EXHIBIT 13
                                                                      ----------






                                                         A SENSE OF COMMUNITY



                                                        |
                                                        |
                             FIRST MUTUAL               |   2002
                             BANCSHARES, INCORPORATED   |   ANNUAL REPORT
                                                        |
                                                        |














<PAGE>


                                                         A SENSE OF COMMUNITY



                                                        |
                                                        |
                             FIRST MUTUAL               |   2002
                             BANCSHARES, INCORPORATED   |   YEAR IN REVIEW
                                                        |
                                                        |













<PAGE>
<TABLE><CAPTION>
SELECTED FINANCIAL DATA

                                                                   DECEMBER 31 ,
                                           2002          2001          2000          1999          1998
<S>                                    <C>           <C>           <C>           <C>           <C>
Total assets                           $745,295,252  $678,348,551  $643,231,466  $581,116,306  $489,230,139
Loans outstanding, net, including
  loans held-for-sale                   627,319,413   567,553,346   489,550,647   454,381,131   386,905,629
Cash and investments                     89,709,773    86,962,256   130,688,734   109,296,117    87,633,724
Savings deposits                        363,122,044   319,842,388   360,562,002   300,333,966   312,331,832
Other deposits                          134,247,575   109,055,274    96,929,907    99,840,124    98,919,316
Advances                                184,393,897   191,354,138   133,284,725   134,486,925    31,765,000
Stockholders' equity                     44,283,837    51,971,297    45,917,271    39,336,659    34,661,953


                                                              YEARS ENDED DECEMBER 31 ,
                                           2002          2001          2000          1999          1998

Interest income                        $ 48,325,363  $ 52,729,806  $ 51,429,148  $ 42,318,490  $ 39,215,420
Interest expense                        (21,686,365)  (31,402,426)  (30,919,406)  (23,293,364)  (21,818,674)
Net interest income                      26,638,998    21,327,380    20,509,742    19,025,126    17,396,746
Other income                              3,236,705     4,030,100     2,090,097     2,948,180     3,229,622
Noninterest expense                     (17,155,904)  (14,295,902)  (12,091,776)  (12,087,151)  (11,987,138)
Provision for loan losses                  (910,000)     (365,000)     (530,000)     (805,000)     (750,000)
Income before taxes and cumulative
  effect of adoption of new
  accounting principle                   11,809,799    10,696,578     9,978,063     9,081,155     7,889,230
Federal income tax                       (4,012,429)   (3,619,200)   (3,379,063)   (3,080,807)   (2,681,534)
Net income                                7,797,370     6,922,131     6,599,000     6,000,348     5,207,696
Return on average assets                       1.10%         1.05%         1.08%         1.12%         1.11%
Return on average equity                      16.20%        14.14%        15.48%        16.22%        15.95%
Diluted earnings per share*                  $ 1.59        $ 1.31        $ 1.26        $ 1.15        $ 0.99
Book value per share*                        $10.43        $10.00        $ 8.94        $ 7.65        $ 6.75
Shares outstanding*                       4,247,166     5,198,563     5,138,415     5,139,900     5,139,203
</TABLE>

*Adjusted for a 10% stock dividend paid May 8, 2002 and May 5,1999

<PAGE>

                                                               FIRST MUTUAL BANK






                                                                      COMMUNITY.




             In addition to being a dependable financial resource on
              the Eastside and in surrounding communities for more
              than 50 years, First Mutual's sense of community is a
              strong commitment to giving consumers and businesses
             what they need to succeed. By building trust, remaining
             responsive, providing flexible solutions and connecting
              customer needs to financial innovations, First Mutual
                continually adapts to the communities it serves.







                                                                             P.1
<PAGE>







                                     TRUSTED

                       A reliable, stable presence in the
                          northwest banking community,
                       First Mutual instills confidence as
                       a business lender and banker while
                        ensuring consistent customer care
                           in all our banking centers.









P.2
<PAGE>











                                     [PHOTO]












                                                                             P.3
<PAGE>










                                   RESPONSIVE

                     First Mutual, a small, local business,
                      easily identifies with the issues of
                        businesses today. With financial
                        decisions made close to home, the
                        advantages of our solutions stay
                            within the local economy.






P.4
<PAGE>









                                     [PHOTO]














                                                                             P.5
<PAGE>







                                   CONNECTED

                         First Mutual reaches out to the
                        business community and consumers,
                        meeting banking needs and staying
                        involved in new innovations that
                      build lasting relationships, not just
                              banking transactions.










P.6
<PAGE>









                                     [PHOTO]











                                                                             P.7
<PAGE>







                                    FLEXIBLE

                         At First Mutual, we'll bend but
                      won't break when providing solutions
                        that work hard. Tried, true, and
                      consistently committed to the success
                       of business customers and enriching
                             the lives of consumers.











P.8
<PAGE>










                                     [PHOTO]













                                                                             P.9
<PAGE>

LETTER TO SHAREHOLDERS


DEAR FELLOW SHAREHOLDERS:

COMMUNITY: A WORD WITH DIFFERENT IMAGES AND MEANINGS. IT IS A PLACE. IT IS A
GROUP OF PEOPLE WITH A COMMON BOND. COMBINED WITH OTHER WORDS, IT CAN ADD
MEANING. FOR EXAMPLE, THE TERM "COMMUNITY BANK" CONVEYS THE IMAGE OF A LOCAL
INSTITUTION WITH LOCAL DECISION-MAKING CAPABILITIES AND A FOCUS ON THE SUCCESS
OF THE COMMUNITIES THAT IT SERVES.

As a community bank, First Mutual Bank has been serving the central Puget Sound
region for more than 50 years. We were founded in order to meet the financial
needs of the newly emerging suburban communities east of Lake Washington, and,
over half a century, the communities we serve now have become significantly
urbanized. As the financial needs of our customers have changed, so has First
Mutual Bank. Urban development has meant the need to shift toward the banking
needs of area businesses, and, in the process, to serve the individual banking
needs of those with whom we have formed new relationships. Our focus, just as it
was 50 years ago, is clearly on our customers.

Our focus on meeting customer needs has served us well. We have provided
critical local capital for sound economic growth on the Eastside. And First
Mutual Bank has grown and prospered right along with the region.

A STABLE PRESENCE
TEN YEARS OF RECORD EARNINGS.
2002 marks the tenth consecutive year of increasing profits for First Mutual.
First Mutual Bancshares, Inc., including its sole banking subsidiary, First
Mutual Bank, earned $7.8 million in 2002. Earnings per share increased 21% to
$1.59, from $1.31 in 2001. Book value per share increased to $10.43 at year-end
2002, up from $10.00 at the end of 2001. Our total assets were $745 million at
the close of the year, up 10% from $678 million at the end of 2001. Return on
average equity for the year 2002 was 16.20%. A more complete discussion of our
financial performance may be found with the Management Discussion and Analysis.

CONSISTENCY IN A CHALLENGING OPERATING ENVIRONMENT.
These results were achieved in spite of a very difficult economic environment. A
drop in economic activity, both nationally and locally, made lenders and
borrowers more cautious. Despite relatively slow growth in the local economy,
First Mutual was able to increase its earning assets. We do not expect to see
significant economic expansion in our region during 2003, but believe we are
well positioned to continue to capture share in the local marketplace.

TRUSTED CREDIT QUALITY.
Recessions always provoke concerns about the quality of bank earnings. Earnings
may suffer as some institutions deal with credit losses. Fortunately, strong
credit quality continues to be a hallmark of First Mutual's loan portfolio. At
year-end 2002, our non-performing assets were a low 0.28% as a percent

P.10
<PAGE>

of assets. This is considerably below a national average of 0.97% at the end of
the third quarter, based on the latest data available (the lower this number,
the better the credit quality). At year-end 2002, we had $7.8 million in loan
loss reserves, which is a very strong 3.7-times coverage of our December 31
level of non-performing loans.

NEW INNOVATIONS, LASTING RELATIONSHIPS
DIVERSIFICATION THROUGH MULTIPLE BUSINESS LINES.
Since the early 1990s, our strategy has been to identify and pursue business
lines that will provide exceptional growth as well as diversification of
opportunity and risk. While residential loans continue to be very profitable for
First Mutual, they no longer make up the majority of our earning asset base.
Commercial loans, primarily commercial real estate loans, are now the most
significant segment of our loan portfolio. In fact, commercial real estate loans
represented 67% of the loan portfolio at the end of 2002.

BUSINESS BANKING.
Over the past several years, and for many years to come, we have committed
significant resources to First Mutual's two newest and fastest growing business
lines, business banking and consumer lending. Business banking has grown to 12%
of the loan portfolio and we would like to see it become a much more significant
portion of the portfolio over the next several years. Under the leadership of
Rick Collette, we are very optimistic about our opportunities to accelerate
growth in this area. A specific focus of business banking is to develop
full-service relationships with community businesses through our banking
centers. We see these new connections as an important source of deposit growth,
particularly business checking accounts.

CONSUMER LENDING.
Under the guidance of Scott Harlan, consumer lending has grown to 9% of the
First Mutual loan portfolio at the end of 2002. Virtually all of the growth in
this segment is in our Sales Finance Department, which now operates in 32
states. Sales Finance purchases home improvement loans from qualified
contractors we have pre-approved. We review and approve each individual borrower
prior to purchasing the loan from the contractor. Products represented are
primarily roofs, siding and windows. We believe this national market will
support continued growth in our consumer loan portfolio and we remain very
satisfied with our credit experience in this market.

A COMMITTED, KNOWLEDGEABLE STAFF.
First Mutual banking centers continue to be the place where we service most of
our customers. Our new banking center format, which provides a more open and
inviting retail atmosphere, has proven to be very popular. We have also found it
to be more conducive to relationship banking and more effective for
cross-selling. We currently have ten banking centers, with an eleventh scheduled
to open in Woodinville in mid-year 2003. We have also signed a lease for our
twelfth banking center to be located in a new building under construction in the
city of Sammamish. We plan to open that center before the end of 2003. In
addition to the growing presence of our banking centers, our customers continue
to increase their use of online banking. 15% of our customers are now signed up
for online banking compared to 13% one year ago.

                                                                            P.11

<PAGE>

We were extremely pleased to announce in December 2002 that Joe Zavaglia will be
joining us in early 2003 as Executive Vice President and head of our Retail
Banking Group. He will lead the continued expansion of banking centers in our
principal market franchise area east of Lake Washington. We feel fortunate that
our community bank atmosphere attracts customers frustrated with large banks. We
also are fortunate that we can attract experienced bankers eager to return to
their banking roots. Our outstanding staff continues to set us apart from our
competitors.

A COMMITMENT TO THE FUTURE
STRUCTURED FOR GROWTH.
In July 2002, First Mutual Bancshares repurchased 20% of its shares in a private
transaction with one shareholder. As part of the funding of this purchase, First
Mutual Bancshares issued $9 million in trust preferred securities. The total
repurchase amounted to nearly $16 million. At present, we have no further plans
for share repurchases. Due to continued strong loan growth, we issued an
additional $4 million in trust preferred securities in January 2003. These funds
will serve as additional capital for the bank's growth.

COMMUNITY OUTLOOK.
First Mutual Bank is located in one of the strongest demographic markets in the
United States. We believe that, over the long term, it will continue to be a
market rich with opportunities for us and our customers. We have strong credit
quality and the product lines necessary to have an effective market presence. We
have a skilled group of professionals committed to providing exceptional levels
of customer service. Our board is also committed to the successful, profitable
growth of the bank and the communities that it serves. The board understands the
needs of the businesses and individuals in those communities, and our objectives
are a reflection of our commitment to meet those needs. Working together, we
look forward to many opportunities in 2003.

Additional information about First Mutual, including copies of press releases,
may be found at our Web site at www.firstmutual.com.

/s/ F. Kemper Freeman, Jr.                 /s/ John R. Valaas
---------------------------                -----------------------------
F. Kemper Freeman, Jr.                     John R. Valaas
Chairman of the Board                      President and CEO


January 31, 2003


P.12
<PAGE>

                                                              BOARD OF DIRECTORS



                                     [PHOTO]




Our executives and board members bring critical business expertise.

From front to back: F. Kemper Freeman, Jr. Chairman of First Mutual
Bancshares, Inc., Chairman and CEO of Bellevue Square Managers, Inc. and
Kemper Development Co. o John R. Valaas President and CEO of First Mutual
Bancshares, Inc. and First Mutual Bank o Mary Case Dunnam Active
volunteer in various community groups and homemaker o Janine Florence
President of Property Development Corp. o Richard S. Sprague Vice President
and Secretary of Bellevue Square Managers, Inc. o Victor E. Parker Chairman and
CEO of Parker Smith & Feek, Inc. o James J. Doud, Jr. Business consultant and
Vice Chairman of First Mutual Bancshares, Inc. o Robert C. Wallace Managing
Partner of Wallace Properties Group and Chairman of Wallace Properties, Inc.
George W. Rowley, Jr. Chairman and CEO of Rowley Enterprises, Inc.

--------------------------------------------------------------------------------
                                                         BANK EXECUTIVE OFFICERS

From left to right:

John R. Valaas                                                 [PHOTO]
President and CEO

Roger A. Mandery                                               [PHOTO]
Executive Vice President, Chief Financial Officer

James R. Boudreau                                              [PHOTO]
Executive Vice President, Chief Credit Officer

Richard J. Collette                                            [PHOTO]
Executive Vice President, Commercial Banking Group

Robin R. Carey                                                 [PHOTO]
Senior Vice President, Operations and Administration

Scott B. Harlan                                                [PHOTO]
Senior Vice President, Residential and Consumer Lending

                                                                            P.13
<PAGE>

CORPORATE PROFILE





First Mutual Bancshares, Inc. (the "Company") is based on the Eastside, the area
immediately east of Seattle and Lake Washington that includes parts of King and
Snohomish counties. 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 and the I-5 corridor, which stretches from Bellingham,
Washington, on the north to Tacoma, Washington, on the south. The ten branches
of this state-chartered, FDIC-insured bank are located in Bellevue (three),
Ballard, Juanita, Kirkland, Redmond, Issaquah, Monroe and West Seattle. In
addition, commercial real estate loan production offices are located in Tacoma
and Bellingham, Washington, and a sales finance office is located in
Jacksonville, Florida.

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 converted to an FDIC-insured mutual savings bank in 1968. It
originally was chartered as a savings and loan association when it opened in
1953. In December 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 October 1999.

In 2002, the Company's net income increased 13% to $7.8 million, or $1.59 per
share, up from $6.9 million, or $1.31 per share, in 2001. Net interest income
for 2002 was $26.6 million, while deposits totaled $497.4 million, and total
assets were $745.3 million at year-end 2002. The Company's common stock trades
on The Nasdaq Stock Market under the symbol FMSB.


P.14
<PAGE>

                                                                          CHARTS


NET INCOME (DOLLARS IN THOUSANDS)

99  $6,000
00  $6,599
01  $6,922
02  $7,797

ASSETS (DOLLARS IN MILLIONS)

99  $581
00  $678
01  $643
02  $745

DEPOSITS (DOLLARS IN MILLIONS)

99  $400
00  $457
01  $429
02  $497

LOAN PRODUCTION (DOLLARS IN MILLIONS)

99  $310
00  $211
01  $323
02  $342

RETURN ON AVERAGE EQUITY (PERCENTAGES)

99  16.2%
00  15.5%
01  14.1%
02  16.2%

NON-PERFORMING ASSETS (PERCENTAGE OF TOTAL ASSETS)

99  0.06%
00  0.38%
01  0.08%
02  0.28%

                                                                            P.15
<PAGE>

STOCK INFORMATION









The Company sold 966,000 shares of common stock in its initial public offering
on December 23, 1985. As of December 31, 2002, there were 4,247,166 shares
outstanding. The shares are held by approximately 1,700 shareholders of record
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 following data are based on the reported sale prices
on the Nasdaq National Market System for the quarters indicated, as reported by
the National Association of Securities Dealers.

The Company paid a cash dividend of five cents ($0.05) per share per quarter for
the first three quarters of 2001. The cash dividend was increased to seven cents
($0.07) per share for the fourth quarter of 2001 and each quarter thereafter in
2002.

Quarter Ending                           High*        Low*
----------------------------------------------------------
March 31, 2001                         $ 12.33     $ 12.16
June 30, 2001                            10.91       10.80
September 30, 2001                       12.64       12.05
December 31, 2001                        12.59       11.95
March 31, 2002                           13.79       13.75
June 30, 2002                            16.45       16.16
September 30, 2002                       15.78       15.76
December 31, 2002                        18.04       18.04

*Adjusted to reflect a 10% stock dividend paid May 8, 2002.

Year (based on December 31)

92  $ 3.07
93  $ 4.12
94  $ 3.98
95  $ 6.78
96  $ 8.77
97  $15.29
98  $10.95
99  $10.91
00  $11.93
01  $12.27
02  $18.04

Stock Value

Closing price adjusted for dividends and splits.

P.16
<PAGE>
<TABLE><CAPTION>
                                                             GENERAL INFORMATION
<S>                                                  <C>
BANCSHARES OFFICERS                                  ANNUAL MEETING
                                                     The annual meeting is scheduled to be held
PRESIDENT                                            April 24, 2003, 3 p.m., at the Hyatt Regency
John R. Valaas, Chief Executive Officer              Bellevue, 900 Bellevue Way NE, Bellevue, Washington.

EXECUTIVE VICE PRESIDENT                             TRANSFER AGENT AND REGISTRAR
Roger A. Mandery, Chief Financial Officer            Mellon Investor Services LLC
                                                     Shareholder Relations
EXECUTIVE VICE PRESIDENT                             P. O. Box 3315
James R. Boudreau                                    South Hackensack, New Jersey 07606
                                                     (800) 522-6645
EXECUTIVE VICE PRESIDENT                             www.melloninvestor.com
Richard J. Collette
                                                     INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
VICE PRESIDENT                                       Moss Adams LLP
Kari A. Stenslie, Controller
                                                     LEGAL COUNSEL
CORPORATE SECRETARY                                  Foster Pepper & Shefelman PLLC
Phyllis A. Easterlin
                                                     INVESTOR RELATIONS COUNSEL
BANK EXECUTIVE OFFICERS                              The Cereghino Group
                                                     5333 15th Avenue S, Suite 1500
PRESIDENT                                            Seattle, Washington 98108
John R. Valaas, Chief Executive Officer              (206) 762-0993

EXECUTIVE VICE PRESIDENT                             FORM 10-K
James R. Boudreau, Chief Credit Officer              A copy of the Form 10-K as filed with the
                                                     Securities and Exchange Commission will be
EXECUTIVE VICE PRESIDENT                             furnished to shareholders upon written request
Richard J. Collette, Commercial Banking Group        to the Secretary, First Mutual Bancshares,
                                                     Inc., P.O. Box 1647, Bellevue, Washington
EXECUTIVE VICE PRESIDENT                             98009-1647.
Roger A. Mandery, Chief Financial Officer
                                                     You may also contact us through our Web site:
SENIOR VICE PRESIDENT                                www.firstmutual.com
Robin R. Carey, Operations and Administration
                                                     FIRST MUTUAL BANCSHARES, INC. AND FIRST MUTUAL BANK
SENIOR VICE PRESIDENT                                CORPORATE HEADQUARTERS AND MAIN OFFICE
Robert J. Everett, Income Property Lending           400 - 108th Avenue NE
                                                     Bellevue, Washington 98004
SENIOR VICE PRESIDENT                                (425) 455-7300
Scott B. Harlan, Residential and Consumer Lending    (425) 453-5302 Fax
                                                     www.firstmutual.com
SENIOR VICE PRESIDENT
Sandy L. Tamiesie, Customer Service Support

VICE PRESIDENT
Kari A. Stenslie, Controller

CORPORATE SECRETARY
Phyllis A. Easterlin
</TABLE>
<TABLE><CAPTION>
-----------------------------------------------------------------------------------------------------------------------
FIRST MUTUAL BANK OFFICES
<S>                           <C>                           <C>                           <C>
BALLARD                       CROSSROADS                    KIRKLAND                      WEST SEATTLE
6301 15th Avenue NW           15635 NE 8th Street           278 Central Way               4520 California Avenue SW
Seattle, Washington 98107     Bellevue, Washington 98008    Kirkland, Washington 98033    Seattle, Washington 98116
(206) 706-0894                (425) 644-4214                (425) 893-9232                (206) 932-6299

BELLEVUE FINANCIAL CENTER     ISSAQUAH                      MONROE                        LOAN PRODUCTION OFFICES
400 - 108th Avenue NE         855 Rainier Boulevard N       19265 State Route 2           1200 10th Street, Suite 103
Bellevue, Washington 98004    Issaquah, Washington 98027    Monroe, Washington 98272      Bellingham, Washington 98225
(425) 453-2801                (425) 392-2673                (360) 794-8686                (360) 714-0433

BELLEVUE WEST                 JUANITA                       REDMOND                       2323 N 31st Street, Suite 200
10001 NE 8th Street           13633 - 100th Avenue NE       16900 Redmond Way             Tacoma, Washington 98403
Bellevue, Washington 98004    Kirkland, Washington 98034    Redmond, Washington 98052     (253) 759-3559
(425) 453-9434                (425) 823-6290                (425) 883-4700
                                                                                          SALES FINANCE LENDING OFFICE
                                                                                          3015 Hartley Road, Suite 12B
                                                                                          Jacksonville, Florida 32257
                                                                                          (888) 204-0204.FIRST MUTUAL
</TABLE>
<PAGE>






                                                 |
                                                 |
                              FIRST MUTUAL       |    2002
                              BANCSHARES, INC.   |    FINANCIAL INFORMATION
                                                 |
                                                 |


















<PAGE>

                          FIRST MUTUAL BANCSHARES, INC.

                                TABLE OF CONTENTS

                           2002 FINANCIAL INFORMATION

Management's Discussion and Analysis of
     Financial Condition and Results of Operations..........................1-18

Independent Auditor's Report..................................................19

Statements of Financial Condition..........................................20-21

Statements of Income.......................................................22-23

Statements of Stockholders' Equity............................................24

Statements of Cash Flows...................................................25-26

Notes to Consolidated Financial Statements.................................27-54

Forward-looking Statements....................................................55






<PAGE>

                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 two
subsidiaries, First Mutual Capital Trust I and First Mutual Capital Trust II.

FINANCIAL HIGHLIGHTS

     First Mutual Bancshares' performance in 2002 reflects another year of
record earnings, continued asset growth, and solid credit quality.

     Net income was up 12.6%, totaling $7,797,000, or $1.59 per diluted share,
which compares to $6,922,000, $1.31 per diluted share, in 2001, and $6,599,000,
$1.26 per diluted share, in 2000. Net income in 2002 was influenced by a
favorable increase in net interest income. Our net interest income in 2002
improved to $26.6 million from $21.3 million in 2001, an increase of 24.9%, as
compared to an increase of $818,000, or 4.0%, from 2000 to 2001. Net interest
income in 2000 totaled $20.5 million.

     Contributing to our record earnings for 2002 was the growth in total
assets, which increased $66.9 million, or 9.9%. By comparison, the increase in
assets in 2001 was $35.1 million, or 5.5%. Those figures compare to the national
average for asset growth for FDIC-insured commercial banks of 5.8% for the 12
months ending September 2002 and 4.9% for 2001. The growth in our assets
occurred principally in the loan portfolio. Portfolio loans (loans receivable)
in 2002 increased to $622.4 million, a growth of 9.2% from 2001's balance of
$570.1 million. The comparative increase in the prior year was 18.6%, or $89.6
million.

     Although our non-performing assets increased on a year-over-year basis,
they remained at relatively low levels. Non-performing assets increased to $2.1
million from $521,000 in 2001. As a percent of assets, non-performing assets
totaled 0.28% in 2002 versus 0.08% the previous year. The comparative ratio for
FDIC-insured commercial banks was 0.97% (September 30, 2002 data) for year 2002
and 0.92% for year-end 2001.

     During the year we issued $9 million in trust preferred securities and
entered into an interest rate swap to fix the interest rate for the first five
years. The proceeds from the issuance were used to fund the repurchase of
approximately 20% of our shares outstanding from one shareholder. This
transaction has proved to be beneficial to us in terms of improving our return
on equity (ROE) and enhancing our earnings per share (EPS). The repurchase
occurred in July and enhanced our EPS by $0.03 in the third quarter and $0.05 in
the fourth quarter. Absent the buyback, the EPS for the year would have been
$1.51, a decline of 5% from our actual results of $1.59. The ROE was also
greater this year because of the share repurchase. Again, absent that
transaction, our ROE for 2002, which was 16.20%, would have been 14.33%. There
are no current plans to repurchase additional shares in 2003.

RESULTS OF OPERATIONS

NET INTEREST INCOME

     Net interest income, which increased 24.9% from the prior year, is
influenced by the level of growth in our earning assets and the repricing
characteristics of our assets/liabilities. The latter, repricing of
assets/liabilities, is in turn influenced by the direction of interest rates. In
2002 we benefited by both an increase in earning assets and the repricing of our
assets/liabilities. In the two prior years the growth in earning assets offset
losses in the repricing of assets/liabilities. The following table includes a
breakdown of the change in earning assets, referred to as "volume," and the
repricing of assets/liabilities labeled "rate."

     Earning assets rose $63.3 million, or 9.7%, in 2002, following increases of
5.5% and 9.6% in 2001 and 2000, respectively. The growth over the past year in
earning assets has come mainly from the increase in the loan portfolio. Net
loans (excluding loans held for sale) rose $52.3 million, or 9.2%, this past
year. Earning assets contributed $2,557,000 to net interest income in 2002. In
2001 and 2000 the growth in assets increased

                                        1
<PAGE>
net interest income by $2,832,000 and $2,899,000, respectively. The contribution
from the change in interest rates totaled $2,756,000 for the year. Unlike 2002,
the change in interest rates negatively impacted both 2001 and 2000 by
$2,015,000 and $1,414,000, respectively.
<TABLE><CAPTION>
RATE VOLUME ANALYSIS                   2002 VS. 2001                    2001 VS. 2000                    2000 VS. 1999
(DOLLARS IN THOUSANDS)          INCREASE (DECREASE) DUE TO:       INCREASE (DECREASE) DUE TO:      INCREASE (DECREASE) DUE TO:
                                                      Total                            Total                            Total
                                Volume      Rate      Change     Volume      Rate      Change     Volume      Rate      Change
                               --------   --------   --------   --------   --------   --------   --------   --------   --------
<S>                            <C>        <C>        <C>        <C>        <C>        <C>        <C>        <C>        <C>
INTEREST INCOME
Investments:
  Available for sale
   securities..............    $  1,742       (291)  $  1,451        511       (176)       335        594         56        650
  Held to maturity
   securities..............      (1,690)      (577)    (2,267)      (434)      (752)    (1,186)       132         (4)       128
  Other equity
   investments.............         (26)       (78)      (104)       210        (87)       123        211        (79)       132
                               --------   --------   --------   --------   --------   --------   --------   --------   --------
     Total investments.....          26       (946)      (920)       287     (1,015)      (728)       937        (27)       910
                               --------   --------   --------   --------   --------   --------   --------   --------   --------
Loans:
  Residential..............         128       (972)      (844)      (301)        (2)      (303)        65        210        275
  Residential
    construction...........         544       (732)      (188)       528       (346)       182        479        227        706

  Multifamily..............         949     (2,079)    (1,130)       277       (395)      (118)     2,201        776      2,977
  Multifamily
    construction...........        (691)      (356)    (1,047)       245       (167)        78        442        355        797
  Commercial real
    estate and business....       2,533     (3,106)      (573)     2,406       (792)     1,614      1,557        692      2,249
  Commercial real
    estate construction....         111       (154)       (43)       213       (222)        (9)       257       (119)       138

  Consumer and other.......       1,019       (681)       338        657        (60)       597        863        196      1,059
                               --------   --------   --------   --------   --------   --------   --------   --------   --------
     Total loans...........       4,593     (8,080)    (3,487)     4,025     (1,984)     2,041      5,864      2,337      8,201
                               --------   --------   --------   --------   --------   --------   --------   --------   --------
     Total interest
       income..............       4,619     (9,026)    (4,407)     4,312     (2,999)     1,313      6,801      2,310      9,111

INTEREST EXPENSE
Deposits:
  Money market deposit
    and checking...........         336     (1,137)      (801)       110       (561)      (451)      (249)        38       (211)

  Regular savings..........          (1)       (49)       (50)       (27)       (19)       (46)       (51)       (64)      (115)

  Time deposits............        (382)    (7,482)    (7,864)       625        (46)       579      2,291      2,421      4,712
                               --------   --------   --------   --------   --------   --------   --------   --------   --------
     Total deposits........         (47)    (8,668)    (8,715)       708       (626)        82      1,991      2,395      4,386

FHLB advances and other....       2,109     (3,114)    (1,005)       772       (358)       414      1,911      1,329      3,240
                               --------   --------   --------   --------   --------   --------   --------   --------   --------
     Total interest
       expense.............       2,062    (11,782)    (9,720)     1,480       (984)       496      3,902      3,724      7,626
                               --------   --------   --------   --------   --------   --------   --------   --------   --------
     Net interest income...       2,557      2,756      5,313      2,832     (2,015)       817      2,899     (1,414)  $ 1 ,485
                               ========   ========   ========   ========   ========   ========   ========   ========   ========
</TABLE>
     The net interest margin rose in 2002 to 3.88% from 3.34% the previous year,
and 3.46% in 2000. The increase in the net interest margin in 2002 is
attributable to a slower decline in the interest income ratio than the
corresponding figure for the decrease in the interest expense ratio. The
interest expense ratio (interest expense/average deposits and borrowings) fell
from 5.19% in 2001 to 3.33% in 2002, a decrease of 1.86%. During the same period
the interest income ratio (interest income/average earning assets) only declined
1.23%. Several factors contributed to the disparate movement in ratios, to
include the effect of interest rates and the repricing characteristics of loans
and deposits.

     The Federal Reserve Bank (FRB) dropped short-term interest rates once
during 2002. This flat interest rate environment allowed the interest-bearing
liabilities, due to the lag effect, to "catch up" to the interest-bearing
assets. In the previous year, 2001, the FRB dropped rates 11 times. Our loan

                                        2
<PAGE>
portfolio, which is largely composed of adjustable-rate loans, fell rapidly that
year as most of those loans were tied to indexes that key off of short-term
rates. The interest-bearing liabilities, on the other hand, did not drop as
dramatically due to their "lagging" nature. In contrast, during 2002, with only
one rate drop by the FRB in November, the adverse effect on the interest-bearing
assets was less than the previous year. Interest-bearing liabilities continued
to reprice downward due to their lagging nature throughout the year, thus
benefiting the Bank with an improved net interest margin.

     Interest-bearing liabilities are heavily influenced by deposits, which make
up 71.0% of all liabilities. In contrast to adjustable-rate loans, deposit rates
are not directly governed by indexes. We set our rates weekly depending on the
general rates in effect for competing financial institutions. When interest
rates drop quickly, as occurred in 2001, there is a tendency for deposit rates
to decline more slowly, because of local competitive factors, than loan and
wholesale rates.


     Quarter Ended                                  Net Interest Margin
     -------------                                  -------------------
     December 31, 2001.....................................3.50%
     March 31, 2002........................................3.94%
     June 30, 2002.........................................3.94%
     September 30, 2002....................................3.95%
     December 31, 2002.....................................3.78%


     A review of the past 12 months shows that the net interest margin began
year 2002 at 3.50% (quarter ended December 31, 2001). The margin then rose to
3.94% for both the first and second quarters, increased slightly to 3.95% in the
third quarter, before dropping to 3.78% in the fourth quarter. As was noted
earlier, the FRB dropped interest rates only once during the year in November.
The impact of that drop contributed to the narrowing of the margin in the fourth
quarter. In the two years previous to 2002 we saw the net interest margin
decline from 3.46% in 2000 to 3.34% in 2001, which in turn was a decline from
3.66% in 1999.

     In addition to falling rates, year 2001 was further negatively affected by
the timing of maturing time deposits. The average balance of time deposits in
2001 was $332 million. Unfortunately, in terms of the effect upon the net
interest margin, $158 million, or 47.6% of these deposits, did not mature until
the fourth quarter. Thus, while the adjustable-rate loan portfolio was repricing
down fairly evenly throughout the year, time deposits were bunched into the
fourth quarter and didn't reprice until late in the year.

     The outlook for 2003 depends on our ability to continue to increase earning
assets and the direction of interest rates. To enhance our ability to grow
earning assets, we have significantly increased the capabilities of the Business
Banking, Consumer and Residential Lending departments. Seventy-three percent
(73%) of the staff additions this year were in those three departments. What we
don't know at this point is the degree to which a difficult local economy will
offset the increased marketing activity of the loan production departments.

     We attempt to measure the effect of changing interest rates with our gap
and interest rate simulation models. The gap model indicates that we are
currently 16.5% positively gapped, meaning that more assets will reprice within
a one-year period than liabilities. That model suggests that rising rates would
be to our advantage. The interest rate simulation model also indicates that
rising rates would be beneficial, calculating that, if rates were to raise 200
basis points ratably over the next 12 months, our net interest income would
improve by 1.9%. If rates were to fall 100 basis points, our net interest income
would probably decline 1.4%. For a further discussion of these two models,
please see the topics, "Market Risk Sensitive Instruments," page 11, and "Asset
and Liability Management," page 12.

     Our forecast for the first quarter of 2003 is for a net interest margin in
the 3.80%-3.90% range. The key assumptions for that forecast include a loan
repayment rate of 25% annually, short-term rates remaining the same, and the
Bank's one-year time deposit rate decreasing ratably over the quarter from 2.30%
to 2.21%.

OTHER OPERATING INCOME

     Other operating income fell in 2002 to $3,237,000 from $4,030,000 the
previous year. The comparable figure for 2000 was $2,090,000. The decline in the
current year was largely due to fewer gains in the sale of

                                        3
<PAGE>

investments. Other operating income is composed of five categories, one of
which, "gain on sale of loans," is further divided into four sub-categories.

     GAIN ON SALE OF LOANS

                                              2002         2001         2000
                                           ----------   ----------   ----------
     Sale of mortgage servicing rights     $  237,000   $  858,000   $  801,000
     Gain/loss on interest rate locks
       and forward commitments                 31,000     215,000             0
     Secondary market gains/losses            778,000     324,000      (525,000)
     Mortgage servicing rights (MSRs)          80,000     143,000       273,000
                                           ----------   ----------   ----------
     TOTAL                                 $1,126,000   $1,540,000   $  549,000

     SALE OF MORTGAGE SERVICING RIGHTS. The gains on servicing rights were
relatively flat in years 2000 and 2001, and then fell dramatically this year,
dropping $621,000, or 72%. The trend in the last three years is the result of
several changes: the decision to eliminate the residential servicing portfolio
for others and a preference for selling loans servicing released as opposed to
servicing retained.

     In the fall of 1997 we evaluated the loan servicing market and initiated a
series of sales that eventually led to the liquidation of the residential
servicing portfolio. Those bulk sales totaled $93 million in 1998, $51 million
in 2000, $78 million in 2001, and $19 million in 2002. A small servicing
portfolio of $46 million remains and is largely composed of commercial real
estate loans. The servicing rights related to those loans are not readily
saleable. The decision to sell our servicing portfolio was prompted by our
concern that increased loan prepayments, caused by falling interest rates, would
diminish the value of the servicing portfolio. That decision in 1997 to sell the
servicing portfolio was a prudent action as interest rates have since declined.

     The second major impact on gains from the sale of servicing is related to a
change in operating procedure that occurred in 2001 when we moved from a
preference for selling loans servicing retained to servicing released. The
difference between these two methods is that servicing-retained loans are sold
separately from their servicing rights. When the loans are sold, the servicing
rights are capitalized on our balance sheet until the rights are sold, or until
the loans underlying the servicing rights are paid in full. If the servicing
rights were sold, the gain would be recorded as a gain from the sale of mortgage
servicing rights. During the time that we own the servicing rights, service fee
income is recorded with each payment collected. With the servicing-released
sales, both the loans and servicing rights are sold at the same time. Although
the economic value of either method, if executed at the same time, is largely
the same to us, the timing of when and where the gains are recognized is very
different. Because of these timing differences a change from one method to
another affects the results reported in our financial statements.

     Total residential loan sales in 2002 amounted to $53 million, of which 87%
were servicing-released sales. In the previous year we sold $77 million in
residential loans, and 91% of those loans were servicing-released sales. The
comparable figures for year 2000 were $37 million in sales, with 42% of those
transactions as servicing-released sales. The decision to both sell the
residential servicing portfolio and shift from a servicing-retained to a
servicing-released preference resulted in a drop in gains from the sale of
servicing rights. In year 2003, it is unlikely that we will see the level of
gains in the sale of servicing that was experienced in years 2000 and 2001.

         GAIN/LOSS ON INTEREST RATE LOCKS AND FORWARD COMMITMENTS. Interest-rate
locks and forward commitments declined year-over-year from a gain of $215,000
last year to $31,000. There were no comparable figures for year 2000. This
sub-category of "gain on sale of loans" is the result of Statement of Financial
Accounting Standards (SFAS) No. 133, ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND
HEDGING ACTIVITIES, as amended, which became effective on January 1, 2001. The
accounting standard requires the mark-to-market of all interest-rate locks on
loans pending sale into the secondary market and forward commitments.
Interest-rate locks occur when we guarantee a rate on a loan for a set period,
typically a 15-, 30- or 45-day period, while the loan is being processed. During
that period our obligation is considered a financial derivative. Forward

                                        4
<PAGE>

commitments, on the other hand, are contracts that we have with security dealers
to deliver loans at a set price. Those contracts are usually in $1 million
amounts with a 90-day term. They are also considered to be financial
derivatives.

     The change between the last two years is less than it initially appears in
that in year 2001, because it was the first year for the new accounting
statement, a loss was reported separately as a change in accounting principle on
the face of the income statement. That amount was a loss of $155,000 after tax,
or $235,000 before tax. After the two figures are added together, the pre-tax
loss in 2001, from marking-to-market the rate locks and forward commitments, was
$20,000, which compares to this year's gain of $31,000.

     Market gains or losses occur whenever there is a change in mortgage rates.
If interest rates decline, the mark-to-market of forward commitments results in
a loss. Just the opposite is true for interest-rate locks. The amount of
gain/loss at the end of a financial statement period depends on which direction
interest rates have moved and the relative totals of forward commitments to
interest-rate locks. At year-end 2002 both forward commitments and interest-rate
locks each totaled $4 million.

     SECONDARY MARKETING GAINS/LOSSES. Secondary market gains/losses are the
cash gains or losses from the sale of loans into the secondary market and the
resulting gain/loss from the settlement, called "pair-offs," of forward
commitments. The gain/loss from the sale of loans into the secondary market
includes both loans sold servicing released and servicing retained. Pair-off
gains/losses occur when forward commitments settle without the corresponding
loans being delivered into the secondary market at the same time. This happens
on a routine basis as the forward commitments are typically for a 90-day period,
while it often takes either more or less time to close and deliver a loan into
the secondary market. As was noted in an earlier discussion of marking-to-market
forward commitments, rising mortgage rates make forward commitments more
valuable, while falling rates have the opposite effect.

     Secondary market fees amounted to a gain of $778,000 for 2002 as compared
to a gain of $324,000 for 2001, and a loss of $525,000 for 2000. The increase
for the year is largely a result of fee income generated from the sale of
consumer loans and a significant drop in pair-off losses.

                                     2002             2001             2000
                                  ---------        ---------        ---------
     FEES FROM THE SALES OF:
     Residential Loans:
       Servicing Retained         $  94,000        $ (65,000)       $(256,000)
       Servicing Released           358,000          431,000           57,000
       Pair-offs                   (196,000)        (399,000)        (396,000)
                                  ---------        ---------        ---------
     Total Residential Loans        256,000          (33,000)        (595,000)
     Consumer Loans                 523,000          357,000           70,000
                                  ---------        ---------        ---------
     Total                        $ 778,000        $ 324,000        $(525,000)
                                  =========        =========        =========

     SALES OF:
     Residential Loans:
       Servicing Retained        $7.0 million     $7.0 million     $21.3 million
       Servicing Released       $46.4 million    $69.6 million     $15.7 million
       Consumer Loans           $16.9 million    $ 6.7 million           NA

     Fees from the sale of residential loans amounted to a gain of $256,000 in
2002 as compared to losses of $33,000 and $595,000 in years 2001 and 2000,
respectively. As seen in the preceding table, residential fee income is
comprised of servicing-released fees, servicing-retained fees, and pair-off
fees.

     Servicing-released loan sale gains totaled $358,000 as compared to $431,000
last year, and $57,000 in year 2000. As was noted earlier, our emphasis on
selling loans serviced released has accounted for most of the change when
comparing year 2000 to the two subsequent years. The difference between the
current year and last year is the drop in sales from $70 million in 2001 to $46
million this year. Much of that difference is

                                        5
<PAGE>

related to a shift towards retaining more residential loans in our loan
portfolio. In 2002 $148 million in residential loans were originated, of which
$53 million were sold. The previous year's loans closed totaled $136 million,
and $76 million were sold. The comparable figures for 2000 were $67 million in
loans originated, and $37 million in sales. Our focus over the last few years on
custom construction lending has allowed the Bank to retain an increased portion
of the loans closed.

     Servicing-retained loan sales typically result in a loss. We generally
recover that loss through the sale of mortgage servicing rights (see discussion
under the heading "Sale of Mortgage Servicing Rights" on page 4). In year 2002
we recorded a gain on the sale of loans into the secondary market of $94,000 as
compared to losses of $65,000 in the prior year, and $256,000 in 2000. The gain
in 2002 occurred even though loans sold servicing retained were the same as the
prior year. The results seen this year were largely due to good fortune when
executing the sales; we would not expect gains in a typical year. Pair-off
losses tied to the hedging activities of residential loans being held-for-sale
for 2002 totaled $196,000 as compared to $399,000 for 2001 and $396,000 for
2000. In 2001, during a period when we were more active in mortgage-banking
activities, rates fell throughout the year making the hedging of interest rates
more difficult. Over the past year we have changed our strategy and deemphasized
our salable residential loan products in relation to our overall product menu.
Competitive pressure in the conforming loan market (which are the loans that we
generally sell) has encouraged us to focus more on the portfolio and
construction products that we offer.

     Gains from the sale of consumer loans amounted to $523,000 in 2002,
$357,000 in 2001, and $70,000 in 2000. Loans sold have steadily increased over
the last three years, from a negligible amount in 2000, to $7 million last year,
and $17 million this year. Our forecast for year 2003 is for gains from loan
sales to drop significantly. Although we anticipate that loan origination volume
will increase over year 2002 results, we intend to portfolio more of those
loans. We have been pleased with the performance to date of the home improvement
loans that we have retained in our portfolio. The yield on the home improvement
loan portfolio is considerably higher than our other loan portfolios, and the
level of charge offs and non-performing assets has been very satisfactory.

     MORTGAGE SERVICING RIGHTS (MSRS). Mortgage servicing rights (MSRs) are
associated with servicing-retained loan sales. When a loan is sold separate from
its servicing rights (and we retain that right), we capitalize, per SFAS
Standard No. 140, ACCOUNTING FOR TRANSFERS AND SERVICING OF FINANCIAL ASSETS AND
EXTINGUISHMENT OF LIABILITIES, the fair market value of that right. The amount
of MSRs capitalized and recognized in income totaled $80,000 for 2002 as
compared to $143,000 for 2001 and $273,000 for 2000. The total loan sales
related to the capitalization of the MSRs in 2002 amounted to $7.0 million as
compared to $7.0 million in 2001 and $21.3 million in 2000. The downward trend
in MSRs is largely attributable to a change in both the mix and calculation of
the MSRs. The mix of servicing-retained loan sales is typically comprised of
residential, income property and business banking loans. Because of the nature
of income property and business banking loans, their valuations tend to be far
less than residential loans. In year 2000 gains from residential loans
represented 95% of the capitalized servicing-retained loan sales, which
contrasts with 33% this year. The comparable figure for year 2001 was 70%.

     The other factor impacting MSRs is the valuation used for each type of
loan. Periodically, and at least annually, we review the calculation of fair
market values, of which a key consideration is loan prepayments. Because of the
heavy loan prepayments in the last few years, we have reduced the valuation of
capitalized MSRs.

SERVICING FEES, NET OF AMORTIZATION

     In 2002 net service fee income from the mortgage servicing portfolio
totaled $103,000 as compared to $106,000 in 2001. The comparable figure for 2000
was $552,000. Service fees principally consist of the fees that we collect for
servicing loans for others. The bulk sales of servicing rights over the last few
years have eroded the balance of that portfolio. The loans serviced for others
portfolio balance has decreased over a three-year period, from $174 million in
2000 to $47 million last year, and $46 million at year-end 2002. As was
commented on earlier, the election to sell the servicing portfolio because of
consistently decreasing mortgage rates has turned out to be a fortunate decision
for us. We don't anticipate changing that strategy in 2003.

                                        6
<PAGE>

GAIN ON SALE OF INVESTMENTS

     Our gains amounted to $508,000 this year as compared to $1,165,000 in 2001.
We didn't have any comparable sales in 2000. The investment sales consisted of
security sales and the sale of an ATM network last year.

     Gains on security sales totaled $479,000 in 2002. That figure compares to
gains of $700,000 last year. Because of declining mortgage rates for the last
two years, it has been to our advantage to sell a security and realize a gain on
that sale rather than wait for the security to prepay at par with no gain.
Security sales this year amounted to $35 million. Sales last year totaled $44
million. We have also executed several sales in early 2003, totaling $8.6
million, with gains of $229,000.

     The ATM network sale involved the liquidation of our interest in the
TransAlliance Limited Partnership. The general partner, Electronic Data Systems
(EDS), purchased our interest along with that of the other limited partners. We
realized a gain of $464,000 in year 2001, and another $29,000 was received this
year as part of the wrap-up of the liquidation.

FEES ON DEPOSIT SERVICES

     Deposit fee income has steadily increased over the last three years, from
$278,000 in year 2000 to $334,000 last year, and again this year to $472,000.
Virtually all that income is attributable to checking accounts. Our growth in
checking account balances has been solid, increasing from $31 million in 2000 to
$44 million this year. In the last 12 months the growth in business checking
accounts has been particularly strong. These account balances are up 79%, from
$9.2 million last year to $16.5 million.

     In addition to the increase in checking account totals, we have introduced
several new checking account products that have been well received. Our
"CheckPay Solutions" product has been very popular, which in turn has improved
our fee income.

OTHER INCOME

     Other income is composed of a variety of sources of which loan fees
constitute the most significant item. Our fee income from this source has risen
steadily from $253,000 in year 2000, to $458,000 last year, to $579,000 in 2002.
In the last couple of years most of that income is attributable to loan
prepayment and extension fees. Loan prepayment fees are up dramatically, from
$169,000 last year to $303,000. Although the fee income from the early repayment
of a loan partially compensates us for the loss of the loan, we would much
prefer to retain the asset. Loan payoff rates have been particularly high in the
last three years. Prepayment rates were 14.4% in 2000, 22.7% in 2001, and 24.5%
this year.

     Extension fees are another significant component of loan fees, totaling
$97,000 in 2000, $249,000 last year, and $200,000 this year. Extension fees
occur when a construction project is not completed on time. We are typically
paid a fee to work with the borrower through the extended period needed to
finish the project. Although we are concerned when a construction project is not
completed on time, it is unusual for these loans not to be concluded in a
satisfactory manner. Thus, while loans prepaid early usually result in the loss
of an asset, extended loans generally culminate in a loan asset.

OTHER OPERATING EXPENSES

SALARIES AND EMPLOYEE BENEFITS

     Compensation costs have risen substantially in the last two years after
having declined slightly three years ago. Employee expenses in 2002 increased
$1,770,000, or 20.9%, as compared to a rise of $1,313,000, or 18.4%, from 2000
to 2001. A decrease of $148,000, or 2.0%, occurred from 1999 to 2000. Salaries
and employee benefits costs were affected by an increase in staff and a rise in
loan officer commissions.

     The staffing level, referred to as full-time equivalent (FTE), totaled 164
at year-end 2002. That figure compares to 143 at December 2001, and 126 the
previous year. The staffing increase this year was largely focused in our
lending departments. Business Banking, a department that has seen its staffing
level increase

                                        7
<PAGE>

sharply in the last few years, further grew its personnel count by 50%. The
Consumer Lending and Residential departments also saw staff increases of 15% and
56%, respectively.

     We anticipate an additional increase in compensation expense of between 20%
and 23% in 2003. Staffing levels are expected to rise by over 20%, with about
half of that increase occurring in our retail branch network. The staffing
levels in the branches were static this year. In 2003 we expect to open an
office in Woodinville, and possibly a second branch on the Eastside. The
remainder of the staff additions is split about evenly between the loan
production and the administrative support departments.

     In addition to compensation costs rising, due to a growth in staffing
levels, we also increased salary levels by 3.48% in 2002 as a result of our
annual compensation reviews and position promotions.

     Loan officer commissions totaled $1,012,000 in 2002, up 21.2% on a
year-over-year comparison. Loan originations increased 7.2% to $342 million as
compared to last year. Commission expense totaled $835,000 in 2001 and $535,000
in 2000 on loan volume of $319 million and $210 million, respectively. A change
in commission plans during the year added to the increase in commission expense.

     One of the issues that complicates the reporting of compensation expense is
the deferral of loan origination costs. In accordance with the current
accounting literature, standard loan origination costs are deferred and
amortized over the life of the loan. The standard loan costs, which are
determined for each loan type, are then deducted from operating expense, with
the net figures reported in the financial statements. Compensation is thus
comprised of the expected items such as salaries, benefits and commissions, but
also the effect of deferred loan origination costs, which can vary substantially
from year-to-year, as seen in the following chart.

                                         2002           2001           2000

   Salaries and Benefits             $ 11,685,000   $  9,426,000   $  8,018,000
   Deferred Loan Origination Costs     (1,449,000)      (960,000)      (866,000)
                                     ------------   ------------   ------------
   Net Salaries and Benefit Costs    $ 10,236,000   $  8,466,000   $  7,152,000
                                     ============   ============   ============
   Loan Originations                 $342,000,000   $319,000,000   $210,000,000
                                     ============   ============   ============

     Our projections for compensation expense for 2003 include both the expected
costs for labor and the anticipated benefit from the deferral of loan
origination expenses. If loan originations were to change materially from our
projections, our operating costs could be significantly impacted.

OCCUPANCY EXPENSE

     Occupancy expense of $2,353,000 in 2002 was up 10.4% from $2,131,000 the
previous year. The comparative figure for 2000 was $1,812,000. In the last three
years we have opened two full-service branches, a loan production office, and
have added leased space at the Bellevue headquarters.

     In September of 2000 the Kirkland office was opened, and subsequently in
August of 2001 the Juanita office commenced operation. A consumer loan
production office in Florida was opened in 2001. Over the past few years leased
space has steadily increased in the Bellevue corporate headquarters to
accommodate the growth of staff in the lending and administrative support
departments. In March 2002 we ceased operations at the Bellingham branch,
although the facility was retained through the end of the original lease term,
which expired in February 2003. After the branch was closed, this space was used
to accommodate an income property loan production office through February 2003,
at which time a more functional space was leased for that office. The Bellingham
retail branch facility proved to be too distant from the corporate headquarters
in Bellevue to adequately support its operations.

                                        8
<PAGE>

OTHER EXPENSES

     Other expenses rose from $3,699,000 in 2001 to $4,566,000 in 2002. From
2000 to 2001, costs grew $571,000, or 18.3%. A number of items contributed to
the increase in other operating expenses, to include marketing/public relations,
legal and office supplies expense.

     In late 2001 we focused our marketing activities in a new Marketing
Department. The principal objective of this department is to increase our
marketing presence in the Puget Sound area. That department is off to a great
start and has been of tremendous value to both our established lines of
business, as well as the new lines, such as Business and Community Banking. As a
result, marketing and public relations expenses have risen sharply, from
$489,000 in 2001 to $845,000 in 2002, or 72.8%. The comparable figure for 2000
was $528,000. We anticipate that our costs will again increase significantly in
2003.

     Legal expenses have risen over the past three years. Legal costs totaled
$179,000 in 2000, increasing to $300,000 in 2001, and $381,000 this past year.
In addition to routine corporate matters, we have incurred expenses related to
the issuance of trust preferred securities and the 20% stock repurchase, as well
as the continued nationwide expansion of the Sales Finance Department. Expenses
associated with those items accounted for over half of the legal expenses for
the year.

     In July we repurchased approximately 20% of our stock from the MGN Group
LLC. This was an unforeseen opportunity to acquire one-fifth of our stock in a
single transaction at close to market rates. To partially fund that transaction,
we issued $9 million in trust preferred securities. For a further discussion of
that security, see "Capital" on page 15. We also incurred legal costs to
continue the expansion of the Sales Finance program. That department is now
capable of originating home improvement loans in 32 states. Legal expenses for
years 2001 and 2000 related primarily to the Sales Finance program expansion and
general corporate matters, respectively.

     Our office supplies expense rose $79,000, or 34.7%, in 2002. The cost of
office supplies totaled $229,000 in 2001, which compared to $209,000 in 2000.
Rising costs over the last few years are largely attributable to the increase in
staff occurring from an expansion of the business lines. In the past two years
the growth in staff has averaged approximately 14.4%, and business lines such as
Sales Finance, Business Banking, and the retail branch offices have increased,
resulting in a need for more general office supplies.

RESERVE AND PROVISION FOR LOAN LOSSES

     The provision for loan losses reflects the amount deemed appropriate to
produce an adequate reserve for estimated losses that exist based on the
inherent risk characteristics of the Bank's loan portfolio. In determining the
appropriate reserve balance, we take into consideration the profile of the loan
portfolio, the local and national economic outlook, and the current and
historical performance of the loan portfolio.

     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. That department analyzes the loan portfolio from a historical credit
perspective and a composition and geographic concentration viewpoint. The Asset
Management Department then prepares an economic analysis of the Puget Sound
region to include, when appropriate, employment forecasts, housing sales,
vacancy rates, commercial real estate analysis, and comments on the area's major
employers. That information is then reviewed by our Commercial Loan Committee,
which further evaluates national and international trends and makes a
recommendation as to the loan loss provision to the Audit Committee of the Board
of Directors. The Audit Committee considers the input of the Asset Management
Department and the recommendation of the Commercial Loan Committee and
determines the appropriate level of reserves. The Board of Directors reviews and
ratifies the actions of the Audit Committee.

     A $910,000 provision for loan losses was charged to operations in 2002,
raising the loan loss reserve balance to $7,754,000 at December 31, 2002. At
year-end 2001, the reserve balance was $7,032,000, which in turn was an increase
of $303,000 over 2000's balance of $6,729,000.

                                        9
<PAGE>

     Two key considerations that led to the increase in the reserve for loan
losses included the growth in the loan portfolio and an assessment of the local
and national economies.

     Since year-end 2001 the net loan portfolio (excluding loans held-for-sale)
has increased $52 million. Most of that growth was in the residential loan area,
which is generally considered lower risk than the commercial real estate or
business banking loans, although the economy in the Northwest can have a
significant effect on the performance of all loan types.

     The national and local economic environments over the past year have been
of concern. Negative economic news has continued to accumulate throughout the
year. The stock market, which was influenced by corporate accounting scandals
earlier in the year, has been volatile in the past few months in part because of
concerns about a possible war with Iraq and the economy. The Northwest economy
has been more adversely impacted than the national economy, and economists
predict that it is expected to lag any national economic recovery by a year or
more.

     Another significant factor that has influenced the amount of the loan loss
provision for the last three years has been the level of non-performing assets
as a percentage of total assets. That ratio was 0.28% at year-end 2002, and
compares to 0.08% last year, and 0.38% in 2000. The comparative ratio for
FDIC-insured commercial banks was 0.97% at September 30, 2002, and 0.92% for
year 2001. For a number of years we have experienced better than average ratios
for non-performing assets. If the economy were to further deteriorate, we are
hopeful that our past credit underwriting will continue to allow us to
outperform other financial institutions as to non-performing assets.

ADOPTION OF NEW ACCOUNTING PRINCIPLE

     Statement of Financial Accounting Standards (SFAS) No. 148, ACCOUNTING FOR
STOCK-BASED COMPENSATION - TRANSITION AND DISCLOSURE, became effective for
financial statements for fiscal years ending after December 15, 2002. The new
accounting standard amends APB Opinion No. 28, INTERIM FINANCIAL REPORTING and
SFAS No. 123, ACCOUNTING FOR STOCK-BASED COMPENSATION, to require prominent
disclosure about the effects on reported net income of an entity's accounting
policy decisions with respect to stock-based compensation and to require
disclosures about those effects in interim financial information. We have
elected to continue to use the intrinsic value method of accounting and, as a
result, the provisions of this statement are not expected to have a material
effect on our financial position or results of operations.


REVIEW OF FINANCIAL CONDITION

INVESTMENT SECURITIES

     Investment securities increased slightly, from $72 million at year-end 2001
to $75 million as of December 31, 2002, a rise of 3.3%. Although the year-end
balances have changed little, there was considerable activity within the
securities portfolio during the year. Security purchases for year 2002 totaled
$38.3 million, sales of securities amounted to $35.0 million, while
approximately $1 million in securities matured, and $14.5 million in loans were
securitized from our loan portfolio. The security purchases during the year
replenished the securities portfolio to just above its beginning-of-the-year
level. The security sales were executed to both take advantage of market gains
and, as a defensive measure, to realize premiums on securities before they
prepaid at par.

     The current investment securities balance, as of January 31, 2003, is $65
million. During January 2003, $8.6 million in mortgage-backed instruments have
been sold, resulting in gains of $229,000, and one security totaling $1.2
million has been purchased. Although it was our intent at the end of 2001 to
significantly increase the securities portfolio in 2002, market offering rates
were not attractive enough to warrant raising the portfolio beyond its year-end
balance. Our current plan is to increase the securities portfolio by $14 million
in 2003, although we are concerned about growing the portfolio at rate levels
that are at 40-plus-year lows. Whether or not we will be able to successfully
increase the portfolio will depend in large measure on the direction of interest
rates and the slope of the yield curve.

                                       10
<PAGE>

LOANS

     The loan portfolio is segregated into two components: loans held-for-sale
and loans receivable. Loans held-for-sale is that portion of the loan portfolio
which is pending sale and delivery into the secondary market. Loans receivable
are loans held in the loan portfolio of which the largest component is
commercial real estate.

     Loans held-for-sale totaled $13 million at December 31, 2002, an increase
of $9 million from the previous year-end. At December 31, 2001, loans
held-for-sale totaled $4 million. It is not unusual for the balance in loans
held-for-sale to change significantly from year to year. The normal balance for
loans held-for-sale is in the range of $4 to $12 million, but will vary with
construction lending and refinancing activity.

     Portfolio loans increased 9.1% in 2002, from $570 million at December 31,
2001, to $622 million at year-end 2002. The growth in the loan portfolio is the
result of a slight increase in portfolio loan originations, which was partially
offset by a rise in the repayment of loans. Loans closed for the portfolio
totaled $245 million in 2002, up from $243 million in 2001. Loan principal
repayments, which were $172 million in 2001, increased this year to $181
million.

DEPOSITS

     Deposits increased $68 million, or 16.0%, in 2002, which contrasts with a
decrease of 6.3% in 2001. The comparative ratio for FDIC-insured institutions
was an increase of 6.0% in the 12 months ending September 30, 2002. Included in
this year's deposit growth are approximately $17 million of brokered deposits,
which we acquired in the first quarter of 2002. The remaining $51 million
increase in deposits was characterized by an emphasis on low-cost deposits and
an improvement in the mix of deposits.

     The trend for the last three years has been mixed. In year 2000 deposits
increased 14.3%, with almost all of that growth occurring in time deposits. Last
year deposits fell 6.3%, again with almost all of the change occurring in the
time deposit category. This year net growth occurred in all deposit categories,
with 49% (excluding broker deposits) coming from the lower cost money
market/checking category. Part of the success in 2002 can be attributed to the
newer business lines, Business and Community Banking. Business checking accounts
alone this year rose 79%. We have focused much of our resources, both management
and financial, on those business lines, and we look forward to continuing that
level of emphasis in 2003.


MARKET RISK SENSITIVE INSTRUMENTS

     Market risk is the risk of loss from adverse changes in market prices and
rates. A significant market risk arises from interest rate risk inherent in our
lending, deposit, borrowing, and mortgage-banking activities. To that end, we
actively monitor and manage interest rate risk exposure.

     A number of measures are utilized to monitor and manage interest rate risk,
including income simulation and interest "gap" analysis (further discussed under
the subheading "Asset and Liability Management" on page 12). An income
simulation model is primarily used to assess the impact on earnings changes that
interest rates may produce. Key assumptions in the model include prepayment
speeds on mortgage-related assets, cash flows and maturities of financial
instruments held for purposes other than trading, changes in market conditions,
loan volumes and pricing, deposit sensitivity, consumer preferences, and
management's capital leverage plans. These assumptions are inherently uncertain;
therefore, the model cannot precisely estimate net interest income or precisely
predict the impact of higher or lower interest rates on net interest income.
Actual results may significantly differ from simulated results due to timing,
magnitude and frequency of interest rate changes, and changes in market
conditions and specific strategies, among other factors.

     During 2002 we discontinued the use of the rate shock simulations to
forecast changes in net interest income and the market value of equity. We
believe that a rate ramp simulation produces results that more closely track
actual performance. The difference between the two models is the assumption
regarding the timing of the interest rate increases or decreases. A rate shock
model assumes rates immediately rise or fall 200 basis points, whereas a rate
ramp assumes a steady increase in interest rates over a 12-month period. All
numbers presented reflect the results of the rate ramp simulation.

                                       11
<PAGE>
     Based on the results of simulations as of December 31, 2002, and December
31, 2001, the estimated impact of a steady change in interest rates over the
next 12 months is shown in the table below.
<TABLE><CAPTION>
                                     2002 Percentage Change         2001 Percentage Change
                                     ----------------------         ----------------------
     Ratable Change in Interest   Net Interest   Net Portfolio   Net Interest   Net Portfolio
     Rates (in basis points)         Income          Value          Income          Value
     --------------------------      ------          -----          ------          -----
     <S>                              <C>            <C>              <C>           <C>
     +200 .......................      2%            (11)%            (1)%          (12)%
     (100).......................     (1)              0              (1)            (2)
     (200).......................     N/A            N/A              (3)            (7)
</TABLE>

     The interest rate scenarios reflected above represent the results of
possible near-term interest rate movements. Approximately 75% of the loan
portfolio is tied to rate indexes that are one year or less in duration. These
indexes include Prime, Federal Home Loan Bank of Seattle (FHLB) Advance Rate,
London Interbank Offering Rate (LIBOR), and Constant Maturity Treasury (CMT),
all of which as of December 31, 2002, were below 2%. Therefore, given the
current interest rate levels, we believe that a scenario simulating a decline of
200 basis points is unlikely, as this would place the absolute rate of these
indexes below zero.

     The percentages shown represent changes over a 12-month period in net
interest income and net portfolio value under the various rate scenarios. Net
portfolio value is defined as the net market value of our assets and
liabilities, which have been estimated by calculating the present value of their
cash flows. The cash flows have been adjusted to account for projected
amortization, prepayments, core deposit decay rates, and other factors.

     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 obtain the
maximum net interest margin. We rely primarily on our asset and liability
structure to control interest rate risk.


ASSET AND LIABILITY MANAGEMENT

     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 in
a systematic manner. In addition to a simulation model, an interest "gap"
analysis is used to measure the effect interest rate changes have on net
interest income. The gap is the difference between the amount of
interest-earning assets maturing or repricing within a specific time period and
the amount of interest-bearing liabilities maturing or repricing in that same
time period. A gap is considered positive when the amount of
interest-rate-sensitive assets exceeds the amount of interest-rate-sensitive
liabilities. A gap is considered negative in the reverse situation.

     The following table shows the one-year interest-rate-sensitive gap by
contractual repricing or maturity at December 31:

                                                        2002          2001
                                                     ---------     ---------
                                                         (IN THOUSANDS)
     One-year repricing assets                       $ 600,577     $ 506,137
     One-year repricing liabilities                    477,932       413,029
                                                     ---------     ---------
     One-year gap                                    $ 122,645     $  93,108
                                                     =========     =========
     Total assets                                    $ 745,295     $ 678,349
                                                     =========     =========
     Interest-rate-sensitive gap as a
        percent of assets                                16.5%         13.7%

                                       12
<PAGE>
     It is generally assumed that during a period of rising interest rates, the
net earnings of an institution with a negative gap may be adversely affected due
to its interest-bearing liabilities repricing to a greater extent than its
interest-earning assets. Conversely, during a period of falling interest rates,
net earnings may increase. That assumption, however, is based on the premise
that assets/liabilities within a one-year time frame will generally move in the
same direction at approximately the same rate. A concern, however, is that the
relationship between one-year asset/liabilities may not be as strongly
correlated as originally assumed. Loans with one-year repricing characteristics
are tied to a number of indexes to include one-year Treasury, LIBOR, and FHLB
rates. Those indexes are subject to the movement of the one-year market rates.
On the other hand, time deposits, which constitute the bulk of the one-year
repricing liabilities, are subject to the local financial institutions' market.
Pricing for time deposits is dependent on customer preferences and the
subjective pricing influence of local banks, credit unions, etc. Thus, while the
bulk of our loans are tied to national and international money markets, deposits
are subject to the conditions of the Puget Sound area.

     One method of managing our interest rate risk is through the marketing and
funding of adjustable-rate loans. As of December 31, 2002, 92% of the loan
portfolio had adjustable rates. We also originate and sell long-term, fixed-rate
mortgage loans, which have been written to specifications of the Federal Home
Loan Mortgage Corporation (Freddie Mac) and the Federal National Mortgage
Association (Fannie Mae).

     We review on a monthly basis interest rate trends, and where appropriate
hedging techniques are employed. 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. During the last three
years the extent of our off-balance-sheet derivative agreements has been the use
of forward loan commitments which are used to hedge the loans held-for-sale. In
2002 we also entered into an interest rate swap with the FHLB. The purpose of
the swap is to protect against potential adverse interest rate volatility that
could be realized from the trust preferred securities issuance in June 2002. The
swap accomplishes this by fixing the interest rate payable for the first five
years of the trust preferred securities' life. We may decide to enter into these
types of off-balance-sheet instruments in the future when it is beneficial to
the Bank.

ASSET QUALITY

     Non-performing assets totaled $2.1 million at year-end 2002 as compared to
$521,000 last year. Non-performing assets as a percent of total assets amounted
to 0.28% at the end of 2002, up from 0.08% at December 2001. The following table
details the type of property held as collateral and our estimate as to any loss
of principal and interest.

                              NON-PERFORMING ASSETS

     Mini-storage loan, Puget Sound area.
       No anticipated loss........................................ $  1,253,000
     Office building loan, Puget Sound area. Subsequent
       to year-end this loan was purchased in a trustee
       foreclosure sale. We did not incur a loss on that sale.....      343,000
     Two residential loans, Puget Sound area.
       No anticipated loss........................................      360,000
     Residential, out-of-state. No anticipated loss...............       66,000
     Time deposit loan. Fully collateralized by cash..............        3,000
     Two motorcycle loans, out-of-state. Both of these
       loans have been reinstated.................................        7,000
     Four home improvement loans, in-state. No anticipated loss...       31,000
     Two home improvement loans, in-state. Both loans
       are to be charged off......................................       11,000
                                                                   ------------
     Total Non-performing Loans................................... $  2,074,000
                                                                   ------------
     Repossessed property (principally spas and motorcycles)......       45,000
                                                                   ------------
     Total Non-performing Assets.................................. $  2,119,000
                                                                   ============

                                       13
<PAGE>
     The status of the larger non-performing assets as of February 12, 2003, is
as follows:

     o    The mini-storage loan for $1,253,000 is under the management of a
          court-appointed receiver. The property is generating positive cash
          flows after debt service. The trustee foreclosure sale is scheduled in
          the second quarter of 2003. No anticipated loss.

     o    Two residential loans for $360,000: The first loan is for a "spec"
          house which is 90% complete and expected to pay off prior to the
          trustee's sale, with no anticipated loss. The other residential loan
          has a scheduled trustee's sale during the first quarter of 2003, again
          with no anticipated loss.

     o    The out-of-state residential loan for $66,000 is a single-family
          residence. There is not an anticipated loss.

LIQUIDITY

     Liquidity refers to the ability to generate sufficient cash to meet the
funding needs of current loan demand, deposit withdrawals, principal and
interest payments with respect to outstanding borrowings, and to pay operating
expenses. The need for liquidity is affected by loan demand, net changes in
deposit levels, and the scheduled maturities of borrowings. We can minimize the
cash required during times of heavy loan demand by modifying credit policies or
reducing marketing efforts. Liquidity is derived from assets by receipt of
interest and principal payments and prepayments, by the ability to sell assets
at market prices, earnings, and by utilizing unpledged assets as collateral for
borrowings. Liquidity is also derived from a variety of funding sources,
including deposits, advances from the FHLB, and other short- and long-term
borrowings.

     The principal use of funds is to invest in securities and loans. Security
purchases amounted to $38.3 million in 2002, down 9.8% from $42.4 million in
purchases in 2001, and purchases totaled $5 million in 2000. Loan originations,
including mortgage-banking activities, totaled $342 million, $323 million, and
$211 million during 2002, 2001, and 2000, respectively. Principal repayments on
portfolio loans totaled $181 million, $172 million, and $100 million for the
same periods. Funds obtained from loan sales amounted to $89 million in 2002,
$98 million in 2001, and $43 million in 1999.

     Our line of credit with the FHLB has been established at 40% of assets.
Borrowings totaled $184 million, $191 million, and $133 million, at December 31,
2002, 2001, and 2000, respectively. These borrowings represented 24.7% of the
year-end assets in 2002, 28.2% in 2001, and 20.7% in 2000.

     FHLB borrowings decreased in 2002 in response to a growth in deposits
during the year. It is our intent to fund asset growth principally through the
growth of deposits. In year 2003 we anticipate an increase in deposits, and
expect to continue to work towards adjusting the deposit mix to include more
low-cost deposits.

     Unused lines of credit available to us include $114 million in FHLB
advances and $50 million in reverse repo lines. In addition, the holding company
is currently seeking a $5 million line of credit with a national financial
institution. We also have the option of funding asset growth or funding
withdrawals with brokered deposits.

     Another source of liquidity is trust preferred securities (TPS). We issued
$9 million in securities last summer, and another $4 million in January 2003.
This liquidity source serves the dual function of providing funds for operations
and as a source of capital. Because the TPS funding source is more expensive
than our other liquidity sources, it is used primarily for its capital sourcing
properties (for a further discussion of TPS, see "Capital" following this
section). The practical limit to this liquidity source is 50% of shareholder
equity, which at year-end 2002 was $44 million. Thus, the practical limit to
this source is $22 million, of which we have funded $13 million to date.

     In addition to the funding of loans and securities, we used $16 million of
our liquidity sources to repurchase 20% of our stock. That buyback was an
unforeseen opportunity, and we do not anticipate a transaction of that nature in
2003.

     A routine funding requirement for us is the purchase or construction of
branch offices. In the last three years we have added two new offices and built

                                       14
<PAGE>
a new facility for our Ballard office. The funding requirements usually range
from $1 million to $2 million per facility. In early March 2003 we purchased an
office building for $12 million for the purpose of providing space for retail
branch operations and administrative support. In addition we expect to conclude
the construction of the Woodinville branch for an additional $350,000, and the
acquisition of a future branch site for approximately $2.6 million. We have also
taken a contingent lease for a third branch office on the Eastside at an
estimated cost of $200,000-$400,000 for building improvements and equipment. All
of these sites are to be funded from our normal liquidity sources, which we
believe to be adequate. For additional information regarding liquidity, see the
Statement of Cash Flows in the Consolidated Financial Statements.

CAPITAL

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

                                                                       Well
                                                                    Capitalized
     CAPITAL RATIOS                             The Company   FMB     Minimum
     --------------                             -----------   ---     -------
     Total capital to risk-weighted assets........  10.9%     10.7%    10.0%
     Tier 1 capital to risk-weighted assets.......   9.6       9.4      6.0
     Tier 1 leverage capital to average assets....   7.1       7.0      5.0

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

     In 2002, in addition to capital provided through retained earnings, we have
augmented our regulatory capital with trust preferred securities (TPS). These
securities have a maturity of 30 years and are redeemable at par after five
years, with certain exceptions. The TPS securities are treated on our financial
statements as a liability, but qualify as capital for regulatory capital limits.
They are eligible for Tier I leverage capital treatment up to 25% of shareholder
equity, and for risk-weighted capital up to 50% of shareholder equity. We have
issued $13 million in securities ($9 million in 2002 and $4 million in 2003),
which is 29% of our December 31, 2002, shareholder equity. There are no present
plans to issue additional TPS securities, and we believe that our current
capital, plus retained earnings for year 2003, will meet our budgeted growth in
assets for the forthcoming year.

BUSINESS SEGMENTS

     Effective January 1, 2002, a fundamental change was implemented in the way
we view the segments within the Bank. Previously we had identified three
segments of business: consumer banking, residential lending, and commercial
lending. We have re-evaluated the composition of the segments and combined the
consumer and residential segments as well as added an additional segment -
Investment Securities. Our operating segments are primarily defined by product
type and customer segments. New methodologies that are now applied to the
measurement of segment profitability include:

     o    A new funds transfer pricing system, which allocates actual net
          interest income between segment users, and is based upon the funding
          needs and the relative duration of the loans or securities within each
          segment.

     o    The retail deposit-gathering branch network income and expenses are
          now allocated to the business segments based on their asset size.

                                       15
<PAGE>

     o    In previous reports, the calculation for the provision for loan and
          lease losses was not allocated to the business segments.

     o    Operating income and expenses are allocated to segments whenever they
          may be directly attributed to their activities. Indirect income and
          overhead costs are credited or charged to the segments whenever they
          are specifically identified as providers or users of the ancillary
          internal service, or are allocated based on some common denominator.

     Historical periods have been restated to conform to this new presentation.
Under the new structure, the reportable segments include the following:

     CONSUMER LENDING - Consumer lending includes residential and home equity
lending, direct consumer loans, and consumer dealer financing contracts.
Residential lending offers loans to borrowers to purchase, refinance, or build
homes secured by one-to-four-unit family dwellings. Consumer loans include lines
of credit and loans for purposes other than home ownership. Included within the
consumer lending segment is a mortgage-banking operation, which sells loans in
the secondary mortgage market. The mortgage-banking operation may choose to
retain or sell the rights to service the loans sold (i.e., collection of
principal and interest payments) depending upon market conditions.

     COMMERCIAL LENDING - Commercial lending offers permanent and interim
construction loans for multifamily housing (over four units) and commercial real
estate properties, and loans to small- and medium-sized businesses for financing
inventory, accounts receivable, and equipment, among other things. The
underlying real estate collateral or business asset being financed typically
secures these loans.

     INVESTMENT SECURITIES - The investment securities segment includes the
investment securities portfolio. Although we do not consider this to be an
operating business line, security investments are a necessary part of liquidity
management for the Bank.

     These segments are managed separately because each business unit requires
different processes and different marketing strategies to reach the customer
base that purchases those products and services. All three segments derive a
majority of their revenue from interest, 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

     Net income has increased for the last few years, from $793,000 in 2000, to
$1,063,000 last year, to $1,193,000 in 2002. The rise in income was largely the
result of a steady increase in net interest income, which was partially offset
by a continued increase in operating expenses.

     Net interest income has increased over the past three years as a result of
a rise in interest-earning assets and a decline in interest expense. Average
interest-earning assets increased $24 million, or 16.5%, in 2002 as compared to
2001, and $18 million, or 13.8%, from 2000 to 2001. This segment has benefited
from the rise in interest income associated with the increased loan originations
in the Sales Finance and Custom Construction loan areas.


              PERCENTAGE OF LOAN ORIGINATION INCREASES YEAR-TO-YEAR

                                          SALES FINANCE     CUSTOM CONSTRUCTION
                                          -------------     -------------------
     2001 - 2002..........................     63.1%                79.5%
     2000 - 2001..........................     80.4                 25.2
     1999 - 2000..........................     42.7                 68.6


     Interest expense totaled $5.3 million as compared to $7.0 million in 2001,
and $6.4 million in 2000. As was true for the Bank as a whole, the consumer
segment benefited this year from the lagging effect of the repricing of the
deposits. With only one rate drop by the FRB this year, the pricing of the
liabilities had an opportunity to "catch up" to the assets. During 2001 rates
dropped rapidly and the adjustable-rate loans

                                       16
<PAGE>

repriced regularly depending upon their underlying index, whereas deposits,
which are not based on an index, repriced largely in concert with competitors.

     Operating expenses rose $871,000, or 20.7%, from $4.2 million in 2000, to
$5.1 million last year, and a further $1.0 million, or 20.1%, in 2002. Expenses
for this segment have increased as a result of adding new offices and expanding
the consumer lending departments. In the last three years, the Bank has opened
two full-service branch offices and expanded the Sales Finance Loan Department.
The Sales Finance Department opened an office in Jacksonville, Florida, and
expanded their workforce and office space at the corporate headquarters in
Bellevue. In addition to occupancy expense, compensation, employee benefits, and
legal expenses have also increased to enable the Sales Finance Department to
expand nationally.

     The outlook for the consumer segment is mixed. In order for us to continue
to meet our liquidity requirements, this segment will need to open additional
full-service offices. Each new office will burden the segment until such time as
the size, mix of deposits, and products sold for these new branches reach the
minimum desired objectives. To offset this extra expense burden, we are hopeful
that other parts of the consumer lending area, in particular the Sales Finance
Department, will materially increase their contribution over the next few years.
With that goal in mind, we have taken several actions in the last couple of
years to improve the return on investment from that department. The Sales
Finance Department now originates home improvement loans nationwide, in 32
states. Prior to that expansion, we were focused in the Northwest. Secondly,
beginning in the fourth quarter, we initiated the transition from selling all
loans originated outside the Northwest to that of portfolioing many of those
loans. To mitigate future loan losses, we have entered into an agreement with a
national insurance company to provide credit default insurance on a portion of
the sales finance loans. The default insurance pays 100% of the loss on any
given loan, up to an overall liability cap as defined in the insurance policy.
The insurance coverage, when applicable, is typically for loans with credit
scores in the range of 680-740. The Sales Finance Department's portfolio, which
was $31.4 million at year-end, should grow at a much stronger pace as a result
of these changes. We anticipate that portfolio will approach $60 million by
year-end 2003.

COMMERCIAL LENDING

     Commercial lending is the most profitable segment, contributing 80.9% of
the overall net income for the Bank. Net income in 2002 totaled $6,305,000,
rising $197,000, or 3.2%, from 2001. Net income for 2001 and 2000 totaled
$6,108,000 and $5,636,000, respectively.

     The increase in income for 2002 is principally the result of a rise in net
interest income and non-interest income, partially offset by an increase in
operating expenses.

     Like the consumer segment, the commercial segment benefited from the
continued growth in net interest income due to a decline in the interest expense
for year 2002. As was true for the Bank as a whole, the interest paid on
deposits and borrowings for the segment did not adjust as quickly as the loan
portfolio during the rapid drop in interest rates during 2001. In 2002 the rates
paid on deposits had time to adjust downward as those deposits came up for
renewal. As a result, interest expense for the commercial lending segment for
the year totaled $11.9 million as compared to $17.7 million in 2001 and $18.1
million in 2000. This decline in interest expense helped to boost the net
interest margin for this segment to $18.9 million for 2002. The comparable
figures for 2001 and 2000 were $16.6 million and $14.9 million, respectively.

     Non-interest income has also been on the increase for the past three years.
Other operating income increased 37.3%, or $335,000, as compared to 2001.
Non-interest income totaled $897,000, up 44.7% from $620,000 in 2000. The
largest contributors to this rise in other income are fees derived from early
prepayment of loans and extension fees. With rates dropping dramatically in
2001, and still further in 2002, there has been a propensity on the part of the
borrowers to prepay their loans in order to reduce their interest rate. As a
result, we have seen an increase in the fees associated with the early repayment
of a portion of this loan portfolio. Loan prepayment fees totaled $303,000 in
2002 as compared to $169,000 the previous year and $46,000 in 2000.

                                       17
<PAGE>

     Non-interest expense for this segment has also been on the rise for the
past three years. In 2002 non-interest expense increased $1.8 million, or 23.5%,
to $9.9 million, from $8.0 million in 2001. The comparable figure for year 2001
was $6.7 million. Escalating compensation costs associated with the expansion of
the Business and Community Banking areas contributed significantly to the
increase in operating expenses. Over the past year the Bank has focused on
growing these business lines and as a result expenses have increased in
accordance with that effort.

INVESTMENT SECURITIES

     Net income increased for the investment securities segment, from a loss of
$249,000 in 2001 to a gain of $299,000. This segment benefited from a rise in
net interest income, which was partially offset by a decline in non-interest
income.

     Net interest income jumped for this business segment, from a loss of
$464,000 in 2001 to a gain of $971,000 this year. Again, the reason for the
increase is due to a significant decline in interest expense. Interest expense
totaled $6.7 million in 2001, declining $2.3 million, or 34.3%, as compared to
this year.

     Non-interest income decreased from $1.3 million in 2001 to $608,000 this
year due to gains realized from the sale of securities and the liquidation of
our interest in an ATM network. Gains on security sales totaled $479,000 in
2002. That figure compares to gains of $700,000 last year. There were no
security sales in year 2000. Because of declining mortgage rates for the last
several years, it has been to our advantage to sell securities and realize a
premium on those sales rather than wait for the securities to prepay at par.
Security sales this year amounted to $35 million as compared to sales last year
of $44 million. We have also executed several sales in early 2003, totaling $8.6
million, with gains of $229,000.

     The ATM network sale involved the liquidation of our interest in the
TransAlliance Limited Partnership. The general partner, Electronic Data Systems
(EDS), purchased our interest along with that of the other limited partners. We
realized a gain of $464,000 in year 2001, and another $29,000 this year as part
of the wrap-up of the liquidation.

                                       18
<PAGE>

                          INDEPENDENT AUDITOR'S REPORT


Board of Directors
First Mutual Bancshares, Inc. and Subsidiaries


     We have audited the accompanying consolidated statement of financial
condition of First Mutual Bancshares, Inc. and Subsidiaries (the Company) as of
December 31, 2002 and 2001, and the related consolidated statements of income,
stockholders' equity and cash flows for the years then ended. These consolidated
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits.

     We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the
consolidated financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the consolidated 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.
We believe that our audits provide a reasonable basis for our opinion.

     In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial condition of the Company
as of December 31, 2002 and 2001, and the results of its operations and its cash
flows for the years then ended, in conformity with accounting principles
generally accepted in the United States of America.



/s/ Moss Adams LLP

Everett, Washington
January 21, 2003

                                       19
<PAGE>
<TABLE><CAPTION>

                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
                 CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION


                                     ASSETS

                                                                                  DECEMBER 31,
                                                                         -----------------------------
                                                                              2002            2001
                                                                         -------------   -------------
<S>                                                                      <C>             <C>
Cash and cash equivalents:
     Interest-earning deposits with banks ............................   $   6,203,843   $   5,761,548
     Noninterest-earning demand deposits and cash on hand ............       8,767,684       8,853,755
                                                                         -------------   -------------
                                                                            14,971,527      14,615,303

Mortgage-backed and other securities available-for-sale ..............      58,380,204      45,961,301
Loans receivable held-for-sale .......................................      12,699,004       4,475,792
Mortgage-backed and other securities held-to-maturity,
     fair value of $16,925,864 and $26,890,439 .......................      16,358,042      26,385,652

Loans receivable, net:
     Loans receivable ................................................     622,374,515     570,109,616
     Reserve for loan losses .........................................      (7,754,106)     (7,032,062)
                                                                         -------------   -------------
                                                                           614,620,409     563,077,554

Accrued interest receivable ..........................................       3,435,343       3,556,110
Mortgage servicing rights ............................................          49,914          47,810
Land, buildings, and equipment, net ..................................      10,964,441       8,831,022
Federal Home Loan Bank (FHLB) stock, at cost .........................      10,443,200       9,759,300
Other assets .........................................................       3,373,168       1,638,707
                                                                         -------------   -------------
            Total assets .............................................   $ 745,295,252   $ 678,348,551
                                                                         =============   =============
</TABLE>
                             SEE ACCOMPANYING NOTES.

                                       20
<PAGE>

                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
                 CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

                      LIABILITIES AND STOCKHOLDERS' EQUITY


<TABLE><CAPTION>


                                                                                  DECEMBER 31,
                                                                         -----------------------------
                                                                              2002            2001
                                                                         -------------   -------------
<S>                                                                      <C>             <C>
Liabilities:
      Deposits:
           Money market deposit and checking accounts ................   $ 134,247,575   $ 109,055,274
           Regular savings ...........................................       8,386,918       7,855,528
           Time deposits .............................................     354,735,126     311,986,860
                                                                         -------------   -------------

                Total deposits .......................................     497,369,619     428,897,662

      Drafts payable .................................................         369,034       1,015,927
      Accounts payable and other liabilities .........................       8,080,632       3,446,997
      Advance payments by borrowers for taxes and insurance ..........       1,798,233       1,662,530
      FHLB advances ..................................................     184,143,897     191,104,138
      Other advances .................................................         250,000         250,000
      Trust preferred securities .....................................       9,000,000            --
                                                                         -------------   -------------

                Total liabilties .....................................     701,011,415     626,377,254
                                                                         -------------   -------------

Stockholders' equity:
      Common stock, $1 par value; authorized, 10,000,000
           shares; issued and outstanding, 4,247,166 and
           4,725,966 shares ..........................................       4,247,166       4,725,966
      Additional paid-in capital .....................................      24,028,610      31,411,296
      Retained earnings ..............................................      15,214,220      16,025,853
      Accumulated other comprehensive income (loss):
           Unrealized gain (loss) on securities available-for-sale,
                net of federal income tax ............................         793,841        (191,818)
                                                                         -------------   -------------

                Total stockholders' equity ...........................      44,283,837      51,971,297
                                                                         -------------   -------------

                                                                         $ 745,295,252   $ 678,348,551
                                                                         =============   =============
</TABLE>






                             SEE ACCOMPANYING NOTES.

                                       21
<PAGE>

                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
                        CONSOLIDATED STATEMENTS OF INCOME


<TABLE><CAPTION>

                                                                        YEARS ENDED DECEMBER 31,
                                                               ----------------------------------------
                                                                   2002          2001           2000
                                                               -----------   -----------    -----------
<S>                                                            <C>           <C>            <C>
INTEREST INCOME:
      Loans receivable .....................................   $42,924,954   $46,452,572    $43,681,631
      Interest on AFS securities ...........................     3,362,101     1,960,298      1,878,548
      Interest on HTM securities ...........................     1,281,288     3,499,819      5,315,026
      Interest other .......................................       757,020       817,117        553,943
                                                               -----------   -----------    -----------
                                                                48,325,363    52,729,806     51,429,148
                                                               -----------   -----------    -----------
INTEREST EXPENSE:
      Deposits .............................................    13,994,645    22,708,013     22,987,040
      FHLB advances and other ..............................     7,691,720     8,694,413      7,932,366
                                                               -----------   -----------    -----------
                                                                21,686,365    31,402,426     30,919,406
                                                               -----------   -----------    -----------
         Net interest income ...............................    26,638,998    21,327,380     20,509,742
PROVISION FOR LOAN LOSSES ..................................       910,000       365,000        530,000
                                                               -----------   -----------    -----------
         Net interest income after provision for loan
            losses .........................................    25,728,998    20,962,380     19,979,742
                                                               -----------   -----------    -----------
OTHER OPERATING INCOME:
      Servicing fees, net of amortization ..................       103,170       105,729        551,933
      Gain on sales of loans ...............................     1,126,439     1,539,731        549,000
      Gain on sales of investments .........................       507,863     1,164,533           --
      Fees on deposit services .............................       472,025       334,485        278,207
      Other ................................................     1,027,208       885,622        710,957
                                                               -----------   -----------    -----------

         Total other operating income ......................     3,236,705     4,030,100      2,090,097
                                                               -----------   -----------    -----------

OTHER OPERATING EXPENSES:
      Salaries and employee benefits .......................    10,236,341     8,466,396      7,152,487
      Occupancy ............................................     2,353,175     2,130,829      1,812,023
      Other ................................................     4,566,388     3,698,677      3,127,266
                                                               -----------   -----------    -----------

         Total other operating expenses ....................    17,155,904    14,295,902     12,091,776
                                                               -----------   -----------    -----------

         Income before federal income taxes and cumulative
            effect of adoption of new accounting principle .    11,809,799    10,696,578      9,978,063
                                                               -----------   -----------    -----------
FEDERAL INCOME TAXES:
      Current ..............................................     3,680,429     3,439,200      3,100,038
      Deferred .............................................       332,000       180,000        279,025
                                                               -----------   -----------    -----------

                                                                 4,012,429     3,619,200      3,379,063
                                                               -----------   -----------    -----------
         Income before cumulative effect of adoption of new
            accounting principle, net of federal income
            tax ............................................     7,797,370     7,077,378      6,599,000
         Cumulative effect of adoption of new accounting
            principle, net of federal income tax ...........          --        (155,247)          --
                                                               -----------   -----------    -----------
NET INCOME .................................................   $ 7,797,370   $ 6,922,131    $ 6,599,000
                                                               ===========   ===========    ===========
</TABLE>
                             SEE ACCOMPANYING NOTES.

                                       22
<PAGE>

                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
                        CONSOLIDATED STATEMENTS OF INCOME

<TABLE><CAPTION>
                                                                        YEARS ENDED DECEMBER 31,
                                                               ----------------------------------------
                                                                   2002          2001           2000
                                                               -----------   -----------    -----------
<S>                                                            <C>           <C>            <C>
PER SHARE DATA
      Basic earnings per common share before cumulative
         effect of adoption of new accounting principle,
         net of federal income tax .........................   $      1.64   $      1.37    $      1.28
      Cumulative effect of adoption of new accounting
         principle, net of federal income tax ..............          --           (0.03)          --
                                                               -----------   -----------    -----------
      Basic earnings per common share ......................   $      1.64   $      1.34    $      1.28
                                                               ===========   ===========    ===========

      Earnings per common share before cumulative effect
         of adoption of new accounting principle, net of
         federal income tax, assuming dilution .............   $      1.59   $      1.34    $      1.26
      Cumulative effect of adoption of new accounting
         principle, net of federal income tax, assuming
         dilution ..........................................          --           (0.03)          --
                                                               -----------   -----------    -----------
      Earnings per common share assuming dilution ..........   $      1.59   $      1.31    $      1.26
                                                               ===========   ===========    ===========

WEIGHTED AVERAGE SHARES OUTSTANDING ........................     4,789,022     5,176,856      5,137,824
                                                               ===========   ===========    ===========

WEIGHTED AVERAGE SHARES OUTSTANDING INCLUDING DILUTIVE
      STOCK OPTIONS ........................................     4,893,051     5,263,765      5,212,527
                                                               ===========   ===========    ===========
</TABLE>








                             SEE ACCOMPANYING NOTES.

                                       23
<PAGE>

                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
                 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

<TABLE><CAPTION>
                                                                        Common Stock            Additional
                                                                ----------------------------      Paid-in         Retained
                                                                   Shares          Amount         Capital         Earnings
                                                                ------------    ------------    ------------    ------------
<S>                                                                <C>          <C>             <C>             <C>
BALANCE, December 31, 1999 ..................................      4,672,636    $  4,672,636    $ 31,116,359    $  4,527,356

      Options exercised, including tax benefit
         of $6,431 ..........................................          8,650           8,650          42,186
      Retirement of shares repurchased ......................        (10,000)        (10,000)        (40,000)        (51,874)
      Repayment of ESOP debt ................................
      Cash dividend declared ($0.20 per share) ..............                                                       (933,913)
      Comprehensive income:
         Net income .........................................                                                      6,599,000
         Other comprehensive income (loss) -
           Change in unrealized gain on securities
           available-for-sale, net of federal income tax ....
                                                                ------------    ------------    ------------    ------------

BALANCE, December 31, 2000 ..................................      4,671,286       4,671,286      31,118,545      10,140,569

      Options exercised, including tax benefit of $117,015 ..         54,680          54,680         292,751
      Repayment of ESOP debt ................................
      Cash dividend declared ($0.22 per share) ..............                                                     (1,036,847)
      Comprehensive income:
         Net income .........................................                                                      6,922,131
         Other comprehensive income (loss) -
           Change in unrealized gain on securities
           available-for-sale, net of federal income tax ....
                                                                ------------    ------------    ------------    ------------

BALANCE, December 31, 2001 ..................................      4,725,966       4,725,966      31,411,296      16,025,853

      Options exercised, including tax benefit
         of $169,903 ........................................         67,573          67,573         551,848
      Retirement of shares repurchased ......................     (1,019,256)     (1,019,256)    (13,963,793)       (815,419)
      10% stock dividend ....................................        472,883         472,883       6,029,259      (6,502,142)
      Cash dividend declared ($0.28 per share) ..............                                                     (1,291,442)
      Comprehensive income:
         Net income .........................................                                                      7,797,370
         Other comprehensive income (loss) -
           Change in unrealized gain on securities
           available-for-sale and interest rate swap, net
           of federal income tax ............................
                                                                ------------    ------------    ------------    ------------

BALANCE, December 31, 2002 ..................................      4,247,166    $  4,247,166    $ 24,028,610    $ 15,214,220
                                                                ============    ============    ============    ============
</TABLE>
<PAGE>
<TABLE><CAPTION>

                                                                 Employee
                                                                   Stock
                                                                 Ownership       Accumulated
                                                                   Plan         Comprehensive
                                                                   (ESOP)          Income
                                                                    Debt           (Loss)           Total
                                                                ------------    ------------    ------------
<S>                                                                <C>          <C>             <C>
BALANCE, December 31, 1999 ..................................   $   (310,739)   $   (668,953)   $ 39,336,659

      Options exercised, including tax benefit
         of $6,431 ..........................................           --              --            50,836
      Retirement of shares repurchased ......................           --              --          (101,874)
      Repayment of ESOP debt ................................        212,918            --           212,918
      Cash dividend declared ($0.20 per share) ..............           --              --          (933,913)
      Comprehensive income:
         Net income .........................................           --              --         6,599,000
         Other comprehensive income (loss) -
           Change in unrealized gain on securities
           available-for-sale, net of federal income tax ....           --           753,645         753,645
                                                                ------------    ------------    ------------

BALANCE, December 31, 2000 ..................................        (97,821)         84,692      45,917,271

      Options exercised, including tax benefit of $117,015 ..           --              --           347,431
      Repayment of ESOP debt ................................         97,821            --            97,821
      Cash dividend declared ($0.22 per share) ..............           --              --        (1,036,847)
      Comprehensive income:
         Net income .........................................           --              --         6,922,131
         Other comprehensive income (loss) -
           Change in unrealized gain on securities
           available-for-sale, net of federal income tax ....           --          (276,510)       (276,510)
                                                                ------------    ------------    ------------

BALANCE, December 31, 2001 ..................................           --          (191,818)     51,971,297

      Options exercised, including tax benefit
         of $169,903 ........................................           --              --           619,421
      Retirement of shares repurchased ......................           --              --       (15,798,468)
      10% stock dividend ....................................           --              --              --
      Cash dividend declared ($0.28 per share) ..............           --              --        (1,291,442)
      Comprehensive income:
         Net income .........................................           --              --         7,797,370
         Other comprehensive income (loss) -
           Change in unrealized gain on securities
           available-for-sale and interest rate swap, net
           of federal income tax ............................           --           985,659         985,659
                                                                ------------    ------------    ------------

BALANCE, December 31, 2002 ..................................   $       --      $    793,841    $ 44,283,837
                                                                ============    ============    ============
</TABLE>


                             SEE ACCOMPANYING NOTES.

                                       24
<PAGE>

                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
                      CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE><CAPTION>




                                                                        YEARS ENDED DECEMBER 31,
                                                               ----------------------------------------
                                                                   2002          2001           2000
                                                               -----------   -----------    -----------
<S>                                                            <C>           <C>            <C>
OPERATING ACTIVITIES:
      Net income ...........................................   $ 7,797,370   $ 6,922,131    $ 6,599,000
      Adjustments to reconcile net income
                to net cash from operating activities:
           Provision for loan losses .......................       910,000       365,000        530,000
           Depreciation and amortization ...................       900,500     1,214,216        790,105
           Deferred loan origination fees, net
                of accretion ...............................      (387,664)     (658,829)      (376,558)
           Amortization of mortgage servicing
                rights .....................................        46,187        24,287         67,935
           Gain on sales of loans ..........................    (1,126,439)   (1,611,294)      (573,365)
           Gain on sale of repossessed real estate .........          --          (9,296)          --
           Gain on sale of securities available-for-sale ...      (478,925)     (700,321)          --
           Gain on sale of other investments ...............       (28,939)     (464,212)          --
           FHLB stock dividends ............................      (621,300)     (557,900)      (483,135)
           Deferred federal income taxes ...................      (332,000)     (180,000)      (279,025)
           Changes in operating assets and liabilities:
                Loans receivable held-for-sale .............    (8,223,212)   11,298,549    (13,064,591)
                Accrued interest receivable ................       120,767     1,109,406       (824,605)
                Other assets ...............................       235,437      (560,697)    (1,793,097)
                Drafts payable .............................      (646,893)     (284,155)       (81,292)
                Accounts payable and other liabilities .....     2,086,256      (143,375)       (96,286)
                Advance payments by borrowers
                    for taxes and insurance ................       135,703       178,398       (105,180)
                Federal income taxes .......................       939,794       497,266       (293,432)
                                                               -----------   -----------    -----------
                Net cash provided (used) by
                    operating activities ...................     1,326,642    16,439,174     (9,983,526)
                                                               -----------   -----------    -----------

INVESTING ACTIVITIES:
      Loan originations ....................................   (244,575,384) (243,456,913)  (155,229,165)
      Loan principal repayments ............................   180,787,665   172,095,040     99,714,993
      Increase (decrease) in undisbursed loan proceeds .....    11,810,430   (17,369,810)    10,128,585
      Principal repayments and redemptions on
           mortgage-backed and other securities ............    22,138,735    54,131,108      9,459,547
      Purchase of securities held-to-maturity ..............      (250,000)   (2,996,250)    (4,500,000)
      Purchase of securities available-for-sale ............   (52,490,003)  (39,377,552)          --
      Purchase of premises and equipment ...................    (2,998,452)   (2,225,965)    (2,662,763)
      Purchase of FHLB stock ...............................       (62,600)   (1,452,000)      (245,865)
      Proceeds from sale of loans ..........................       335,393     1,146,155      1,115,528
      Proceeds from other investments ......................        28,939       472,769           --
      Proceeds from sale of securities .....................    30,463,849    39,913,161           --
      Proceeds from sale of real estate
           held-for-sale ...................................          --       1,433,584           --
                                                               -----------   -----------    -----------

                Net cash (used) by investing activities ....   (54,811,428)  (37,686,673)   (42,219,140)
                                                               -----------   -----------    -----------
</TABLE>
                             SEE ACCOMPANYING NOTES.

                                       25
<PAGE>

                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
               CONSOLIDATED STATEMENTS OF CASH FLOWS - (Continued)

<TABLE><CAPTION>

                                                                       YEARS ENDED DECEMBER 31,
                                                               ----------------------------------------
                                                                   2002          2001           2000
                                                               -----------   -----------    -----------
<S>                                                             <C>          <C>             <C>
FINANCING ACTIVITIES:
      Net increase (decrease) in deposit accounts ..........    54,928,448   (51,399,621)    34,563,819
      Interest credited to deposit accounts ................    13,543,509    22,805,374     22,754,000
      Proceeds from trust preferred securities .............     9,000,000          --             --
      Proceeds from advances ...............................   206,934,892   286,448,463    658,919,725
      Repayment of advances ................................   (213,895,133) (228,379,050)  (660,121,925)
      Dividends paid .......................................    (1,321,756)     (939,593)      (934,405)
      Proceeds from exercise of stock options ..............       449,518       230,416         44,405
      Repurchase/retirement of common stock ................   (15,798,468)         --         (101,874)
      Repayment of employee stock
           ownership plan debt .............................          --          97,821        212,918
                                                               -----------   -----------    -----------

                Net cash provided by financing
                    activities .............................    53,841,010    28,863,810     55,336,663
                                                               -----------   -----------    -----------

NET INCREASE IN CASH AND
      CASH EQUIVALENTS .....................................       356,224     7,616,311      3,133,997

CASH AND CASH EQUIVALENTS,
      Beginning of year ....................................    14,615,303     6,998,992      3,864,995
                                                               -----------   -----------    -----------

      End of year ..........................................   $14,971,527   $14,615,303    $ 6,998,992
                                                               ===========   ===========    ===========

SUPPLEMENTAL DISCLOSURES OF
           CASH FLOW INFORMATION
      Loans originated for mortgage banking
           activities ......................................   $97,625,950   $79,601,434    $55,835,410
                                                               ===========   ===========    ===========

      Loans originated for investment activities ...........   $244,575,384  $243,456,913   $155,229,165
                                                               ===========   ===========    ===========

      Proceeds from sale of loans held-for-sale ............   $89,402,738   $97,604,381    $42,770,819
                                                               ===========   ===========    ===========

      Cash paid during the year for:
           Interest ........................................   $21,686,110   $31,712,683    $30,652,129
                                                               ===========   ===========    ===========

           Income taxes ....................................   $ 3,761,000   $ 2,962,500    $ 3,775,280
                                                               ===========   ===========    ===========
SUPPLEMENTAL DISCLOSURES OF
           NON-CASH INVESTING ACTIVITIES
      Loans transferred to (from) real estate
           held-for-sale, net ..............................   $      --     $(1,352,611)   $ 1,352,611
                                                               ===========   ===========    ===========

      Loans securitized into securities held-to-
           maturity and available-for-sale .................   $14,485,309   $ 4,914,393    $22,550,393
                                                               ===========   ===========    ===========
</TABLE>

                             SEE ACCOMPANYING NOTES.

                                       26
<PAGE>

                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

                  YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000


NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

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

     First Mutual Capital Trust I (the Trust) 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 acquire junior
subordinated debentures issued by the Bank. The Bank used the proceeds to
repurchase and retire common stock of the Company.

     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, First Mutual Services, Inc.,
and First Mutual Capital Trust I (collectively, the Company). All significant
intercompany transactions have been eliminated. Certain reclassifications have
been made to the 2001 and 2000 financial statements to conform to the 2002
presentation.

     USE OF ESTIMATES - The preparation of financial statements in conformity
with generally accepted accounting principles requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Changes in these estimates and assumptions are
considered reasonably possible and may have a material impact on the financial
statements.

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

     NATURE OF BUSINESS - The Bank is a community-oriented bank offering a
variety of products to retail customers while concentrating its lending
activities on housing, commercial real estate, and business loans. The Bank
conducts business from its main office in Bellevue, Washington, and its ten
branches in the greater Puget Sound area. The Bank accepts deposits from the
general public and provides lending services to citizens of the greater Puget
Sound area and offers consumer home improvement loans to borrowers in 32 states.
In addition to portfolio lending, the Bank operates a mortgage banking
operation.

     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. The
Company places its 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.

                                       27
<PAGE>

                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

     SECURITIES - Securities are classified at acquisition into three
categories: held-to-maturity, available-for-sale and held-for-trading.
Securities are classified as held-to-maturity when the Company has the ability
and positive intent to hold them to maturity. Securities classified as
available-for-sale are maintained for future liquidity requirements and may be
sold prior to maturity. There were no securities classified as held-for-trading
during 2002, 2001 and 2000.

     Securities held-to-maturity, are carried at cost, adjusted for amortization
of premiums and accretion of discounts to maturity. Unrealized losses on
securities held-to-maturity caused by fluctuations in fair value are recognized
when it is determined that an, other-than-temporary, decline in value has
occurred. Unrealized gains and losses on securities available-for-sale are
excluded from earnings and are reported net of tax as a separate component of
comprehensive income until realized. Realized gains and losses on sales are
computed on the specific identification method and are included in operations on
the date sold.

     LOANS RECEIVABLE, LOANS RECEIVABLE HELD-FOR-SALE AND RESERVE FOR LOAN
LOSSES - Loans receivable are stated at unpaid principal balances less the
reserve for loan losses and deferred loan origination fees. Mortgage loans
securitized and transferred into the securities portfolio are transferred at
amortized cost.

     The Bank follows the practice of stopping interest accruals on loans past
due 90 days and over unless it is reasonably assured that all principal and
interest due on the loan will be fully recovered.

     The reserve for loan losses is maintained at a level that is sufficient to
provide for estimated losses based on evaluating known and inherent risks in the
loan portfolio. This reserve is provided for based upon management's continuing
analysis of the factors underlying the quality of the loan portfolio. Management
believes the allowance for loan losses and the valuation of foreclosed assets
held-for-sale are adequate. While management uses available information to
recognize losses on loans and foreclosed assets held-for-sale, changes in
economic conditions may necessitate revisions of these estimates in future
years. In addition, various regulatory agencies, as an integral part of their
examination processes, periodically review the Bank's allowance for loan losses
and valuation of foreclosed assets held-for-sale. Such agencies may require the
Bank to recognize additional losses based on their judgment using information
available to them at the time of their examination.

     For income property and business loans, loan quality is evaluated on an
individual basis and an appropriate grade is assigned. The grades range from
three-or-better, for the better quality loans, to grades four, five and six for
loans with potential problems. Loss reserves are then computed on the loan
balance for each grade using ratios developed from historical loss experience.
For the residential and consumer loans, management computes loss reserves on a
portfolio-wide basis, but provides higher reserves for specific loans that are
delinquent or are known to have problems.

     Management then considers other factors in evaluating the adequacy of the
reserve for loan losses. These factors include changes in the size and
composition of the loan portfolio, actual loan loss experience, current and
anticipated economic conditions, detailed analysis of individual loans for which
full collectibility may not be assured, and determination of the existence and
realizable value of the collateral and guarantees securing the loans. The
reserve is based upon factors and trends identified by management at the time
financial statements are prepared. The ultimate recovery of loans is susceptible
to future market factors beyond management's control, which may result in losses
or recoveries differing significantly from those provided in the financial
statements.

                                       28
<PAGE>

                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

     Management also evaluates income property and business loans for impairment
on an individual basis. A loan is considered impaired when it is probable that
the Bank will not collect all amounts due (principal and interest) under the
terms of a loan agreement. The valuation of impaired loans is based on the
present value of expected future cash flows using the loan's effective interest
rate or the loan's observable market price or fair value of the collateral, if
the loan is collateral dependent. The amount by which the recorded investment in
the loan exceeds market price or the fair value of the collateral is included in
the allocated reserve for loan losses. Any portion of an impaired loan
classified as loss under regulatory guidelines is charged off. The remaining
groups of smaller-balance homogeneous loans are evaluated collectively for
impairment.

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

     REAL ESTATE HELD-FOR-SALE - Real estate held-for-sale includes properties
acquired through foreclosure. These properties are initially recorded at the
lower of cost or fair market value and are subsequently evaluated to determine
that the carrying value does not exceed the then-current fair market value of
the property. Losses that result from ongoing periodic valuation of these
properties are charged to operations in the period in which they are identified.
The amounts that will ultimately be recovered from real estate held-for-sale may
differ substantially from the carrying value of the assets because of future
market factors beyond management's control.

     LAND, BUILDINGS, AND EQUIPMENT - Premises and equipment are stated at cost,
less accumulated depreciation. Depreciation is computed on the straight-line
method over the estimated useful lives as follows:

     Buildings and improvements........................... 10 to 40 years
     Leasehold improvements............................... 5 to 20 years
     Furniture, fixtures and equipment.................... 1 to 5 years

     The Company follows the policy of capitalizing expenditures for betterments
and major renewals, and expenses ordinary maintenance and repairs as incurred.

     MORTGAGE SERVICING RIGHTS - Originated servicing rights are recorded when
mortgage loans are originated and subsequently sold or securitized (and held as
available-for-sale securities) with the servicing rights retained. The total
cost of the mortgage loans is allocated between servicing rights and the loans
(without the servicing rights) based on their relative fair values. The cost
relating to the mortgage servicing rights is capitalized and amortized 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.

     In order to determine the fair value of servicing rights, management uses a
valuation model that calculates the present value of future cash flows.
Assumptions used in the valuation model include market discount rates and
anticipated prepayment speeds. The prepayment speeds are based on loan
prepayment forecasts derived from the consensus of investment banking firms as
reported by online, fixed-income quotation systems. In addition, estimates of
the cost of servicing per loan, an inflation rate, ancillary income per loan and
default rates are used.

     Management assesses impairment of the capitalized mortgage servicing rights
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 rights. Impairment is
assessed on a stratum-by-stratum basis with any impairment recognized through a
valuation allowance for each impaired stratum. The servicing rights are
stratified based on the predominant risk characteristics of the underlying
loans: fixed-rate loans and adjustable-rate loans.

     EMPLOYEE STOCK OWNERSHIP PLAN - The Bank sponsors an Employee Stock
Ownership Plan (ESOP). Statement of Position (SOP) No. 93-6, EMPLOYERS'
ACCOUNTING FOR EMPLOYER STOCK OWNERSHIP PLANS, was effective as of January 1994.
As is allowed under SOP No. 93-6, the Bank continues to account for ESOP
transactions for shares purchased by the ESOP prior to 1994 under SOP No. 76-3.
Accordingly, the Bank records compensation expense based on the amounts
contributed by the Bank to the ESOP and includes unallocated ESOP shares as
outstanding for purposes of its earnings per share calculation.

                                       29
<PAGE>

                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

     ESOP stock purchases have been insignificant since January 1994. At such
time that the ESOP purchases material amounts of stock in future periods, such
transactions will be accounted for in accordance with the provisions of SOP 93-6
as described below.

     Under SOP 93-6, as shares are released from collateral, compensation
expense is recorded equal to the then current market price of the shares, and
the shares become outstanding for purposes of earnings per share calculations.
Stock and cash dividends on allocated shares are recorded as a reduction of
retained earnings and paid directly to plan participants or distributed directly
to participants' accounts. Cash dividends on unallocated shares are recorded as
a reduction of debt and accrued interest. Stock dividends on unallocated shares
are recorded as an increase to the unearned shares issued to the employee stock
ownership trust contra-equity account and distributed to participants over the
remaining debt service period. Currently there are no unallocated shares in the
plan.

     STOCK-BASED COMPENSATION PLANS - Statement of Financial Accounting
Standards (SFAS) No. 148, ACCOUNTING FOR STOCK-BASED COMPENSATION - TRANSITION
AND DISCLOSURE, became effective for financial statements for fiscal years
ending after December 15, 2002. The new accounting standard amends APB Opinion
No. 28, INTERIM FINANCIAL Reporting and SFAS No. 123, ACCOUNTING FOR STOCK-BASED
COMPENSATION, to require prominent disclosure about the effects on reported net
income of an entity's accounting policy decisions with respect to stock-based
compensation and to require disclosures about those effects in interim financial
information. Management has elected to continue to use the intrinsic value
method of accounting and as a result the provisions of this statement are not
expected to have a material effect on the Company's financial position or
results of operations.

     At December 31, 2002, the Company had three stock-based employee/director
compensation plans, which are described more fully in Note 17. The plans are
accounted for under the recognition and measurement principles of APB Opinion
No. 25, ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES, and related interpretations.
No stock-based employee or director compensation cost is reflected in net
income, as all options granted under those plans had an exercise price equal to
the market value of the underlying common stock on the date of grant. The
following table illustrates the effect on net income and earnings per share if
the fair value recognition provisions of FASB Statement No. 123, ACCOUNTING FOR
STOCK-BASED COMPENSATION, had been adopted.

<TABLE><CAPTION>
                                                                        Year Ended December 31,
                                                               ----------------------------------------
                                                                   2002          2001           2000
                                                               -----------   -----------    -----------
<S>                                                            <C>           <C>            <C>
Net income, as reported ....................................   $ 7,797,370   $ 6,922,131    $ 6,599,000
Deduct: Total stock-based employee/
     director compensation expense
     determined under fair value based
     method for all awards, net of
     related tax effects ...................................      (173,780)     (159,690)      (210,218)
                                                               -----------   -----------    -----------
Pro forma net income .......................................   $ 7,623,590   $ 6,762,441    $ 6,388,782
                                                               ===========   ===========    ===========
Earnings per share:
     Basic - as reported ...................................   $      1.64   $      1.34    $      1.28
     Basic - pro forma .....................................          1.59          1.31           1.25
     Diluted - as reported .................................          1.59          1.31           1.26
     Diluted - pro forma ...................................          1.56          1.28           1.23
</TABLE>

     The compensation expense included in the pro forma net income and net
income per share figures in the previous table are not likely to be
representative of the effect on reported net income for future years because
options vest over several years and additional awards generally are made each
year.

                                       30
<PAGE>

                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

     INCOME TAXES - The Company files a consolidated tax return which includes
income earned by its subsidiaries. The Company accounts 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.

     LOAN FEE INCOME AND INTEREST INCOME ON LOANS RECEIVABLE - Loan origination
fees and certain direct loan origination costs related to loan origination
activities are deferred. Net deferred fees are amortized into income over the
contractual or actual life of the loan as an adjustment to the loan yield. Net
deferred fees related to loans sold are recognized in income at the time the
loans are sold.

     Interest income is accrued on loans receivable until management doubts the
collectibility of the loan or the unpaid interest, at which time a reserve for
any accrued interest is established.

     INTEREST RATE RISK MANAGEMENT - Management may hedge certain mortgage
banking transactions with purchased option contracts and forward sales
commitments. Net gains or losses on these options are considered in the
calculation of the lower of cost or fair value for loan receivables
held-for-sale.

     The Company has adopted SFAS No. 133, ACCOUNTING FOR DERIVATIVE INSTRUMENTS
AND HEDGING ACTIVITIES, as amended (SFAS No. 133), which requires that all
derivative instruments be reported on the balance sheet at fair value and
establishes criteria for designation and effectiveness of hedging relationships.
The Company does not speculate on the direction of interest rates in its
management of interest rate risk nor hold or issue derivative financial
instruments for trading purposes. Changes in fair value of derivatives are
recorded each period in current earnings or other comprehensive income,
depending on whether a derivative is designated and qualifies for hedge
accounting and, if it does, the type of hedge transaction.

     One of the primary risks facing the Bank is interest rate risk on mortgage
loans held-for-sale and loan commitments. Under certain circumstances, the Bank
undertakes to limit interest rate risk on uncommitted fixed-rate mortgage loans
held-for-sale through the use of forward commitments to deliver mortgage-backed
securities for a specific price. These forward commitments, in conjunction with
uncommitted mortgage loans held-for-sale, eliminate a portion of the interest
rate risk.

     EARNINGS PER SHARE (EPS) DATA - The Company displays basic and diluted EPS
in the income statement. Basic EPS is computed by dividing net income by the
weighted average number of shares outstanding during the year. Diluted EPS
reflects the potential dilutive effect of stock options and is computed by
dividing net income by the weighted average number of shares outstanding during
the year, plus the dilutive common shares that would have been outstanding had
the stock options been exercised. A reconciliation of the numerator and
denominator used for the basic EPS to the numerator and denominator used for the
diluted EPS is provided in Note 14.

NOTE 2 - RESERVE BALANCES

     The Bank is required to maintain an average reserve balance of $25,000 in
its account with the Federal Reserve. For the years ended December 31, 2002,
2001, and 2000, the Bank complied with this requirement.

                                       31
<PAGE>

                 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, 2002 and 2001 are summarized as follows:

<TABLE><CAPTION>
                                                  Gross         Gross
                                  Amortized    Unrealized     Unrealized    Estimated
                                     Cost         Gains         Losses      Fair Value
                                 -----------   -----------   -----------   -----------
<S>                              <C>           <C>           <C>           <C>
   2002
     Freddie Mac securities ..   $ 4,085,161   $   175,273   $      --     $ 4,260,434
     Fannie Mae securities ...    39,485,379     1,553,171          --      41,038,550
     US agency securities ....    12,963,967       117,253          --      13,081,220
                                 -----------   -----------   -----------   -----------

                                 $56,534,507   $ 1,845,697   $      --     $58,380,204
                                 ===========   ===========   ===========   ===========
   2001
     Freddie Mac securities ..   $ 5,276,304   $    13,813   $     5,779   $ 5,284,338
     Fannie Mae securities ...    40,975,631        59,065       357,733    40,676,963
                                 -----------   -----------   -----------   -----------

                                 $46,251,935   $    72,878   $   363,512   $45,961,301
                                 ===========   ===========   ===========   ===========
</TABLE>

     Proceeds from the sale of securities during 2002, 2001, and 2000 were
$30,463,849, $28,142,793, and $0, respectively. Gross gains on those sales were
$478,925, $546,467, and $0, respectively. No gross losses were realized on sales
during 2002, 2001, and 2000.

     The amortized cost and estimated fair value of mortgage-backed and other
securities available-for-sale at December 31, 2002, by contractual maturity, are
shown below. Expected maturities will differ from contractual maturities because
issuers may have the right to call or prepay obligations with or without
prepayment penalties.

<TABLE><CAPTION>
                                                                            Amortized     Estimated
                                                                              Cost        Fair Value
                                                                         -------------   -------------
<S>                                                                      <C>             <C>
Due after five years through ten years ...............................   $  36,487,870   $  37,826,686
Due after ten years ..................................................      20,046,637      20,553,518
                                                                         -------------   -------------
                                                                         $  56,534,507   $  58,380,204
                                                                         =============   =============
</TABLE>

                                       32
<PAGE>

                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

NOTE 4 - MORTGAGE-BACKED AND OTHER SECURITIES HELD-TO-MATURITY

     The amortized cost and estimated fair value of mortgage-backed and other
securities are summarized as follows:

<TABLE><CAPTION>
                                                            Gross         Gross
                                            Amortized    Unrealized    Unrealized    Estimated
                                              Cost          Gains        Losses      Fair Value
                                           -----------   -----------   -----------   -----------
<S>                                        <C>           <C>           <C>           <C>
     December 31, 2002:
           Fannie Mae certificates .....   $14,265,994   $   594,144   $      --     $14,860,138
           Freddie Mac certificates ....       729,270        14,146          --         743,416
           Municipal bonds .............     1,337,161          --          40,936     1,296,225
           REMICs ......................        25,617           468          --          26,085
                                           -----------   -----------   -----------   -----------
                                           $16,358,042   $   608,758   $    40,936   $16,925,864
                                           ===========   ===========   ===========   ===========

     December 31, 2001:
           Fannie Mae certificates .....   $24,068,746   $   497,926   $      --     $24,566,672
           Freddie Mac certificates ....     1,103,892         7,459          --       1,111,351
           Municipal bonds .............     1,112,852          --           1,580     1,111,272
           REMICs ......................       100,162           999            17       101,144
                                           -----------   -----------   -----------   -----------
                                           $26,385,652   $   506,384   $     1,597   $26,890,439
                                           ===========   ===========   ===========   ===========
</TABLE>

     The amortized cost and estimated fair value of mortgage-backed and other
securities held-to-maturity at December 31, 2002, by contractual maturity, are
shown below. Sales from the held-to-maturity portfolio during 2002, 2001, and
2000 amounted to $0, $11.5 million (par value), and $0, respectively. Gross
gains on the sales in 2001 totaled $153,854. The circumstances leading up to the
sales related to deterioration in the issuers' creditworthiness and the
securities were near their maturity date.

<TABLE><CAPTION>
                                                          Amortized      Estimated
                                                             Cost        Fair Value
                                                        -------------   -------------
     <S>                                                <C>             <C>
     Due after one year through five years ..........   $   8,666,735   $   8,989,344
     Due after five years through ten years .........       2,159,071       2,281,191
     Due after ten years ............................       5,532,236       5,655,329
                                                        -------------   -------------
                                                        $  16,358,042   $  16,925,864
                                                        =============   =============
</TABLE>

                                       33
<PAGE>

                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

NOTE 5 - LOANS RECEIVABLE, NET AND LOANS RECEIVABLE HELD-FOR-SALE

     Loans receivable consisted of the following as of December 31:

<TABLE><CAPTION>

                                                                                   2002             2001
                                                                              -------------    -------------
<S>                                                                           <C>              <C>
     Real estate:
           Single-family residential ......................................   $  93,207,714    $  83,886,436
           Single-family construction .....................................      79,397,115       52,461,658
           Income property:
                Commercial construction ...................................      17,693,750       16,887,200
                Commercial real estate ....................................     219,346,560      200,716,409
                Multifamily construction ..................................      10,175,075       14,895,824
                Multifamily residential ...................................     177,621,143      174,061,911
     Consumer and other loans .............................................      57,626,918       42,487,950
     Business loans .......................................................      14,682,658       11,994,811
                                                                              -------------    -------------
                                                                                669,750,933      597,392,199
     Less:
           Deferred loan origination fees .................................        (149,592)        (537,204)
           Undisbursed loan proceeds ......................................     (34,527,822)     (22,269,587)
           Reserve for loan losses ........................................      (7,754,106)      (7,032,062)
                                                                              -------------    -------------
                                                                                627,319,413      567,553,346
     Loans receivable held-for-sale .......................................     (12,699,004)      (4,475,792)
                                                                              -------------    -------------
     Loans receivable, net ................................................   $ 614,620,409    $ 563,077,554
                                                                              =============    =============
</TABLE>

     A substantial portion of the Company's 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 economy and, to a certain extent, the dominant industries in
that region such as aerospace, international trade, and high technology.

     Single-family residential, permanent, and construction loans are primarily
secured by collateral located in Western Washington. Income property loans, by
county or state in which the property resides, are as follows at December 31,
2002:

<TABLE><CAPTION>
                                  King       Snohomish       Pierce       Whatcom
                                 County        County        County        County        Oregon         Other        Total
                              ------------  ------------  ------------  ------------  ------------  ------------  ------------
<S>                           <C>           <C>           <C>           <C>           <C>           <C>           <C>
     Income property:
          Commercial
             construction ..  $  2,550,000  $  3,678,500  $ 11,465,250  $       --    $       --    $       --    $ 17,693,750
          Commercial
             real estate ...   116,929,265    28,235,524    31,422,196     4,639,878    16,728,958    21,390,739   219,346,560
          Multifamily
             construction ..     6,927,036          --       1,415,000          --       1,833,039          --      10,175,075
          Multifamily
             residential ...    67,646,992     9,042,141    26,383,686     6,784,059    44,984,500    22,779,765   177,621,143
                              ------------  ------------  ------------  ------------  ------------  ------------  ------------

                              $194,053,293  $ 40,956,165  $ 70,686,132  $ 11,423,937  $ 63,546,497  $ 44,170,504  $424,836,528
                              ============  ============  ============  ============  ============  ============  ============
</TABLE>

                                       34
<PAGE>
                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

     Loan originations include both adjustable and fixed interest rate loans. At
December 31, 2002, the composition of those loans was as follows:

<TABLE><CAPTION>
                                                                 Adjustable
                                                   Fixed rate       Rate         Total
                                                  ------------  ------------  ------------
<S>                                               <C>           <C>           <C>
     Term to maturity or rate adjustment
           Due within one year .................  $ 12,862,404  $505,456,796  $518,319,200
           After one but within three years ....     1,692,232    58,745,067    60,437,299
           After three but within five years ...     5,912,650    14,941,777    20,854,427
           After five but within ten years .....    16,320,431          --      16,320,431
           After ten years .....................    11,388,056          --      11,388,056
                                                  ------------  ------------  ------------
                                                  $ 48,175,773  $579,143,640  $627,319,413
                                                  ============  ============  ============
</TABLE>

     Single-family adjustable-rate loans typically have both periodic and
lifetime adjustment limitations. Permanent income property adjustable-rate loans
generally only have lifetime adjustment limitations. Both types of
adjustable-rate loans are generally indexed to either the one-, three-, or
five-year Constant Maturity Treasury (CMT), the Federal Home Loan Bank's cost of
funds or the 1-year London Interbank Offering Rate (LIBOR) index. Future market
factors may affect the correlation of the interest rate adjustment with the
rates the Bank pays on the short-term deposits that have been primarily utilized
to fund these loans.

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

<TABLE><CAPTION>
                                                      2002          2001          2000
                                                  ------------  ------------  ------------
<S>                                               <C>           <C>           <C>
     Balance, beginning of year ................  $  7,032,062  $  6,729,166  $  6,309,268
           Provision for loan losses ...........       910,000       365,000       530,000
           Charge offs .........................      (271,249)     (137,606)     (111,781)
           Recoveries ..........................        83,293        75,502         1,679
                                                  ------------  ------------  ------------
     Balance, end of year ......................  $  7,754,106  $  7,032,062  $  6,729,166
                                                  ============  ============  ============
</TABLE>

     Non-performing loans as of December 31 are summarized as follows:

<TABLE><CAPTION>
                                                                    2002          2001
                                                                ------------  ------------
<S>                                                             <C>             <C>
     Non-performing loans ....................................  $  2,073,525  $    498,033
     Percentage of total loans ...............................          0.33%         0.09%
</TABLE>

     At year-end 2002 there were two impaired loans totaling $16,684. There were
no impaired loans at year-end 2001 and 2000.

     The Bank serviced loan balances owned by other investors with aggregate
principal balances of $46,064,572 and $47,182,005 as of December 31, 2002 and
2001, respectively.

     Outstanding commitments to borrowers for loans totaled $185,705,000 and
$106,361,000 at December 31, 2002 and 2001, respectively. Outstanding
commitments to sell loans to investors, which totaled $12,304,000 and $5,480,400
at December 31, 2002 and 2001, respectively, hedge against interest rate
fluctuations from the time of the loan commitment until the date at which loans
are sold, which is generally within 60 days.

     Commitments to extend credit generally have fixed expiration dates. Since
portions of the commitments are expected to expire without being drawn upon, the
total commitment amounts do not necessarily represent future cash requirements.
Prior to extending commitments, each customer's creditworthiness is evaluated on

                                       35
<PAGE>

                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

a case-by-case basis. The amount of collateral obtained upon extension of credit
is based on management's credit evaluation of the borrower. Collateral held
includes residential and income-producing properties.


NOTE 6 - ACCRUED INTEREST RECEIVABLE

     Accrued interest receivable at December 31 is summarized as follows:

                                            2002         2001
                                         ----------   ----------
     Loans receivable ................   $3,087,795   $3,189,081
     Securities available-for-sale....      259,109      220,690
     Securities held-to-maturity .....       88,439      146,339
                                         ----------   ----------
                                         $3,435,343   $3,556,110
                                         ==========   ==========



NOTE 7 - MORTGAGE SERVICING RIGHTS AND SERVICING FEES

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

                                                 2002          2001
                                              ---------     ---------
Balance, beginning of year ...............    $  47,810     $ 145,097
      Additions ..........................       79,700       143,490
      Sales ..............................      (31,409)     (216,490)
      Amortization .......................      (46,187)      (24,287)
                                              ---------     ---------
Balance, end of year .....................    $  49,914     $  47,810
                                              =========     =========



     Changes in the valuation for impairment of mortgage servicing rights for
the years ended December 31:

                                               2002       2001          2000
                                               ----       ----       ---------
Balance, beginning of year .............       $ --       $ --       $ 120,226
      Additions ........................         --         --            --
      Recoveries .......................         --         --        (120,226)
                                               ----       ----       ---------
Balance, end of year ...................       $ --       $ --       $    --
                                               ====       ====       =========


     Servicing fee income, net of amortization, consisted of the following for
the years ended December 31:
<TABLE><CAPTION>
                                                   2002         2001         2000
                                                ---------    ---------    ---------
<S>                                             <C>          <C>          <C>
Servicing fees ..............................   $ 149,357    $ 130,016    $ 499,642
Amortization and recovery (provision) for
      impairment of mortgage servicing rights     (46,187)     (24,287)      52,291
                                                ---------    ---------    ---------
Loan servicing fees, net ....................   $ 103,170    $ 105,729    $ 551,933
                                                =========    =========    =========
</TABLE>

                                       36
<PAGE>

                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)



NOTE 8 - LAND, BUILDINGS, AND EQUIPMENT

     The following is a summary of land, buildings, and equipment at December
31:
                                                     2002            2001
                                                 ------------    ------------
Land .........................................   $  3,249,022    $  3,278,678
Buildings ....................................      7,740,053       5,619,447
Furniture, fixtures, and equipment ...........      4,033,178       3,466,243
Leasehold improvements .......................      1,035,940         964,302
                                                 ------------    ------------
                                                   16,058,193      13,328,670
Less accumulated depreciation and amortization     (5,093,752)     (4,497,648)
                                                 ------------    ------------
                                                 $ 10,964,441    $  8,831,022
                                                 ============    ============

     Depreciation expense for the years ended December 31, 2002, 2001, and 2000
amounted to $862,000, $789,000, and $752,000, respectively.

     Seven office locations are leased under operating leases. Total lease
obligations are as follows:

     2003...................................................   $   958,585
     2004...................................................       937,469
     2005...................................................       966,523
     2006...................................................       936,621
     2007...................................................       502,024
                                                               -----------
                                                               $ 4,301,222
                                                               ===========

     Total lease expenses were $838,925, $725,660, and $536,410 for the years
ended December 31, 2002, 2001, and 2000, respectively.











                                       37
<PAGE>

                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

NOTE 9 - DEPOSITS

     Deposits consisted of the following at December 31:
<TABLE><CAPTION>
                                         Weighted
                                      Average Rate at         2002                      2001
                                        December 31,  ---------------------     ---------------------
                                            2002         Amount     Percent        Amount     Percent
                                           -----      ------------   -----      ------------   -----
<S>                                        <C>        <C>            <C>        <C>            <C>
Terms
   Money market deposit and checking
        accounts, including noninterest-
        bearing deposits of $16,661,417
        (2002) and $11,818,284 (2001) ..     1.1%     $134,247,575    27.0%     $109,055,274    25.4%
                                           -----      ------------   -----      ------------   -----

   Regular savings .....................     0.8%        8,386,918     1.6         7,855,528     1.8
                                           -----      ------------   -----      ------------   -----
   Time deposits:
        1 to 6 months ..................     1.3%       25,255,307     5.1        28,550,340     6.7
        7 to 12 months .................     2.9%      190,742,851    38.4       168,506,354    39.3
        13 to 18 months ................     2.3%       52,588,245    10.6        59,315,710    13.8
        2 to 10 years ..................     4.3%       86,148,723    17.3        55,614,456    13.0
                                           -----      ------------   -----      ------------   -----
   Total time deposits .................     3.0%      354,735,126    71.4       311,986,860    72.8
                                           -----      ------------   -----      ------------   -----
   Total deposits ......................     2.5%     $497,369,619     100%     $428,897,662     100%
                                           =====      ============   =====      ============   =====
</TABLE>

     Deposits at December 31, 2002 and 2001, included public funds of
$11,277,540 and $6,106,703, respectively. Mortgage-backed securities with a book
value of $1,662,013 and $748,434 were pledged as collateral on these deposits at
December 31, 2002 and 2001, respectively, which exceeds the minimum collateral
requirement established by the Washington Public Deposit Protection Commission.

     As of December 31, 2002, scheduled maturities of time deposits were as
follows:

     Year Ending
     December 31,
     ------------
     2003.....................................................  $ 264,229,656
     2004.....................................................     52,592,155
     2005.....................................................     10,960,969
     2006.....................................................     11,346,854
     2007.....................................................     15,395,795
     Thereafter...............................................        209,697
                                                                -------------
                                                                $ 354,735,126
                                                                =============

     Included in deposits are time deposits greater than or equal to $100,000 of
$124,607,752 and $112,685,075 at December 31, 2002 and 2001, respectively.
Interest on time deposits greater than or equal to $100,000 totaled $4,587,764,
$6,302,223, and $6,394,805 for the years ended December 31, 2002, 2001, and
2000, respectively. Also included in deposits are accounts of approximately
$3,350,000 and $3,185,000 at December 31, 2002 and 2001, respectively, which are
controlled by members of the Board of Directors and management.

                                       38
<PAGE>

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

                                        2002          2001          2000
                                    -----------   -----------   -----------
Time deposits ...................   $12,309,266   $20,171,363   $19,666,095
Money market deposit and checking     1,592,787     2,393,143     3,120,818
Regular savings .................        92,592       143,507       200,127
                                    -----------   -----------   -----------
                                    $13,994,645   $22,708,013   $22,987,040
                                    ===========   ===========   ===========


NOTE 10 - FHLB AND OTHER ADVANCES

     The Company's borrowings consisted of the following at December 31:

                                                 2002            2001
                                             ------------    ------------
FHLB advances ............................   $184,143,897    $191,104,138
                                             ============    ============

FHLB advances:
      Maximum outstanding at any month end   $196,436,638    $191,104,138
      Average outstanding ................    175,573,277     145,329,485
      Weighted average interest rates:
           Annual ........................          4.111%          5.962%
           End of year ...................          3.520%          4.321%

Other advances ...........................   $    250,000    $    250,000
                                             ============    ============


     Under the terms of the FHLB advances, in addition to FHLB stock held, the
Bank must maintain unencumbered collateral of at least 95% of agency
MBS/CMOs/REMICS, 83% of one-to-four-unit family permanent mortgages and 80% of
multi-family permanent loans. At December 31, 2002, the minimum book value of
eligible collateral pledged for these borrowings was $240,561,000. 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, 2002 mature as follows:

                                              Interest Rates        Amount
                                              --------------    -------------
     2003..................................    1.35 - 7.48%     $ 123,042,595
     2004..................................    3.23 - 5.50%        36,332,260
     2005..................................    4.00 - 4.94%         9,833,750
     2006..................................    3.11 - 6.25%        10,222,792
     2010..................................        4.93%            4,000,000
     2011..................................        5.19%              712,500
                                                                -------------
                                                                $ 184,143,897
                                                                =============

     The other advances mature on January 27, 2003, with an interest rate of
3.174%.


NOTE 11 - TRUST PREFERRED SECURITIES

     The Trust, a wholly-owned subsidiary of the Company, 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. On June 27, 2002, the Trust issued $9 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%. The Company
entered into a swap with the FHLB to fix the interest rate at

                                       39
<PAGE>

8.18% for a period of 5 years (Note 24). These securities are considered Tier I
capital for the purposes of regulatory capital requirements. 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.
The Company owns all of the common securities of the Trust. The Company has
fully and unconditionally guaranteed the capital securities along with all
obligations of the Trust under the trust agreements. Distributions payable are
treated as interest expense in the consolidated statement of income.


NOTE 12 - FEDERAL TAXES ON INCOME

     For tax years beginning prior to January 1, 1996, a qualified thrift
institution, such as the Bank, was allowed a bad debt deduction based on a
percentage of taxable income or on actual experience. Accordingly, the Bank used
the percentage of taxable income method prior to 1996.

     The Small Business Job Protection Act of 1996 (the Act) required qualified
thrift institutions to recapture their post-1987 additions to their bad debt
reserves. Such recaptured amounts are to be taken into taxable income ratably
over a six-year period, which began with the year ended December 31, 1998.

     As of December 31, 1997, these additions were $1,973,380, of which $328,897
was recaptured in taxable income for 2002 and 2001. The Act also repealed the
reserve method of accounting for tax bad debt deductions and required thrifts to
calculate the tax bad debt deduction based on actual current loan losses. The
recapture of the post-1987 additions to tax basis bad debt reserves does not
result in a charge to earnings as these amounts have been provided for in the
deferred tax liability.

     If bad debt deductions taken for federal income tax purposes before 1987
are later used for purposes other than bad debt losses, they will be subject to
federal income taxes at the prevailing corporate rates. Retained earnings at
December 31, 2002, 2001, 2000, and 1999 includes $640,000, for which no federal
taxes had been provided in the financial statements. The Bank does not
anticipate that retained earnings will be used in any way which would result in
payment of taxes.

     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:

                                          2002         2001
                                       ---------    ---------
     Mortgage servicing rights .....   $    --      $ 122,000
     Loan origination fees and costs     161,000      411,000
     FHLB stock dividends ..........     235,000      190,000
     Reserve for loan losses .......    (379,000)    (238,000)
     Other, net ....................     315,000     (305,000)
                                       ---------    ---------
                                       $ 332,000    $ 180,000
                                       =========    =========

                                       40
<PAGE>

                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

     At December 31, the significant components of the Company's net deferred
tax asset were as follows:

<TABLE><CAPTION>
                                                            2002            2001
                                                         -----------    -----------
<S>                                                      <C>            <C>
Deferred tax assets:
      Reserve for loan losses ........................   $ 2,419,000    $ 2,040,000
      Other, net .....................................       209,000        524,000
      Unrealized loss on available-for-sale securities          --          100,000
                                                         -----------    -----------
                                                           2,628,000      2,664,000
                                                         -----------    -----------
Deferred tax liabilities:
      Loan origination fees and costs ................     1,067,000        906,000
      FHLB stock dividends ...........................     1,546,000      1,311,000
      Mortgage servicing rights ......................         7,000          7,000
      Unrealized gain on available-for-sale securities
        and interest rate swap .......................       415,000           --
                                                         -----------    -----------
                                                           3,035,000      2,224,000
                                                         -----------    -----------
Net deferred tax asset (liability) ...................   $  (407,000)   $   440,000
                                                         ===========    ===========
</TABLE>
     A reconciliation of the effective income tax rate with the federal
statutory rate is as follows:
<TABLE><CAPTION>
                                     2002                    2001                    2000
                             --------------------    --------------------    --------------------
                                Amount      Rate        Amount      Rate        Amount      Rate
                             -----------  -------    -----------  -------    -----------  -------
     <S>                     <C>          <C>        <C>          <C>        <C>          <C>
     Federal income tax at
           statutory rates   $ 4,015,332       34%   $ 3,636,837       34%   $ 3,392,541       34%
     Effect of tax-exempt
           interest income       (10,805)       0%       (11,783)       0%       (85,876)      (1)%
     Other ...............         7,902        0%        (5,854)       0%        72,398        1%
                             -----------  -------    -----------  -------    -----------  -------
                             $ 4,012,429       34%   $ 3,619,200       34%   $ 3,379,063       34%
                             ===========  =======    ===========  =======    ===========  =======
</TABLE>

NOTE 13 - STOCKHOLDERS' EQUITY AND REGULATORY CAPITAL REQUIREMENTS

     RESTRICTED RETAINED EARNINGS - Under Washington State law, pre-conversion
retained earnings are restricted for the protection of pre-conversion
depositors. Restricted retained earnings at December 31, 2002, totaled $132,755.

     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, the
Company 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 Company's 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 the Company to maintain minimum amounts and ratios (set forth in the

                                       41
<PAGE>

                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

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, 2002, that
the Company met all capital adequacy requirements to which it is subject.

     As of December 31, 2002 and 2001, the FDIC categorized the Bank as well
capitalized under the regulatory framework for prompt corrective action. To be
categorized as well capitalized, the Bank must maintain minimum total
risk-based, Tier I risk-based, and Tier I leverage ratios as set forth in the
table. There are no conditions or events since that notification that management
believes have changed the Bank's category.

     Actual capital amounts and ratios for First Mutual Bancshares, Inc.
(consolidated) and First Mutual Bank are presented in the table below:
<TABLE><CAPTION>
                                                                                                          To Be Well Capitalized
                                                                                       For Capital        Under Prompt Corrective
                                                                Actual              Adequacy Purposes         Action Provisions
                                                       -----------------------   ----------------------   -----------------------
                                                          Amount         Ratio      Amount       Ratio       Amount        Ratio
                                                       -----------      ------   -----------   --------   -----------    --------
As of December 31, 2002:
<S>                                                    <C>              <C>      <C>          <C><C>     <C>            <C><C>
   Total capital (to risk-weighted assets):
        First Mutual Bancshares, Inc. (consolidated)   $59,317,922      10.88%   $43,698,711   >= 8.00%           N/A         N/A
        First Mutual Bank ..........................    57,792,693      10.65%    43,487,126   >= 8.00%   $54,358,908    >= 10.00

   Tier I capital (to risk-weighted assets):
        First Mutual Bancshares, Inc. (consolidated)    52,489,998       9.63%    21,849,355   >= 4.00%           N/A         N/A
        First Mutual Bank ..........................    50,997,830       9.40%    21,743,563   >= 4.00%    32,615,344    >=  6.00

   Tier I capital (to average assets):
        First Mutual Bancshares, Inc. (consolidated)    52,489,998       7.08%    29,660,312   >= 4.00%           N/A         N/A
        First Mutual Bank ..........................    50,997,830       6.99%    29,181,423   >= 4.00%    36,476,778    >=  5.00

As of December 31, 2001:
   Total capital (to risk-weighted assets):
        First Mutual Bancshares, Inc. (consolidated)   $58,529,933      11.51%   $40,747,631   >= 8.00%           N/A         N/A
        First Mutual Bank ..........................    58,365,905      11.48%    40,742,418   >= 8.00%   $50,928,022    >= 10.00

   Tier I capital (to risk-weighted assets):
        First Mutual Bancshares, Inc. (consolidated)    52,163,115      10.25%    20,373,816   >= 4.00%           N/A         N/A
        First Mutual Bank ..........................    51,999,902      10.22%    20,371,209   >= 4.00%    30,556,813    >=  6.00

   Tier I capital (to average assets):
        First Mutual Bancshares, Inc. (consolidated)    52,163,115       7.89%    26,454,868   >= 4.00%           N/A         N/A
        First Mutual Bank ..........................    51,999,902       7.87%    26,441,677   >= 4.00%    33,052,097    >=  5.00
</TABLE>

     The holding company 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.

     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.

                                       42
<PAGE>

                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

NOTE 14 - EARNINGS PER SHARE

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

<TABLE><CAPTION>
                                                              Income      Shares(1)    Per Share(1)
                                                           (Numerator)   (Denominator)   Amount
                                                            ----------    ----------    --------
<S>                                                         <C>           <C>            <C>
     Year ended December 31, 2002:
           Basic EPS:
                Income available to common shareholders .   $7,797,370     4,789,022      $1.64
                                                                                          =====
           Effect of dilutive stock options .............                    104,029
                                                            ----------    ----------

           Diluted EPS:
                Income available to common shareholders
                     plus assumed stock options exercised   $7,797,370     4,893,051      $1.59
                                                            ==========    ==========      =====

     Year ended December 31, 2001:
           Basic EPS:
                Income available to common shareholders .   $6,922,131     5,176,856      $1.34
                                                                                          =====
           Effect of dilutive stock options .............                     86,909
                                                            ----------    ----------

           Diluted EPS:
                Income available to common shareholders
                     plus assumed stock options exercised   $6,922,131     5,263,765      $1.31
                                                            ==========    ==========      =====

     Year ended December 31, 2000:
           Basic EPS:
                Income available to common shareholders .   $6,599,000     5,137,824      $1.28
                                                                                          =====
           Effect of dilutive stock options .............                     74,703
                                                            ----------    ----------

           Diluted EPS:
                Income available to common shareholders
                     plus assumed stock options exercised   $6,599,000     5,212,527      $1.26
                                                            ==========    ==========      =====
</TABLE>
-----------
(1) Shares and EPS have been adjusted for a 10% stock dividend paid May 8, 2002.

NOTE 15 - OTHER OPERATING EXPENSES

     Salaries and employee benefits consisted of the following for the years
ended December 31:
<TABLE><CAPTION>
                                                           2002            2001            2000
                                                       ------------    ------------    ------------
<S>                                                    <C>             <C>             <C>
     Salaries and employee benefits incurred .......   $ 11,685,205    $  9,426,344    $  8,018,737
     Amounts deferred with loan origination fees ...     (1,448,864)       (959,948)       (866,250)
                                                       ------------    ------------    ------------
                                                       $ 10,236,341    $  8,466,396    $  7,152,487
                                                       ============    ============    ============
</TABLE>
     Direct costs of originating loans are deferred and capitalized with the
related loan origination fees collected. Deferral of costs varies directly with
the volume of loan originations.

                                       43
<PAGE>

NOTE 16 - RETIREMENT PLAN AND TRUST

     The Bank has a 401(k) retirement plan and trust for employees. All
employees who have completed 90 days of service are eligible to contribute to
the plan. Additionally, after meeting the one-year-of-service and the
minimum-hours-worked requirements employees are eligible to receive
employer-matching contributions. The Bank funds the annual cost of the plan as
accrued. Effective June 1, 2002, employees may contribute up to 50% of their
salaries to the plan up to the annual Internal Revenue Service (IRS) limit. The
Bank matches 75% of the employees' contributions up to 6% of the employees'
compensation. At plan year-end, the Bank contributes an additional 3% of the
employees' compensation. Participants are fully vested in employer contributions
to the plan upon six years of employment.

     The Bank's contributions to the 401(k) retirement plan and trust were
$439,551, $332,424, and $355,604 for the years ended December 31, 2002, 2001,
and 2000, respectively. There were no significant changes in the rate of
contributions to the plan between those years.


NOTE 17 - EMPLOYEE STOCK OWNERSHIP PLAN

     In 1985, the Bank established an ESOP to provide benefits to all employees
who have completed one year of service and meet the minimum-hours-worked
requirement. The plan is noncontributory on the part of the participants and
provides for full vesting upon completion of five years of service. The plan
provides for the distribution of accumulated benefits to the employees or their
beneficiaries upon death, termination, or retirement. The Bank loaned the ESOP's
trustee $200,000 for the purchase of the Bank's common stock at the initial
offering price in 1985. During 1990, the Bank's Board of Directors authorized
the trustee to borrow an additional $1,464,375 from the Bank to purchase 139,600
more shares (unadjusted for subsequent stock dividends and stock splits) of the
Bank's common stock in the open market. Upon formation of the holding company,
First Mutual Bank stock was converted to First Mutual Bancshares, Inc. stock.
Shares of stock are allocated to employees as the loans are repaid. As of
December 31, 2002, the loan balance was paid in full.

     Shares held by the ESOP at December 31, 2002, were as follows:

                           Number of       Price Range      Average Price
                            Shares          Per Share         Per Share
                          ----------     --------------     -------------
     Allocated
        Vested .........     332,814
        Non-vested .....       3,743
                          ----------
                             336,557     $1.09 - $18.04          $2.74
                          ==========

     Contributions to the ESOP during the years ended December 31, 2002, 2001,
and 2000 were $25,003, $25,000, and $99,556, respectively.

NOTE 18 - STOCK OPTION PLAN

The Company has stock option plans for directors and employees. Options have a
term of six or ten years and are granted at fair market value on the grant date.
The Company's Board of Directors 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, 2002, 621,612 shares of
common stock, adjusted for stock dividends, were available for grant under the
plan. A total of 233,073 shares are currently exercisable at December 31, 2002.
All schedules presented in this footnote are adjusted for stock dividends and
stock splits.

                                       44
<PAGE>

                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

     A summary of the stock option plans at December 31, 2002, 2001, and 2000,
and changes during the years ended on those dates is presented below:
<TABLE><CAPTION>
                                                                                 Weighted         Weighted
                                                                Range of          Average          Average
                                                 Shares      Exercise Price*   Exercise Price*   Fair Value*
                                                -------      --------------    --------------    ----------
<S>                                             <C>           <C>                  <C>               <C>
     BALANCE, December 31, 1999 ............    424,410       $3.07-$14.46         $ 9.15
     Exercisable at year end: 220,779 shares                                         6.48
           Options granted .................     52,525           8.86               8.86            $3.61
           Options exercised ...............     (9,515)       3.92-9.98             4.67
           Options terminated ..............     (5,019)       6.51-14.41           10.87
                                                -------

     BALANCE, December 31, 2000 ............    462,401        3.07-14.46            9.19
     Exercisable at year end: 296,319 shares                                         8.18
           Options granted .................     35,640        10.94-12.40          11.62             4.93
           Options exercised ...............    (60,148)       3.07-9.98             3.83
           Options terminated ..............    (32,293)       4.03-14.41            8.54
                                                -------

     BALANCE, December 31, 2001 ............    405,600        3.07-14.46           10.25
     Exercisable at year end: 265,388 shares                                         9.96
           Options granted .................    125,932        15.00-15.75          15.39            10.96
           Options exercised ...............    (68,073)       3.98-11.25            6.60
           Options terminated ..............    (17,758)       10.94-15.75          14.35
                                                -------
     BALANCE, December 31, 2002 ............    445,701        3.98-15.75           12.10
                                                =======
</TABLE>
Exercisable at year end: 233,073 shares
--------------
*Per Share

     The following table summarizes information about stock options outstanding
at December 31, 2002:
<TABLE><CAPTION>
                   Options Outstanding                         Options Exercisable
---------------------------------------------------------  ----------------------------
                                                Weighted
                    Number        Weighted      Average      Number       Weighted
   Range of       of Shares       Average      Remaining    of Shares       Average
Exercise Price*  Outstanding  Exercise Price*    Life      Exercisable  Exercise Price*
---------------  -----------  ---------------  ----------  -----------  ---------------
<S>                   <C>         <C>           <C>            <C>         <C>
 $3.00 - $6.00       31,308       $ 4.00        2.2 years      31,308      $ 4.00
  6.01 -  9.00       68,331         8.11        6.2 years      34,275        7.37
  9.01 - 12.00      101,785        10.83        6.3 years      64,145       10.67
 12.01 - 15.00      180,477        14.44        4.3 years     103,345       14.44
 15.01 - 18.00       63,800        15.75        9.5 years         --          --
                  ---------                                  --------
                    445,701                                   233,073
                  =========                                  ========
-------------
*Per Share
</TABLE>

     The Company applies Accounting Principles Board Opinion No. 25, ACCOUNTING
FOR STOCK ISSUED TO EMPLOYEES, and related interpretations in accounting for its
stock option plans. Accordingly, no compensation cost has been recognized for
its stock option plan for the years ended December 31, 2002, 2001, and 2000.

     The fair value of options granted under the stock option plans was
estimated on the date of grant using the Black-Scholes option-pricing model with
the following weighted-average assumptions used: Annual

                                       45
<PAGE>

                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

dividend yield of 1.82% for 2002, 1.56% for 2001, and 2.05% for 2000; expected
volatility of 37% for 2002, 35% for 2001, and 34% for 2000; and expected lives
of 7.5 years for 2002, 7.6 years for 2001, and 8.1 years for 2000. The risk-free
interest rate assumptions were 3.12%, 6.29%, and 6.29% for 2002, 2001, and 2000,
respectively.

NOTE 19 - CONTINGENCIES

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

NOTE 20 - SUBSEQUENT EVENTS

     First Mutual Capital Trust II (the Trust), 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 acquire
junior subordinated debentures issued by the Bank. The Bank will use the
proceeds to fund anticipated loan growth.

     The Bank is engaged in a pending purchase, to be closed by the end of
second quarter 2003. The purchase price is approximately $12 million to be
funded from normal funding sources. The project being purchased is an office
building located in Bellevue. The purpose of the acquisition is to provide
office space for branch banking, lending, and administrative operations.

     The Bank is committed to acquire and build a branch in the Puget Sound area
for an estimated cost of $2.6 million. Secondly, the Bank has entered into a
contingent lease agreement to open an additional branch on the Eastside.
Thirdly, the Woodinville branch site, which began construction in 2002, will
require an estimated $350,000 to complete.

NOTE 21 - 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.








                                       46
<PAGE>

     The estimated fair value of financial instruments is as follows at December
31, 2002 and 2001 (in thousands):
<TABLE><CAPTION>
                                                            2002                                  2001
                                            -----------------------------------    ---------------------------------
                                                         Estimated    Favorable                Estimated   Favorable
                                            Carrying       Fair     (Unfavorable)  Carrying      Fair    (Unfavorable)
                                              Value        Value      Variance       Value       Value     Variance
                                            ---------    ---------    ---------    ---------   ---------   ---------
     Assets:
     <S>                                    <C>          <C>          <C>          <C>         <C>         <C>
       Cash and cash equivalents ........   $  14,972    $  14,972    $    --      $  14,615   $  14,615   $    --
       Securities available-for-sale ....      58,380       58,380         --         45,961      45,961        --
       Loans held-for-sale ..............      12,699       12,699         --          4,476       4,476        --
       Mortgage-backed and other
            securities held-to-maturity .      16,358       16,926          568       26,386      26,890         504
       Loans receivable .................     614,620      615,735        1,115      563,078     565,581       2,503
       Accrued interest receivable ......       3,435        3,435         --          3,556       3,556        --
       Mortgage servicing portfolio .....          50           85           35           48          71          23
       FHLB stock .......................      10,443       10,443         --          9,759       9,759        --
                                                                      ---------                            ---------
            Favorable (unfavorable)
                 variance ...............                                 1,718                                3,030
                                                                      ---------                            ---------

     Liabilities:
       Demand, savings, and money
            market deposits .............     142,634      142,634         --        116,911     116,911        --
       Time deposits ....................     354,735      360,070       (5,335)     311,987     313,367      (1,380)
       Drafts payable ...................         369          369         --          1,016       1,016        --
       Advance payments by borrowers
            for taxes and insurance .....       1,798        1,798         --          1,663       1,663        --
       Short-term FHLB advances .........     123,043      123,570         (527)      93,594      94,340        (746)
       Long-term FHLB advances ..........      61,101       60,863          238       97,510      98,288        (778)
       Other advances ...................         250          250         --            250         250        --
       Trust preferred securities .......       9,000        9,085          (85)        --          --          --
                                                                      ---------                            ---------
            Favorable (unfavorable)
                 variance ...............                                (5,709)                              (2,904)
                                                                      ---------                            ---------
     Net favorable (unfavorable) variance                             $  (3,991)                           $     126
                                                                      =========                            =========
</TABLE>

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

     SECURITIES, LOANS HELD-FOR-SALE, AND COMMITMENTS TO SELL LOANS - The fair
value of securities and loans receivable held-for-sale, and forward commitments,
are based on quoted market rates and dealer quotes.

     LOANS RECEIVABLE - For variable-rate loans that reprice frequently and with
no significant change in credit risk, fair values are based on carrying values.
The fair value of the loans that have fixed interest rates or variable rates
which do not reprice frequently are estimated using discounted cash flow
analysis, using 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, using 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.

                                       47
<PAGE>

     DEPOSIT LIABILITIES - Under SFAS No. 107, the fair value of deposits with
no stated maturity, such as noninterest-bearing demand deposits, savings, NOW
accounts, and 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.

     TRUST PREFERRED SECURITIES - The carrying amount of trust preferred
securities are estimated using discounted cash flow analyses based on the
Company's 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.

     MORTGAGE SERVICING PORTFOLIO - The carrying value of the mortgage servicing
portfolio is mortgage servicing rights as defined by SFAS No. 125, ACCOUNTING
FOR TRANSFERS AND SERVICING OF FINANCIAL ASSETS AND EXTINGUISHMENT OF
LIABILITIES. The fair value of the mortgage servicing portfolio is based upon a
valuation model that calculates the present value of future cash flows.

     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, 2002 and 2001.
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.



                                       48
<PAGE>

                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

NOTE 22 - SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)

<TABLE><CAPTION>
YEAR ENDED                               FIRST          SECOND           THIRD          FOURTH
  DECEMBER 31, 2002                     QUARTER         QUARTER         QUARTER         QUARTER          TOTAL
                                     ------------    ------------    ------------    ------------    ------------
<S>                                  <C>             <C>             <C>             <C>             <C>
Interest income ..................   $ 12,086,185    $ 12,171,103    $ 12,206,870    $ 11,861,205    $ 48,325,363
Interest expense .................      5,580,073       5,470,565       5,394,961       5,240,766      21,686,365
                                     ------------    ------------    ------------    ------------    ------------
Net interest income ..............   $  6,506,112    $  6,700,538    $  6,811,909    $  6,620,439    $ 26,638,998
                                     ============    ============    ============    ============    ============
Provision for loan losses ........   $     50,000    $     85,000    $    650,000    $    125,000    $    910,000
                                     ============    ============    ============    ============    ============
Other operating income and
      expenses, net ..............   $ (3,478,057)   $ (3,720,616)   $ (2,984,335)   $ (3,736,191)   $(13,919,199)
                                     ============    ============    ============    ============    ============
Net income .......................   $  1,970,808    $  1,916,398    $  2,102,935    $  1,807,229    $  7,797,370
                                     ============    ============    ============    ============    ============
Basic earnings per share .........   $       0.38    $       0.37    $       0.46    $       0.43    $       1.64
                                     ============    ============    ============    ============    ============
Earnings per share assuming
      dilution ...................   $       0.37    $       0.36    $       0.45    $       0.41    $       1.59
                                     ============    ============    ============    ============    ============
Weighted average shares
      outstanding ................      5,201,312       5,205,791       4,527,841       4,234,636       4,789,022
                                     ============    ============    ============    ============    ============
Weighted average shares
      outstanding including effect
      of dilutive stock options ..      5,257,930       5,310,505       4,639,084       4,355,291       4,893,051
                                     ============    ============    ============    ============    ============

YEAR ENDED
  DECEMBER 31, 2001

Interest income ..................   $ 13,609,388    $ 13,442,940    $ 13,203,065    $ 12,474,413    $ 52,729,806
Interest expense .................      8,450,323       8,159,094       8,009,926       6,783,083      31,402,426
                                     ------------    ------------    ------------    ------------    ------------
Net interest income ..............   $  5,159,065    $  5,283,846    $  5,193,139    $  5,691,330    $ 21,327,380
                                     ============    ============    ============    ============    ============
Provision for loan losses ........   $    215,000    $     50,000    $     50,000    $     50,000    $    365,000
                                     ============    ============    ============    ============    ============
Other operating income and
      expenses, net ..............   $ (2,092,610)   $ (2,631,343)   $ (2,468,756)   $ (3,073,093)   $(10,265,802)
                                     ============    ============    ============    ============    ============

Net income .......................   $  1,731,138    $  1,722,066    $  1,769,497    $  1,699,430    $  6,922,131
                                     ============    ============    ============    ============    ============
Basic earnings per share
      after adoption of
      new accounting principle ...   $       0.34    $       0.33    $       0.34    $       0.33    $       1.34
                                     ============    ============    ============    ============    ============
Earnings per share assuming
      dilution after adoption of
      new accounting principle ...   $       0.33    $       0.33    $       0.33    $       0.32    $       1.31
                                     ============    ============    ============    ============    ============
Weighted average shares
      outstanding ................      5,157,438       5,171,612       5,183,158       5,194,737       5,176,856
                                     ============    ============    ============    ============    ============
Weighted average shares
      outstanding including effect
      of dilutive stock options ..      5,264,732       5,250,416       5,266,074       5,273,360       5,263,765
                                     ============    ============    ============    ============    ============
</TABLE>

                                       49
<PAGE>

                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

NOTE 23 - SEGMENTS

     Effective January 1, 2002 management implemented a fundamental change in
the way that it views the segments within the Company. Previously management had
identified three segments of business: consumer banking, residential lending,
and commercial lending. Management has re-evaluated the composition of the
segments and combined the consumer and residential segments as well as added an
additional segment: investment securities. The management reporting process
measures the performance of the operating segments based on the management
structure of the Company and is not necessarily comparable with similar
information for any other financial institution. The operating segments are
defined by product type and customer segments. Management continues to enhance
its segment reporting process methodologies. These methodologies are based on
the management reporting process, which assigns certain balance sheet and income
statement items to the responsible operating segment. New methodologies that are
now applied to the measurement of segment profitability include:

     o    A new funds transfer pricing system, which allocates actual net
          interest income between funds users, is based upon the funding needs
          and the relative duration of the loans or securities within each
          segment.

     o    The retail deposit gathering branch network income and expenses are
          now allocated to the business segments based on their asset size.

     o    In previous reports, the calculation for the provision for loan and
          lease losses was not allocated to the business segments.

     o    Operating income and expenses are allocated to segments whenever they
          can be directly attributed to their activities. Indirect income and
          overhead costs are credited or charged to the segments whenever they
          are specifically identified as providers or users of the ancillary
          internal service, or are allocated based on some common denominator.

     Historical periods have been restated to conform to this new presentation.
Under the new structure, the reportable segments include the following:

     o    CONSUMER LENDING - Consumer lending includes residential and home
          equity lending, direct consumer loans, and consumer dealer financing
          contracts. Residential lending offers loans to borrowers to purchase,
          refinance, or build homes secured by one-to-four-unit family
          dwellings. Consumer loans include lines of credit and loans for
          purposes other than home ownership. Included within the consumer
          lending segment is a mortgage banking operation, which sells loans in
          the secondary mortgage market. The mortgage banking operation 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.

     o    COMMERCIAL LENDING - Commercial lending offers permanent and interim
          construction loans for multifamily housing (over four units) and
          commercial real estate properties, and loans to small- and
          medium-sized businesses for financing inventory, accounts receivable,
          and equipment, among other things. The underlying real estate
          collateral or business asset being financed typically secures these
          loans.

     o    INVESTMENT SECURITIES - The investment securities segment includes the
          investment securities portfolio. Although management does not consider
          this to be an operating business line, security investments are a
          necessary part of liquidity management for the Company.

     These segments are managed separately because each business unit requires
different processes and different marketing strategies to reach the customer
base that purchases those products and services. All three segments derive a
majority of their revenue from interest, and management relies primarily on net
interest revenue in managing these segments. No single customer provides more
than 10% of the Company's revenues.

                                       50
<PAGE>

                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

NOTE 23 - SEGMENTS (CONTINUED)

     Financial information for the Company's segments is shown below for the:

<TABLE><CAPTION>
                                                                            Years Ended December 31,
                                                  -------------------------------------------------------------------
                                                            Consumer       Commercial       Security
                                                             Lending         Lending       Investments       Total
                                                           -----------     -----------     -----------    -----------
<S>                                               <C>      <C>             <C>             <C>            <C>
Interest income ..............................    2002     $12,139,028     $30,785,305     $5,401,030     $48,325,363
                                                  2001      12,178,152      34,270,567      6,281,087      52,729,806
                                                  2000      10,643,953      33,025,368      7,759,827      51,429,148

Interest expense .............................    2002       5,338,901      11,917,172      4,430,292      21,686,365
                                                  2001       7,007,455      17,650,123      6,744,848      31,402,426
                                                  2000       6,419,366      18,080,772      6,419,268      30,919,406

Net interest income ..........................    2002       6,800,127      18,868,133        970,738      26,638,998
                                                  2001       5,170,697      16,620,444       (463,761)     21,327,380
                                                  2000       4,224,587      14,944,596      1,340,559      20,509,742

Provision for loan losses ....................    2002         279,291         630,709            --          910,000
                                                  2001         112,823         252,177            --          365,000
                                                  2000         163,825         366,175            --          530,000

Net interest income, after provision for
     loan losses .............................    2002       6,520,836      18,237,424        970,738      25,728,998
                                                  2001       5,057,874      16,368,267       (463,761)     20,962,380
                                                  2000       4,060,762      14,578,421      1,340,559      19,979,742

Other operating income .......................    2002       1,397,232       1,231,859        607,614       3,236,705
                                                  2001       1,870,763         897,253      1,262,084       4,030,100
                                                  2000       1,352,260         620,156        117,681       2,090,097

Other operating expense ......................    2002       6,105,200       9,891,994      1,158,710      17,155,904
                                                  2001       5,082,223       8,010,815      1,202,864      14,295,902
                                                  2000       4,210,897       6,659,177      1,221,702      12,091,776

Income before federal income taxes and
     cumulative effect of adoption of
     new accounting principle ................    2002       1,812,868       9,577,289        419,642      11,809,799
                                                  2001       1,846,414       9,254,705       (404,541)     10,696,578
                                                  2000       1,202,125       8,539,400        236,538       9,978,063

Federal income taxes .........................    2002         619,409       3,272,307        120,713       4,012,429
                                                  2001         627,781       3,146,600       (155,181)      3,619,200
                                                  2000         408,722       2,903,396         66,945       3,379,063

Income before cumulative effect of
      adoption of new accounting principle ...    2002       1,193,459       6,304,982        298,929       7,797,370
                                                  2001       1,218,633       6,108,105       (249,360)      7,077,378
                                                  2000         793,403       5,636,004        169,593       6,599,000
</TABLE>

                                       51
<PAGE>

                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
<TABLE><CAPTION>
                                                                        Years Ended December 31,
                                                -----------------------------------------------------------------
                                                          Consumer     Commercial      Security
                                                          Lending        Lending      Investments       Total
                                                        -----------    -----------    -----------    ------------
<S>                                             <C>       <C>            <C>              <C>           <C>
Net income ..................................   2002      1,193,459      6,304,982        298,929       7,797,370
                                                2001      1,063,386      6,108,105       (249,360)      6,922,131
                                                2000        793,403      5,636,004        169,593       6,599,000

Total interest earning assets (averages).....   2002    171,644,928    429,393,825     97,819,892     698,858,645
                                                2001    147,373,686    406,497,795    102,889,127     656,760,608
                                                2000    129,511,107    362,636,259    124,520,848     616,668,214
</TABLE>

NOTE 24 - DERIVATIVE ACTIVITIES AND MARKET RISK

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

     Forward commitments are used to limit market risk. The Company had open
forward contracts to deliver mortgage-backed securities at a future date,
coinciding with uncommitted mortgage loans held-for-sale, to eliminate a portion
of the market risk for a specified price. Depending on the directional movement
of the security, the maximum loss is limited to the face value of the
commitment.

     At December 31, 2002, the fair value of financial instruments defined as
derivatives consisted of:

                                                      Notional        Fair
                                                       Amount         Value
                                                    -----------     --------
     Interest-rate-lock loan commitments.........   $ 4,314,000     $ 67,749
     Outstanding commitments to sell loans.......     4,000,000      (32,500)
     Interest rate swap..........................     9,000,000     (624,404)


     The Company does not have an effective hedging program for its conforming
loans as defined by SFAS No. 133, ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND
HEDGING ACTIVITIES, as amended, and therefore gains and losses on derivative
financial instruments are recognized currently in the income statement.

     The Company entered into a swap agreement with the FHLB to hedge the
variability of cash flows to be paid related to the trust preferred securities.
The hedge is a qualifying cash flow hedge with changes in the fair value
recorded in other comprehensive income.

                                       52
<PAGE>

                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

NOTE 25 - PARENT COMPANY ONLY FINANCIAL STATEMENTS

     Summary of condensed parent company financial information for First Mutual
Bancshares, Inc. for December 31, 2002 and 2001 (in thousands):


            STATEMENT OF FINANCIAL CONDITION

                                                     December 31,
                                                  -----------------
    ASSETS                                          2002      2001
                                                  -------   -------
       Cash ...................................   $   675   $   321
       Investments in subsidiaries ............    52,071    51,808
       Other assets ...........................     1,163       457
                                                  -------   -------
     Total assets .............................   $53,909   $52,586
                                                  =======   =======

     LIABILITIES AND STOCKHOLDERS' EQUITY

     Liabilities:
       Borrowings .............................   $   250   $   250
       Other liabilities ......................     9,375       365
                                                  -------   -------
                                                    9,625       615
     Stockholders' equity .....................    44,284    51,971
                                                  -------   -------
     Total liabilities and stockholders' equity   $53,909   $52,586
                                                  =======   =======


                  STATEMENT OF INCOME

                                                      Years Ended December 31,
                                                    ----------------------------
                                                      2002      2001       2000
                                                    -------   -------    -------
    INCOME
       Equity in undistributed net income
         from subsidiaries ......................   $ 8,268   $ 7,090    $ 6,864
                                                    -------   -------    -------
     OTHER EXPENSE
       Compensation and employee benefits .......        96        (2)       214
       Other operating expense ..................       619       256        187
                                                    -------   -------    -------
         Total expenses .........................       715       254        401
                                                    -------   -------    -------
         Income before federal income taxes .....     7,553     6,836      6,463

     FEDERAL INCOME TAX BENEFIT .................       244        86        136
                                                    -------   -------    -------
     NET INCOME .................................   $ 7,797   $ 6,922    $ 6,599
                                                    =======   =======    =======

                                       53
<PAGE>

                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

                             STATEMENT OF CASH FLOWS
<TABLE><CAPTION>
                                                                         Years Ended December 31,
                                                                    --------------------------------
                                                                      2002        2001        2000
                                                                    --------    --------    --------
OPERATING ACTIVITIES
<S>                                                                 <C>         <C>         <C>
      Net income ................................................   $  7,797    $  6,922    $  6,599
      Adjustments to reconcile net cash from operating activities
           Equity in undistributed earnings of subsidiaries .....     (8,268)     (7,090)     (6,864)
           Increase in other assets .............................       (706)       (177)       (188)
           Increase (decrease) in other liabilities .............        (69)        (72)         29
                                                                    --------    --------    --------
             Net cash provided (used) by operating activities ...     (1,246)       (417)       (424)

INVESTING ACTIVITIES
      Dividends received from subsidiaries ......................      9,270       1,060         960

FINANCING ACTIVITIES
      Dividends paid ............................................     (1,322)       (940)       (934)
      Proceeds from exercise of stock options ...................        450         230          44
      Repurchase and retirement of common stock .................    (15,798)       --          (102)
      Proceeds from issuance of trust preferred securities ......      9,000
      Repayment of employee stock ownership plan (ESOP) debt ....       --            98         213
                                                                    --------    --------    --------
             Net cash provided (used) by financing activities ...     (7,670)       (612)       (779)
                                                                    --------    --------    --------

NET INCREASE (DECREASE) IN CASH AND CASH
           EQUIVALENTS ..........................................        354          31        (243)
      Beginning of year .........................................        321         290         533
                                                                    --------    --------    --------
      End of year ...............................................   $    675    $    321    $    290
                                                                    ========    ========    ========
</TABLE>
                                       54
<PAGE>

FORWARD-LOOKING STATEMENTS

     This Annual Report to Shareholders contains statements concerning 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, forecast, hopeful, indicate, outlook and
suggests generally constitute forward-looking statements. Such forward-looking
statements include statements referring to our expectations regarding future net
interest rate margins and the anticipated effects of changes in interest rates
on the Company, our anticipated increase in volume of loan originations,
particularly from the Sales Finance Department, our anticipated increases in
deposits, our expectations for branch office expansion, our forecast for
prepayments and the pricing for time deposits, our expectations for increases in
compensation expense and staffing levels, our anticipated loss from the
resolution of non-performing loans, our belief that our liquidity and capital
sources are adequate to fund our asset growth, and our expectations regarding
our relatively low ratio of non-performing loans. Although the Company believes
that the expectations expressed in these forward looking statements are based
upon reasonable assumptions within the bounds of our knowledge of our business,
operations and prospects, these forward-looking statements are subject to
numerous uncertainties and risks, many of which are beyond the control of the
Company. Actual events, results, and developments will ultimately differ from
the expectations and may differ materially from those expressed or implied in
such forward-looking statements. Factors which could affect actual results
include economic conditions in the Company's market area and nationally;
interest rate risks, fluctuations and timing; the impact of competitive
products, services and pricing; the success of our credit risk management; our
ability to control costs and expenses; loan 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.


                                       55
<PAGE>
























                                     FIRST
                                     MUTUAL
                                   BANCSHARES


                             400 - 108th Avenue NE
                           Bellevue, Washington 98004
                                 (425) 455-7300