005, and 2004.
  Servicing
        fee income, net of amortization, consisted of the following for the years
        ended
        December 31:
  **2006**
              
              **2005**
              
              **2004**Servicing
                  fees
              
              $
              2,742,513
              
              $
              2,252,324
              
              $
              1,185,714Amortization
              
              
              (1,464,722
              )
              
              (952,704
              )
              
              (871,726
              )Loan
                  servicing fees, net
              
              $
              1,277,791
              
              $
              1,299,620
              
              $
              313,988
 56
 **FIRST
        MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**
  At
        December 31, 2006, 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, 2006 is estimated to be as follows:
  2007
              
              $
              1,689,6072008
              
              
              1,289,6552009
              
              
              796,8062010
              
              
              235,266Gross
                    carrying value of servicing assets
              
              $
              4,011,334
 
  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
        2006.
        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.
  **Note
        7— Land, Buildings, and Equipment**
  The
        following is a summary of land, buildings, leasehold improvements, and
        furniture, fixtures, and equipment at December 31:
  **2006**
              
              **2005**Land
              
              $
              13,792,965
              
              $
              13,731,369Buildings
              
              
              24,358,004
              
              
              20,863,538Furniture,
                  fixtures, and equipment
              
              
              5,308,971
              
              
              5,629,939Leasehold
                  improvements
              
              
              863,259
              
              
              1,052,25144,323,199
              
              
              41,277,097Less
                  accumulated depreciation and amortization
              
              
              (8,757,087
              )
              
              (7,793,099
              )$
              35,566,112
              
              $
              33,483,998
  Depreciation
        and amortization expense for the years ended December 31, 2006, 2005, and
        2004
        amounted to $2,060,000, $1,651,000, and $1,321,000, respectively.
  Four
        office locations are leased under operating leases. Total lease obligations
        for
        the next five years are as follows:
  **Year
                Ending December 31,**2007
              
              $
              270,9292008
              
              
              261,8422009
              
              
              221,2182010
              
              
              135,5882011
              
              
              135,588$
              1,025,165
  Total
        lease expenses were $288,000, $322,000, and $313,000 for the years ended
        December 31, 2006, 2005, and 2004, respectively.
 
 57
 **FIRST
        MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**
  Lease
        income totaled $726,000, $627,000, and $627,000 for the years ended December
        31,
        2006, 2005, and 2004, respectively.
  Future
        minimum lease receipts from lessees for the next five years are as
        follows:
  **YearEndingDecember
                    31,**2007
                
                $
                513,5182008
                
                
                489,8722009
                
                
                371,9532010
                
                
                119,8682011
                
                
                37,034$
                1,532,245
  During
        2006 two banking centers were under construction. In accordance with SFAS
        34, *Capitalization* *of
        Interest Cost,* we
        capitalize 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 interest on a $600,000
        note at 6%.
  During
        the year ended December 31, 2006, capitalized interest related to the
        construction of two new banking centers was as follows:
  **CanyonPark**
                
                **West
                    Seattle**Interest
                    capitalized during 2006
                
                $
                89,000
                
                $
                43,000
  The
        total
        interest capitalized in 2006 totaled $132,000. The West Seattle banking center
        was completed in April
        2006 and the interest costs were transferred to the basis of the asset. Interest
        capitalized in 2005 totaled $133,000; no interest was capitalized in
        2004.
  **Note
        8— Deposits**
  Deposits
        consisted of the following at December 31:
  **Weighted**
                **Average
                  Rate****at****December
                  31,**
              
              **2006**
              
              **2005**Terms
              
              **2006**
              
              **Amount**
              
              **Percent**
              
              **Amount**
              
              **Percent**Money
                  market deposit and checking accounts, including noninterest-bearing
                  deposits of $55,360,000 (2006) and $30,914,000 (2005)
              
              
              2.7%
              
              $
              313,693,904
              
              
              39.0%
              
              $
              263,444,641
              
              
              34.6%Savings
              
              
              1.0%
              
              
              6,701,770
              
              
              0.8
              
              
              8,053,510
              
              
              1.1Time
                  deposits:
                1
                  to 6 months
              
              
              4.8%
              
              
              91,852,472
              
              
              11.4
              
              
              25,325,763
              
              
              3.37
                  to 12 months
              
              
              4.7%
              
              
              252,697,770
              
              
              31.4
              
              
              166,316,334
              
              
              21.913
                  to 23 months
              
              
              4.2%
              
              
              72,122,113
              
              
              8.9
              
              
              199,509,548
              
              
              26.22
                  to 10 years
              
              
              4.2%
              
              
              68,726,875
              
              
              8.5
              
              
              98,070,841
              
              
              12.9Total
                  time deposits
              
              
              4.6%
              
              
              485,399,230
              
              
              60.2
              
              
              489,222,486
              
              
              64.3Total
                  deposits
              
              
              3.8%
              
              $
              805,794,904
              
              
              100%
              
              $
              760,720,637
              
              
              100%
 
 58
 **FIRST
        MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**
  Deposits
        at December 31, 2006 and 2005, included public funds of $9,506,000 and
        $5,628,000, respectively. Mortgage-backed securities with a book value of
        $1,129,000 and $935,000 and fair values of $1,120,000 and $954,000 were pledged
        as collateral on these deposits at December 31, 2006 and 2005, respectively,
        which exceeds the minimum collateral requirement established by the Washington
        Public Deposit Protection Commission.
  As
        of
        December 31, 2006, scheduled maturities of time deposits were as
        follows:
  **Year
                Ending December 31,**2007
              
              $
              443,704,7182008
              
              
              18,814,0462009
              
              
              13,537,6122010
              
              
              3,521,4532011
              
              
              5,638,205Thereafter
              
              
              183,196$
              485,399,230
  Included
        in deposits are time deposits greater than or equal to $100,000 of $220,161,000
        and $216,507,000
        at December 31, 2006 and 2005, respectively. Interest on time deposits greater
        than or equal to $100,000
        totaled $9,073,000, $5,916,000, and $4,733,000 for the years ended December
        31,
        2006, 2005, and 2004, respectively. Also included in deposits are accounts
        of
        approximately $7,006,000 and $7,712,000 at December 31, 2006 and 2005,
        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:
  **2006**
              
              **2005**
              
              **2004**Time
                  deposits
              
              $
              20,147,085
              
              $
              14,152,631
              
              $
              9,712,012Money
                  market deposit and checking
              
              
              6,690,147
              
              
              3,967,963
              
              
              2,512,022Savings
              
              
              73,142
              
              
              70,789
              
              
              68,091$
              26,910,374
              
              $
              18,191,383
              
              $
              12,292,125
  Note 9— FHLB and Other Advances
  Borrowings
          consisted of the following at December 31:
 **2006**
              
              **2005**FHLB
                  advances
              
              $
              171,932,307
              
              $
              225,705,005FHLB
                  advances:
                Maximum
                  outstanding at any month end
              
              $
              261,230,693
              
              $
              265,215,985Average
                  outstanding
              
              
              226,033,715
              
              
              235,113,503Weighted
                  average interest rates:
                Annual
              
              
              4.923
              %
              
              3.080
              %End
                  of year
              
              
              5.292
              %
              
              3.777
              %Other
                  advances
              
              $
              4,600,000
              
              $
              4,600,000
 
  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
 
 59
 **FIRST
        MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**
  by
        the
        FHLB, 83% of one-to-four-unit family permanent mortgages, and 80% of multifamily
        permanent loans. 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, 2006 mature as follows:
  **Interest
                  Rates**
              
              **Amount**2007
              
              
              2.52%—5.63%
              
              $
              85,469,8072008
              
              
              3.13%—5.33%
              
              
              21,500,0002009
              
              
              3.65%—5.74%
              
              
              60,250,0002010
              
              
              4.93%
              
              
              4,000,0002011
              
              
              5.19%
              
              
              712,500$
              171,932,307
  The
        other
        advances are comprised of: a $4,000,000 line of credit which matures on February
        28, 2007, with an interest rate of 7.37% 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
        10 — 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 (See Note 21 — Derivative Activities
        and Market Risk). 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 6.5 1% 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.
  The
        Company does not consolidate First Mutual Capital Trust I or II or First
        Mutual
        Statutory Trust III in
        accordance with SFAS Interpretation Number 46R, *Consolidation
        of Variable Interest Entities.*
 
 60
  **FIRST
        MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**
  **Note
        11 — Federal Taxes on Income**
  Deferred
        federal income taxes constitute the differences in the reporting of income
        and
        expense for financial
        statement and income tax purposes. The components of deferred income tax
        provision (benefit) are as
        follows for the years ended December 31:
  **2006**
              
              **2005**
              
              **2004**Loan
                  origination fees and costs
              
              $
              (394,000
              )
              $
              375,000
              
              $
              531,000FHLB
                  stock dividends
              
              
              (45,000
              )
              
              18,000
              
              
              118,000Reserve
                  for loan and lease losses
              
              
              5,000
              
              
              (269,000
              )
              
              (313,000
              )Other,
                  net
              
              
              (148,000
              )
              
              (125,000
              )
              
              212,000$
              (582,000
              )
              $
              (1,000
              )
              $
              548,000
  At
        December 31, the significant components of the net deferred tax
        asset/(liability) were as follows:
 **2006**
              
              **2005**Deferred
                  tax assets:
                Reserve
                  for loan and lease losses
              
              $
              3,295,000
              
              $
              3,300,000Unrealized
                  loss on available-for-sale securities
              
              
              834,000
              
              
              773,000Other,
                  net
              
              
              493,000
              
              
              353,0004,622,000
              
              
              4,426,000Deferred
                  tax liabilities:
                Loan
                  origination fees and costs
              
              
              2,160,000
              
              
              2,554,000FHLB
                  stock dividends
              
              
              1,891,000
              
              
              1,936,000Accumulated
                  depreciation
              
              
              356,000
              
              
              320,000Servicing
                  assets
              
              
              17,000
              
              
              17,000Other,
                  net
              
              
              134,000
              
              
              178,0004,558,000
              
              
              5,005,000Net
                  deferred tax asset/(liability)
              
              $
              64,000
              
              $
              (579,000
              )
  A reconciliation of the effective income tax rate with
        the
        federal statutory rate is as follows:
  **2006**
              
              **2005**
              
              **2004****Amount**
              
              **Rate**
              
              **Amount**
              
              **Rate**
              
              **Amount**
              
              **Rate**Federal
                  income tax at statutory rates
              
              $
              5,866,710
              
              
              35%
              
              $
              5,393,951
              
              
              34%
              
              $
              4,831,665
              
              
              34%Effect
                  of tax-exempt interest income
              
              
              (11,398
              )
              
              0%
              
              
              (23,304
              )
              
              0%
              
              
              (22,520
              )
              
              0%Incentive
                  stock options
              
              
              122,693
              
              
              1%
              
              
              —
              
              
              0%
              
              
              —
              
              
              0%Other
              
              
              (195,639
              )
              
              (1%)
              
              
              11,576
              
              
              0%
              
              
              9,626
              
              
              0%$
              5,782,366
              
              
              35%
              
              $
              5,382,223
              
              
              34%
              
              $
              4,818,771
              
              
              34%
  **Note
        12— 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, 2006, totaled
        $80,000.
 
 61
 **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,
        2006
        and 2005, that the Company met all capital adequacy requirements to which
        it is
        subject.
  As
        of
        December 31, 2006, 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, an
        institution must maintain minimum Total risk-based, Tier I risk-based, and
        Tier
        I leverage ratios as set forth
        in
        the following 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
                    PromptCorrectiveActionProvisions****Amount**
                
                **Ratio**
                
                **Amount**
                
                **Ratio**
                
                **Amount**
                
                **Ratio**As
                  of December 31,
                  2006:Total
                    capital (to risk-weighted assets):First
                    Mutual Bancshares, Inc.
                
                $
                98,436,489
                
                
                12.14%
                
                $
                64,856,783
                
                
                >8.00%
                
                
                N/A
                
                
                N/AFirst
                    Mutual Bank
                
                
                100,356,183
                
                
                12.39%
                
                
                64,779,021
                
                
                >8.00%
                
                $
                80,973,777
                
                
                >10.00%Tier
                    I capital (to risk-weighted assets):First
                    Mutual Bancshares, Inc.
                
                
                88,382,003
                
                
                10.90%
                
                
                32,428,391
                
                
                >4.00%
                
                
                N/A
                
                
                N/AFirst
                    Mutual Bank
                
                
                90,301,698
                
                
                11.15%
                
                
                32,389,511
                
                
                >4.00%
                
                
                48,584,266
                
                
                >6.00%Tier
                    I capital (to average assets):First
                    Mutual Bancshares, Inc.
                
                
                88,382,003
                
                
                7.97%
                
                
                44,380,313
                
                
                >4.00%
                
                
                N/A
                
                
                N/AFirst
                    Mutual Bank
                
                
                90,301,698
                
                
                8.30%
                
                
                43,524,853
                
                
                >4.00%
                
                
                54,406,066
                
                
                >5.00%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%
 
 62
 **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
        13 — 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)**Year
                  ended December 31, 2006:
                Basic
                  EPS:
                Income
                  available to common shareholders
              
              $
              10,979,662
              
              
              6,650,209
              
              
              $
                  1.65Effect
                  of dilutive stock options
              
              
              
              
              
              213,886Diluted
                  EPS:
                Income
                  available to common shareholders plusassumed
                  stock options exercised
              
              $
              10,979,662
              
              
              6,864,095
              
              
              $
                  1.60Year
                  ended December 31, 2005:
                Basic
                  EPS:
                Income
                  available to common shareholders
              
              $
              10,318,649
              
              
              6,643,270
              
              
              $
                  1.55Effect
                  of dilutive stock options
              
              
              
              
              
              285,204Diluted
                  EPS:
                Income
                  available to common shareholders plusassumed
                  stock options exercised
              
              $
              10,318,649
              
              
              6,928,474
              
              
              $
                  1.49Year
                  ended December 31, 2004:
                Basic
                  EPS:
                Income
                  available to common shareholders
              
              $
              9,287,813
              
              
              6,580,515
              
              
              $
                  1.41Effect
                  of dilutive stock options
              
              
              
              
              
              311,558Diluted
                  EPS:
                Income
                  available to common shareholders plusassumed
                  stock options exercised
              
              $
              9,287,813
              
              
              6,892,073
              
              
              $
                  1.34
 
 
 (1)
              Shares
                  and EPS have been adjusted for a 10% stock dividend paid April
                  7, 2004 and
                  a five-for-four stock split paid on October 4,
                  2006.
  **Note
        14 — 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
 
 63
 **FIRST
        MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**
  their
        salaries to the plan up to the annual Internal Revenue Service limit. The
        Bank
        matches 75% of the employees’
        contributions up to 6% of the employees’ compensation. Participants are fully
        vested in employer contributions to the plan upon six years of service.
  The
        Bank’s contributions to the 401(k) retirement plan and trust were $483,000,
        $744,000, and $629,000 for the
        years ended December 31, 2006, 2005, and 2004, respectively. For years 2004
        and
        2005 the Bank made profit sharing contributions to the plan representing
        an
        additional 3% of all eligible employees’ compensation. There was no additional
        3% contribution made in year 2006.
  **Note
        15— Employee Stock Ownership Plan (ESOP)**
  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, 2006, were as follows:
  **Number
                    of**
                  **Shares**
                
                
                **Average
                    Cost**
                  **Per
                    Share**Allocated:Vested
                
                
                472,120Non-vested
                
                
                4,198476,318
                
                
                $  
                      2.52
  Contributions
        to the ESOP for the years ended December 31, 2006, 2005, and 2004 were $120,003, $99,986,
        and $99,996, respectively. The contribution for 2006 was approved by the
        Board
        of Directors at its December
        2006 meeting; the shares contributed are reflected in the total shown
        above.
  **Note
        16 — Stock Option Plans**
  We
        have
        four stock option plans for directors and employees (1992 Director/Employee
        Option Plan, 1995 Director/Employee Option Plan, 2000 Director/Employee Option Plan, and the
        2005
        Employee Option Plan (the Plans)). Options have a contractual life of six,
        seven
        or ten years and a requisite service period of two, three, or four years
        and are
        granted at fair market value on the grant date. The Compensation and Stock
        Option Committee determines 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, 2006, 656,891 shares of common
        stock, adjusted for stock dividends, were available for grant under the plan.
        All schedules presented in this footnote are adjusted for stock dividends
        and
        stock splits.
 64
 **FIRST
        MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**
  A
        summary
        of the stock option plans at December 31, 2006 and changes during the year
        are
        presented below:
  **Shares**
                
                **Weighted**
                  **Average**
                  **Exercise
                    Price(1)**
                
                **Weighted**
                  **Average
                    Grant Date**
                  **Fair
                    Value(1)**BALANCE,
                    December 31, 2005
                
                
                698,250
                
                $
                13.78Exercisable
                    at year end: 324,579 shares
                  Options
                    granted
                
                
                150,314
                
                
                21.39
                
                $
                3.84Options
                    exercised
                
                
                (47,950
                )
                
                7.62Options
                    terminated
                
                
                (38,507
                )
                
                19.71BALANCE,
                    December 31, 2006
                
                
                762,107
                
                $
                15.37Exercisable
                  at year
                  end: 397,273 shares
  
 (1) 
        per share
  The
        weighted average remaining term in years and the aggregate intrinsic value
        for
        options outstanding at December
        31, 2006 were 5.2 years and $5,954,592, respectively. The weighted average
        remaining term in years and the aggregate intrinsic value for options
        exercisable at December 31, 2006 were 4.3 years and $4,724,271, respectively.
        The weighted average grant date fair value was $3.84, $4.42, and $8.21 at
        December 31, 2006, 2005, and 2004.
  There
        were 153,314 options granted during the year ended December 31, 2006. There
        were
        146,816 options
        granted during 2005. The total intrinsic value (amount by which fair value
        of
        the underlying stock exceeds
        the exercise price of an option on exercise date) of options exercised during
        the 12 months ended December 31, 2006, 2005, and 2004 were $655,315, $2,394,376,
        and $1,060,191, respectively.
  We
        have
        estimated the fair value of all stock option awards as of the date of the
        grant
        by applying a Black-Scholes
        pricing model. The ranges of weighted-average assumptions for the options
        issued
        during the 12
        months ended December 31, 2006 are as follows:
  **Non-Qualified
                  Plans**
              
              **Incentive
                  Plans**Expected
                  Price Volatility
              
              
              18.1%-19.4%
              
              
              19.3%Risk-Free
                  Interest Rate
              
              
              4.8%-5.
                  1%
              
              
              4.8%Dividend
                  Yield
              
              
              1.4%-1.5%
              
              
              1.4%Expected
                  Life in Years
              
              
              4.8
                  years
              
              
              4.9
                  years
  The
        expected price volatility was based on the historical volatility of the stock
        price, the risk-free interest rate was based on the US Treasury Constant
        Maturity yields for periods similar to the expected life of the options,
        the
        dividend yield was based on current cash dividend yields and the expected
        life
        was based on historical data.
  Cash
        received from options exercised for the 12 months ended December 31, 2006
        and
        2005 totaled $365,447 and $1,433,616, respectively. We issue new shares to
        satisfy option exercises.
  At
        December 31, 2006, there was $1,164,552 in total unrecognized compensation
        cost
        related to unvested share-based compensation arrangements granted under the
        Plan. That compensation is expected to be recognized over a weighted-average
        period of 1.6 years.
 
 65
 **FIRST
        MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**
  **Note
        17 — Off-Balance Sheet Activities**
  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, 2006, approximately 28% 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 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
        2006, 2005, or 2004.
  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.
  A
        summary
        of the notional amounts of our financial instruments with off-balance-sheet
        risk
        at December 31, are as follows:
  **2006**
              
              **2005****(Dollars
                  in thousands)**Commitments
                  to extend credit
              
              $
              72,990
              
              $
              109,923Unfunded
                  commitments under lines of credit
              
              $
              210,093
              
              $
              205,385Standby
                  letters of credit
              
              $
              6,638
              
              $
              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) following any future Change-Of-Control of First Mutual
        Bank and expire in February
        2007, December 2008, and July 2011 depending upon the agreement.
 
 66
 **FIRST
        MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**
  **Note
        18 — 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 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,
        2006 and 2005:
  **2006**
              
              **2005****Carrying**
                **Value**
              
              **Estimated**
                **Fair**
                **Value**
              
              **Carrying**
                **Value**
              
              **Estimated**
                **Fair**
                **Value****(Dollars
                  in thousands)**Assets:
                Cash
                  and cash equivalents
              
              $
              25,362
              
              $
              25,362
              
              $
              25,781
              
              $
              25,781Securities
                  available-for-sale
              
              
              89,728
              
              
              89,728
              
              
              114,450
              
              
              114,450Loans
                  held-for-sale
              
              
              13,733
              
              
              13,782
              
              
              14,684
              
              
              14,684Mortgage-backed
                  and other securities held-to-maturity
              
              
              5,620
              
              
              5,585
              
              
              6,966
              
              
              6,971Loans
                  receivable, net
              
              
              883,703
              
              
              885,180
              
              
              867,997
              
              
              862,231Accrued
                  interest receivable
              
              
              5,534
              
              
              5,534
              
              
              5,350
              
              
              5,350Servicing
                  assets
              
              
              4,011
              
              
              4,488
              
              
              1,866
              
              
              2,639FHLB
                  stock
              
              
              13,122
              
              
              13,122
              
              
              13,122
              
              
              13,122Liabilities:
                Demand,
                  savings, and money market deposits
              
              
              320,396
              
              
              320,396
              
              
              271,498
              
              
              271,498Time
                  deposits
              
              
              485,399
              
              
              485,652
              
              
              489,222
              
              
              488,378Drafts
                  payable
              
              
              1,314
              
              
              1,314
              
              
              734
              
              
              734Advance
                  payments by borrowers for taxes andinsurance
              
              
              1,583
              
              
              1,583
              
              
              1,671
              
              
              1,671Short-term
                  FHLB advances
              
              
              85,470
              
              
              85,536
              
              
              203,428
              
              
              203,096Long-term
                  FHLB advances
              
              
              86,462
              
              
              86,528
              
              
              22,277
              
              
              22,241Other
                  advances
              
              
              4,600
              
              
              4,600
              
              
              4,600
              
              
              4,485Long-term
                  debentures
              
              
              17,000
              
              
              16,820
              
              
              17,000
              
              
              16,750Derivatives:
                Interest
                  rate swaps
              
              
              (168
              )
              
              (168
              )
              
              29
              
              
              29Yield
                  maintenance contracts
              
              
              182
              
              
              182
              
              
              —
              
              
              —Rate
                  lock commitments
              
              $
              8
              
              $
              8
              
              $
              27
              
              $
              27
  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.
 
 67
 **FIRST
        MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**
  *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.
  *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 107, *Disclosures
        about Fair Value of Financial Instruments,* 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, 2006 and 2005. 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.
 68
 **FIRST
        MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**
  **Note
        19 — Selected Quarterly Financial Data (Unaudited)**
  **First**
                **Quarter**
              
              **Second**
                **Quarter**
              
              **Third**
                **Quarter**
              
              **Fourth**
                **Quarter**
              
              **Total****Year
                  Ended December 31, 2006**Interest
                  income
              
              $
              18,948,757
              
              $
              19,824,591
              
              $
              20,958,234
              
              $
              20,440,661
              
              $
              80,172,243Interest
                  expense
              
              
              8,717,317
              
              
              9,800,067
              
              
              10,776,198
              
              
              10,778,783
              
              
              40,072,365Net
                  interest income
              
              $
              10,231,440
              
              $
              10,024,524
              
              $
              10,182,036
              
              $
              9,661,878
              
              $
              40,099,878Provision
                  for loan and lease losses
              
              $
              71,000
              
              $
              134,837
              
              $
              267,250
              
              $
              491,781
              
              $
              964,868Noninterest
                  income and noninterest expenses, net
              
              $
              (5,973,463
              )
              $
              (5,777,289
              )
              $
              (5,389,418
              )
              $
              (5,232,812
              )
              $
              (22,372,982
              )Net
                  income
              
              $
              2,714,072
              
              $
              2,711,737
              
              $
              3,000,738
              
              $
              2,553,115
              
              $
              10,979,662Basic
                  earnings per share
              
              $
              0.41
              
              $
              0.41
              
              $
              0.45
              
              $
              0.38
              
              $
              1.65Earnings
                  per share assuming dilution
              
              $
              0.40
              
              $
              0.40
              
              $
              0.43
              
              $
              0.37
              
              $
              1.60Weighted
                  average shares outstanding
              
              
              6,627,298
              
              
              6,644,804
              
              
              6,655,307
              
              
              6,672,248
              
              
              6,650,209Weighted
                  average shares outstanding including effect of dilutive stock
                  options
              
              
              6,758,785
              
              
              6,790,098
              
              
              6,850,441
              
              
              6,917,827
              
              
              6,864,095**Year
                  Ended December 31, 2005**Interest
                  income
              
              $
              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 and lease 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
              
              $
              0.39
              
              $
              0.38
              
              $
              0.41
              
              $
              0.37
              
              $
              1.55Earnings
                  per share assuming dilution
              
              $
              0.37
              
              $
              0.36
              
              $
              0.39
              
              $
              0.37
              
              $
              1.49Weighted
                  average shares outstanding
              
              
              6,626,544
              
              
              6,648,771
              
              
              6,688,416
              
              
              6,609,043
              
              
              6,643,270Weighted
                  average shares outstanding including effect of dilutive stock
                  options
              
              
              6,940,378
              
              
              6,942,769
              
              
              6,967,296
              
              
              6,863,145
              
              
              6,928,474
   69
 **FIRST
        MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**
  **Note
        20 — 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 offers loans to borrowers to purchase, refinance, or buildhomes
                  secured by one-to-four-unit family dwellings. They also finance
                  the
                  purchase or refinance ofbuildable residential lots.
  §
              *Business
                  Banking Lending —*Business
                  Banking lending offers a full range of banking services to small
                  and
                  medium size businesses including deposit and cash management products,
                  loans for financing receivables, inventory, equipment as well as
                  permanent
                  and interim construction loans for commercial real estate. The
                  underlying
                  real estate collateral or business asset being financed typically
                  secures
                  these loans.
  §
              *Income
                  Property Lending —*Income
                  Property lending offers permanent and interim construction loans
                  for
                  multifamily housing (over four units), manufactured housing communities,
                  commercial real estate properties, and 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.
 
 70
 **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
              
              
              2004
              
              $
              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
              
              
              67,362,6252006
              
              
              10,864,271
              
              
              26,891,000
              
              
              12,794,479
              
              
              29,622,493
              
              
              80,172,243Interest
                  expense
              
              
              2004
              
              
              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
              
              
              27,179,3242006
              
              
              4,824,802
              
              
              14,644,088
              
              
              5,626,267
              
              
              14,977,208
              
              
              40,072,365Net
                  interest income
              
              
              2004
              
              
              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
              
              
              40,183,3012006
              
              
              6,039,469
              
              
              12,246,912
              
              
              7,168,212
              
              
              14,645,285
              
              
              40,099,878Provision
                  for loan andlease
                  losses
              
              
              2004
              
              
              502,314
              
              
              318,689
              
              
              177,479
              
              
              566,518
              
              
              1,565,0002005
              
              
              545,690
              
              
              181,740
              
              
              221,200
              
              
              551,370
              
              
              1,500,0002006
              
              
              342,884
              
              
              129,264
              
              
              366,352
              
              
              126,368
              
              
              964,868Net
                  interest income, afterprovision
                  for loan andlease
                  losses
              
              
              2004
              
              
              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
              
              
              38,683,3012006
              
              
              5,696,585
              
              
              12,117,648
              
              
              6,801,860
              
              
              14,518,917
              
              
              39,135,010Noninterest
                  income
              
              
              2004
              
              
              1,932,676
              
              
              859,507
              
              
              478,842
              
              
              980,851
              
              
              4,251,8762005
              
              
              2,338,032
              
              
              1,329,644
              
              
              626,976
              
              
              1,060,309
              
              
              5,354,9612006
              
              
              4,419,414
              
              
              1,490,043
              
              
              906,556
              
              
              1,304,769
              
              
              8,120,782Noninterest
                  expense
              
              
              2004
              
              
              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
              
              
              28,337,3902006
              
              
              7,513,242
              
              
              7,862,950
              
              
              7,882,786
              
              
              7,234,786
              
              
              30,493,764Income
                  before provisionfor
                  federal incometaxes
              
              
              2004
              
              
              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
              
              
              15,700,8722006
              
              
              2,602,757
              
              
              5,744,741
              
              
              (174,370
              )
              
              8,588,900
              
              
              16,762,028Provision
                  for federalincome
                  taxes
              
              
              2004
              
              
              670,856
              
              
              1,400,288
              
              
              (226,474
              )
              
              2,974,101
              
              
              4,818,7712005
              
              
              478,725
              
              
              1,899,377
              
              
              35,805
              
              
              2,968,316
              
              
              5,382,2232006
              
              
              898,991
              
              
              1,981,562
              
              
              (64,340
              )
              
              2,966,153
              
              
              5,782,366Net
                  income
              
              
              2004
              
              
              1,291,580
              
              
              2,699,508
              
              
              (424,429
              )
              
              5,721,154
              
              
              9,287,8132005
              
              
              920,537
              
              
              3,640,935
              
              
              77,320
              
              
              5,679,857
              
              
              10,318,6492006
              
              
              1,703,766
              
              
              3,763,179
              
              
              (110,030
              )
              
              5,622,747
              
              
              10,979,662Total
                  interest earningassets
                  (averages)
              
              
              2004
              
              
              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
              
              
              999,750,5912006
              
              
              117,991,695
              
              
              365,595,260
              
              
              171,306,971
              
              
              379,109,113
              
              
              1,034,003,039
  **Note
        21 — Derivative Activities and Market Risk**
  ***Derivative
        Financial Instruments***
  We
        have
        stand-alone derivative financial instruments in the form of interest rate
        swap
        agreements, which derive their value from underlying interest rates. These
        transactions involve both credit and market risk. The notional amounts are
        the
        amounts on which calculations, payments, and the value of the derivative
        are
        based.
 71
 **FIRST
        MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**
  The
        notional amount does not represent direct credit exposure. Direct credit
        exposure is limited to the net difference
        between the calculated amounts to be received and paid, if any. Such difference,
        which represents the fair
        value of the derivative instruments, is reflected on the balance sheet as
        other
        assets and other liabilities.
  We
        are
        exposed to credit-related losses in the event of nonperformance by the
        counterparties to these agreements. Credit risk of the financial contracts
        is
        controlled through the credit approvals, limits and monitoring procedures,
        and
        we do not expect the counterparties to fail their obligations.
  Derivative
        instruments are generally either negotiated OTC contracts or standardized
        contracts executed on a
        recognized exchange. Negotiated OTC derivative contracts are generally entered
        into between two counterparties
        that negotiate specific agreement terms, including the underlying instrument,
        amount, exercise prices
        and maturity.
  **Risk
        Management Policies-Hedging Instruments**
  The
        primary focus of the Bank’s asset/liability management program is to monitor the
        sensitivity of the net portfolio value and net income under varying interest
        rate scenarios to take steps to control risk. On a monthly basis we simulate
        the
        net portfolio value and the net income expected to be earned over a 12-month
        period following the date of simulation. The simulation is based on a projection
        of market interest rates at varying levels and estimates the impact of such
        market rates on the levels of interest-earning assets and interest-bearing
        liabilities during the measurement period. Based upon the outcome of the
        simulation analysis, management may decide to take steps to change the mix and or duration of
        certain
        types of assets and/or liabilities to achieve desired results.
  ***Interest
        Rate Risk Management-Fair Value Hedging Instruments***
  We
        originate fixed- and variable-rate loans. Fixed-rate loans expose us to
        variability in their fair value due to changes in the level of interest rates.
        Management believes that it is prudent to limit the variability in the fair
        value of a portion of our fixed-rate loans. It is our objective to hedge
        the
        change in fair value of fixed-rate loans at coverage levels that are
        appropriate, given anticipated or existing interest rate levels and other
        market
        considerations, as well as the relationship of change in this asset to other
        assets of the Bank. To meet this objective, we utilize interest rate swaps
        as an
        asset/liability management strategy to hedge the change in value of specific
        loans due to changes in expected interest rate assumptions. These interest
        rate
        swap agreements are contracts to make a series of fixed-rate payments in
        exchange for receiving a series of floating rate payments.
  At
        December 31, 2006, the following information is related to two outstanding
        interest rate swap agreements used to hedge fixed-rate loans that qualify
        for
        fair value hedge accounting:
  **2006**Notional
                  amount
              
              $
              1,436,503Weighted
                  average pay rate
              
              
              5.31
              %Weighted
                  average receive rate
              
              
              5.35
              %Weighted
                  average maturity in years
              
              
              15Unrealized
                  loss relating to interest rate swaps
              
              $
              23,517
  These
        agreements provide for us to make payments at a fixed-rate determined by
        a
        specified index (one-month LIBOR) in exchange for receiving payments at a
        floating rate.
  At
        December 31, 2006, the unrealized loss relating to use of interest rate swaps
        was recorded in other liabilities. We did not have any swaps used to hedge
        fixed-rate loans in 2005.
 
 72
 **FIRST
        MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**
  ***Interest
        Rate Risk Management-Derivative Instruments Not Designated As Hedging
        Instruments***
  Certain
        derivative instruments do not meet SFAS 133 hedging requirements. These
        undesignated derivative
        instruments are recognized on the consolidated balance sheet at fair value,
        included in other assets and/or
        liabilities, with changes in fair value recorded in other noninterest
        income.
  In
        2002
        we entered into an interest rate swap agreement with the FHLB to convert
        our
        $9.0 million floating-rate
        trust preferred securities (TPS) funding to a fixed-rate. Prior to the third
        quarter of 2006 the swap was
        accounted for as a cash flow hedge. The hedge, under current accounting
        literature at the time, was a qualifying cash flow hedge under the “shortcut”
method as prescribed by SFAS 133 with changes in the fair value recorded
        in
        other comprehensive income. The Bank pays the FHLB a fixed-rate of 4.53%
        and
        receives the equivalent of three-month LIBOR.
  During
        the third quarter of 2006, it was noted through a series of recent technical
        interpretations, hedges on TPSs were no longer eligible for the short-cut
        method
        of accounting that we had been applying. Accordingly, we determined the
        derivative no longer qualified for the short-cut method and therefore hedge
        accounting was discontinued. The derivative will continue to be recorded
        on the
        balance sheet at its fair value with
        changes in the fair value previously recorded in other comprehensive income
        reclassified and included in current
        earnings. During the third quarter, the cumulative change in the fair value
        of
        the swap since inception, which totaled $52,000, was transferred out of other
        comprehensive income to earnings and recorded on a prospective basis in
        noninterest income.
  During
        2006, we began to utilize interest rate swaps in connection with the
        underwriting of longer-term, fixed-rate, commercial real estate loans. Under
        this program, we originate commercial mortgage loans with amortization schedules
        of up to 30 years, with an initial 10 year fixed rate. To hedge the interest
        rate risk exposure
        presented by 10 year, fixed rate instruments, we utilize interest rate swaps
        on
        a loan-by-loan basis to convert
        each loan’s fixed rate to an adjustable rate subject to repricing relative to a
        market index rate, typically the one-month London Interbank Offering Rate
        (LIBOR). These interest rate swaps will be used solely
        for the purpose of managing the interest rate risk associated with longer-term,
        fixed-rate assets and will not be
        used for speculative purposes. We currently have two interest rate swaps
        of this
        type on the books related to two fixed-rate, commercial loans.
  In
        addition to the interest rate swaps associated with these loans, the borrowers
        entered into yield maintenance agreements that have been determined to be
        derivatives. Although the interest rate swap derivatives and yield maintenance
        agreements are not constructed as a hedge, their valuations tend to move
        in
        opposite directions constituting an offset to each other.
  At
        December 31, 2006, the following information is related to two outstanding
        interest rate swap agreements and two yield maintenance agreements that are not designated as
        hedging instruments:
  **2006**Notional
                  amount
              
              $
              3,042,257Weighted
                  average pay rate
              
              
              5.85
              %Weighted
                  average receive rate
              
              
              5.35
              %Weighted
                  average maturity in years
              
              
              10Unrealized
                  loss relating to interest rate swaps
              
              $
              183,250
  As
        of
        December 31, 2006 we had pledged one mortgage-backed security with a book
        value
        of $161,000 and a
        market value of $155,000 as collateral for swap agreements entered into with
        our
        counterparty.
 
 73
 **FIRST
        MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**
  ***Derivative
        Loan Commitments***
  Mortgage
        loan commitments are referred to as derivative loan commitments if the loan
        that
        will result from exercise of the commitment will be held-for-sale upon funding.
        We enter into commitments to fund residential
        mortgage loans at specified times in the future, with the intention that
        these
        loans will subsequently be sold
        in the secondary market. A mortgage loan commitment binds the Bank to lend
        funds
        to a potential borrower at a specified interest rate and within a specified
        period of time, generally up to 60 days after inception of the rate
        lock.
  Outstanding
        derivative loan commitments expose us to the risk that the price of the loans
        arising from exercise of the loan commitment might decline from inception
        of the
        rate lock to funding of the loan due to increases in interest rates. If interest
        rates increase, the value of these loan commitments decreases. Conversely,
        if
        interest rates decrease, the value of these loan commitments increases. The
        notional amount of undesignated mortgage loan commitments was $1,169,750
        and
        $3,189,470 at December 31, 2006 and 2005, respectively. The fair value of
        such
        commitments was a liability of $7,750 and $27,348, respectively.
  ***Forward
        Loan Sale Commitments***
  To
        protect against the price risk inherent in derivative loan commitments, we
        utilize “best efforts” forward loan commitments to mitigate the risk of
        potential decreases in the values of loans that would result from the exercise
        of the derivative loan commitment.
  With
        a
“best efforts” contract, we commit to deliver an individual mortgage loan of a
        specified principal amount and quality to an investor if the loan to the
        underlying borrower closes. Generally, the price the investor will pay the
        seller for an individual loan is specified prior to the loan being funded
        (e.g.,
        on the same day the lender commits to lend funds to a potential borrower).
        Our
“best efforts” contracts do not result in a requirement to pay a “pair-off”
fee.
  **Note
        22 — Legal Contingencies**
  Various
        legal claims also arise from time to time in the normal course of business
        which, in the opinion of management, will have no material effect on the
        Company’s consolidated financial statements.
  **Note
        23 — Other Comprehensive Income/(Loss)**
  The
        components of other comprehensive income/(loss) and related tax effects are
        as
        follows:
  **2006**
              
              **2005**Unrealized
                  holding gains/(losses) on securities available-for-sale
              
              $
              44,117
              
              $
              (1,453,868
              )Tax
                  benefit
              
              
              50,389
              
              
              508,854Net
                  of tax amount
              
              
              94,506
              
              
              (945,014
              )Net
                  unrealized gain on derivative used for cash flow hedge
              
              
              47,039
              
              
              255,645Reclassification
                  adjustment — transfer to earnings(1)
              
              
              (50,651
              )
              
              —Net
                  unrealized gains/(losses)
              
              
              (3,612
              )
              
              255,645Tax
                  effect
              
              
              (15,545
              )
              
              (89,476
              )Net
                  of tax amount
              
              
              (19,157
              )
              
              166,169$
              75,349
              
              $
              (778,845
              )
 
 74
 **FIRST
        MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**
  The
        components of accumulated other comprehensive income, included in stockholders’
equity, are as follows:
  **2006**
              
              **2005**Net
                  unrealized gains/(losses) on securities available for sale
              
              $
              (2,194,325
              )
              $
              (2,238,442
              )Tax
                  effect
              
              
              833,844
              
              
              783,455Net
                  of tax amount
              
              $
              (1,360,481
              )
              $
              (1,454,987
              )Net
                  unrealized gain/(loss) on derivative used for cash flow hedge
              
              
              76,512
              
              
              29,473Less
                  reclassification adjustment — transfer to earnings(1)
              
              
              (50,651
              )
              
              —Tax
                  effect
              
              
              (25,861
              )
              
              (10,316
              )Net
                  of tax amount
              
              $
              —
              
              $
              19,157$
              (1,360,481
              )
              $
              (1,435,830
              )
 
 (1)
              Please
                  see Note 21 — Derivative Activities and Market Risk for more information.
  **Note
        24— Parent Company Only Financial Statements**
  Summary
        of condensed parent company financial information for First Mutual Bancshares,
        Inc. for December 31, 2006 and 2005:
  **Statement
        of Financial Condition**
  **December
                    31,****2006**
              
              **2005****(Dollars
                  in thousands)**ASSETSCash
              
              $
              1,008
              
              $
              6,722Investments
                  in subsidiaries
              
              
              89,468
              
              
              76,544Other
                  assets
              
              
              1,284
              
              
              3,725Total
                  assets
              
              $
              91,760
              
              $
              86,991LIABILITIES
                  AND STOCKHOLDERS’ EQUITY
                Liabilities
                Borrowings
              
              $
              4,000
              
              $
              4,000Other
                  liabilities
              
              
              17,738
              
              
              22,96421,738
              
              
              26,964Stockholders’
                  equity
              
              
              70,022
              
              
              60,027Total
                  liabilities and stockholders’ equity
              
              $
              91,760
              
              $
              86,991
  75
 **FIRST
        MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**
  **Statement
        of Income**
  **Years
                  Ended December 31,****2006**
              
              **2005**
              
              **2004****(Dollars
                  in thousands)**INCOME
                Equity
                  in undistributed net income from subsidiaries
              
              $
              12,462
              
              $
              11,585
              
              $
              10,314NONINTEREST
                  EXPENSE
                Compensation
                  and employee benefits
              
              
              328
              
              
              310
              
              
              205Other
              
              
              1,940
              
              
              1,621
              
              
              1,358Total
                  noninterest expense
              
              
              2,268
              
              
              1,931
              
              
              1,563Income
                  before provision for federal income taxes
              
              
              10,194
              
              
              9,654
              
              
              8,751PROVISION
                  FOR FEDERAL INCOME TAX BENEFIT
              
              
              786
              
              
              665
              
              
              537NET
                  INCOME
              
              $
              10,980
              
              $
              10,319
              
              $
              9,288
  **Statement
        of Cash Flows**
  **Years
                  Ended December 31,****2006**
              
              **2005**
              
              **2004****(Dollars
                  in thousands)**OPERATING
                  ACTIVITIES
                Net
                  income
              
              $
              10,980
              
              $
              10,319
              
              $
              9,288Adjustments
                  to reconcile net cash from operating activitiesEquity
                  in undistributed earnings of subsidiaries
              
              
              (12,462
              )
              
              (11,585
              )
              
              (10,314
              )Federal
                  income tax refund
              
              
              662
              
              
              —
              
              
              264Other
                  assets
              
              
              2,441
              
              
              (1,127
              )
              
              (592
              )Accounts
                  payable and other liabilities
              
              
              (771
              )
              
              478
              
              
              83Net
                  cash provided/(used) by operating activities
              
              
              850
              
              
              (1,915
              )
              
              (1,271
              )INVESTING
                  ACTIVITIES
                Dividends
                  from subsidiaries
              
              
              355
              
              
              9,155
              
              
              1,350FINANCING
                  ACTIVITIES
                Dividends
                  paid
              
              
              (7,486
              )
              
              (1,970
              )
              
              (1,548
              )Proceeds
                  from exercise of stock options
              
              
              467
              
              
              1,434
              
              
              882Repurchase
                  and retirement of common stock
              
              
              —
              
              
              (3,654
              )
              
              —Proceeds
                  from borrowings
              
              
              —
              
              
              3,000
              
              
              500Contribution
                  to employee stock ownership plan
              
              
              100
              
              
              100
              
              
              50Net
                  cash used by financing activities
              
              
              (6,919
              )
              
              (1,090
              )
              
              (116
              )NET
                  INCREASE/(DECREASE) IN CASH AND CASHEQUIVALENTS
              
              
              (5,714
              )
              
              6,150
              
              
              (37
              )Beginning
                  of year
              
              
              6,722
              
              
              572
              
              
              609End
                  of year
              
              $
              1,008
              
              $
              6,722
              
              $
              572




76
 
 **General
        Information**
  **Stock
                    Symbol******
                  NASDAQ:
                    FMSB
                  
                  **Registered
                    Shareholder Assistance******
                  Mellon
                    Investor Services, our transfer agent, can help you with a variety
                    of
                    shareholder-related services including:
                  Change
                        of name or address
                    Lost
                        or stolen dividend checks or stock certificates
                    Transfer
                        of stock to another person
                    Stock
                        sales
                    Converting
                        paper certificates to electronic sharesYou
                    can call Shareholder Services toll-free at 1-866-737-9890 or
                    access your
                    account via the internet at
                  www.
                    melloninvestor.com/isd.Send inquiries via mail to: Mellon investor Services, 480 WA
                    Blvd., Jersey
                    City, NJ 07310.
                  
                  **First
                    Mutual on the Internet**
                  First
                    Mutual publications and investor relations information are available
                    on
                    the internet at:www.firstmutual.com
                  Current
                        and historical stock prices
                    Dividend
                        information
                    Press
                        releases, news and events
                    Financial
                        highlights
                    Management
                        presentations
                    Annual
                        Report
                    Form
                        10-K and other SEC filings
                    Requests
                        for information or printed copies of publicationsPrinted
                    copies of Form 10-K, the Annual Report or the Code of Business
                    Conduct and
                    Ethics may also be requested by writing to: First Mutual Bancshares,
                    Inc.,
                    Attn: Corporate Secretary, PO Box 1647, Bellevue, WA
                    98009-1647.
                  
                  **Investor
                    Relations**
                  The
                    Cereghino Group
                  1809
                    7th Avenue, Suite 1414
                  Seattle,
                    WA 98101
                  (206)
                    762-0993
                  
                  **Annual
                    Meeting**
                  The
                    2007 Annual Meeting of Shareholders will be held at 3:00 PM on
                    Thursday,
                    April 26, 2007, at:
                  
                  The
                    Westin Bellevue
                  600
                    Bellevue Way NE
                  Bellevue,
                    WA
                  
                  **Corporate
                    Headquarters and Main********Office**
                  FIRST
                    MUTUAL BANCSHARES, INC. AND
                  FIRST
                    MUTUAL BANK
                  400
                    108th Avenue NE
                  Bellevue,WA
                    98004
                  (425)
                    455-7300
                  (425)
                    453-5302 fax
                  www.firstmutual.com
                
                **Bancshares
                    Officers**
                  PRESIDENT
                  John
                    R. Valaas, Chief Executive Officer
                  
                  EXECUTIVE
                    VICE PRESIDENT
                  Roger
                    A. Mandery, CPA, Chief Financial Officer
                  
                  SENIOR
                    VICE PRESIDENT
                  Kari
                    A. Stenslie, CPA, CMA, Controller
                  
                  CORPORATE
                    SECRETARY
                  Janine
                    M. Berryman
                  
                  **Bank
                    Officers**
                  PRESIDENT
                  John
                    R. Valaas, Chief Executive Officer
                  
                  EXECUTIVE
                    VICE PRESIDENT
                  James
                    R. Boudreau, Sr. Credit Risk Officer
                  
                  EXECUTIVE
                    VICE PRESIDENT
                  Robin
                    R. Carey, Operations and Administration
                  
                  EXECUTIVE
                    VICE PRESIDENT
                  Richard
                    J. Collette,Commercial
                    Banking Group
                  
                  EXECUTIVE
                    VICE PRESIDENT
                  Scott
                    B. Harlan, Consumer and Residential Lending
                  
                  EXECUTIVE
                    VICE PRESIDENT
                  Roger
                    A. Mandery, CPA, Chief Financial Officer
                  
                  EXECUTIVE
                    VICE PRESIDENT
                  George
                    D. Smeby, Chief Credit Risk Officer
                  
                  EXECUTIVE
                    VICE PRESIDENT
                  Joseph
                    P. Zavaglia, Retail Banking Group
                  
                  SENIOR
                    VICE PRESIDENT
                  Robert
                    J. Everett, Income Property Lending
                  
                  SENIOR
                    VICE PRESIDENT
                  Thomas
                    E. Kasanders,
                  Manager,
                    Business Banking Lending
                  
                  SENIOR
                    VICE PRESIDENT
                  Ellen
                    Morgan, Marketing
                  
                  SENIOR
                    VICE PRESIDENT
                  Jeff
                    L. Olson, Residential Lending
                  
                  SENIOR
                    VICE PRESIDENT
                  Frederick
                    H. Reininger,
                  Manager,
                    Income Property Lending
                  
                  SENIOR
                    VICE PRESIDENT
                  Kari
                    A. Stenslie, CPA, CMA, Controller
                  
                  SENIOR
                    VICE PRESIDENT
                  Sandy
                    L. Tamiesie,
                  Customer
                    Service Support
                  
                  CORPORATE
                    SECRETARY
                  Janine
                    M. Berryman
                  
                  **Independent
                    Certified Public********Accountant**
                  Moss
                    Adams LLP
                
                **Legal
                    Counsel******
                  Foster
                    Pepper PLLC
                  
                  **First
                    Mutual Banking Centers**
                  
                  BALLARD
                  6301
                    15th Avenue NW
                  Seattle,
                    WA 98107
                  (206)
                    706-0894
                  
                  BELLEVUE
                  400
                    108th Avenue NE
                  Bellevue,WA
                    98004
                  (425)
                    453-2801
                  
                  BELLEVUE
                    WEST
                  10001
                    NE 8th Street
                  Bellevue,
                    WA 98004
                  (425)
                    453-9434
                  
                  CROSSROADS
                  15635
                    NE 8th Street
                  Bellevue,
                    WA 98008
                  (425)
                    644-4214
                  
                  ISSAQUAH
                  855
                    Rainier Boulevard N
                  Issaquah,
                    WA 98027
                  (425)
                    392-2673
                  
                  JUANITA
                  13633
                    l00th Avenue NE
                  Kirkland,
                    WA 98034
                  (425)
                    823-6290
                  
                  KIRKLAND
                  278
                    Central Way
                  Kirkland,
                    WA 98033
                  (425)
                    893-9232
                  
                  MONROE
                  19265
                    US-2
                  Monroe,
                    WA 98272
                  (360)
                    794-8686
                  
                  REDMOND
                  16900
                    Redmond Way
                  Redmond,
                    WA 98052
                  (425)
                    883-4700
                  
                  SAMMAMISH
                  336
                    228th Avenue NE, Suite 100
                  Sammamish,
                    WA 98074
                  (425)
                    391-5097
                  
                  WEST
                    SEATTLE
                  4102
                    California Avenue SW
                  Seattle,
                    WA 98116
                  (206)
                    932-6299
                  
                  WOODINVILLE
                  13415
                    NE 175th Street
                  Woodinville,
                    WA 98072
                  (425)
                    482-7509
                  
                  **Sales
                    Finance Lending Offices******
                  414
                    Old Hard Road, Suite 108
                  Orange
                    Park, Florida 32003
                  (888)
                    204-0204
                  
                  56
                    Macomb Place
                  Mt.
                    Clemens, Michigan 48046
                  (888)
                    451-1601













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







First Mutual Bancshares, Inc.








First
        Mutual Bancshares, Inc.   t   400 108th
        Avenue NE   t  
Bellevue, WA 98004   t  
(425)
        455-7300