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


                                      2003

                    F I N A N C I A L   I N F O R M AT I O N

                                   ----FOR----

                                  First Mutual
                                Bancshares, inc.

                        YOUR LIFE. YOUR DREAM. YOUR BANK.













                                                          FIRST
                                                          MUTUAL
                                                          Bancshares


<PAGE>

                          FIRST MUTUAL BANCSHARES, INC

                                TABLE OF CONTENTS

                           2003 FINANCIAL INFORMATION

Forward-looking Statement
Management's Discussion and Analysis of Financial
  Condition and Results of Operations..................................     1-23
Independent Auditor's Report...........................................       24
Consolidated Statements of Financial Condition.........................    25-26
Consolidated Statements of Income......................................    27-28
Consolidated Statements of Stockholders' Equity and
  Comprehensive Income.................................................       29
Consolidated Statements of Cash Flows..................................    30-31
Notes to Consolidated Financial Statements.............................    32-58












This section contains the 2003 Financial Information for First Mutual
Bancshares, Inc. Please refer to the attached Annual Report for the Annual
Letter to Shareholders and Stock Information.

<PAGE>

FORWARD-LOOKING STATEMENT

     This Management's Discussion and Analysis contains statements concerning
anticipated future operations, trends, expectations, and prospects of First
Mutual Bancshares, Inc. and First Mutual Bank (together, the "Company") that
are forward-looking statements for the purposes of the safe harbor provisions
under the Private Securities Litigation Reform Act of 1995. Statements
containing words such as "anticipate", "believe", "estimate", "expect",
"forecast", "forward-looking", "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 from various business segments, 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 fluctuations, timing, and related risks; the impact of competitive
products, services, and pricing; the success of our credit risk management; our
ability to control costs and expenses; loan 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.




<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
three trusts, First Mutual Capital Trust I, First Mutual Capital Trust II, and
First Mutual Statutory Trust III.


FINANCIAL HIGHLIGHTS

      First Mutual Bancshares' performance in 2003 reflects another year of
record income, continued asset growth, and solid credit quality.

      Net income grew 7.7%, totaling $8,396,000, or $1.73 per diluted share,
which compares to $7,797,000, $1.45 per diluted share, in 2002, and $6,922,000,
$1.19 per diluted share, in 2001. Net income in 2003 was influenced by a
favorable increase in both net interest income and other operating income. Our
net interest income in 2003 improved to $30.7 million from $26.6 million in
2002, an increase of 15.4%, compared to an increase of $5,312,000, or 24.9% from
2001 to 2002. Net interest income in 2001 totaled $21.3 million. Our other
operating income also improved, 13.2%, from $3.2 million in 2002 to $3.7
million. The comparable figures for the years 2002 and 2001 showed a decline of
19.7%, from $4.0 million in 2001 to $3.2 million in 2002. Other operating income
in 2000 amounted to $2.1 million.

      Contributing to our record earnings for 2003 was the growth in total
assets, which increased $115.5 million, or 15.5%. By comparison, the increase in
assets in 2002 was $66.9 million, or 9.9%. Those figures compare to the national
average for asset growth for all FDIC-insured institutions of 8.13% for the 12
months ending September 2003 and 7.20% for calendar 2002. The growth in our
assets in 2003 occurred principally in the loan portfolio (loans receivable),
which increased to $723.7 million, growth of 16.3% from 2002's balance of $622.4
million. The comparative increase in the prior year was 9.2%, or $52.3 million.

      Our non-performing assets continued to remain at relatively low levels,
declining to $538,000 from $2.1 million in 2002. As a percent of total assets,
non-performing assets were 0.06% at year-end 2003, versus 0.28% the previous
year. The comparative ratio for FDIC-insured institutions was 0.77% as of
September 30, 2003, and 0.90% for year-end 2002.

      Twice during the year we issued Trust Preferred Securities (TPS) totaling
$8 million. The first issue occurred in January, for $4 million, and was used to
support the asset growth in 2003. The proceeds from our second issue in
December, also for $4 million, are intended to provide funds and capital for
asset growth in 2004.


RESULTS OF OPERATIONS

NET INTEREST INCOME

      Net interest income represents our primary source of earnings. Changes in
our net interest income are influenced by the levels of growth in, and mix of,
our various earning assets and funding sources, along with the repricing
characteristics of those assets and liabilities. The repricing of our assets and
liabilities is, in turn, influenced by the levels of, and changes in, interest
rates. For the year ending December 31, 2003, our net interest income increased
$4.1 million, or 15%, over the prior year, to $30.7 million as our net interest
margin for the year was 3.99%, improving relative to the 2002 level of 3.88%,
and the 2001 margin of 3.34%. Net interest margin is calculated by dividing our
net interest income by our average earning assets for the period, and is a
representative number of the profitability of our earning asset portfolio and
funding sources.

      The increase in our net interest income for 2003 was primarily
attributable to a higher level of earning assets compared to 2002, though asset
and liability repricing also contributed to the improvement. In 2002, we
benefited from both an increase in earning assets as well as favorable repricing
of our assets and liabilities,

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<PAGE>

while in 2001 the growth in earning assets was needed to offset the unfavorable
repricing of assets and liabilities. The following table illustrates the effects
of these variables on net interest income, with the results related to the level
of earning assets referred to as "volume," and the effects of asset and
liability repricing labeled "rate."
<TABLE><CAPTION>

                              RATE/VOLUME ANALYSIS

                                   2003 VS. 2002                    2002 VS. 2001                    2001 VS. 2000
                            INCREASE/(DECREASE) DUE TO       INCREASE/(DECREASE) DUE TO       INCREASE/(DECREASE) DUE TO
                          ------------------------------   ------------------------------   ------------------------------
                           VOLUME      RATE       TOTAL     VOLUME      RATE       TOTAL     VOLUME      RATE       TOTAL
                          --------   --------   --------   --------   --------   --------   --------   --------   --------
<S>                       <C>        <C>        <C>        <C>        <C>        <C>        <C>        <C>        <C>
INTEREST INCOME

INVESTMENTS:
Available for sale
securities .............  $    540   $ (1,126)  $   (586)  $  1,742   $   (291)  $  1,451   $    511   $   (176)  $    335
Held to maturity
securities .............      (551)       (52)      (603)    (1,690)      (577)    (2,267)      (434)      (752)    (1,186)
Other equity investments       (48)         8        (40)       (26)       (78)      (104)       210        (87)       123
                          --------   --------   --------   --------   --------   --------   --------   --------   --------
Total Investments.......       (59)    (1,170)    (1,229)        26       (946)      (920)       287     (1,015)      (728)
                          --------   --------   --------   --------   --------   --------   --------   --------   --------
LOANS:
Residential ............     1,664       (745)       919        128       (972)      (844)      (301)        (2)      (303)
Residential construction     1,359        104      1,463        544       (732)      (188)       528       (346)       182
Multifamily ............       709     (1,636)      (927)       949     (2,079)    (1,130)       277       (395)      (118)
Multifamily construction       (85)        45        (40)      (691)      (356)    (1,047)       245       (167)        78
Commercial real estate
and business ...........     1,397     (2,310)      (913)     2,533     (3,106)      (573)     2,406       (792)     1,614
Commercial real estate
construction ...........       (36)       (64)      (100)       111       (154)       (43)       213       (222)        (9)
Consumer and other .....     1,806        354      2,160      1,019       (681)       338        657        (60)       597
                          --------   --------   --------   --------   --------   --------   --------   --------   --------
Total loans ............     6,814     (4,252)     2,562      4,593     (8,080)    (3,487)     4,025     (1,984)     2,041
                          --------   --------   --------   --------   --------   --------   --------   --------   --------
Total interest
income .................     6,755     (5,422)     1,333      4,619     (9,026)    (4,407)     4,312     (2,999)     1,313
                          --------   --------   --------   --------   --------   --------   --------   --------   --------
INTEREST EXPENSE

DEPOSITS:
Money market deposit
accounts and checking ..       616       (391)       225        336     (1,137)      (801)       110       (561)      (451)
Regular savings ........         8        (31)       (23)        (1)       (49)       (50)       (27)       (19)       (46)
Time deposits ..........       814     (3,029)    (2,215)      (382)    (7,482)    (7,864)       625        (46)       579
                          --------   --------   --------   --------   --------   --------   --------   --------   --------
Total deposits .........     1,438     (3,451)    (2,013)       (47)    (8,668)    (8,715)       708       (626)        82
                          --------   --------   --------   --------   --------   --------   --------   --------   --------
FHLB advances and
other ..................     1,511     (2,263)      (752)     2,109     (3,114)    (1,005)       772       (358)       414
                          --------   --------   --------   --------   --------   --------   --------   --------   --------
Total Interest
Expense ................     2,949     (5,714)    (2,765)     2,062    (11,782)    (9,720)     1,480       (984)       496
                          --------   --------   --------   --------   --------   --------   --------   --------   --------
Net interest income ....  $  3,806   $    292   $  4,098   $  2,557   $  2,756   $  5,313   $  2,832   $ (2,015)  $    817
                          ========   ========   ========   ========   ========   ========   ========   ========   ========
</TABLE>


EARNING ASSET GROWTH (VOLUME)

      Over the last three years, the improvement in our net interest income has
primarily been the result of growth of our earning asset base. For 2003, our
average earning assets totaled $771 million, a 12% increase over the $687
million average level for 2002. This followed year-over-year growth of nearly 8%
in 2002 and

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<PAGE>

over 7% for 2001, when average earning assets rose to $638 million in 2001 from
$594 million in 2000. However, while growth in the level of average earning
assets has been a recurring theme over the last few years, those categories
responsible for the growth have evolved in response to changes in strategy and
market conditions.

      As seen in the above table, the majority of earning asset growth occurred
in the loan portfolio, with changes in the volume of our security holdings
contributing only modestly to the overall net interest income improvement in
2001, before becoming virtually flat in 2002 and 2003. While it appears as
though there were significant changes in the line items within the investment
category, this was actually a case of securities classified as
"held-to-maturity" either maturing or being called by the issuers, and the
replacement securities and other new purchases being classified as
"available-for-sale."

      In contrast, our average loans, including loans held for sale and net of
the reserve for loan losses, grew by 12% in 2001, to $529 million, then 13% in
both 2002 and 2003, to $597 million and $676 million, respectively. It was this
growth in average loan balances that effectively drove the $4,312,000 (2001),
$4,619,000 (2002), and $6,755,000 (2003) volume-based improvements in net
interest income. In reviewing the rate/volume analysis table, it becomes
apparent that those categories with the greatest influence on overall
volume-based interest income changes have evolved over the last three years.

      In 2001, our commercial real estate and business loans contributed the
majority of volume-based interest income growth for both loans and assets
overall. In 2002, while commercial real estate and business loans were again
responsible for most of the volume-based interest income growth, consumer and
multifamily loans became more significant to the total improvement. Finally, for
2003, the improvement in our interest income attributable to additional volume
was no longer driven primarily by a single loan category, but instead by the
combination of consumer, residential, commercial real estate and business,
residential construction, and multifamily loans.

      The evolution in the contributions of the various loan categories to net
interest income is a result of both our internal decisions and market conditions
over the last three years. For example, in the last couple of years we have
focused on building the earning assets and profitability of our Sales Finance
Division, which is responsible for producing most of the loan volume in the
"Consumer and Other" category. As a part of this strategy, we decided to retain
in our portfolio a greater percentage of those loans originated outside the
Northwest. By retaining more of these loans, this category showed stronger
growth than in prior years, with a pronounced effect on interest income. In
contrast, the reduced significance of commercial real estate and business loans
to the overall changes was, in part, attributable to market conditions. The soft
local economy of the last year reduced the number of quality commercial banking
relationship opportunities in the market. With fewer desirable deals in the
marketplace, the commercial real estate and business loan category, which had
accounted for the majority of volume-based interest income growth in 2001 and
2002, remained a factor, but a less significant one.

      Our asset growth is generally funded by increases in deposits and
wholesale borrowings. As of December 31, 2002, our deposits totaled $497
million, up from $429 million at December 31, 2001, which represented a decline
from $457 million at year-end 2000. Over the course of 2003, deposit growth of
nearly $87 million, or 17%, brought the level of total deposits to $584 million.
Checking and money market products accounted for approximately $58 million, or
two-thirds of this deposit growth, which helped to reduce our overall cost of
funds. While this may at first seem inconsistent with the above table, which
indicates a greater volume-related impact on interest expense for time deposits
than for checking accounts and money market deposit accounts (MMDA), those
accounts have lower rates than most time deposit categories.

      Because we have been unable to fully support our asset growth with new
deposits, we have utilized Federal Home Loan Bank (FHLB) advances as a
supplemental funding mechanism. While FHLB advances rose only 5% from year-end
2002 to 2003, the level of average advances in 2003 tended to run above the
levels for the same periods in 2002. This was particularly evident in the second
and third quarters, before average advances declined in the fourth quarter.
Outstanding FHLB advances totaled $214 million and $212 million at the ends of
the second and third quarters of 2003, and were then reduced to $194 million at
December 31, 2003, as funding sources (deposit growth and the TPS) exceeded
fourth quarter asset growth and allowed

                                        3
<PAGE>

short-term advances to be paid down. As a result, interest expense attributable
to FHLB advances increased $1,511,000 in 2003 over the previous year, despite a
fairly minimal change in year-end balances. In both 2001 and 2002, changes in
deposit balances were insufficient to keep up with asset growth. Consequently,
additional volumes of FHLB advances and other wholesale borrowings were needed
to fund incremental assets in those years. The impacts of these additional
volumes on interest expense totaled $772,000 in 2001 and $2,109,000 in 2002.


ASSET YIELDS, FUNDING COSTS, AND NET INTEREST MARGIN (RATE)

      Our net interest margin for 2003 rose to 3.99%, up from 3.88% for 2002.
This was the second consecutive year for improvement in the margin, since
declining to 3.34% for 2001 from 3.46% in 2000. The movements in our margin over
this period have been largely influenced by the overall interest rate
environment, policy decisions of the Federal Reserve Bank, and competitive
forces in the local deposit market.

      During the last three years, the Federal Reserve Bank cut rates a total of
13 times, 11 in 2001, and once each in 2002 and 2003. Yields on our loan
portfolio, primarily adjustable-rate loans that reprice annually based on
one-year index rates, fell rapidly in 2001 in response to the rate cuts, and
then declined less dramatically in the more stable rate environments of 2002 and
2003. In contrast, pricing on our deposit accounts, which are largely centered
in time deposit balances, is not tied to short-term market index rates, but
instead is driven primarily by competitive factors in our local market.
Consequently, in an environment where rates are falling quickly, the pricing of
our deposits will tend to lag the market index rates, and decline in a more
gradual fashion. This occurred in 2001, and the combination of rapidly declining
market index rates, and therefore adjustable-rate loan yields, with slowly
moving deposit pricing resulted in a compression of our net interest margin from
3.46% to 3.34%. Also impacting the margin in 2001 was the timing of maturing
certificates of deposit repricing. Approximately $158 million, or 48%, of
maturing time deposits did not reprice until the fourth quarter of 2001.
Consequently, while the adjustable-rate loan portfolio was repricing downward
fairly steadily throughout the year, a large concentration of time deposits did
not reprice until late in the year.

      In 2002, the Federal Reserve cut rates only once. As a result, while loan
yields continued to decline, a greater impact was seen in deposit pricing, which
continued its descent in response to the previous year's Federal Reserve Bank
activity. With liability costs declining more rapidly than asset yields, the net
interest margin for the year improved from 3.34% to 3.88%. This trend continued,
as detailed below, for 2003, with liability costs again continuing to decline
more rapidly than asset yields, resulting in an improvement in the net interest
margin to 3.99%.

      QUARTER ENDED                                          NET INTEREST MARGIN
      -------------                                          -------------------

      December 31, 2002.......................................      3.78%
      March 31, 2003..........................................      3.84%
      June 30, 2003...........................................      3.89%
      September 30, 2003......................................      4.01%
      December 31, 2003.......................................      4.09%

      A review of the past 12 months shows that our net interest margin began
the year at 3.78% (quarter ended December 31, 2002), and then improved
throughout 2003. While the margin increased in each quarter of 2003, the six and
five basis point rises in first and second quarters were slower than the 12
basis point rise in the third quarter and the additional eight basis point
increase in the fourth quarter.

      The yield on our earning assets fell to 6.16% for the year ended December
31, 2003, compared to 6.87% for 2002, a reduction of 71 basis points, as our
adjustable-rate assets continued to reprice at lower levels. Typically, these
falling asset yields would be expected to result in the compression of the net
interest margin, as adjustable-rate loans are systematic in their repricing,
while time deposit rates tend to lag the downward movement in major rate
indexes. However, while our asset yields declined over the course of the year,
we were able to avoid the margin compression that usually follows by combining
three factors: growth in checking and money market products, increasing our
usage of wholesale funds in the first half of the year, and repricing our time
deposits at more favorable terms in the second half of the year.

                                        4
<PAGE>

      Our utilization of wholesale funds was largely focused on FHLB advances.
The increased use of FHLB advances as a funding source in 2003 had two primary
implications for net interest income. First, when interest rates were declining
in 2003, our time deposit rates typically lagged the movements of wholesale
market rates, and thus increasing wholesale borrowings frequently allowed us to
lock in a lower cost of funds. Second, on a forward-looking basis, as these
wholesale borrowings are tied to major market indexes, they should reprice in a
manner similar to index-linked adjustable-rate loans.

      In addition to the previously mentioned growth in checking and money
market accounts, another deposit-related factor that contributed to the net
interest margin improvement was the reduction in our time deposit costs in the
third and fourth quarters. Despite growth of over $28 million in time deposit
balances from year-end 2002 to 2003, the interest paid on these deposits fell
approximately $2.2 million in 2003. As noted earlier, our time deposit pricing
typically lagged the declines in wholesale fund rates observed in early 2003. By
the third quarter, however, our time deposit rates were adjusting to reflect the
prevailing market rates. Consequently, new deposits in the last half of 2003
were typically acquired at rates below those paid earlier in the year, and time
deposits maturing in the last half of 2003 were largely retained at rates below
their maturing rate. The benefit from the more favorable pricing was most
pronounced in the third and fourth quarters.

      The declining deposit pricing, together with the locking in of additional
wholesale funds earlier in the year, resulted in the cost on interest bearing
liabilities dropping 80 basis points in 2003 to 2.44%, compared to 3.24% in
2002. These factors offset our declining asset yields and translated to the net
interest margin of 3.99% for the year ended December 31, 2003, improving from
3.88% in 2002 and 3.34% in 2001.

      Our forecast for the first quarter of 2004 is for a net interest margin in
the 4.00%-4.10% range. This outlook depends upon key assumptions including, but
not limited to, loan and deposit growth, mix, pricing, loan repayment behavior,
and a stable short-term rate environment.


OTHER OPERATING INCOME

      Other operating income rose in 2003 to $3,663,000, from $3,237,000 the
previous year, and $4,030,000 in 2001. The improvement in the current year was
largely due to increased rental income from the purchase of our Corporate
Headquarters, First Mutual Center. Other operating income is composed of five
categories, one of which, "gain on sales of loans," is further divided into
three sub-categories.

GAIN ON SALES OF LOANS
                                                2003        2002         2001
                                              --------   ----------   ----------
      Consumer (Sales Finance) Loan Sales...  $410,000   $  522,000   $  357,000
      Residential Loan Sales................   469,000      553,000    1,183,000
      Commercial Loan Sales.................   105,000       52,000          --
                                              --------   ----------   ----------
      Total Gain on Sales of Loans..........  $984,000   $1,127,000   $1,540,000
                                              ========   ==========   ==========


CONSUMER LOAN SALES

      The gain on our consumer loan sales has varied over the past three years
in response to strategic changes in this part of our business. The home
improvement loan program, which is our primary type of consumer loan, was
developed by our Sales Finance Department. For a number of years, that
Department focused its activities in the Northwest, until 2001, when we opened
an office in Florida to cover the eastern United States. With the expansion into
new territory and the addition of an office on the East Coast, we felt that it
was prudent to sell home improvement loans originated outside of the Northwest,
our normal lending area. In 2001, we sold $6.7 million of consumer loans for a
gain of $357,000. The previous year our gain on home improvement loans amounted
to only $16,000.

      In the fall of 2002, we evaluated the historical performance of the
consumer loans closed outside the Northwest and reconsidered our earlier
decision to sell those loans. The yield on the home improvement loan portfolio
was greater than our other loan portfolios, and the level of charge-offs and
non-performing assets had

                                        5
<PAGE>

been very satisfactory. Because our transition to the retention of those loans
did not begin until the fourth quarter of 2002, loan sales that year totaled
$16.9 million, with a net gain of $522,000.

      In late summer 2003, we again altered our position on consumer loan sales.
The home improvement loan portfolio had grown dramatically, and at that time
accounted for 25% of our total loan growth. Although the performance of that
portfolio continued to remain satisfactory, we believed that we would be well
served to sell a portion of those loans. Loan sales in 2003 totaled $12.9
million, with 53% of those sales occurring in the fourth quarter. The gain for
the year was $410,000. Our outlook for 2004 is for loan sales to range from
$20$40 million. Even with the increased level of sales, we still expect the home
improvement loan portfolio to grow by 20%-30%.


RESIDENTIAL LOAN SALES

      The gain on residential loan sales has trended downward over the last
three years, from $1.2 million in 2001 to $469,000 in 2003. The activities
affecting the gains in residential lending can be grouped into three general
categories.

                                                  2003       2002        2001
                                                --------   --------   ----------
      Sale of Mortgage Servicing Rights.......  $ 43,000   $237,000   $  858,000
      Gain/Loss on Interest Rate Lock and
        Forward Commitments...................   (11,000)    31,000      214,000
      Secondary Marketing Gains/Losses........   437,000    285,000      111,000
                                                --------   --------   ----------
      Total Residential Gain on Sales of Loans  $469,000   $553,000   $1,183,000
                                                ========   ========   ==========

      SALE OF MORTGAGE SERVICING RIGHTS. The gains on servicing rights have
fallen dramatically in the last three years, as a result of our decision to
eliminate the residential servicing portfolio. In the fall of 1997, we evaluated
the loan servicing market and initiated a series of sales that eventually led to
the liquidation of our residential servicing portfolio. Those bulk sales totaled
$93 million in 1998, $51 million in 2000, $78 million in 2001, and $19 million
in 2002. There were no servicing sales in 2003; the gain of $43,000 reported in
2003 is the final settlement of a sale that occurred in late 2002. 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 our servicing portfolio was a
fortuitous action as interest rates have since declined substantially.

      GAIN/LOSS ON INTEREST RATE LOCKS AND FORWARD COMMITMENTS. Gains or losses
on rate locks and forward commitments are 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
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 2001 and 2002 is less than it initially appears because
in 2001, the first year for the new accounting statement, a loss was reported
separately as a change in accounting principle. That loss was $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 $21,000, compared to a gain of $31,000 in 2002, and a loss of
$11,000 in 2003.

      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 2003, the loan

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<PAGE>

amounts underlying the interest-rate lock commitments totaled $1.7 million and
there were no outstanding forward commitments.


      SECONDARY MARKETING GAINS/LOSSES. Secondary market gains/losses are the
cash gains or losses from the sale of loans into the secondary market, the
resulting gain/loss from the settlement, called "pair-offs," of forward
commitments and the gain from mortgage servicing rights. Secondary market fees
amounted to a gain of $437,000 in 2003 compared to gains of $285,000 in 2002 and
$111,000 in 2001. Our residential loan sales were up slightly, at $58.4 million
in 2003, from $53.5 million in 2002. Both years were down sharply from loan
sales of $76.6 million in 2001.

      The relative poor results in 2001, considering the greater level of loan
sales, was largely due to a $399,000 loss in pair-off fees. 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. Our pair-off fee loss of $196,000 in 2002 dropped to a
loss of $57,000 in 2003. In the last couple of years, we have reduced our
reliance on forward commitments preferring instead to sell most of our loans on
a "best efforts" basis. With a best-efforts contract, we are not obligated to
deliver a loan in which the borrower, after initiating a loan application with
us, subsequently chooses to originate his/her loan with another lender. Although
the risk of incurring pair-off losses is less with a best-efforts contract, the
opportunity for gain is also reduced.


COMMERCIAL LOAN SALES

      Our commercial loan sales have gradually increased their presence in terms
of gain on sale of loans. The gains were $105,000 in the most recent year, up
from $52,000 in 2002. There were no comparable gains in 2001. Loan sales have
also edged up over the last three years, from $14.3 million in 2001, to $19.1
million in 2002, and $24.5 million in 2003. Unlike our residential and consumer
loan operations, the primary purpose of a commercial loan sale is to accommodate
our customers by increasing our capacity to lend to any given individual. We
expect to see a continued increase in commercial loan sales as we grow the
commercial loan portfolio, and thus the number of customers that we serve.


SERVICING FEES, NET OF AMORTIZATION

      In 2003, net service fee income from the mortgage servicing portfolio
totaled $69,000, compared to $103,000 in 2002 and $106,000 in 2001. Service fees
principally consist of the fees that we collect for servicing loans for others,
and in the last three years that has not been a significant source of fee
income. For residential loans, we routinely sell the servicing rights along with
the underlying loan. In prior years we followed the same practice with our
consumer loans. The only loan sales in which we retained the servicing rights
occurred in our commercial area. However, with the shift from retaining consumer
loans to selling a significant portion of the new originations, the servicing
portfolio will grow. The effect in fee income will not be significant in any
given year, but to the extent that we continue to sell consumer and commercial
loans servicing fee income should gradually increase.


GAIN ON SALES OF INVESTMENTS

      Our gains amounted to $663,000 in 2003, as compared to $508,000 in 2002,
and $1,165,000 in 2001. Because of declining mortgage rates for the last three
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 $39 million, compared to $35 million in
2002 and $44 million in 2001. We have also executed a par value sale of $5
million, with a gain of $71,000, which will be reflected in our first quarter
2004 results. We don't anticipate that 2004 security sales will approach the
levels that we have seen in the last three years, as interest rates edged up
last summer and reduced the attractiveness of those sales. Of course, if
mortgage rates were to move significantly down from their present levels we
would once again be interested in capturing market gains before the underlying
loans repaid at par.

                                        7
<PAGE>

      The investment gains seen in 2001 included a gain of $464,000 on the sale
of an ATM network that liquidated 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.


FEES ON DEPOSIT SERVICES

      Deposit fee income has steadily increased over the last three years, from
$334,000 in year 2001 to $472,000 last year, and $516,000 in 2003. Virtually all
that income is attributable to checking accounts, where balances have increased
from $33 million in 2001 to $62 million in 2003. In the last 12 months, the
growth in business checking accounts has been particularly strong, up 37% from
$17.5 million last year to $23.9 million in 2003.


OTHER INCOME

      Other income is composed of a variety of sources, of which rental income
currently constitutes the most significant item. Our fee income from this source
was $713,000 in 2003, up sharply from $99,000 in the two prior years. The
increase in rental income is largely the result of the purchase in March 2003 of
our Corporate Headquarters, First Mutual Center. Located in Bellevue, First
Mutual Center is a seven-story building that we acquired for $12 million. At
year-end 2003, we occupied 39% of the building. The remainder of the building is
available for lease, and of that portion of the property 53% is presently
occupied. We are hopeful that by December 2004 we will be able to lease a
significant portion of the vacant space.

      In years 2002 and 2001 the principal source of other income was loan fees.
Revenue from loan fees totaled $579,000 in 2002 and $458,000 in 2001. The
comparable figure for this year is $281,000. Loan fees are largely composed of
prepayment and extension fees, which accounted for 91% of loan fee income in
2001, 87% in 2002, and 71% this year. The spike in mortgage rates in the third
quarter of 2003 adversely influenced fee income from these sources. The outlook
for 2004 is most likely to be a further decline from the results seen in 2003.
In the first half of the year we reported loan fee income of $183,000. Our loan
fee income fell to $98,000 in the second half, trending down from $55,000 in the
third quarter to $43,000 in the fourth quarter.


OTHER OPERATING EXPENSES

      Our operating expenses rose $3.36 million, or 20%, to $20.5 million in
2003, compared to $17.2 million in the prior year. This followed increases of
$2.86 million, or 20%, in 2002 and $2.20 million, or 18%, in 2001. The increased
expense in 2003 followed a three-year trend in which costs have risen as a
result of additional staffing expenses brought on by our loan and deposit
growth, and higher commission and incentive plan payouts. Also contributing to
the growth in costs in 2003 were increases in costs tied to our sales finance
portfolio and lending operations.


SALARIES AND EMPLOYEE BENEFITS

      Salary and benefit expenses rose $2.2 million, or 22%, from $10.2 million
in 2002 to $12.4 million for 2003, and accounted for most of the increase in
operating expenses. This rate of increase was comparable to the increases of
21%, or $1.8 million, in 2002, and 18%, or $1.3 million, in 2001. While the
additional expense was primarily attributable to salaries and benefits for staff
added during the year, higher loan officer commissions and incentive plan
payments also contributed to the increase.

      The growth in salary and benefit expenses was largely the result of higher
staffing levels relative to the same period in 2002. Between December 31, 2002
and 2003, our staffing level, as measured by full-time-equivalent (FTE) employee
count, rose 23% from 164 FTE at December 31, 2002, to 201 at December 31, 2003.
This followed an increase from 143 FTE at year-end 2001. Most of this growth was
centered in loan and deposit servicing areas, particularly those related to
sales finance lending and consumer loan servicing, and was made necessary by the
significant loan growth that occurred in 2003. Additionally, the new Woodinville
and Sammamish banking centers opened in the third and fourth quarters of 2003,
accounting for seven of the new employees. We also added four positions in our
information systems area to ensure that our technology

                                        8
<PAGE>

continues to support our growth. The 2002 additions were primarily centered in
lending departments, including business banking and residential lending, which
grew their personnel counts by 50% and 56%, respectively.

      Also contributing to the increase in costs were higher commissions and
bonus expenses, which rose $481,000, or 39%, to $1.71 million in 2003, up from
$1.23 million in 2002, as well as other incentive compensation, which increased
$169,000. The rising commission expense was, in part, a product of new deposit
and loan incentive plans for our business banking and community business banking
officers. The incentive programs for our banking centers were another factor
that contributed to increased compensation expense. As previously noted, deposit
growth over the last year has been centered largely in checking and money market
accounts, including business checking accounts. The increase in other incentive
compensation was attributable to the accrual of a year-end bonus as a result of
the improved financial performance of the Bank over the past year.

      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.

                                            2003          2002          2001
                                       ------------  ------------  ------------
      Salaries and Benefits..........  $ 14,370,000  $ 11,483,000  $  9,291,000
      Deferred Loan Origination Costs    (1,915,000)   (1,247,000)     (825,000)
                                       ------------  ------------  ------------
      Net Salaries and Benefits Costs. $ 12,455,000  $ 10,236,000  $  8,466,000
                                       ============  ============  ============
      Loan Originations..............  $424,364,000  $342,201,000  $323,058,000
                                       ============  ============  ============

OCCUPANCY

      Our occupancy expense was little changed, rising $90,000, or 4%, to $2.44
million in 2003. This was substantially less than the increase in the two
previous years, including a 10% increase in occupancy expense from $2.13 million
to $2.35 million in 2002, as well as the 2001 increase, when costs rose 18%.

      Despite the modest overall change from the prior year, there were
significant differences among various expense categories as a result of the
acquisition of our corporate headquarters, First Mutual Center. Our rent and
lease expense declined $516,000, or 62%, compared to 2002, based on the
elimination of lease expense on First Mutual Center. That benefit was partly
offset by the additional lease and occupancy expenses of our new Sammamish and
Woodinville banking centers. Also offsetting the reduced corporate headquarters
lease costs were increased expenses for maintenance and repairs, utilities,
property taxes, and depreciation on First Mutual Center. The growth in occupancy
expense in prior years was attributable to the opening of new banking centers
and a loan production office, as well as the leasing of additional space at the
First Mutual Center building.


OTHER EXPENSES

      Other expenses rose $1.05 million, or 23%, from $4.57 million in 2002 to

$5.62 million in 2003, largely due to costs related to our sales finance loan
portfolio, office supplies, marketing, and technology related expenses. This
rate of increase was comparable to that of 2002, when expenses rose $868,000, or
23%, and to 2001, when costs grew $571,000, or 18%.

      The single most significant jump in other operating expense was the
increase in credit insurance premiums for our sales finance loan portfolio. In
the fourth quarter of 2002, we began to insure against default risk on sales
finance loans to borrowers with credit scores below a certain level. We utilized
insurance policies designed to reimburse us for credit losses up to a set amount
for each pool of insured loans. The insurance

                                        9
<PAGE>

premiums for this coverage, approximately 2% of insured balances, rose from
$9,000 in 2002 to nearly $258,000 in 2003, based on the growth of insured loans
within the sales finance portfolio. As of December 31, 2003, insured loans
accounted for approximately 37% of the total sales finance portfolio and roughly
47% of new loan volumes. Based on the current portfolio and new volume mix, we
expect the level of insured loans to continue to increase, and with it, the
expense related to credit insurance.

      In addition to the expense associated with this insurance, our sales
finance activities have also resulted in increased out-of-state income tax
expenses. As a result of expanding the territory in which our Sales Finance
Division operates to 38 states, this expense grew from $26,000 in 2002 to nearly
$82,000 in 2003, an increase of 211%.

      Our office supplies expense rose approximately $146,000, or 47%, in 2003
to $454,000. This followed an increase of $79,000, or 35%, in 2002. The rising
cost of supplies in recent years is largely attributable to growth in staff and
loan volumes over the periods. As our business lines grow and require additional
staff, our demand for general office supplies increases. Additionally, the
growth in loan applications and originations in 2003 further increased demand
for forms and other office supplies.

      Marketing expenses, to promote our banking centers and commercial banking
segment, were also significantly higher relative to the prior year, totaling
$918,000, an increase of $270,000, or 42%, over 2002. This was the second
significant increase in as many years, as marketing expense had risen
substantially in 2002 following the establishment of a new Marketing Department
in late 2001. At the end of 2002, we expected that marketing expenditures would
again increase significantly in 2003. We believe that our current level of
marketing support is adequate and do not anticipate that those costs will
increase materially from their present levels.

      Internet and data processing related costs rose $172,000, or 31%, from
their 2002 levels, totaling $721,000 in 2003. This increase was primarily
attributable to our growth in 2003, which required expenditures for improved
infrastructure to accommodate the increased data flow, as well as higher
processing costs on an ongoing basis. Additionally, set-up costs associated with
our new Woodinville and Sammamish banking centers further contributed to the
increase in data processing expenses.

      Legal costs for 2003 rose 6% over the prior year level, totaling $404,000.
While legal fees related to routine corporate matters actually declined slightly
from the prior year, additional real estate owned (REO) and repossessed asset
related expenses resulted in the overall increase. The rate of increase in 2003
was substantially less than the 27% observed in 2002, when legal expenses rose
from $300,000 to $381,000. The increase that year resulted in large part from a
combination of fees incurred in repurchasing approximately 20% of our
outstanding stock from MGN Group LLC, an institutional investor, and the
nationwide expansion of our Sales Finance lending activities.

      Additionally, expenses associated with miscellaneous outside services rose
$172,000, or 55%, compared with the prior year. Among the factors contributing
to the increase were outside services associated with the purchase of First
Mutual Center, and a change in our interest rate risk modeling service provider
at the end of 2002.


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, and commercial real estate analysis. That information is then
reviewed by our Loan Policy Committee, which further evaluates national and

                                       10
<PAGE>

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

      The provision for loan losses has increased over the last three years from
$365,000 in 2001 to $910,000 last year to $1,150,000 in 2003. A number of
considerations have contributed to that trend, including the growth in the loan
portfolio, an ongoing assessment of the local and national economies, the
increase in the amount of charged-off loans, and the level of non-performing
assets.

      During 2003, the net loan portfolio (excluding loans held-for-sale)
increased $101 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. Our loan growth in 2002
was $52 million, down from $90 million in 2001.

      The national economy, as measured by Gross Domestic Product, was
particularly strong in the last half of 2003, up over 8% in the third quarter.
Although we remain cautious about the regional economic conditions, we have seen
signs of improvement. The Puget Sound Index increased 2.3% in the third quarter
and the Puget Sound Forecaster expects continued growth in 2004. That upbeat
view is dramatically different from our perspective in 2002. Last year, both the
national and local economic environments were a concern, with the Northwest
economy significantly weaker than the national economy.

      Loans that we have charged off, net of recoveries, totaled $498,000 this
year, up from $188,000 in 2002 and $62,000 the prior year. The upward trend in
charged-off loans is largely attributable to the home improvement loan
portfolio. That portfolio accounted for 82% of the net charged-off loans in
2001, 78% in 2002, and 65% this year. While we do insure a portion of our home
improvement loan portfolio, we do continue to experience charge-offs on the
portion that is not covered by insurance. The level of charged-off loans is
commensurate with that type of business, and within the industry norm. We
anticipate that the amount of charged-off loans will rise as the home
improvement loan portfolio increases in size and existing loans mature.

      Another 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 0.06% at year-end 2003, and compares
to 0.28% last year, and 0.08% in 2001. The comparative ratio for FDIC-insured
institutions was 0.77% at September 30, 2003, and 0.90% at year-end 2002. For a
number of years, we have experienced better than average ratios for
non-performing assets. If the economy were to deteriorate, we are hopeful that
our past credit underwriting will continue to allow us to outperform other
financial institutions in regard to nonperforming assets.


ADOPTION OF NEW ACCOUNTING PRINCIPLES

      In January 2003, the FASB issued Interpretation No. 46, CONSOLIDATION OF
VARIABLE INTEREST ENTITIES (VIE), as amended and interpreted. It defined a VIE
as a corporation, partnership, trust, or any other legal structure used for the
business purpose that either does not have equity investors with voting rights
or has equity investors that do not provide sufficient financial resources for
the entity to support its activities. This Interpretation will require a VIE to
be consolidated or deconsolidated by a company generally based on the risk of
loss or return. Effective December 31, 2003, we adopted Interpretation No. 46.
Accordingly, our VIEs in the form of trusts set up to issue Trust Preferred
Securities have been deconsolidated. The adoption of the Interpretation did not
have a significant impact on our financial position or results of operations.

      In April 2003, the FASB issued Statement No. 149, AMENDMENT OF STATEMENT
133 ON DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES. This Statement amends and
clarifies financial accounting and reporting for derivative instruments,
including certain derivative instruments embedded in other contracts
(collectively referred to as derivatives) and for hedging activities under FASB
Statement No. 133, ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES.
This Statement is effective for contracts entered into or

                                       11
<PAGE>

modified after June 30, 2003. Adoption of the Statement did not result in an
impact on our statement of financial position or results of operations.

      In May 2003, the FASB issued Statement No. 150, ACCOUNTING FOR CERTAIN
FINANCIAL INSTRUMENTS WITH CHARACTERISTICS OF BOTH LIABILITIES AND EQUITY. This
Statement establishes standards for how an issuer classifies and measures
certain financial instruments with characteristics of both liabilities and
equity. It requires that an issuer classify a financial instrument that is
within its scope as a liability, or an asset in some circumstances. Many of
those instruments were previously classified as equity. This Statement is
effective for financial instruments entered into or modified after May 31, 2003,
and otherwise is effective at the beginning of the first interim period
beginning after June 15, 2003, except for mandatory redeemable financial
instruments of nonpublic entities. Adoption of the Statement did not result in
an impact on our statement of financial position or results of operations.


CRITICAL ACCOUNTING POLICIES AND ESTIMATES

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

      For additional information regarding the allowance for loan losses, see
"Reserve and Provision for Loan Losses" in this Management Discussion and
Analysis and "Loans Receivable, Loans Receivable Held-For-Sale, and Reserve for
Loan Losses" in Note 1 to the Consolidated Financial Statements. For additional
information regarding servicing assets, see "Gain on Sales of Loans" in this
Management Discussion and Analysis and "Servicing Assets" in Note 1 as well as
"Note 7 - Servicing Assets and Servicing Fees" in the Consolidated Financial
Statements. For additional information regarding loan origination fees and
costs, see "Loan Fee Income and Interest Income on Loans Receivable" in Note 1
to the Consolidated Financial Statements. These critical accounting policies are
also discussed in the "Critical Accounting Policies" section of the 10K.


REVIEW OF FINANCIAL CONDITION

INVESTMENT SECURITIES

      Investment securities increased from $75 million at year-end 2002 to $87
million as of December 31, 2003, a rise of 16%. There was considerable activity
within the securities portfolio during the year. Security purchases in 2003
totaled $77 million, sales of securities amounted to $39 million, while
approximately $11 million in securities were either called or matured. 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, 2004, is $94
million. In January, we sold $5 million in mortgage-backed instruments,
resulting in a gain of $71,000. We also purchased two securities totaling $10
million, which will settle in March. Our plan in 2003 was to increase our
investment portfolio by $14 million. The actual result for the year was growth
of $12 million, which we consider to be reasonably close to our forecast. Our
budget for 2004 envisions virtually no growth in the investment portfolio. We
continue to be concerned about significantly increasing the portfolio at rate
levels that are at 45-year lows for short-term rates.


LOANS

      The loan portfolio is segregated into two components: loans held-for-sale
and loans receivable. Loans held-for-sale are pending sale and delivery to an
investor.

                                       12
<PAGE>

      Loans held-for-sale totaled $10 million at December 31, 2003, a decrease
of $3 million from the previous year-end. It is not unusual for the balance in
loans held-for-sale to change significantly from year to year. The normal
balance is in the range of $4 million-$12 million, but will vary with lending
and refinancing activity.

      Portfolio loans increased 16% in 2003, from $622 million at December 31,
2002, to $724 million at year-end 2003. The growth in the loan portfolio is the
result of a sharp increase in portfolio loan originations, which was partially
offset by a rise in the repayment of loans. Loans closed for the portfolio
totaled $331 million in 2003, up from $245 million in 2002. Loan principal
repayments, which were $181 million in 2002, increased this year to $204
million.


DEPOSITS

      Deposits grew $87 million, or 17%, in 2003, compared to an increase of $68
million in 2002. The comparative ratio for FDIC-insured institutions was an
increase of 9% in the 12 months ending September 30, 2003. Included in both
years' deposit growth are brokered deposits, of which $17 million was acquired
in 2002, and $5 million in 2003.

      The change in the mix of funds in the last couple of years has been
encouraging, as that growth has been characterized by an emphasis on low-cost
deposits. Money market and checking accounts were up $58 million in 2003, and
constituted 70% of the growth in deposits, excluding brokered deposits. In the
prior year, excluding the $17 million of brokered deposits, money market and
checking accounts were responsible for 49% of the increase in deposits. Part of
the success in the last two years can be attributed to the newer business lines,
business and community banking. Business checking account balances alone rose
37% this year. 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 2004.


MARKET RISK SENSITIVE INSTRUMENTS

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

      A number of measures are utilized to monitor and manage interest rate
risk, including net interest income and economic value of equity simulation
models, as well as a traditional "gap" model. We prepare these models on a
monthly basis for review by our Asset Liability Committee (ALCO), senior
management, and Board of Directors. The use of these models requires us to
formulate and apply assumptions to various balance sheet items. Assumptions
regarding interest rate risk are inherent in all financial institutions, and may
include prepayment speeds on loans and mortgage-backed securities, cash flows
and maturities of financial instruments held for purposes other than trading,
changes in market conditions, loan volumes and pricing, deposit sensitivities,
consumer preferences, and capital leverage plans. We believe that the data and
assumptions used for our models are reasonable representations of our portfolio
and possible outcomes under the various interest rate scenarios. Nonetheless,
these assumptions are inherently uncertain; therefore, the models cannot
precisely estimate net interest income or predict the impact of higher or lower
interest rates on net interest income. Actual results may differ significantly
from simulated results due to timing, magnitude and frequency of interest rate
changes, and changes in market conditions and specific strategies, among other
factors.

                                       13
<PAGE>
NET INTEREST INCOME (NII) AND ECONOMIC VALUE OF EQUITY (EVE) SIMULATION MODEL
RESULTS

                         DECEMBER 31, 2003               DECEMBER 31, 2002
                         PERCENTAGE CHANGE               PERCENTAGE CHANGE
CHANGE IN          -------------------------------------------------------------
INTEREST RATES     NET INTEREST   ECONOMIC VALUE   NET INTEREST   ECONOMIC VALUE
(IN BASIS POINTS)     INCOME        OF EQUITY         INCOME        OF EQUITY
----------------   -------------------------------------------------------------
+200............       1.14%          (8.50)%           1.94%        (10.58)%
+100............        N/A           (5.06)%            N/A          (3.89)%
-100............      (1.18)%          2.34%           (1.44)%         0.18%
-200............         *               *                *              *
------------
* Because a large percentage of our loan portfolio is tied to indexes that are
at historically low levels, a downward 200 basis points scenario could not be
computed.


NET INTEREST INCOME SIMULATION

      The "net interest income" figures in the above table refer to changes from
"base case" and assume a zero-growth balance sheet and a steady increase or
decrease in interest rates over a 12-month period. Base case is our forecast of
net interest income if rates were to remain unchanged from the current rates.

      The December 31, 2003 results of our income simulation model indicate that
our net interest income is projected to increase by 1.14% in an environment
where interest rates increase by 200 basis points (bps), and decline 1.18% in a
100 bps falling interest rate scenario. The magnitudes of these changes suggest
that there is little sensitivity in net interest income over a one-year horizon,
with relatively consistent net interest income in the base case projection and
the rising and falling rate ramp scenarios.

      Net interest income sensitivity is also affected by the rate floors on our
loan portfolio. If the fully-indexed rate on one of these loans reaches a level
significantly below the level of the rate floor, the loan effectively becomes a
fixed-rate instrument and may not reprice upwards in a rising rate scenario.
Consequently, in the rising rate scenario, the revenue generated on a
significant percentage of the loan portfolio remains constant as funding costs
rise.

      Incorporated into the model assumptions is the observed tendency for loan
and investment prepayments to accelerate in falling interest rate scenarios and
slow when interest rates rise. In all interest rate scenarios, the size of the
balance sheet is assumed to remain stable, with no balance sheet growth or
contraction regardless of interest rate movements. Therefore, implicit in this
assumption are additional assumptions for increased new securities purchases and
loan originations at lower interest rate levels to offset accelerated
prepayments, and conversely, reduced security purchases and loan production when
rates increase and prepayments slow.

ECONOMIC VALUE OF EQUITY (EVE) SIMULATION

      The EVE analysis goes beyond simulating earnings for a specified period to
estimating the present value of financial instruments in our portfolio, and then
analyzing how the economic value of the portfolio would be affected by various
alternative interest rate scenarios. The portfolio's economic value is
calculated by generating principal and interest cash flows for the entire life
of all assets and liabilities, then discounting these cash flows back to their
present values. The assumed discount rate used for each projected cash flow is a
current market rate, such as a London Interbank Offering Rate (LIBOR), FHLB, or
swap curve rate, and from alternative instruments of comparable risk and
duration.

      In the simulated 200 bps upward shift of the yield curve, the discount
rates used to calculate the present values of assets and liabilities will
increase, causing the present values of both assets and liabilities to fall,
with more prominent effects on longer-term, fixed-rate instruments.
Additionally, when interest rates rise, the cash flows on our assets will
typically decelerate as borrowers become less likely to prepay their loans. As
the cash flows on these assets are shifted further into the future, their
present values are further reduced. Based on our December 31, 2003 model
results, the effects of rising rates were more pronounced for our assets, which
would
                                       14
<PAGE>

have declined in value by an estimated 3.16% versus an approximately 2.61%
decline in the value of liabilities. Consequently, the economic value of our
equity was negatively impacted in this scenario, declining 8.50%.

      The opposite occurs when rates decline, as the discount rates used to
calculate the present values of assets and liabilities will decrease, causing
the present values of both assets and liabilities to rise. The EVE is expected
to be positively impacted in this scenario. Counteracting this effect, however,
is the tendency of cash flows to accelerate in a falling rate scenario, as
borrowers refinance their existing loans at lower interest rates. These loan
prepayments prevent the present values of these assets from increasing in a
declining rate scenario, illustrating an effect referred to as negative
convexity. Taking this negative convexity into account, the simulation results
indicated that the impact to EVE was less pronounced in the falling rate
scenario. In this case, the economic values of both assets and liabilities at
December 31, 2003 were positively impacted when rates were assumed to fall by
100 bps, assets by 1.47% and liabilities by 1.38%. This resulted in a positive
impact to the economic value of our equity of 2.34%.

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


ASSET AND LIABILITY MANAGEMENT

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

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


GAP MODEL

      The gap model quantities the mismatch between assets maturing, repricing,
or prepaying within a period, and liabilities maturing or repricing within the
same period. A gap is considered positive when the amount of
interest-rate-sensitive assets exceeds the amount of interest-rate-sensitive
liabilities within a given period. A gap is considered negative in the reverse
situation.

      Our 12-month interest rate sensitivity gap, expressed as a percentage of
assets, fell from 16.5% at year-end 2002 to 7.9% at December 31, 2003. These
results indicate that we remain asset sensitive, or positively gapped, with more
assets than liabilities expected to mature, reprice, or prepay within the next
year, though less so than at the 2002 year-end. The gap report has implied an
asset sensitive position for a number of quarters, dating back to September
2001. The change in the gap was driven by the mix of the additions to each side
of the balance sheet during 2003, as well as the overall balance sheet growth.

                                       15
<PAGE>

                     ONE-YEAR INTEREST RATE SENSITIVITY GAP

                                                          12/31/03     12/31/02
                                                          --------     --------
                                                             (IN THOUSANDS)

      One-Year Repricing/Maturing Assets..............    $632,428     $600,577
      One-Year Repricing/Maturing Liabilities.........     564,707      477,932
                                                          --------     --------
      One-Year Gap....................................    $ 67,721     $122,645
                                                          ========     ========
      Total Assets....................................    $860,844     $745,295
                                                          ========     ========
      One-Year Interest Rate Gap as a
        Percentage of Assets..........................      7.9%        16.5%

      Asset growth of nearly $116 million, or 15.5%, in 2003 was centered in
assets that would not be subject to maturity or repricing in the following 12
months. These assets included $12 million for the purchase of our corporate
headquarters, First Mutual Center, and $30 million of growth in fixed-rate
consumer loans. Also falling into this category were new single and multifamily
residential and commercial real estate adjustable-rate loans (ARMs), often tied
to one-year FHLB or LIBOR indexes, but for which the interest rate is fixed for
the first three to ten years of the loan. Overall, those assets not subject to
maturity or repricing within 12-months rose nearly $84 million over the year,
while assets expected to mature or reprice within the 12-month time horizon
increased approximately $32 million from their level as of December 2002.

      By comparison, liabilities subject to maturity or repricing in the next 12
months rose approximately $87 million over the prior year-end. This increase was
the result of many factors, including growth in money market accounts, a shift
in time deposits from longer-term instruments to shorter-term six- and
seven-month certificates, as well as a net increase in FHLB advances maturing
within the subsequent 12-month period. Money market account balances rose
significantly, up $48 million from the year-end 2002 level. Balances of six- and
seven-month time deposits increased from $33 million at December 2002 to $106
million at the 2003 year-end, in response to promotional rates offered in the
second and third quarters. As total retail time deposits grew only modestly from
December 2002 levels, the growth in six- and seven-month certificates largely
represented a shift from other accounts, primarily nine- to 14-month time
deposits. This shift from longer-term to shorter-term certificates contributed
to the reduction in gap. Additionally, the volume of our FHLB borrowings
scheduled to mature within 12-months increased by over $14 million compared to
the prior year-end.

      The greater increase of liabilities maturing/repricing in the next 12
months versus assets maturing/repricing resulted in a net $55 million reduction
in our dollar gap. This gap ratio was further reduced by the overall growth in
the balance sheet during the period, which increased from $745 million to $861
million. The combined effect of these two factors led to the decline in the
one-year gap ratio from 16.5% to 7.9% of total assets.

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


ASSET QUALITY

      Non-performing assets totaled $538,000 at year-end 2003, compared to $2.1
million last year. Non-performing assets as a percent of total assets was 0.06%
at the end of 2003, down from 0.28% at December

                                       16
<PAGE>

2002. 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

Two single-family residences, Western WA. No anticipated loss........   $181,000
An unsecured line of credit. No anticipated loss.....................     24,000
Fifteen consumer loans. Full recovery anticipated from insurance
  claims.............................................................    141,000
Eighteen consumer loans. No anticipated loss.........................    159,000
Two consumer loans. We anticipate charging these loans off in the
  First quarter......................................................     22,000
                                                                        --------
Total Non-Performing Loans...........................................   $527,000
                                                                        --------
Repossessed property (principally spas and motorcycles)..............     11,000
                                                                        --------
Total Non-Performing Assets..........................................   $538,000
                                                                        ========

      Since year-end 2003, we have collected the full amount owed on the two
single-family homes that totaled $181,000.


LIQUIDITY

      Our primary sources of liquidity are loan and security sales and
repayments, deposits, and wholesale funds. Secondary sources include cash from
operations, a line of credit with another financial institution at the Holding
Company and the issuance of Trust Preferred Securities. Our principal uses of
liquidity are the acquisition of loans and securities and the purchase of plant
and equipment.

      In 2003, we originated $424 million in loans and purchased $77 million in
securities. We funded most of that activity with $391 million in loan and
security sales and repayments. The net difference, $110 million, was funded
largely by an $87 million increase in deposits, a $10 million growth in FHLB
borrowings, and the issuance of $8 million in Trust Preferred Securities. In
2002, the net funding shortfall of new loans and securities, less loan and
security sales and prepayments, was $60 million. The comparable figure for 2001
was $19 million.

      Our funding from the inflow of deposits can vary widely from year to year.
Deposit balances increased $87 million this year, compared to a rise of $68
million in 2002 and a loss of funds totaling $29 million in 2001. An outflow of
deposits is unusual and has occurred only four times in the last 20 years. Our
ability to raise liquidity to support our asset growth through deposits is
dependent on our ability to compete with other financial institutions both on
rate and service. Although we control the quality of service that we provide, we
have no control over the prevailing rates in our marketplace.

      Our other primary source of liquidity is wholesale funds, which includes
FHLB borrowings, brokered deposits, and reverse repurchase lines of credit. The
most significant source of wholesale funds is FHLB borrowings. At year-end 2003,
our FHLB borrowings amounted to $194 million, up $10 million from $184 million
the prior year. FHLB borrowings at December 31, 2001 were $191 million. Our
credit line with the FHLB, which is reviewed annually, has been established at
40% of assets. As a percentage of year-end assets, our FHLB borrowings were 22%
this year, 25% in 2002 and 28% in 2001. The line is collateralized with
securities and single-family and multifamily loans. The risks associated with
this funding source include the reduction or non-renewal of the line. We also
potentially have the risk of insufficient collateral to utilize the full line.

      Broker originated deposits totaled $22 million at year-end 2003, and $17
million in 2002. Brokered deposits do not require the use of collateral and are
not restricted by the amount of funds that can be obtained from this source.
Because of risk management practices, we tend to limit the utilization of this
resource.

      Reverse repurchase lines are lines of credit collateralized by securities.
We currently have lines totaling $50 million, of which the full amount is
currently available. There was no usage of these lines in the previous

                                       17
<PAGE>

two years. The risks attendant with these lines is the withdrawal of the line
based on the credit standing of the Bank and the potential lack of sufficient
collateral to support the lines.

      Our secondary sources of liquidity, cash from operations, the Holding
Company line of credit, and the issuance of Trust Preferred Securities have a
limited capacity to fund asset growth. Cash from operations is limited to the
earnings activity of the Bank, while the other two sources are limited by our
credit standing, and in the case of TPS, federal banking regulations.

      Cash from operations can be viewed, on a very limited basis, as net income
adjusted for certain non-cash items such as the provision for loan loss,
amortization and depreciation, and FHLB stock dividends. Liquidity from that
source totaled $10 million in 2003, $9 million last year, and $8 million in
2001.

      The Holding Company has on three occasions issued Trust Preferred
Securities. We issued $9 million in securities in 2002, and $4 million in
January 2003 and again in December. 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. Shareholder equity totaled $51
million at year-end 2003. Thus, the practical limit to this source is $25
million, of which we have funded $17 million to date.

      In addition to using liquidity to fund loans and securities, we routinely
invest in plant and equipment, which is largely the acquisition of banking
center properties. In March of 2003, we purchased our Corporate Headquarters for
$12 million. The Woodinville banking center was completed this year, and a
leased facility for a banking center on the Sammamish Plateau was opened. Our
plans for 2004 include remodeling a number of our older banking centers.

      Four of our existing offices are particularly dated and require extensive
remodeling. In one of those offices we will need to build an entire new
facility. The capital cost of the updates is expected to be $3.2 million. A
property acquisition that has been under consideration for several years is the
Canyon Park site. If that banking center and office building were to be
completed in 2005, the liquidity requirement would approach $4.3 million.

      An unusual transaction occurred in 2002. 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 2004.

CONTRACTUAL OBLIGATIONS AND COMMITMENTS

      The following table sets forth our long-term obligations:
<TABLE><CAPTION>
                                                   PAYMENTS DUE PER PERIOD
                                    -----------------------------------------------------
                                              LESS THAN
                                      TOTAL     1 YEAR   1-3 YEARS  3-5 YEARS  THEREAFTER
                                    -----------------------------------------------------
                                                   (DOLLARS IN THOUSANDS)
<S>                                 <C>        <C>        <C>        <C>        <C>
      Debt.......................   $594,374   $433,840   $108,285   $ 30,252   $ 21,997
      Fixed Interest on Debt(1)..      2,416        535      1,071        810        --
      Operating Leases...........      2,314         23        131        289      1,871
                                    --------   --------   --------   --------   --------
      Total......................   $599,104   $434,398   $109,487   $ 31,351   $ 23,868
                                    ========   ========   ========   ========   ========
</TABLE>

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

      At December 31, 2003, our obligations related to debt totaled $594 million
to be paid over the next 30 years. Included in this amount are time deposits and
FHLB borrowings totaling $383 million and $194 million, respectively, and the
debt related to the three trust preferred security issuances totaling $17
million. In addition, the Holding Company has a line of credit with an
outstanding balance of $500,000 which is renewable annually. The interest rate
related to the $9 million TPS is adjustable. The interest rates

                                       18
<PAGE>

for the TPS issuances in January and December 2003 are fixed for the first five
years at 6.87% and 6.51%, respectively.

      We also have operating leases comprised of leases for office space and
equipment.


OFF-BALANCE SHEET COMMITMENTS

      At December 31, 2003, the Bank's commitments consisted of commitments to
extend credit to borrowers in which the borrower has not formally accepted the
financing arrangement or where the borrower has not drawn upon some portion of
the credit that was extended to them. Standby letters of credit are conditional
commitments issued by the Bank to guarantee the performance of a customer to a
third party or payment by a customer to a third party. The credit risk involved
in issuing letters of credit is essentially the same as that involved in
extending loan facilities to customers. We routinely charge a fee for these
credit facilities. We have not been required to perform on any financial
guarantees. The Holding Company does not issue financial guarantees.

      The following table sets forth the Bank's off-balance sheet commitments:
<TABLE><CAPTION>
                                                     AMOUNT OF COMMITMENT EXPIRATION PER PERIOD
                                                    --------------------------------------------
                                                    LESS THAN
                                          TOTAL      1 YEAR    1-3 YEARS   3-5 YEARS   THEREAFTER
                                        --------    --------    --------    --------    --------
                                                         (DOLLARS IN THOUSANDS)
<S>                                     <C>         <C>         <C>         <C>         <C>
      Commitments to Extend Credit....  $230,304    $196,315    $  4,055    $    205    $ 29,729
      Standby Letters of Credit.......        70          70         --          --          --
                                        --------    --------    --------    --------    --------
      Total...........................  $230,374    $196,385    $  4,055    $    205    $ 29,729
</TABLE>

CAPITAL

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

                                                                WELL-CAPITALIZED
CAPITAL RATIOS                            THE COMPANY     FMB        MINIMUM
--------------------------------------------------------------------------------
Total capital to risk-weighted assets        12.15%      11.82%       10.0%
Tier 1 capital to risk-weighted assets       10.22%      10.57%        6.0%
Tier 1 leverage capital to average assets     7.33%       7.71%        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 both 2002 and 2003, in addition to capital provided through retained
earnings, we augmented our regulatory capital with Trust Preferred Securities.
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 $17 million in securities ($9 million in 2002
and $8 million in 2003), which is 33% of our year-end 2003 shareholder equity.
There are no present plans to issue additional TPS, and we believe that our
current capital, plus retained earnings for year 2004, will meet our budgeted
growth in assets for the forthcoming year.

                                       19
<PAGE>

BUSINESS SEGMENTS

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

      The reportable segments include the following:

      o   CONSUMER LENDING - Consumer lending includes residential and home
          equity lending, direct consumer loans, and consumer dealer financing
          contracts (sales finance). 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. In addition,
          this segment also sells loans into the secondary market. We may choose
          to retain or sell the right to service the loans sold (i.e.,
          collection of principal and interest payments) depending upon market
          conditions.

      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 we do not consider this to
          be an operating business line, security investments are integral to
          the 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 the products and services. The consumer and commercial
lending segments derive a majority of their revenue from interest income, and we
rely primarily on net interest revenue in managing these segments. No single
customer provides more than 10% of the Bank's revenues.

CONSUMER LENDING

      Net income for the consumer lending segment rose $1,070,000 to $2,263,000
in 2003, up from $1,193,000 in 2002. This followed a modest increase of $130,000
in 2002 from the 2001 level of $1,063,000. The increase in net income for 2003
was a result of substantial growth in earning assets and net interest income,
which was partly offset by rising operating expenses.

      Net interest income for the consumer segment, net of the provision for
loan losses, totaled $10,375,000 for 2003. This represented continued
improvement over the 2001 level of $5,058,000 and an increase of nearly
$3,854,000, or 59%, over the $6,521,000 earned in 2002. This improvement in net
interest income was principally due to a 43% increase in the consumer segment's
average earning assets, which totaled $245 million for 2003, up from $172
million in 2002, and $147 million in 2001. Earning asset growth in 2003 was
centered primarily in residential and sales finance loans. The increase in home
improvement loans was driven by our decision to retain within our portfolio a
greater portion of the loans originated outside the Northwest. In addition to
providing incremental earning assets, the growth of custom construction and
sales finance loans as a percentage of total loans contributed to net interest
income growth due to the higher margins earned on these loans. Custom
construction loans generally earn higher rates of interest because of the
greater level of risk assumed as compared to permanent mortgages. Additionally,
sales finance loans typically command higher interest rates than most other loan
categories. With these additional assets and higher yields, interest income
earned on the portfolio totaled $16,684,000 in 2003, up $4,545,000 from
$12,139,000 in 2002, which was little changed from the 2001 level of
$12,178,000. In contrast, interest expense rose only $531,000 for 2003, to
$5,870,000. In 2002, interest expense declined significantly, from $7,007,000 in
2001 to $5,339,000, as the impact of reductions in funding rates more than
offset the cost of the additional funds that were required to support the $24
million in average earning asset growth.

                                       20
<PAGE>

      The consumer lending segment's non-interest income rose $165,000, from
$1,397,000 in 2002, to $1,563,000 this year, and was primarily attributable to
rental income allocated to the segment. This allocated rental income has become
a significant source of non-interest income for the various business lines since
the acquisition of First Mutual Center in the first quarter of 2003. Rental
income allocated to the consumer segment totaled $191,000 for the year, with no
comparable income received in the prior year. Excluding this allocation of
revenue, non-interest income was little changed, as additional custom
construction and other fee income in 2003 largely offset reductions in gains on
sales compared to the prior year.

      Gains from residential loan sales totaled $469,000 for 2003, down
approximately 15% from $553,000 the prior year. The 2002 results benefited from
a bulk sale of $19 million in mortgage servicing rights in the third quarter of
2002, which resulted in a net gain of $237,000 for the year. No comparable sales
occurred in 2003.

      Gains realized from the sales of home improvement loans fell $112,000, or
21% in 2003, compared to the prior year, as loan sales dropped from $16.9
million in 2002, to $12.9 million for 2003. The reduction in loans sold was the
result of a change in strategy from selling loans originated outside the
Northwest to retaining these loans in our portfolio. Our intention in 2004 is to
sell between $5 million - $10 million in home improvement loans each quarter,
for an annual total of $20 million - $40 million. Taking this increased level of
loan sales into consideration, we still expect the sales finance loan portfolio
to grow by 20% - 30% in 2004.

      The consumer lending segment's non-interest expense increased $2,391,000,
or 39%, to $8,496,000 for 2003, compared to $6,105,000 for the prior year. The
growth in costs is due to rising compensation, loan administration, and other
allocated costs, and credit and servicing expenses. This year's growth in
expense follows an increase of $1,023,000, or 20%, in 2002 over the 2001 level
of $5,082,000. The rise in costs in 2002 was principally attributable to the
opening of additional offices and expansion of our Consumer Lending Department.

      Compensation expense for this segment rose significantly in 2003, based
largely upon higher production-driven compensation in the wholesale lending and
sales finance operations. The Wholesale Division loan closings totaled $164
million in 2003, and sales finance loan originations surpassed the $70 million
mark, with closings exceeding 7,000 loans. Accompanying the additional loan
volumes has been the need for expanded support to service these loans.
Consequently, loan administration and support costs allocated to this segment
increased relative to the prior year.

      Another contributing factor to the rising non-interest expense was the
cost of credit insurance for the sales finance loan portfolio. As noted in the
"Other Operating Expenses" section, late in 2002 we began to insure against
default risk on our sales finance loans to borrowers with credit scores below a
certain level. To accomplish this, we utilize insurance policies designed to
reimburse us for credit losses up to a set dollar amount for each pool of
insured loans. The insurance premiums for this coverage, approximately 2% of the
insured balances, rose from $9,000 in 2002 to nearly $258,000 in 2003.

COMMERCIAL LENDING

      Net income for the commercial segment declined $392,000, or 6%, from
$6,305,000 in 2002, to $5,913,000 for 2003, as an increase in net interest
income was more than offset by rising operating expenses. The segment's net
income had improved in 2002, albeit modestly, over the 2001 level of $6,108,000,
as improvements in net interest and non-interest income were sufficient to
offset higher operating expenses.

      The commercial lending segment's net interest income after provision for
loan losses rose $392,000 for 2003, to $18,629,000, compared to $18,237,000 in
2002, as a $2,455,000, or 21%, reduction in interest expense more than offset a
$1,983,000, or 6.4%, decline in interest income and an $80,000 increase in the
provision for loan losses. While a positive result, this was substantially less
than the prior year's improvement of $1,869,000, over the 2001 net interest
income of $16,368,000 after provision for loan losses. Funding costs bank-wide
have declined over the last three years as time deposits gradually repriced at
lower rates following rate reductions by the Federal Reserve Bank. As previously
noted, the Federal Reserve cut rates 11 times in 2001, and once in each of 2002
and 2003 (see the Results of Operations, Net Interest Income section for more
information). Based on the "lagging" nature of time deposit pricing, the 11
cuts in 2001 were the primary driver of the

                                       21
<PAGE>

substantial reduction in funding costs in 2002. Later rate reductions then
contributed to the continued funding cost reductions in 2003. Also contributing
to the reduction in funding costs was an increased reliance on FHLB advances,
which had proven to be less expensive than retail deposits. Although asset
growth for the commercial lending segment was substantially less than the
consumer segment, it succeeded in building incremental assets over the year. The
commercial segment's average earning assets totaled $455 million for 2003, an
increase of $25 million, or 6%, compared to the 2002 average level of $429
million. This was in line with the prior year, when assets grew nearly 6% over
the 2001 average level of $406 million. The modest growth of the commercial
lending segment was in keeping with our expectations, given the soft local
economy of the last year and the resulting decline in the number of quality
commercial banking relationship opportunities in the market.

      The commercial segment's other operating income remained relatively flat
compared to 2002, totaling $1,263,000 for 2003, up from $1,232,000 for the prior
year.

      Non-interest expense in 2003 rose $1,008,000 to $10,900,000. That increase
followed a rise of $1,881,000 in 2002 over the 2001 level of $8,011,000. The
growth in costs in 2003 was largely attributable to the additional
infrastructure put in place to administer and support the commercial portfolio,
as well as increased retail banking center expenses allocated to the commercial
lending segment. Additionally, marketing expense for the commercial segment rose
approximately $72,000, based principally on expenditures for the business
banking and community business banking divisions. The increase in costs in 2002
was primarily due to escalating compensation expenses associated with expanding
our business banking and community business banking areas.


INVESTMENT SECURITIES

      Net income for the investment securities segment declined $79,000, or 26%,
from $299,000 in 2002 to $220,000 in 2003, based on declining net interest
income, which was partly offset by a $230,000 increase in non-interest income.
In 2001, the operations of this segment resulted in a loss of $249,000 for the
year, as funding costs of $6,745,000 exceeded the interest income earned on the
portfolio, which totaled $6,281,000. This situation occurred when securities
yields fell much more rapidly than our funding costs, which, as previously
noted, are largely time-deposit-based and tend to lag movements of market index
rates.

      Net interest income on the investment portfolio declined from $971,000 for
2002 to $583,000 in 2003, with interest income falling $1,226,000, or 23%, to
$4,175,000, while interest expense dropped $839,000, or 19%, to $3,591,000. The
decline in interest income was attributable, in large part, to turnover within
the portfolio. As rates declined and loan prepayments increased, we made the
decision to sell some of our higher yielding securities and realize the gains
inherent in them before the underlying loans prepaid at par. The securities sold
were then replaced with lower yielding instruments issued in the prevailing rate
environment with a negative effect on the segment's margin. It should be noted,
however, that part of the impact to the portfolio margin was recovered through
gains on sales of those securities sold at premiums in the fourth quarter of
2002 and first three quarters of 2003. Average portfolio size was not a
significant factor in the change in interest income levels, as the investment
segment's average earning assets have remained fairly consistent over the last
three years, declining from $103 million in 2001, to $97.8 million in 2002, and
then increasing modestly to $98.7 million in 2003.

      Non-interest income rose $230,000, or 38%, on a year-to-year comparison,
from $608,000 in 2002, to $838,000 for 2003. The additional income was primarily
attributable to increased gains from sales of investments, which totaled
$663,000 for 2003, up from $508,000 the prior year. Also contributing to the
increase in non-interest income was $95,000 in rental income from the First
Mutual Center building allocated to the investment securities segment. As First
Mutual Center was acquired in the first quarter of 2003, there was no comparable
income last year. Non-interest income totaled $1,262,000 in 2001 due to higher
gains on securities sales, which were $700,000 in 2001, as well as $464,000
received from the liquidation of our interest in an ATM network.

                                       22
<PAGE>

      Operating expenses were little changed from the prior year, falling by
$37,000, to $1,122,000 for 2003. The investment segment's operating expenses
consist primarily of banking center and other overhead expenses allocated out to
the business segments based upon the size of the segments' earning asset
portfolios.



































                                       23
<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, 2003 and 2002, and the related consolidated statements of income,
stockholders' equity and comprehensive income and cash flows for each of the
three years in the period ended December 31, 2003. 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, 2003 and 2002, and the results of their operations and their
cash flows for each of the three years in the period ended December 31, 2003, in
conformity with accounting principles generally accepted in the United States of
America.


/s/ Moss Adams LLP
----------------------
Moss Adams LLP

Everett, Washington
January 27, 2004



                                       24
<PAGE>

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

                                     ASSETS
<TABLE><CAPTION>
                                                                   DECEMBER 31,
                                                          -----------------------------
                                                               2003            2002
                                                          -------------   -------------
<S>                                                       <C>             <C>
Cash and cash equivalents:
 Interest-earning deposits with banks .................. $     845,607   $   6,203,843
 Noninterest-earning demand deposits and cash on hand ..     6,581,448       8,767,684
                                                         -------------   -------------
                                                             7,427,055      14,971,527

Mortgage-backed and other securities available-for-sale     77,623,789      58,380,204
Loans receivable, held-for-sale .......................     10,143,319      12,699,004
Mortgage-backed and other securities held-to-maturity,
  fair value of $9,109,635 and $16,925,864 ............      8,903,441      16,358,042
Loans receivable, net:
  Loans receivable ....................................    723,710,645     622,374,515
  Reserve for loan losses .............................     (8,406,198)     (7,754,106)
                                                         -------------   -------------
                                                           715,304,447     614,620,409

Accrued interest receivable ...........................      3,649,032       3,435,343
Servicing assets ......................................        468,413          49,914
Land, buildings, and equipment, net ...................     24,180,509      10,964,441
Federal Home Loan Bank (FHLB) stock, at cost ..........     11,035,500      10,443,200
Other assets ..........................................      2,108,572       3,373,168
                                                         -------------   -------------
     Total assets .....................................  $ 860,844,077   $ 745,295,252
                                                         =============   =============
</TABLE>








                             See accompanying notes.

                                       25
<PAGE>


                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
          CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION - (CONTINUED)
                      LIABILITIES AND STOCKHOLDERS' EQUITY

                                                           DECEMBER 31,
                                                  -----------------------------
                                                       2003            2002
                                                  -------------   -------------
Liabilities:

Deposits:

  Money market deposit and checking accounts ...  $ 191,948,350   $ 134,247,575
  Regular savings ..............................      8,710,867       8,386,918
  Time deposits ................................    383,231,431     354,735,126
                                                  -------------   -------------
     Total deposits ............................    583,890,648     497,369,619

  Drafts payable ...............................        357,256         369,034
  Accounts payable and other liabilities .......     12,899,194       8,080,632
  Advance payments by borrowers for taxes and
    insurance ..................................      1,727,345       1,798,233
  FHLB advances ................................    193,642,878     184,143,897
  Other advances ...............................        500,000         250,000
  Long-term debentures .........................     17,000,000       9,000,000
                                                  -------------   -------------
     Total liabilities .........................    810,017,321     701,011,415
                                                  -------------   -------------

Stockholders' equity:

  Common stock, $1 par value; authorized,
   10,000,000 shares; issued and outstanding,
   4,729,693 and 4,247,166 shares ..............      4,729,693       4,247,166
  Additional paid-in capital ...................     33,678,181      24,028,610
  Retained earnings ............................     12,832,652      15,214,220
  Accumulated other comprehensive income (loss):
   Unrealized gain (loss) on securities
   available-for-sale and interest rate
   swap, net of federal income tax .............       (413,770)        793,841
                                                  -------------   -------------
     Total stockholders' equity ................     50,826,756      44,283,837
                                                  -------------   -------------
                                                  $ 860,844,077   $ 745,295,252
                                                  =============   =============




                             See accompanying notes.

                                       26
<PAGE>

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

                                             YEARS ENDED DECEMBER 31,
                                     ----------------------------------------
                                         2003          2002          2001
                                     ------------  ------------  ------------
INTEREST INCOME:
  Loans receivable ................  $ 45,487,357  $ 42,924,954  $ 46,452,572
  Interest on AFS securities ......     2,824,565     3,362,101     1,960,298
  Interest on HTM securities ......       631,236     1,281,288     3,499,819
  Interest other ..................       718,375       757,020       817,117
                                     ------------  ------------  ------------
                                       49,661,533    48,325,363    52,729,806
                                     ------------  ------------  ------------

INTEREST EXPENSE:
  Deposits ........................    11,984,052    13,994,645    22,708,013
  FHLB advances and other .........     6,939,660     7,691,720     8,694,413
                                     ------------  ------------  ------------
                                       18,923,712    21,686,365    31,402,426
                                     ------------  ------------  ------------
  Net interest income .............    30,737,821    26,638,998    21,327,380
                                     ------------  ------------  ------------

PROVISION FOR LOAN LOSSES: ........     1,150,000       910,000       365,000
                                     ------------  ------------  ------------
  Net interest income after
   provision for loan losses ......    29,587,821    25,728,998    20,962,380
                                     ------------  ------------  ------------

OTHER OPERATING INCOME:
  Servicing fees, net of
    amortization ..................        69,431       103,170       105,729
  Gain on sales of loans ..........       984,063     1,126,439     1,539,731
  Gain on sales of investments ....       662,564       507,863     1,164,533
  Fees on deposit services ........       516,107       472,025       334,485
  Other ...........................     1,430,788     1,027,208       885,622
                                     ------------  ------------  ------------
     Total other operating income .     3,662,953     3,236,705     4,030,100
                                     ------------  ------------  ------------

OTHER OPERATING EXPENSES:
  Salaries and employee benefits ..    12,454,918    10,236,341     8,466,396
  Occupancy .......................     2,443,363     2,353,175     2,130,829
  Other ...........................     5,619,620     4,566,388     3,698,677
                                     ------------  ------------  ------------
     Total other operating expenses    20,517,901    17,155,904    14,295,902
                                     ------------  ------------  ------------
  Income before federal income
   taxes and cumulative effect of
   adoption of new accounting
   principle ......................    12,732,873    11,809,799    10,696,578
                                     ------------  ------------  ------------

FEDERAL INCOME TAXES:
  Current .........................     3,523,860     3,680,429     3,439,200
  Deferred ........................       813,275       332,000       180,000
                                     ------------  ------------  ------------
                                        4,337,135     4,012,429     3,619,200
                                     ------------  ------------  ------------

  Income before cumulative effect
   of adoption of new accounting
   principle, net of federal
   income tax .....................     8,395,738     7,797,370     7,077,378

  Cumulative effect of adoption
   of new accounting principle,
   net of federal income tax ......          --            --        (155,247)
                                     ------------  ------------  ------------
NET INCOME ........................  $  8,395,738  $  7,797,370  $  6,922,131
                                     ============  ============  ============

                             See accompanying notes.

                                       27
<PAGE>

                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
                CONSOLIDATED STATEMENTS OF INCOME - (CONTINUED)
<TABLE><CAPTION>
                                                                                   YEARS ENDED DECEMBER 31,
                                                                           ---------------------------------------
                                                                               2003          2002          2001
                                                                           -----------   -----------   -----------
<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.................................................    $      1.78   $      1.48   $      1.25

  Cumulative effect of adoption of new accounting principle,
    net of federal income tax..........................................            --            --          (0.03)
                                                                           -----------   -----------   -----------
  Basic earnings per common share......................................    $      1.78   $      1.48   $      1.22
                                                                           ===========   ===========   ===========

  Earnings per common share before cumulative effect of
    adoption of new accounting principle, net of federal
    income tax, assuming dilution......................................    $      1.73   $      1.45   $      1.22

  Cumulative effect of adoption of new accounting principle,
    net of federal income tax, assuming dilution.......................            --            --          (0.03)
                                                                           -----------   -----------   -----------
  Earnings per common share assuming dilution..........................    $      1.73   $      1.45   $      1.19
                                                                           ===========   ===========   ===========

WEIGHTED AVERAGE SHARES OUTSTANDING....................................      4,708,752     5,267,924     5,694,542
                                                                           ===========   ===========   ===========

WEIGHTED AVERAGE SHARES OUTSTANDING
  INCLUDING DILUTIVE STOCK OPTIONS.....................................      4,866,327     5,382,356     5,790,142
                                                                           ===========   ===========   ===========
</TABLE>

                             See accompanying notes.

                                       28
<PAGE>

                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES

    CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME

<TABLE><CAPTION>
                                                                                                Employee
                                                                                                  Stock
                                                                                                Ownership  Accumulated
                                              Common Stock         Additional                      Plan   Comprehensive
                                         ----------------------     Paid-in        Retained      (ESOP)      Income
                                          Shares       Amount       Capital        Earnings       Debt       (Loss)        Total
                                         ---------  -----------   ------------   ------------   ---------   ---------   -----------
<S>                                      <C>        <C>           <C>            <C>            <C>         <C>         <C>
BALANCE, December 31, 2000 ............  4,671,286  $ 4,671,286   $ 31,118,545   $ 10,140,569   $ (97,821)  $  84,692   $45,917,271
                                         =========  ===========   ============   ============   =========   =========   ===========
  Comprehensive income:
    Net income ........................                                             6,922,131                             6,922,131
    Other comprehensive (loss),
        net of tax:
      Unrealized (loss)
          on securities
          available-for-sale ..........                                                                      (276,510)     (276,510)
                                                                                                                        -----------
  Total comprehensive income ..........                                                                                   6,645,621
  Options exercised, including
      tax benefit of $117,015 .........     54,680       54,680        292,751                                              347,431
  Repayment of ESOP debt ..............                                                            97,821                    97,821
  Cash dividend declared
    ($0.22 per share) .................                                            (1,036,847)                           (1,036,847)
                                         ---------  -----------   ------------   ------------   ---------   ---------   -----------
BALANCE, December 31, 2001 ............  4,725,966    4,725,966     31,411,296     16,025,853        --      (191,818)   51,971,297
                                         ---------  -----------   ------------   ------------   ---------   ---------   -----------
  Comprehensive income:
    Net income ........................                                             7,797,370                             7,797,370
    Other comprehensive income
        (loss), net of tax:
      Unrealized gain on securities
        available-for-sale ............                                                                     1,391,521     1,391,521
      Unrealized (loss) on interest
        rate swap                                                                                            (405,862)     (405,862)
                                                                                                                        -----------
  Total comprehensive income                                                                                              8,783,029
  Options exercised, including
      tax benefit of $169,903 .........     67,573       67,573        551,848                                              619,421
  Retirement of shares repurchased .... (1,019,256)  (1,019,256)   (13,963,793)      (815,419)                          (15,798,468)
  10% stock dividend ..................    472,883      472,883      6,029,259     (6,502,142)                                 --
  Cash dividend declared
    ($0.28 per share) .................                                            (1,291,442)                           (1,291,442)
                                         ---------  -----------   ------------   ------------   ---------   ---------   -----------
BALANCE, December 31, 2002 ............  4,247,166    4,247,166     24,028,610     15,214,220        --       793,841    44,283,837
                                         ---------  -----------   ------------   ------------   ---------   ---------   -----------
  Comprehensive income:
    Net income ........................                                             8,395,738                             8,395,738
    Other comprehensive income
        (loss), net of tax:
      Unrealized gain on securities
        available-for-sale ............                                                                        87,186        87,186
      Unrealized (loss) on interest
        rate swap .....................                                                                    (1,294,797)   (1,294,797)
                                                                                                                        -----------
  Total comprehensive income ..........                                                                                   7,188,127
  Options exercised, including
      tax benefit of $219,124 .........     53,040       53,040        571,618                                              624,658
  Issuance of stock through
      employees' stock plans ..........      1,386        1,386         23,617                                               25,003
  10% stock dividend ..................    428,101      428,101      9,054,336     (9,482,437)                                 --
  Cash dividend declared
    ($0.28 per share) .................                                            (1,294,869)                           (1,294,869)
                                         ---------  -----------   ------------   ------------   ---------   ---------   -----------
BALANCE, December 31, 2003 ............  4,729,693  $ 4,729,693   $ 33,678,181   $ 12,832,652   $    --     $(413,770)  $50,826,756
                                         =========  ===========   ============   ============   =========   =========   ===========
</TABLE>
                             See accompanying notes.

                                       29
<PAGE>

                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
                      CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE><CAPTION>

                                                                   YEARS ENDED DECEMBER 31,
                                                        ---------------------------------------------
                                                             2003            2002            2001
                                                        -------------   -------------   -------------
<S>                                                     <C>             <C>             <C>
OPERATING ACTIVITIES:
  Net income .........................................  $   8,395,738   $   7,797,370   $   6,922,131
  Adjustments to reconcile net income to net cash from
    operating activities:
    Provision for loan losses ........................      1,150,000         910,000         365,000
    Depreciation and amortization ....................      1,109,746         900,500       1,214,216
    Deferred loan origination fees, net of accretion .     (1,375,998)       (387,664)       (658,829)
    Amortization of servicing assets .................         98,277          46,187          24,287
    Gain on sales of loans ...........................       (984,063)     (1,126,439)     (1,611,294)
    Gain on sale of repossessed real estate
      and other assets ...............................        (23,515)           --            (9,296)
    Gain on sales of securities available-for-sale ...       (662,564)       (478,925)       (700,321)
    Gain on sales of other investments ...............           --           (28,939)       (464,212)
    FHLB stock dividends .............................       (592,300)       (621,300)       (557,900)
    Deferred federal income taxes ....................       (813,275)       (332,000)       (180,000)
    Changes in operating assets and liabilities:
      Loans receivable held-for-sale .................      2,555,685      (8,223,212)     11,298,549
      Accrued interest receivable ....................       (213,689)        120,767       1,109,406
      Other assets ...................................     (1,051,794)        235,437        (560,697)
      Drafts payable .................................        (11,778)       (646,893)       (284,155)
      Accounts payable and other liabilities .........      6,839,874       2,086,256        (143,375)
      Advance payments by borrowers for taxes and
        insurance ....................................        (70,888)        135,703         178,398
      Federal income taxes ...........................      1,074,577         939,794         497,266
                                                        -------------   -------------   -------------
      Net cash provided by operating activities ......     15,424,033       1,326,642      16,439,174
                                                        -------------   -------------   -------------

INVESTING ACTIVITIES:
  Loan originations ..................................   (331,091,827)   (244,575,384)   (243,456,913)
  Loan principal repayments ..........................    203,551,451     180,787,665     172,095,040
  Increase (decrease) in undisbursed loan proceeds ...     29,612,514      11,810,430     (17,369,810)
  Principal repayments and redemptions on mortgage-
    backed and other securities ......................     36,931,131      22,138,735      54,131,108
  Purchase of securities held-to-maturity ............     (1,098,881)       (250,000)     (2,996,250)
  Purchase of securities available-for-sale ..........    (75,710,656)    (52,490,003)    (39,377,552)
  Purchase of premises and equipment .................    (14,326,118)     (2,998,452)     (2,225,965)
  Purchase of FHLB stock .............................           --           (62,600)     (1,452,000)
  Proceeds from sale of loans ........................           --           335,393       1,146,155
  Proceeds from other investments ....................           --            28,939         472,769
  Proceeds from sale of securities ...................     25,442,072      30,463,849      39,913,161
  Proceeds from sale of real estate held-for-sale ....        282,354            --         1,433,584
                                                        -------------   -------------   -------------
      Net cash (used) by investing activities ........   (126,407,960)    (54,811,428)    (37,686,673)
                                                        -------------   -------------   -------------
</TABLE>

                             See accompanying notes.

                                       30
<PAGE>

                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
               CONSOLIDATED STATEMENTS OF CASH FLOWS - (CONTINUED)
<TABLE><CAPTION>
                                                                              YEARS ENDED DECEMBER 31,
                                                                    --------------------------------------------
                                                                        2003            2002            2001
                                                                    ------------    ------------    ------------
<S>                                                                <C>             <C>             <C>
FINANCING ACTIVITIES:
  Net increase (decrease) in deposit accounts ...................     75,175,800      54,928,448     (51,399,621)
  Interest credited to deposit accounts .........................     11,345,229      13,543,509      22,805,374
  Proceeds from long-term debentures (trust preferred
     securities) ................................................      8,000,000       9,000,000             --
  Issuance of stock through employees stock plan ................         25,003             --              --
  Proceeds from advances ........................................    490,921,754     206,934,892     286,448,463
  Repayment of advances .........................................   (481,172,773)   (213,895,133)   (228,379,050)
  Dividends paid ................................................     (1,261,092)     (1,321,756)       (939,593)
  Proceeds from exercise of stock options .......................        405,534         449,518         230,416
  Repurchase/retirement of common stock .........................            --      (15,798,468)            --
  Repayment of employee stock ownership plan debt ...............            --              --           97,821
                                                                    ------------    ------------    ------------
      Net cash provided by financing activities .................     103,439,455      53,841,010      28,863,810
                                                                    ------------    ------------    ------------

NET INCREASE (DECREASE) IN CASH AND
   CASH EQUIVALENTS .............................................     (7,544,472)        356,224       7,616,311
CASH AND CASH EQUIVALENTS,
   Beginning of year ............................................     14,971,527      14,615,303       6,998,992
                                                                    ------------    ------------    ------------
   End of year ..................................................   $  7,427,055    $ 14,971,527    $ 14,615,303
                                                                    ============    ============    ============


SUPPLEMENTAL DISCLOSURES OF CASH
   FLOW INFORMATION
   Loans originated for mortgage banking activities .............   $ 93,272,670    $ 97,625,950    $ 79,601,434
                                                                    ============    ============    ============
   Loans originated for investment activities ...................   $331,091,827    $244,575,384    $243,456,913
                                                                    ============    ============    ============
   Proceeds from sale of loans held-for-sale ....................   $ 95,828,355    $ 89,402,738    $ 97,604,381
                                                                    ============    ============    ============
   Cash paid during the year for:
      Interest ..................................................   $ 19,121,039    $ 21,686,110    $ 31,712,683
                                                                    ============    ============    ============
      Income taxes ..............................................   $  3,849,000    $  3,761,000    $  2,962,500
                                                                    ============    ============    ============

SUPPLEMENTAL DISCLOSURES OF NON
   CASH INVESTING ACTIVITIES
   Loans transferred (from) real estate
      held-for-sale, net ........................................   $        --     $        --     $ (1,352,611)
                                                                    ============    ============    ============
   Loans securitized into securities held-to-maturity
      and available-for-sale ....................................   $        --     $ 14,485,309    $  4,914,393
                                                                    ============    ============    ============
</TABLE>

                             See accompanying notes.

                                       31
<PAGE>
                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                  YEARS ENDED DECEMBER 31, 2003, 2002, AND 2001

NOTE 1 - SUMMARY OF SIGNINCANT 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 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.

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

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

      During the fourth quarter of 2003, the Company adopted Financial
Accounting Standards Board (FASB) Interpretation Number 46, CONSOLIDATION OF
VARIABLE INTEREST ENTITIES, and in accordance with the Interpretation, will no
longer be consolidating its ownership interests in First Mutual Capital Trust I
or II or First Mutual Statutory Trust III. The adoption of the Interpretation
did not have a material effect on the Company's financial condition or results
of operations.

      PRINCIPLES OF CONSOLIDATION AND BASIS OF PRESENTATION - The consolidated
financial statements include the accounts of First Mutual Bancshares, Inc. and
its wholly-owned subsidiaries, First Mutual Bank and First Mutual Services, Inc.
(collectively, the Company). All significant intercompany transactions have been
eliminated. Certain reclassifications have been made to the 2002 and 2001
financial statements to conform to the 2003 presentation.

      USE OF ESTIMATES - The preparation of financial statements in conformity
with accounting principles generally accepted in the United States of America
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities 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, the value
of servicing assets, amortization of deferred loan fees/costs, 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 residential, consumer, commercial real estate, and business loans.
The Bank conducts business from its main office in Bellevue, Washington, its
twelve branches

                                       32
<PAGE>
                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

in the greater Puget Sound area, loan production offices in Tacoma and
Bellingham, Washington, and a multi-state sales finance division with an office
in Jacksonville, Florida. The Bank accepts deposits from the general public,
provides lending services to citizens of Washington and Oregon and offers
consumer home improvement loans to borrowers in 38 states.

      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.

      SECURITIES - Securities are classified at acquisition into one of three
categories: held-to-maturity, available-for-sale or 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 2003, 2002 and
2001.

      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 net of deferred loan origination fees/costs.
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 believed to
be 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

                                       33
<PAGE>
                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

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.

      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 expensing ordinary maintenance and repairs as
incurred.

      SERVICING ASSETS - Originated servicing assets are recorded when loans are
originated and subsequently sold or securitized (and held as available-for-sale
securities) with the servicing rights retained. The total cost of the loans is
allocated between servicing assets and the loans (without the servicing rights)
based on their relative fair values. The cost relating to the 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 assets, 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 servicing assets based
on recalculations of the present value of remaining future cash flows using
updated market discount rates and prepayment speeds. Subsequent loan prepayments
and changes in prepayment assumptions in excess of those forecasted can

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

adversely impact the carrying value of the servicing assets. Impairment is
assessed on a stratum-by-stratum basis with any impairment recognized through a
valuation allowance for each impaired stratum. The servicing assets are
stratified based on the types of loans and the underlying collateral.

      EMPLOYEE STOCK OWNERSHIP PLAN - The Bank sponsors an Employee Stock
Ownership Plan (ESOP). 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 employees stock
ownership trust contra-equity account and distributed to participants' accounts
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.

      At December 31, 2003, the Company had three stock-based employee/director
compensation plans, which are described more fully in Note 18. The plans are
accounted for under the recognition and measurement principles of APB Opinion
No. 25, ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES, and related interpretations.
No stock-based employee or director compensation cost is reflected in net
income, as all options granted under those plans had an exercise price equal to
the market value of the underlying common stock on the date of grant. The
following table illustrates the effect on net income and earnings per share if
the fair value recognition provisions of FASB Statement No. 123, ACCOUNTING FOR
STOCK-BASED COMPENSATION, had been adopted.
<TABLE><CAPTION>
                                                                          YEARS ENDED DECEMBER 31,
                                                                   --------------------------------------
                                                                      2003          2002          2001
                                                                   ----------    ----------    ----------
<S>                                                                <C>           <C>           <C>
Net income, as reported.......................................     $8,395,738    $7,797,370    $6,922,131

Deduct: Total stock-based employee/director compensation
  expense determined under fair value based method for all
  awards, net of related tax effects..........................       (327,461)     (173,780)     (159,690)
                                                                   ----------    ----------    ----------
Pro forma net income..........................................     $8,068,277    $7,623,590    $6,762,441
                                                                   ==========    ==========    ==========
Earnings per share:

  Basic - as reported.........................................     $     1.78    $     1.48    $     1.22
  Basic - pro forma...........................................           1.71          1.45          1.19
  Diluted - as reported.......................................     $     1.73    $     1.45    $     1.19
  Diluted - pro forma.........................................           1.66          1.42          1.16
</TABLE>

                                       35
<PAGE>
                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

      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.

      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/costs are amortized into income over
the contractual or actual life of the loan as an adjustment to the loan yield.
Net deferred fees/costs 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.

      ADVERTISING COSTS - Advertising costs are expensed as incurred and totaled
$918,000, $648,000, and $363,000 for the years ended December 31, 2003, 2002,
and 2001, respectively.

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

      The Company has adopted SFAS No. 133, ACCOUNTING FOR DERIVATIVE
INSTRUMENTS AND HEDGING ACTIVITIES, as amended, 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 Bank. For the years ended December 31,
2003, 2002, and 2001, the Bank complied with this requirement.

                                       36
<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, 2003 and 2002 are summarized as follows:
<TABLE><CAPTION>

                                                                          GROSS         GROSS
                                                            GROSS       UNREALIZED    UNREALIZED
                                            AMORTIZED     UNREALIZED   LOSSES LESS   LOSSES MORE    ESTIMATED
                                               COST         GAINS      THAN 1 YEAR   THAN 1 YEAR   FAIR VALUE
                                           -----------   -----------   -----------   -----------   -----------
<S>                                       <C>           <C>           <C>           <C>           <C>
2003
  Freddie Mac securities.................  $15,708,833   $    60,174   $   222,620   $       --    $15,546,387
  Fannie Mae securities..................   43,069,484       292,309       324,031           --     43,037,762
  Ginnie Mae securities..................    8,010,938           --         24,688           --      7,986,250
  US agency securities...................   10,980,831       105,409        32,850           --     11,053,390
                                           -----------   -----------   -----------   -----------   -----------
                                           $77,770,086   $   457,892   $   604,189   $       --    $77,623,789
                                           ===========   ===========   ===========   ===========   ===========

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
                                           ===========   ===========   ===========   ===========   ===========
</TABLE>

      Certain investment securities shown above currently have fair values less
than amortized cost and therefore contain unrealized losses. The Company has
evaluated these securities and has determined that the decline in value is
temporary and is related to the change in market interest rates since purchase.
The decline in value is not related to any company or industry specific event.
At December 31, 2003, there were approximately eight investment securities with
unrealized losses. The Company anticipates full recovery of amortized cost with
respect to these securities at maturity or sooner in the event of a more
favorable market interest rate environment.

      Proceeds from the sale of securities during 2003, 2002, and 2001 were
$25,442,072, $30,463,849, and $28,142,793, respectively. Gross gains on those
sales were $662,564, $478,925, and $546,467, respectively. No gross losses were
realized on sales during 2003, 2002, and 2001.

      The amortized cost and estimated fair value of mortgage-backed and other
securities available-for-sale at December 31, 2003, by contractual maturity, are
shown below. Expected maturities will differ from contractual maturities because
issuers may have the right to call or prepay obligations with or without
prepayment penalties.

                                               AMORTIZED       ESTIMATED
                                                  COST         FAIR VALUE
                                              -----------     -----------
  Due after one year through five years.....  $ 3,752,337     $ 3,899,291
  Due after five years through ten years....   10,753,598      10,778,136
  Due after ten years......................    63,264,151      62,946,362
                                              -----------     -----------
                                              $77,770,086     $77,623,789
                                              ===========     ===========

                                       37
<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
                                                            GROSS       UNREALIZED    UNREALIZED
                                            AMORTIZED     UNREALIZED   LOSSES LESS   LOSSES MORE    ESTIMATED
                                               COST         GAINS      THAN 1 YEAR   THAN 1 YEAR   FAIR VALUE
                                           -----------   -----------   -----------   -----------   -----------
<S>                                       <C>           <C>           <C>           <C>           <C>
December 31, 2003:
  Fannie Mae securities..................  $ 7,028,766   $   217,292   $     2,118   $       --    $ 7,243,940
  Freddie Mac securities.................      549,870        11,925           --            --        561,795
  Municipal bonds........................    1,324,283         2,598           --         23,503     1,303,378
  REMICs.................................          522           --            --            --            522
                                           -----------   -----------   -----------   -----------   -----------
                                           $ 8,903,441   $   231,815   $     2,118   $    23,503   $ 9,109,635

December 31, 2002:
  Fannie Mae securities..................  $14,265,994   $   594,144   $       --    $       --    $14,860,138
  Freddie Mac securities.................      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
</TABLE>

      Certain investment securities shown above currently have fair values less
than amortized cost and therefore contain unrealized losses. The Company has
evaluated these securities and has determined that the decline in value is
temporary and is related to the change in market interest rates since purchase.
The decline in value is not related to any company or industry specific event.
There are approximately two investment securities with unrealized losses. The
Company anticipates full recovery of amortized cost with respect to these
securities at maturity or sooner in the event of a more favorable market
interest rate environment.

      The amortized cost and estimated fair value of mortgage-backed and other
securities held-to-maturity at December 31, 2003, by contractual maturity, are
shown below. Sales from the held-to-maturity portfolio during 2003, 2002, and
2001 amounted to $0, $0, and $11.5 million (par value), 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.

                                                       AMORTIZED     ESTIMATED
                                                          COST       FAIR VALUE
                                                      -----------   -----------
  Due less than one year...........................   $       682   $       685
  Due after one year through five years.............    2,300,555     2,374,399
  Due after five years through ten years............    1,171,397     1,229,521
  Due after ten years..............................     5,430,807     5,505,030
                                                      -----------   -----------
                                                      $ 8,903,441   $ 9,109,635
                                                      ===========   ===========

      Securities having a fair value of $2.3 million and an amortized cost of
$2.2 million at December 31, 2003, were pledged to secure public deposits. At
December 31, 2002, both the fair value and amortized cost of the pledged
securities totaled $1.7 million.

                                       38
<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:

                                                       2003           2002
                                                   ------------   ------------
Real estate:
  Single-family residential......................  $131,681,660   $ 93,207,714
  Single-family construction.....................   127,402,678     79,397,115
  Income property:
    Commercial construction......................    19,132,250     17,693,750
    Commercial real estate.......................   211,526,336    219,346,560
    Multifamily construction.....................    16,774,573     10,175,075
    Multifamily residential......................   184,918,933    177,621,143
  Consumer and other loans.......................    85,242,962     57,626,918
  Business loans.................................    20,089,286     14,682,658
                                                   ------------   ------------
                                                    796,768,678    669,750,933
Less:
  Deferred loan origination (fees) costs.........     1,225,622       (149,592)
    Undisbursed loan proceeds....................   (64,140,336)   (34,527,822)
    Reserve for loan losses......................    (8,406,198)    (7,754,106)
                                                   ------------   ------------
                                                    725,447,766    627,319,413

  Loans receivable held-for-sale.................   (10,143,319)   (12,699,004)
                                                   ------------   ------------
  Loans receivable, net..........................  $715,304,447   $614,620,409
                                                   ============   ============

      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,
2003:
<TABLE><CAPTION>
                                         SNOHOMISH      PIERCE        WHATCOM
                          KING COUNTY     COUNTY        COUNTY        COUNTY        OREGON        OTHER         TOTAL
                         ------------  ------------  ------------  ------------  ------------  ------------  ------------
<S>                      <C>           <C>           <C>           <C>           <C>           <C>           <C>
Income property:
 Commercial
    construction.......  $  3,300,000  $  1,770,000  $ 10,292,550  $  1,932,200  $       --    $  1,837,500  $ 19,132,250
 Commercial
    real estate........   106,748,222    27,955,891    32,525,027     3,967,225    13,044,433    27,285,538   211,526,336
 Multifamily
    construction.......    13,292,500          --         330,000          --       2,133,323     1,018,750    16,774,573
 Multifamily
    residential........    62,359,120     7,828,436    33,394,818     6,691,258    46,617,917    28,027,384   184,918,933
                         ------------  ------------  ------------  ------------  ------------  ------------  ------------
                         $185,699,842  $ 37,554,327  $ 76,542,395  $ 12,590,683  $ 61,795,673  $ 58,169,172  $432,352,092
                         ============  ============  ============  ============  ============  ============  ============
</TABLE>


                                       39
<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, 2003, the composition of those loans was as follows:

                                                      ADJUSTABLE
                                        FIXED RATE       RATE          TOTAL
                                       -----------   ------------   ------------
Term to maturity or rate adjustment:

  Due within one year................  $ 8,385,370   $558,519,607   $566,904,977
  After one but within three years...    3,253,734     56,990,325     60,244,059
  After three but within five years..    6,003,141     33,913,292     39,916,433
  After five but within ten years....   34,150,874      2,826,361     36,977,235
    After ten years..................   21,405,062            --      21,405,062
                                       -----------   ------------   ------------
                                       $73,198,181   $652,249,585   $725,447,766
                                       ===========   ============   ============

      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:


                                            2003          2002           2001
                                         ----------    ----------    ----------
  Balance, beginning of year.........    $7,754,106    $7,032,062    $6,729,166
    Provision for loan losses........     1,150,000       910,000       365,000
    Charge offs......................      (639,573)     (271,249)     (137,606)
    Recoveries.......................       141,665        83,293        75,502
                                         ----------    ----------    ----------
  Balance, end of year...............    $8,406,198    $7,754,106    $7,032,062
                                         ==========    ==========    ==========



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

                                                        2003            2002
                                                    -----------      ----------
      Non-performing loans.......................   $   526,869      $2,073,525
      Percentage of total loans..................         0.07%           0.33%

      There were two impaired loans totaling $16,445 and $16,684 (net of
impairment allowances) at year end 2003 and 2002, respectively. The amount of
impairment totaled $4,600 for both years.

      The Bank serviced loan balances owned by other investors with aggregate
principal balances of $76,424,096 and $46,064,572 as of December 31, 2003 and
2002, respectively.

      Outstanding commitments to borrowers for loans totaled $230,374,000 and
$185,705,000 at December 31, 2003 and 2002, respectively. Outstanding
commitments to sell loans to investors, which totaled $6,773,000 and $12,304,000
at December 31, 2003 and 2002, respectively, hedge against interest rate
fluctuations from the time of the loan commitment until the date at which loans
are sold, which is generally within 60 days.

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

                                       40
<PAGE>
                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

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:

                                                    2003          2002
                                                 ----------    ----------
  Loans receivable........................       $3,312,821    $3,087,795
  Securities available-for-sale...........          287,803       259,109
  Securities held-to-maturity.............           48,408        88,439
                                                 ----------    ----------
                                                 $3,649,032    $3,435,343
                                                 ==========    ==========


NOTE 7 - SERVICING ASSETS AND SERVICING FEES

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

                                                     2003         2002
                                                   --------     --------
  Balance, beginning of year...................    $ 49,914     $ 47,810
      Additions................................     516,776       79,700
      Sales....................................         --       (31,409)
      Amortization.............................     (98,277)     (46,187)
                                                   --------     --------
  Balance, end of year.........................    $468,413     $ 49,914
                                                   ========     ========

      There were no changes in the valuation for impairment of servicing assets
for the years ended December 31, 2003, 2002, and 2001.

      Servicing fee income, net of amortization, consisted of the following for
the years ended December 31:
                                                  2003       2002        2001
                                                --------   --------    --------
      Servicing fees.........................   $167,708   $149,357    $130,016
      Amortization and recovery (provision)
       for impairment of servicing assets....    (98,277)   (46,187)    (24,287)
                                                --------   --------    --------
      Loan servicing fees, net...............   $ 69,431   $103,170    $105,729
                                                ========   ========    ========

      At December 31, 2003, the expected weighted average life of the Bank's
servicing assets was two years. Projected amortization expense for the gross
carrying value of servicing assets at December 31, 2003 is estimated to be as
follows:

      2004......................................................  $397,404
      2005......................................................    71,009
                                                                  --------
      Gross carrying value of servicing assets..................  $468,413
                                                                  ========

      The projected amortization expense of the servicing asset is an estimate
and should be used with caution. The amortization expense for future periods was
calculated by applying the same quantitative factors, such as estimated
prepayment assumptions that were used to determine the amortization expense for
the fourth quarter of 2003. These factors are subject to significant
fluctuations. Any projection of servicing asset

                                       41
<PAGE>
                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

amortization in future periods is limited by the conditions that existed at the
time the calculations were performed, and may not be indicative of actual
amortization expense that will be recorded in future periods.

NOTE 8 - LAND, BUILDINGS, AND EQUIPMENT

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

                                                    2003              2002
                                                -----------       -----------
  Land.....................................     $11,272,334       $ 3,249,022
  Buildings................................      13,122,088         7,740,053
  Furniture, fixtures, and equipment........      4,685,027         4,033,178
  Leasehold improvements...................       1,084,051         1,035,940
                                                -----------       -----------
                                                 30,163,500        16,058,193
                                                -----------       -----------
  Less accumulated depreciation and
    amortization...........................      (5,982,991)       (5,093,752)
                                                -----------       -----------
                                                $24,180,509       $10,964,441
                                                -----------       -----------

      Depreciation expense for the years ended December 31, 2003, 2002, and 2001
amounted to $1,078,000, $862,000, and $789,000, respectively.

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

      2004...................................................    $  249,007
      2005...................................................       243,497
      2006...................................................       199,096
      2007...................................................       197,872
      2008...................................................       200,498
                                                                 ----------
                                                                 $1,089,970
                                                                 ==========

      Total lease expenses were $322,916, $838,925, and $725,660 for the years
ended December 31, 2003, 2002, and 2001, respectively.

      Sublease income totaled $713,000, $99,000, and $100,000 for the years
ended December 31, 2003, 2002, and 2001, respectively.

                                       42
<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           2003                    2002
                                 December 31,    --------------------   ---------------------
                                    2003          Amount     Percent     Amount      Percent
                                 -----------     --------   ---------   --------    ---------
<S>                                 <C>       <C>            <C>      <C>             <C>
  Terms

    Money market deposit and
      checking accounts,
      including noninterest-
      bearing deposits of
      $25,141,003 (2003) and
      $16,661,417 (2002).........    1.1%      $191,948,350   32.9%    $134,247,575    27.0%
                                               ------------   ----     ------------    ----
    Regular savings..............    0.8%         8,710,867    1.5        8,386,918     1.6
                                               ------------   ----     ------------    ----
    Time deposits:

      1 to 6 months..............    1.3%        32,160,454    5.5       25,255,307     5.1
      7 to 12 months.............    2.0%       212,370,216   36.3      190,742,851    38.4
      13 to 18 months............    2.4%        46,440,901    8.0       52,588,245    10.6
      2 to 10 years..............    3.9%        92,259,860   15.8       86,148,723    17.3
                                               ------------   ----     ------------    ----
    Total time deposits..........    2.5%       383,231,431   65.6      354,735,126    71.4
                                               ------------   ----     ------------    ----
    Total deposits...............    2.0%      $583,890,648    100%    $497,369,619     100%
                                               ============   ====     ============    ====
</TABLE>

      Deposits at December 31, 2003 and 2002, included public funds of
$12,212,921 and $11,277,540, respectively. Mortgage-backed securities with a
book value of $2,241,324 and $1,662,013 were pledged as collateral on these
deposits at December 31, 2003 and 2002, respectively, which exceeds the minimum
collateral requirement established by the Washington Public Deposit Protection
Commission.

      As of December 31, 2003, scheduled maturities of time deposits were as
follows:

      YEAR ENDING DECEMBER 31,
      ------------------------
      2004......................................................  $295,586,562
      2005......................................................    47,758,274
      2006......................................................    13,522,114
      2007......................................................    16,092,443
      2008......................................................     9,987,426
      Thereafter................................................       284,612
                                                                  ------------
                                                                  $383,231,431
                                                                  ============

      Included in deposits are time deposits greater than or equal to $100,000
of $148,907,870 and $124,607,752 at December 31, 2003 and 2002, respectively.
Interest on time deposits greater than or equal to $100,000 totaled $4,225,148,
$4,587,764, and $6,302,223 for the years ended December 31, 2003, 2002, and
2001, respectively. Also included in deposits are accounts of approximately
$3,503,000 and $3,350,000 at December 31, 2003 and 2002, respectively, which are
controlled by members of the Board of Directors and management.

                                       43
<PAGE>
                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

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

                                              2003         2002         2001
                                          -----------  -----------  -----------
  Time deposits.......................    $10,095,366  $12,309,266  $20,171,363
  Money market deposit and checking...      1,818,163    1,592,787    2,393,143
  Regular savings.....................         70,523       92,592      143,507
                                          -----------  -----------  -----------
                                          $11,984,052  $13,994,645  $22,708,013
                                          ===========  ===========  ===========

NOTE 10 - FHLB AND OTHER ADVANCES

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

                                                         2003           2002
                                                     ------------   ------------
  FHLB advances..................................    $193,642,878   $184,143,897
                                                     ============   ============
  FHLB advances:
      Maximum outstanding at any month end.......    $221,751,405   $196,436,638
      Average outstanding........................     203,275,497    175,573,277
      Weighted average interest rates:
         Annual..................................          2.852%         4.111%
         End of year.............................          2.350%         3.520%
  Other advances.................................    $    500,000   $    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, 2003, the minimum book value of
eligible collateral pledged for these borrowings was $280,112,000. 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, 2003 mature as follows:

                                                  INTEREST RATES       AMOUNT
                                                  --------------    ------------
      2004...................................        1.10-5.50%     $137,753,760
      2005...................................        1.45-4.94%       34,983,750
      2006...................................        2.92-6.25%       12,021,112
      2007...................................        2.52-3.01%        4,171,756
      2010...................................        4.93%             4,000,000
      2011...................................        5.19%               712,500
                                                                    ------------
                                                                    $193,642,878
                                                                    ============

      The other advances mature on February 27, 2004, with an interest rate of
3.16%.

NOTE 11 - LONG-TERM DEBENTURES (TRUST PREFERRED SECURITIES)

      First Mutual Capital Trust I is a statutory business trust created for the
exclusive purpose of issuing and selling capital securities and utilizing sale
proceeds to acquire junior subordinated debt issued by the Company. 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 8.18% for a period of five years

                                       44
<PAGE>
                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

(Note 24). These securities are considered capital for the purposes of
regulatory capital requirements, subject to regulatory limitations. Accordingly,
the junior subordinated debentures are the sole assets of the Trust, and
payments under the junior subordinated debentures will be the sole revenues of
the Trust. The Company owns all of the common securities of the Trust.

      First Mutual Capital Trust II was formed in January 2003 for the exclusive
purpose of issuing and selling trust preferred securities and utilizing the $4.0
million in proceeds from the issuance to partially fund the purchase of First
Mutual Center, the building in which the Company's headquarters resides, and to
fund asset growth. In January 2003, the Trust issued $4 million of trust
preferred securities with a 30-year maturity, callable after the fifth year by
the Company. The securities have a fixed rate of 6.87% in the first five years,
and will reset quarterly thereafter at the three-month LIBOR rate, plus 3.30%.
These securities are considered capital for the purposes of regulatory capital
requirements, subject to regulatory limitations. Accordingly, the junior
subordinated debentures are the sole assets of the Trust, and payments under the
junior subordinated debentures will be the sole revenues of the Trust. The
Company owns all of the common securities of the Trust.

      First Mutual Statutory Trust III was formed in December 2003 for the
exclusive purpose of issuing trust preferred securities and utilizing the $4.0
million in proceeds from the issuance to fund future asset growth. In December
2003, the Trust issued $4 million of trust preferred securities with a 30-year
maturity, callable after the fifth year by the Company. The securities have a
fixed rate of 6.51% in the first five years, and will reset quarterly thereafter
at the three-month LIBOR rate, plus 2.85%. These securities are considered
capital for the purposes of regulatory capital requirements, subject to
regulatory limitations. Accordingly, the junior subordinated debentures are the
sole assets of the Trust, and payments under the junior subordinated debentures
will be the sole revenues of the Trust. The Company owns all of the common
securities of the Trust.

      During the fourth quarter of 2003, the Company adopted Financial
Accounting Standards Board (FASB) Interpretation Number 46, CONSOLIDATION OF
VARIABLE INTEREST ENTITIES, and in accordance with the Interpretation, will no
longer be consolidating First Mutual Capital Trust I or II or First Mutual
Statutory Trust III.

NOTE 12 - FEDERAL TAXES ON INCOME

      Deferred federal income taxes constitute the differences in the reporting
of income and expense for financial statement and income tax purposes. The
components of deferred income tax provision (benefit) are as follows for the
years ended December 31:
                                                       2003           2002
                                                    ---------      ---------
      Loan origination fees and costs...........    $ 350,212      $ 161,000
      FHLB stock dividends......................      201,382        235,000
      Reserve for loan losses...................     (221,711)      (379,000)
      Other, net................................      483,392        315,000
                                                    ---------      ---------
                                                    $ 813,275      $ 332,000
                                                    =========      =========

                                       45
<PAGE>
                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS I (CONTINUED)


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

                                                            2003        2002
                                                         ----------  ----------
Deferred tax assets:
  Reserve for loan losses..............................  $2,640,000  $2,419,000
  Other, net...........................................     (89,000)    209,000
  Unrealized loss on available-for-sale securities.....     213,000         --
                                                         ----------  ----------
                                                          2,764,000   2,628,000
                                                         ----------  ----------
Deferred tax liabilities:
  Loan origination fees and costs......................   1,601,000   1,067,000
  FHLB stock dividends.................................   1,748,000   1,546,000
  Servicing assets.....................................       7,000       7,000
  Unrealized gain on available-for-sale
    securities and interest rate swap..................         --      415,000
                                                         ----------  ----------
                                                          3,356,000   3,035,000
                                                         ----------  ----------
Net deferred tax (liability)...........................  $ (592,000) $ (407,000)
                                                         ==========   =========

A reconciliation of the effective income tax rate with the federal statutory
rate is as follows:
<TABLE><CAPTION>
                                  2003                 2002                  2001
                           ------------------   -------------------   -------------------
                             AMOUNT     RATE      AMOUNT      RATE      AMOUNT      RATE
                           ----------  ------   ----------   ------   ----------   ------
<S>                        <C>           <C>    <C>            <C>    <C>            <C>
Federal income tax at
  statutory rates........  $4,340,185    34%    $4,015,332     34%    $3,636,837     34%

Effect of tax-exempt
  interest income........     (15,554)    0%       (10,805)     0%       (11,783)     0%

Other....................      12,504     0%         7,902      0%        (5,854)     0%
                           ----------  ------   ----------   ------   ----------   ------
                           $4,337,135    34%    $4,012,429     34%    $3,619,200     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, 2003, totaled $108,769.

      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
table below) of total and Tier I capital to risk-

                                       46
<PAGE>
                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

weighted assets, and of Tier I capital to average assets. Management believes,
as of December 31, 2003, that the Company met all capital adequacy requirements
to which it is subject.

      As of December 31, 2003, the most recent notification from the FDIC
categorized the Bank as well capitalized under the regulatory framework for
prompt corrective action. To be categorized as well capitalized, the Bank must
maintain minimum total risk-based, Tier I risk-based, and Tier I leverage ratios
as set forth in the table. There are no conditions or events since that
notification that management believes have changed the Bank's category.

      Actual capital amounts and ratios for First Mutual Bancshares, Inc.
(consolidated) and First Mutual Bank are presented in the table below:
<TABLE><CAPTION>
                                                                                                           TO BE WELL CAPITALIZED
                                                                                        FOR CAPITAL       UNDER PROMPT CORRECTIVE
                                                                    ACTUAL          ADEQUACY PURPOSES         ACTION PROVISIONS
                                                            ---------------------------------------------------------------------
                                                               AMOUNT     RATIO      AMOUNT       RATIO      AMOUNT        RATIO
                                                            -----------   ------  -----------     -----    -----------     ------
<S>                                                         <C>           <C>     <C>             <C>      <C>             <C>
As of December 31, 2003:

   Total capital (to risk-weighted assets):
      First Mutual Bancshares, Inc. (consolidated)......    $76,071,944   12.15%  $50,121,076 >/= 8.00%            N/A        N/A
      First Mutual Bank.................................     73,875,751   11.82%   50,027,812 >/= 8.00%    $62,534,765 >/= 10.00%
   Tier I capital (to risk-weighted assets):
      First Mutual Bancshares, Inc. (consolidated)......     63,947,215   10.22%   25,060,538 >/= 4.00%            N/A        N/A
      First Mutual Bank.................................     66,058,905   10.57%   25,013,906 >/= 4.00%     37,520,859 >/=  6.00%
   Tier I capital (to average assets):
      First Mutual Bancshares, Inc. (consolidated)......     63,947,215    7.33%   34,894,210 >/= 4.00%            N/A        N/A
      First Mutual Bank.................................     66,058,905    7.71%   34,282,500 >/= 4.00%     42,853,125 >/=  5.00%

As of December 31, 2002:

   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%
</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.

                                       47
<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, 2003:
      Basic EPS:
        Income available to common shareholders         $8,395,738     4,708,752    $1.78
                                                                                    =====
      Effect of dilutive stock options                                   157,575
                                                        ----------    ----------
      Diluted EPS:
        Income available to common shareholders plus
          assumed stock options exercised               $8,395,738     4,866,327    $1.73
                                                        ==========    ==========    =====
    Year ended December 31, 2002:
      Basic EPS:
        Income available to common shareholders         $7,797,370     5,267,924    $1.48
                                                                                    =====
      Effect of dilutive stock options                                   114,432
                                                        ----------    ----------
      Diluted EPS:
        Income available to common shareholders plus
          assumed stock options exercised               $7,797,370     5,382,356    $1.45
                                                        ==========    ==========    =====
    Year ended December 31, 2001:
      Basic EPS:
        Income available to common shareholders         $6,922,131     5,694,542    $1.22
                                                                                    =====
    Effect of dilutive stock options                                      95,600
                                                        ----------    ----------
    Diluted EPS:
        Income available to common shareholders plus
          assumed stock options exercised               $6,922,131     5,790,142    $1.19
                                                        ==========    ==========    =====
</TABLE>

(1) Shares and EPS have been adjusted for 10% stock dividends paid July 2, 2003
    and May 8, 2002.

NOTE 15  OTHER OPERATING EXPENSES

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

<TABLE><CAPTION>
                                                            2003            2002           2001
                                                        -----------     -----------    -----------
     <S>                                                <C>             <C>            <C>
     Salaries and employee benefits incurred ........   $14,687,438     $11,685,205    $ 9,426,344

     Amounts deferred with loan origination fees ....    (2,232,520)     (1,448,864)      (959,948)
                                                        -----------     -----------    -----------

                                                        $12,454,918     $10,236,341    $ 8,466,396
                                                        ===========     ===========    ===========
</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.

                                       48
<PAGE>
                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

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
$477,539, $439,551, and $332,424 for the years ended December 31, 2003, 2002,
and 2001, 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. The loan was
paid in full during 2001.

      Shares held by the ESOP at December 31, 2003, were as follows:

                                  NUMBER OF      PRICE RANGE      AVERAGE PRICE
                                   SHARES         PER SHARE         PER SHARE
                                   ------         ---------         ---------
      Allocated
          Vested...............   357,920
          Non-vested...........     2,222
                                  -------
                                  360,142       $0.99 - $24.77        $2.65
                                  =======

      Contributions to the ESOP for the years ended December 31, 2003, 2002, and
2001 were $50,011, $25,003, and $25,000, 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, 2003, 581,013
shares of common stock, adjusted for stock dividends, were available for grant
under the plan. A total of 285,373 shares are currently exercisable at December
31, 2003. All schedules presented in this footnote are adjusted for stock
dividends and stock splits.

                                       49
<PAGE>
                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

      A summary of the stock option plans at December 31, 2003, 2002, and 2001,
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, 2000 ............  508,651       $2.80 - $13.15         $ 8.36

Exercisable at year end: 325,953 shares
Options granted .......................   39,207         9.94 - 11.27          10.56           $ 4.48
Options exercised .....................  (66,162)         2.80 - 9.08           3.48
Options terminated ....................  (35,525)        3.67 - 13.10           7.76
                                         -------
BALANCE, December 31, 2001 ............  446,171         3.62 - 13.15           9.32

Exercisable at year end: 291,933 shares
Options granted .......................  138,526        13.64 - 14.32          13.99           $ 9.96
Options exercised .....................  (74,880)        3.62 - 10.23           6.00
Options terminated ....................  (19,534)        9.94 - 14.32          13.05
                                         -------
BALANCE, December 31, 2002 ............  490,283         3.62 - 14.32          11.00

Exercisable at year end: 256,387 shares
Options granted .......................  106,182        16.08 - 18.77          18.35           $10.15
Options exercised .....................  (56,493)        3.62 - 13.15           7.18
Options terminated ....................   (3,436)        5.92 - 14.32          10.30
                                         -------
BALANCE, December 31, 2003 ............  536,536       $3.67 - $18.77         $12.86
                                         =======
Exercisable at year end: 285,373 shares
</TABLE>
-----------------------
* Per Share

      The following table summarizes information about stock options outstanding
at December 31, 2003:

<TABLE><CAPTION>
                               OPTIONS OUTSTANDING                                          OPTIONS EXERCISABLE
     --------------------------------------------------------------------------        -----------------------------
                                                    WEIGHTED          WEIGHTED                              WEIGHTED
                                 NUMBER             AVERAGE            AVERAGE           NUMBER              AVERAGE
         RANGE OF               OF SHARES           EXERCISE          REMAINING          OF SHARES          EXERCISE
      EXERCISE PRICE*          OUTSTANDING           PRICE*              LIFE          EXERCISABLE           PRICE*
      ---------------          -----------           ------              ----          -----------           ------
     <S>                         <C>                <C>              <C>                  <C>               <C>
     $ 3.00 - $ 6.00              24,082             $ 5.64           2.3 years            24,082            $ 5.64
       6.01 -   9.00              49,815               8.06           6.5 years            33,439              8.06
       9.01 -  12.00             124,385              10.07           5.7 years            98,432              9.94
      12.01 -  15.00             232,072              13.63           4.7 years           129,420             13.26
      15.01 -  18.00              19,337              16.46           7.5 years              --                 --
      18.01 -  21.00              86,845              18.77           9.5 years              --                 --
                                 -------                                                  -------
                                 536,536                                                  285,373
                                 =======                                                  =======
</TABLE>
-----------------------
* Per Share

      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 plans for the years ended December 31, 2003, 2002, and 2001.

                                       50
<PAGE>
                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

      The fair value of options granted under the stock option plans was
estimated on the date of grant using the Black-Scholes option-pricing model with
the following weighted-average assumptions used: Annual dividend yield of 1.49%
-1.65% for 2003, 1.82% for 2002, and 1.56% for 2001; expected volatility of 38%
- 48% for 2003, 37% for 2002, and 35% for 2001; and expected lives of 6 years
-10 years for 2003, 7.5 years for 2002, and 7.6 years for 2001. The risk-free
interest rate assumptions were 2.80% - 3.69%, 3.12%, and 6.29% for 2003, 2002,
and 2001, respectively.

      Note: The weighted average assumptions are presented as a range for year
2003 as a result of the requirements of SFAS 123, ACCOUNTING FOR STOCK BASED
COMPENSATION, as amended, which requires the Bank to calculate compensation
expense on a quarterly basis as opposed to the yearly calculation used in 2002
and 2001.

NOTE 19 - COMMITMENTS AND CONTINGENCIES

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

      The Bank's exposure to credit loss in the event of nonperformance by the
other party to the instrument for commitments to extend credit, standby letters
of credit, and financial guarantees written is represented by the contractual
amount of those instruments. The Bank uses the same credit policies in making
commitments and conditional obligations as it does for on-balance-sheet
instruments.

      Commitments to extend credit are agreements to lend to a customer as long
as there is no violation of any condition established in the contract.
Commitments generally have fixed expiration dates or other termination clauses
and may require payment of a fee. Since many of the commitments are expected to
expire without being drawn upon, the total commitment amounts do not necessarily
represent future cash requirements. At December 31, 2003, approximately 27% of
loan commitments were drawn upon by customers. The Bank evaluates each
customer's creditworthiness on a case-by-case basis. The amount of collateral
obtained, if it is deemed necessary by the Bank upon extension of credit, is
based on management's credit evaluation of the borrower. Collateral held varies
but may include accounts receivable, inventory, property, plant, and equipment,
and residential or income-producing commercial properties. The Bank has not
incurred any significant losses on its commitments in 2003 or 2002.

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

      The Bank is committed to acquire and build a banking center in the Canyon
Park area for an estimated cost of $3.5 million. The Bank is currently under
contract to purchase the land given the seller fulfills his obligations
stipulated in the agreement. As of December 31, 2003, approximately $300,000 has
been expended and capitalized for this project.

      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.

                                       51
<PAGE>
                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

      A summary of the notional amount of the Bank's financial instruments with
off-balance-sheet risk at December 31, 2003 follows:

                                                                    AMOUNT
                                                                 ------------
      Commitments to extend credit .........................     $230,304,000
                                                                 ============
      Standby letters of credit ............................     $     70,000
                                                                 ============

NOTE 20 - SUBSEQUENT EVENTS

      The Company declared a 10% stock dividend on February 26, 2004, payable on
April 7, 2004.

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. The estimated fair value of
financial instruments is as follows at December 31, 2003 and 2002 (in
thousands):

<TABLE><CAPTION>
                                                                              2003                               2002
                                                                  ----------------------------        ----------------------------
                                                                                    ESTIMATED                           ESTIMATED
                                                                   CARRYING           FAIR             CARRYING           FAIR
                                                                    VALUE             VALUE             VALUE             VALUE
                                                                  ----------        ----------        ----------        ----------
<S>                                                               <C>               <C>               <C>               <C>
Assets:
   Cash and cash equivalents ..................................   $    7,427        $    7,427        $   14,972        $   14,972

   Securities available-for-sale ..............................       77,624            77,624            58,380            58,380

   Loans held-for-sale ........................................       10,143            10,143            12,699            12,699

   Mortgage-backed and other securities held-to-maturity ......        8,903             9,110            16,358            16,926

   Loans receivable ...........................................      715,304           714,963           614,620           615,735

   Accrued interest receivable ................................        3,649             3,649             3,435             3,435

   Servicing asset ............................................          468               588                50                85

   FHLB stock .................................................       11,036            11,036            10,443            10,443

Liabilities:
   Demand, savings, and money market deposits .................      200,659           200,659           142,634           142,634

   Time deposits ..............................................      383,231           387,342           354,735           360,070

   Drafts payable .............................................          357               357               369               369

   Advance payments by borrowers for taxes and insurance ......        1,727             1,727             1,798             1,798

   Short-term FHLB advances ...................................      137,754           136,779           123,043           123,570

   Long-term FHLB advances ....................................       55,889            55,868            61,101            60,863

   Other advances .............................................          500               495               250               250

   Long-term debenture ........................................       17,000            16,950             9,000             9,085
</TABLE>
                                       52
<PAGE>
                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
<TABLE><CAPTION>
                                                            2003                     2002
                                                    ---------------------  -----------------------
                                                               ESTIMATED                ESTIMATED
                                                    CARRYING     FAIR        CARRYING     FAIR
                                                     VALUE       VALUE        VALUE       VALUE
                                                    ---------------------  -----------------------
<S>                                                  <C>        <C>           <C>          <C>
 Derivatives:
      Interest rate swap........................      (490)      (490)         (33)         (33)
      Rate lock commitments.....................         4          4           68           68
      Outstanding commitments to sell loans.....       --         --          (624)        (624)
</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.

      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.

      LONG-TERM DEBENTURE - The carrying amount of the long-term debentures
(associated with the trust preferred securities issuances) is 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.

      SERVICING ASSET - The carrying value of the servicing asset is as defined
by SFAS No. 140, ACCOUNTING FOR TRANSFERS AND SERVICING OF FINANCIAL ASSETS AND
EXTINGUISHMENT OF LIABILITIES. The fair value of the servicing assets is based
upon a valuation model that calculates the present value of future cash flows.

      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, 2003 and 2002.
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.

                                       53
<PAGE>
                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS I (CONTINUED)

NOTE 22 - SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
<TABLE><CAPTION>
                                             FIRST           SECOND            THIRD           FOURTH
                                            QUARTER          QUARTER          QUARTER          QUARTER          TOTAL
                                         ------------     ------------     ------------     ------------     ------------
<S>                                      <C>              <C>              <C>              <C>              <C>
YEAR ENDED DECEMBER 31, 2003

Interest income .....................    $ 12,008,062     $ 12,277,040     $ 12,524,092     $ 12,852,339     $ 49,661,533

Interest expense ....................       4,932,814        4,840,096        4,613,369        4,537,433       18,923,712
                                         ------------     ------------     ------------     ------------     ------------

Net interest income .................    $  7,075,248     $  7,436,944     $  7,910,723     $  8,314,906     $ 30,737,821
                                         ============     ============     ============     ============     ============

Provision for loan losses ...........    $    135,000     $    325,000     $    350,000     $    340,000     $  1,150,000
                                         ============     ============     ============     ============     ============
Other operating income and
   expenses, net ....................    $ (3,786,530)    $ (4,045,360)    $ (4,131,098)    $ (4,891,960)    $(16,854,948)
                                         ============     ============     ============     ============     ============

Net income ..........................    $  2,087,158     $  2,029,617     $  2,269,225     $  2,009,738     $  8,395,738
                                         ============     ============     ============     ============     ============

Basic earnings per share ............    $       0.44     $       0.43     $       0.48     $       0.43     $       1.78
                                         ============     ============     ============     ============     ============
Earnings per share assuming
   dilution .........................    $       0.44     $       0.42     $       0.46     $       0.41     $       1.73
                                         ============     ============     ============     ============     ============
Weighted average shares
   outstanding ......................       4,686,213        4,709,686        4,714,463        4,724,167        4,708,752
                                         ============     ============     ============     ============     ============
Weighted average shares
   outstanding including effect
   of dilutive stock options ........       4,813,398        4,872,060        4,885,930        4,940,194        4,866,327
                                         ============     ============     ============     ============     ============
YEAR ENDED DECEMBER 31, 2002

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 ............    $       0.34     $       0.33     $       0.42     $       0.39     $       1.48
                                         ============     ============     ============     ============     ============
Earnings per share assuming
   dilution .........................    $       0.33     $       0.33     $       0.41     $       0.38     $       1.45
                                         ============     ============     ============     ============     ============
Weighted average shares
   outstanding ......................       5,721,443        5,726,370        4,980,625        4,658,100        5,267,924
                                         ============     ============     ============     ============     ============
Weighted average shares
   outstanding including effect
   of dilutive stock options ........       5,783,723        5,841,556        5,102,992        4,790,820        5,382,356
                                         ============     ============     ============     ============     ============
</TABLE>
                                       54
<PAGE>
                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

NOTE 23 - SEGMENTS

      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 the 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
segments. Methodologies that are applied to the measurement of segment
profitability include:

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

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

     o    The provision for loan losses is 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.

     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 (sales finance). 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. In addition,
          this segment also sells loans into the secondary market. Management
          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 the products and services. All three segments derive a
majority of their revenue from interest income, and management relies primarily
on net interest revenue in managing these segments. No single customer provides
more than 10% of the Company's revenues.

                                       55
<PAGE>
                 FIRST MUTUAL BANCSHARES, INC. AND SUBSIDIARIES
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

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

<TABLE><CAPTION>
                                                              YEARS ENDED DECEMBER 31,
                                       -------------------------------------------------------------------------
                                                  CONSUMER       COMMERCIAL        INVESTMENT
                                                  LENDING          LENDING         SECURITIES          TOTAL
                                               -------------    -------------     -------------    -------------
<S>                                    <C>     <C>              <C>               <C>              <C>
Interest income ....................   2003    $  16,684,350    $  28,802,555     $   4,174,628    $  49,661,533
                                       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

Interest expense ...................   2003        5,870,357        9,462,198         3,591,157       18,923,712
                                       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

Net interest income ................   2003       10,813,993       19,340,357           583,471       30,737,821
                                       2002        6,800,127       18,868,133           970,738       26,638,998
                                       2001        5,170,697       16,620,444          (463,761)      21,327,380

Provision for loan losses ..........   2003          438,880          711,120                --        1,150,000
                                       2002          279,291          630,709                --          910,000
                                       2001          112,823          252,177                --          365,000
Net interest income, after
  provision for loan losses ........   2003       10,375,113       18,629,237           583,471       29,587,821
                                       2002        6,520,836       18,237,424           970,738       25,728,998
                                       2001        5,057,874       16,368,267          (463,761)      20,962,380

Other operating income .............   2003        1,562,678        1,262,540           837,735        3,662,953
                                       2002        1,397,232        1,231,859           607,614        3,236,705
                                       2001        1,870,763          897,253         1,262,084        4,030,100

Other operating expense ............   2003        8,496,179       10,899,984         1,121,738       20,517,901
                                       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
Income before federal
  income taxes and cumulative
  effect of adoption of new
  accounting principle .............   2003        3,441,612        8,991,793           299,468       12,732,873
                                       2002        1,812,868        9,577,289           419,642       11,809,799
                                       2001        1,846,414        9,254,705          (404,541)      10,696,578

Federal income taxes ...............   2003        1,178,505        3,079,045            79,585        4,337,135
                                       2002          619,409        3,272,307           120,713        4,012,429
                                       2001          627,781        3,146,600          (155,181)       3,619,200
Income before cumulative
  effect of adoption
  of new accounting principle ......   2003        2,263,107        5,912,748           219,883        8,395,738
                                       2002        1,193,459        6,304,982           298,929        7,797,370
                                       2001        1,218,633        6,108,105          (249,360)       7,077,378

Net income .........................   2003        2,263,107        5,912,748           219,883        8,395,738
                                       2002        1,193,459        6,304,982           298,929        7,797,370
                                       2001        1,063,386        6,108,105          (249,360)       6,922,131

Total interest earning assets
  (averages) .......................   2003      244,664,544      454,799,252        98,651,070      798,114,866
                                       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
</TABLE>
                                       56
<PAGE>

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

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.

      At December 31, 2003, the fair value of financial instruments defined as
derivatives consisted of:
                                                    NOTIONAL         FAIR
                                                     AMOUNT          VALUE
                                                   ----------      ---------

      Interest-rate-lock loan commitments .......  $1,711,950      $   4,159
      Interest rate swap ........................   9,000,000       (490,271)

      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.

NOTE 25 - PARENT COMPANY ONLY FINANCIAL STATEMENTS

      Summary of condensed parent company financial information for First Mutual
Bancshares, Inc. for December 31, 2003 and 2002 (in thousands):


<TABLE><CAPTION>
                       STATEMENT OF FINANCIAL CONDITION
                                                                    DECEMBER 31,
                                                            ----------------------------
                                                               2003              2002
                                                            ----------        ----------
<S>                                                         <C>               <C>
ASSETS

  Cash .............................................        $      609        $      675

  Investments in subsidiaries ......................            66,172            52,071

  Other assets .....................................             2,006             1,163
                                                            ----------        ----------

Total assets .......................................        $   68,787        $   53,909
                                                            ==========        ==========
LIABILITIES AND STOCKHOLDERS' EQUITY

Liabilities:
  Borrowings .......................................        $      500        $      250

  Other liabilities ................................            17,460             9,375
                                                            ----------        ----------

                                                                17,960             9,625
Stockholders' equity ...............................            50,827            44,284
                                                            ----------        ----------

Total liabilities and stockholders' equity .........        $   68,787        $   53,909
                                                            ==========        ==========
</TABLE>

                                       57
<PAGE>

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

                               STATEMENT OF INCOME
<TABLE><CAPTION>
                                                                                YEARS ENDED DECEMBER 31,
                                                                    ----------------------------------------------
                                                                       2003              2002              2001
                                                                    ----------        ----------        ----------
<S>                                                                 <C>               <C>               <C>
INCOME

  Equity in undistributed net income from subsidiaries .....        $    9,161        $    8,268        $    7,090
                                                                    ----------        ----------        ----------

OTHER EXPENSE

  Compensation and employee benefits .......................               107                96                (2)

  Other operating expense ..................................             1,057               619               256
                                                                    ----------        ----------        ----------
    Total expenses .........................................             1,164               715               254
                                                                    ----------        ----------        ----------

    Income before federal income taxes .....................             7,997             7,553             6,836

FEDERAL INCOME TAX BENEFIT .................................               399               244                86
                                                                    ----------        ----------        ----------

NET INCOME .................................................        $    8,396        $    7,797        $    6,922
                                                                    ==========        ==========        ==========
</TABLE>
                             STATEMENT OF CASH FLOWS
<TABLE><CAPTION>
                                                                                    YEARS ENDED DECEMBER 31,
                                                                           ------------------------------------------
                                                                             2003             2002             2001
                                                                           --------         --------         --------
<S>                                                                        <C>              <C>              <C>
OPERATING ACTIVITIES
  Net income ......................................................        $  8,396         $  7,797         $  6,922
  Adjustments to reconcile net cash from operating activities
    Equity in undistributed earnings of subsidiaries ..............          (9,161)          (8,268)          (7,090)
    Increase in other assets ......................................            (843)            (706)            (177)
    Increase (decrease) in other liabilities ......................              47              (69)             (72)
                                                                           --------         --------         --------

      Net cash (used) by operating activities .....................          (1,561)          (1,246)            (417)

INVESTING ACTIVITIES
  Dividends (to)/from subsidiaries ................................          (5,900)           9,270            1,060
FINANCING ACTIVITIES
  Dividends paid ..................................................          (1,261)          (1,322)            (940)
  Proceeds from exercise of stock options .........................             406              450              230
  Repurchase and retirement of common stock .......................            --            (15,798)            --
  Proceeds from issuance of long-term debt ........................           8,000            9,000             --
  Proceeds from borrowings ........................................             500             --               --
  Repayment of borrowings .........................................            (250)            --               --
  Repayment of employee stock ownership plan (ESOP) debt ..........            --               --                 98
                                                                           --------         --------         --------

    Net cash provided (used) by financing activities ...............          7,395           (7,670)            (612)
                                                                           --------         --------         --------

NET INCREASE IN CASH AND CASH EQUIVALENTS .........................             (66)             354               31

  Beginning of year ...............................................             675              321              290
                                                                           --------         --------         --------

  End of year .....................................................        $    609         $    675         $    321
                                                                           ========         ========         ========
</TABLE>
                                       58
<PAGE>







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