**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**WashingtonD.C.  20549**

** **

**FORM 10-Q**

** **

**(Mark One)**

**ý****Quarterly ReportPursuant to Section 13 or 15(d) of the Securities and Exchange Act of 1934**

** **

**Forthe quarterly period ended September 30, 2002**

** **

**o****Transition ReportPursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934**

** **

**For thetransition period                 from to                 **

** **

**Commission filenumber  0-26632**

** **

**Pacific Northwest Bancorp**

(Exact name of registrant asspecified in its charter)

 

| **Washington**                                                  |
|-----------------------------------------------------------------|
| (State or other jurisdiction  of incorporation or organization) |
|                                                            |
| **91-1691216**                                                  |
| (I.R.S. Employer  Identification No.)                           |
|                                                            |
| **1111 Third Avenue, Suite 250  Seattle, Washington**           |
| (Address of principal  executive offices)                       |
|                                                            |
| **98101**                                                       |
| (Zip Code)                                                      |
|                                                            |
| Registrant’s telephone number including  area code:        |   | **(206)  624-0600** |

 

Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2)has been subject to such filing requirements for the past 90 days.

 

YES   ý   NO   o

 

As of November 4, 2002, 14,980,152 shares ofcommon stock were outstanding with no par value.

 

 

----

 

**PACIFICNORTHWEST BANCORP**

** **

**INDEX**

 
| **PART  I.**       | **FINANCIAL  INFORMATION**                                                                                             |
|--------------------|------------------------------------------------------------------------------------------------------------------------|
| **Item  1.**       | **Financial  Statements**                                                                                              |
|               |                                                                                                                   |
|               | **Consolidated Statements of Financial  Condition as of September 30, 2002 and December 31, 2001**                     |
|               |                                                                                                                   |
|               | **Consolidated Statements of Income for the  three- and nine-month periods ended September 30, 2002 and 2001**         |
|               |                                                                                                                   |
|               | **Consolidated Statements of Shareholders’  Equity for the nine-month periods ended September 30, 2002 and 2001** |
|               |                                                                                                                   |
|               | **Consolidated Statements of Cash Flows for  the nine-month periods ended September 30, 2002 and 2001**                |
|               |                                                                                                                   |
|               | **Notes to Unaudited Consolidated Financial  Statements**                                                              |
|               |                                                                                                                   |
|               |                                                                                                                   |
| **Item 2.**        | **Management  Discussion and Analysis of Financial Condition and Results of Operations  About Market Risk**            |
|               |                                                                                                                   |
| **Item  3.**       | **Quantitative  and Qualitative Disclosures**                                                                          |
|               |                                                                                                                   |
| **Item 4.**        | **Controls and Procedures**                                                                                            |
|               |                                                                                                                   |
| **PART  II.**      | **OTHER  INFORMATION**                                                                                                 |
|               |                                                                                                                   |
| **Item 1.**        | **Legal  Proceedings**                                                                                                 |
|               |                                                                                                                   |
| **Item 5.**        | **Other  Information**                                                                                                 |
|               |                                                                                                                   |
| **Item 6.**        | **Exhibits  and Reports on Form 8-K**                                                                                  |
|               |                                                                                                                   |
| **SIGNATURES**     |
|               |                                                                                                                   |
| **CERTIFICATIONS** |

 

----

 

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (UNAUDITED)

 
| ***Dollars in thousands***                                                                                          |   | **September 30, 2002** |       | **December 31, 2001** |       |
|---------------------------------------------------------------------------------------------------------------------|--------|------------------------|------------|-----------------------|------------|
|                                                                                                                |   |                   | ** ** |                  | ** ** |
| *Assets*                                                                                                            |   |                   |       |                  |       |
|                                                                                                                |   |                   |       |                  |       |
| Cash and due  from banks                                                                                            |   |                   |       |                  |       |
| Non-interest-bearing                                                                                                |   | $                      | 57,504     |                  | $          | 58,134 |   |
| Interest-bearing                                                                                                    |   | 4,064                  |       | 491                   |       |
| Federal funds  sold and securities purchased under agreements to resell                                             |   | 5,150                  |       | —                |       |
| Securities  available for sale                                                                                      |   | 795,265                |       | 757,018               |       |
| Loans  receivable                                                                                                   |   | 1,816,046              |       | 1,808,555             |       |
| Allowance for  losses on loans                                                                                      |   | (22,785                | )          | (20,123               | )          |
| Net loans  receivable                                                                                               |   | 1,793,261              |       | 1,788,432             |       |
|                                                                                                                |   |                   |       |                  |       |
| Loans held for  sale                                                                                                |   | 22,166                 |       | 43,757                |       |
| Interest  receivable                                                                                                |   | 13,687                 |       | 14,808                |       |
| Other real  estate                                                                                                  |   | 7,478                  |       | 5,762                 |       |
| Premises and  equipment                                                                                             |   | 48,750                 |       | 50,837                |       |
| Goodwill                                                                                                            |   | 16,137                 |       | 16,137                |       |
| Other  intangible assets                                                                                            |   | 1,267                  |       | 1,985                 |       |
| Bank owned life  insurance                                                                                          |   | 51,039                 |       | —                |       |
| Other assets                                                                                                        |   | 9,820                  |       | 4,147                 |       |
|                                                                                                                |   |                   |       |                  |       |
| Total assets                                                                                                        |   | $                      | 2,825,588  |                  | $          | 2,741,508 |   |
|                                                                                                                |   |                   |       |                  |       |
| *Liabilities*                                                                                                       |   |                   |       |                  |       |
|                                                                                                                |   |                   |       |                  |       |
| Deposits:                                                                                                           |   |                   |       |                  |       |
| Non-interest-bearing                                                                                                |   | $                      | 253,569    |                  | $          | 241,674 |   |
| Interest-bearing                                                                                                    |   | 1,566,714              |       | 1,363,181             |       |
| Total deposits                                                                                                      |   | 1,820,283              |       | 1,604,855             |       |
|                                                                                                                |   |                   |       |                  |       |
| Federal Home  Loan Bank (FHLB) advances                                                                             |   | 602,461                |       | 714,526               |       |
| Federal funds  purchased and securities sold under agreements to repurchase                                         |   | 115,402                |       | 149,504               |       |
| Guaranteed  preferred beneficial interests in subordinated debt                                                     |   | 48,000                 |       | 37,500                |       |
| Other  borrowings                                                                                                   |   | 12,073                 |       | 12,621                |       |
| Other  liabilities                                                                                                  |   | 25,036                 |       | 22,016                |       |
|                                                                                                                |   |                   | ** ** |                  | ** ** |
| Total  liabilities                                                                                                  |   | 2,623,255              |       | 2,541,022             |       |
|                                                                                                                |   |                   |       |                  |       |
| *Shareholders’  Equity*                                                                                        |   |                   |       |                  |       |
|                                                                                                                |   |                   |       |                  |       |
| Common stock,  no par value, authorized shares 30,000,000  Issued and outstanding: 14,977,547 and 15,595,204 shares |   | —                 |       | —                |       |
| Paid-in-capital                                                                                                     |   | 7,054                  |       | 26,757                |       |
| Retained  earnings                                                                                                  |   | 189,963                |       | 172,967               |       |
| Accumulated other comprehensive  income                                                                             |   | 5,316                  |       | 1,305                 |       |
| Debt related to  employee stock ownership plan (ESOP)                                                               |   | —                 |       | (543                  | )          |
|                                                                                                                |   |                   | ** ** |                  | ** ** |
| Total  shareholders’ equity                                                                                    |   | 202,333                |       | 200,486               |       |
|                                                                                                                |   |                   |       |                  |       |
| Total  liabilities and shareholders’ equity                                                                    |   | $                      | 2,825,588  |                  | $          | 2,741,508 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

1

----

 

CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)

For the three and nine monthperiods ended September 30, 2002 and 2001

** **
|                                                            |   | **Three-month periods** |       | **Nine-month periods** |       |
|-----------------------------------------------------------------|--------|-------------------------|------------|------------------------|------------|
| ***Dollars in thousands, except per share amounts***            |   | **2002**                | ** ** | **2001**               | ** ** | **2002** | ** ** | **2001** | ** ** |
|                                                            |   |                    | ** ** |                   | ** ** |   | ** ** |   | ** ** |
| *Interest Income*                                               |   |                    |       |                   |       |   |   |   |   |
| Loans  receivable and loans held for sale                       |   | $                       | 34,115     |                   | $          | 38,354 |   | $ | 103,172 |   | $ | 117,457 |   |
| Securities  available for sale                                  |   | 10,046                  |       | 12,166                 |       | 30,837 |   | 39,452 |   |
| Other                                                           |   | 33                      |       | 143                    |       | 108 |   | 580 |   |
|                                                            |   | 44,194                  |       | 50,663                 |       | 134,117 |   | 157,489 |   |
| *Interest Expense*                                              |   |                    |       |                   |       |   |   |   |   |
| Deposits                                                        |   | 9,381                   |       | 13,652                 |       | 28,001 |   | 47,665 |   |
| FHLB advances  and other borrowings                             |   | 6,193                   |       | 7,231                  |       | 19,098 |   | 24,804 |   |
| Securities sold  under agreements to repurchase                 |   | 783                     |       | 2,168                  |       | 2,975 |   | 9,314 |   |
| Guaranteed  preferred beneficial interests in subordinated debt |   | 896                     |       | 987                    |       | 2,723 |   | 2,963 |   |
|                                                            |   | 17,253                  |       | 24,038                 |       | 52,797 |   | 84,746 |   |
|                                                            |   |                    |       |                   |       |   |   |   |   |
| Net interest  income                                            |   | 26,941                  |       | 26,625                 |       | 81,320 |   | 72,743 |   |
|                                                            |   |                    |       |                   |       |   |   |   |   |
| Provision for  losses on loans                                  |   | 1,700                   |       | 1,550                  |       | 5,100 |   | 4,350 |   |
|                                                            |   |                    |       |                   |       |   |   |   |   |
|                                                            |   |                    |       |                   |       |   |   |   |   |
| Net interest  income after provision for losses on loans        |   | 25,241                  |       | 25,075                 |       | 76,220 |   | 68,393 |   |
|                                                            |   |                    |       |                   |       |   |   |   |   |
| *Non-interest Income*                                           |   |                    |       |                   |       |   |   |   |   |
| Service fees                                                    |   | 3,338                   |       | 2,845                  |       | 9,796 |   | 8,536 |   |
| Mortgage  banking revenue                                       |   | 452                     |       | 584                    |       | 1,907 |   | 1,556 |   |
| Investment  product fees and insurance commissions              |   | 513                     |       | 571                    |       | 1,349 |   | 1,792 |   |
| Bank owned life  insurance income                               |   | 540                     |       | —                 |       | 1,039 |   | — |   |
| Gain on sale of  securities available for sale                  |   | —                  |       | 514                    |       | 40 |   | 1,658 |   |
| Gain on sale of  partnership                                    |   | —                  |       | —                 |       | — |   | 574 |   |
| Other                                                           |   | 327                     |       | 596                    |       | 987 |   | 1,747 |   |
|                                                            |   | 5,170                   |       | 5,110                  |       | 15,118 |   | 15,863 |   |
| *Non-interest  Expense*                                         |   |                    |       |                   |       |   |   |   |   |
| Compensation  and employee benefits                             |   | 9,743                   |       | 9,732                  |       | 29,539 |   | 28,812 |   |
| General and  administrative                                     |   | 4,180                   |       | 5,824                  |       | 12,738 |   | 16,148 |   |
| Occupancy and  equipment                                        |   | 3,025                   |       | 3,120                  |       | 9,188 |   | 8,924 |   |
| Data processing                                                 |   | 1,412                   |       | 1,604                  |       | 4,193 |   | 4,593 |   |
| Other real  estate owned                                        |   | 42                      |       | 147                    |       | 52 |   | 161 |   |
| Conversion and  integration                                     |   | —                  |       | —                 |       | — |   | 1,290 |   |
| Severance and  employment agreements                            |   | —                  |       | —                 |       | — |   | 200 |   |
|                                                            |   | 18,402                  |       | 20,427                 |       | 55,710 |   | 60,128 |   |
|                                                            |   |                    | ** ** |                   | ** ** |   | ** ** |   | ** ** |
| Income before  income tax expense                               |   | 12,009                  |       | 9,758                  |       | 35,628 |   | 24,128 |   |
|                                                            |   |                    |       |                   |       |   |   |   |   |
| Income tax  expense                                             |   | 4,056                   |       | 3,651                  |       | 12,199 |   | 9,024 |   |
|                                                            |   |                    |       |                   |       |   |   |   |   |
| Net income                                                      |   | $                       | 7,953      |                   | $          | 6,107 |   | $ | 23,429 |   | $ | 15,104 |   |
|                                                            |   |                    |       |                   |       |   |   |   |   |
| Basic net  income per share                                     |   | $                       | 0.53       |                   | $          | 0.39 |   | $ | 1.53 |   | $ | 0.97 |   |
|                                                            |   |                    |       |                   |       |   |   |   |   |
| Diluted net  income per share                                   |   | $                       | 0.51       |                   | $          | 0.39 |   | $ | 1.49 |   | $ | 0.96 |   |
|                                                            |   |                    |       |                   |       |   |   |   |   |
| Dividends  declared per share                                   |   | $                       | 0.14       |                   | $          | 0.14 |   | $ | 0.42 |   | $ | 0.42 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

2

----

 

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’EQUITY (UNAUDITED)

 
| ***Dollars in thousands, except share data***                                                              |   | **Common Stock,  no par value****Shares** |   | **Paid-in****Capital** |   | **Retained****Earnings** |   | **Accumulated  Other  Comprehensive  Income (Loss)** |   | **Debt  Related****To  ESOP** |   | **Total** |   |
|------------------------------------------------------------------------------------------------------------|--------|-------------------------------------------|--------|------------------------|--------|--------------------------|--------|------------------------------------------------------|--------|-------------------------------|--------|-----------|--------|
| January 1, 2001                                                                                            |   | 15,494,357                                |   | $                      | 26,291 |                     | $      | 159,613                                              |   | $                             | (5,500 | )         | $      | (1,668 | ) | $ | 178,736 |   |
|                                                                                                       |   |                                      |   |                   |   |                     |   |                                                 |   |                          |   |      |   |   |   |   |   |   |
| Dividends  declared, $0.42 per share                                                                       |   |                                      |   |                   |   | (6,537                   | )      |                                                 |   |                          |   | (6,537    | )      |
|                                                                                                       |   |                                      |   |                   |   |                     |   |                                                 |   |                          |   |      |   |
| Issuance of  common stock:                                                                                 |   |                                      |   |                   |   |                     |   |                                                 |   |                          |   |      |   |
| Stock option  plans                                                                                        |   | 71,538                                    |   | 722                    |   |                     |   |                                                 |   |                          |   | 722       |   |
|                                                                                                       |   |                                      |   |                   |   |                     |   |                                                 |   |                          |   |      |   |
| ESOP debt  repayment                                                                                       |   | 30,241                                    |   |                   |   |                     |   |                                                 |   | 854                           |   | 854       |   |
|                                                                                                       |   |                                      |   |                   |   |                     |   |                                                 |   |                          |   |      |   |
| Comprehensive  income:                                                                                     |   |                                      |   |                   |   |                     |   |                                                 |   |                          |   |      |   |
|                                                                                                       |   |                                      |   |                   |   |                     |   |                                                 |   |                          |   |      |   |
| Net income                                                                                                 |   |                                      |   |                   |   | 15,104                   |   |                                                 |   |                          |   | 15,104    |   |
|                                                                                                       |   |                                      |   |                   |   |                     |   |                                                 |   |                          |   |      |   |
| Other  comprehensive income (loss) -                                                                       |   |                                      |   |                   |   |                     |   |                                                 |   |                          |   |      |   |
|                                                                                                       |   |                                      |   |                   |   |                     |   |                                                 |   |                          |   |      |   |
| Reclassification  of securities held to maturity to securities available for sale, net of taxes  of $(321) |   |                                      |   |                   |   |                     |   | (597                                                 | )      |                          |   | (597      | )      |
|                                                                                                       |   |                                      |   |                   |   |                     |   |                                                 |   |                          |   |      |   |
| Unrealized gain  on securities available for sale, net of taxes of $6,690                                  |   |                                      |   |                   |   |                     |   | 12,423                                               |   |                          |   | 12,423    |   |
|                                                                                                       |   |                                      |   |                   |   |                     |   |                                                 |   |                          |   |      |   |
| Reclassification  adjustment for gains included in net income, net of taxes of $580                        |   |                                      |   |                   |   |                     |   | (1,078                                               | )      |                          |   | (1,078    | )      |
|                                                                                                       |   |                                      |   |                   |   |                     |   |                                                 |   |                          |   |      |   |
| Total comprehensive income*                                                                                |   |                                      |   |                   |   |                     |   |                                                 |   |                          |   | 25,852    |   |
| September 30, 2001                                                                                         |   | 15,596,136                                |   | $                      | 27,013 |                     | $      | 168,180                                              |   | $                             | 5,248  |      | $      | (814 | ) | $ | 199,627 |   |
|                                                                                                       |   |                                      |   |                   |   |                     |   |                                                 |   |                          |   |      |   |
| January 1, 2002                                                                                            |   | 15,595,204                                |   | $                      | 26,757 |                     | $      | 172,967                                              |   | $                             | 1,305  |      | $      | (543 | ) | $ | 200,486 |   |
|                                                                                                       |   |                                      |   |                   |   |                     |   |                                                 |   |                          |   |      |   |   |   |   |   |   |
| Dividends  declared, $0.42 per share                                                                       |   |                                      |   |                   |   | (6,433                   | )      |                                                 |   |                          |   | (6,433    | )      |
|                                                                                                       |   |                                      |   |                   |   |                     |   |                                                 |   |                          |   |      |   |
| Issuance of  common stock:                                                                                 |   |                                      |   |                   |   |                     |   |                                                 |   |                          |   |      |   |
| Stock option  plans                                                                                        |   | 145,504                                   |   | 1,992                  |   |                     |   |                                                 |   |                          |   | 1,992     |   |
|                                                                                                       |   |                                      |   |                   |   |                     |   |                                                 |   |                          |   |      |   |
| Purchase and  retirement of common stock                                                                   |   | (780,825                                  | )      | (21,695                | )      |                     |   |                                                 |   |                          |   | (21,695   | )      |
|                                                                                                       |   |                                      |   |                   |   |                     |   |                                                 |   |                          |   |      |   |
| ESOP debt  repayment                                                                                       |   | 17,664                                    |   |                   |   |                     |   |                                                 |   | 543                           |   | 543       |   |
|                                                                                                       |   |                                      |   |                   |   |                     |   |                                                 |   |                          |   |      |   |
| Comprehensive  income:                                                                                     |   |                                      |   |                   |   |                     |   |                                                 |   |                          |   |      |   |
|                                                                                                       |   |                                      |   |                   |   |                     |   |                                                 |   |                          |   |      |   |
| Net income                                                                                                 |   |                                      |   |                   |   | 23,429                   |   |                                                 |   |                          |   | 23,429    |   |
|                                                                                                       |   |                                      |   |                   |   |                     |   |                                                 |   |                          |   |      |   |
| Other  comprehensive income -                                                                              |   |                                      |   |                   |   |                     |   |                                                 |   |                          |   |      |   |
|                                                                                                       |   |                                      |   |                   |   |                     |   |                                                 |   |                          |   |      |   |
| Unrealized gain  on securities available for sale, net of taxes of $2,175                                  |   |                                      |   |                   |   |                     |   | 4,040                                                |   |                          |   | 4,040     |   |
|                                                                                                       |   |                                      |   |                   |   |                     |   |                                                 |   |                          |   |      |   |
| Reclassification adjustment for gains included in net income, net of  taxes of $(11)                       |   |                                      |   |                   |   |                     |   | (29                                                  | )      |                          |   | (29       | )      |
| Total comprehensive income*                                                                                |   |                                      |   |                   |   |                     |   |                                                 |   |                          |   | 27,440    |   |
| September 30, 2002                                                                                         |   | 14,977,547                                |   | $                      | 7,054  |                     | $      | 189,963                                              |   | $                             | 5,316  |      | $      | 0 |   | $ | 202,333 |   |

 

----

| * | Comprehensive income for the  three months ended September 30, 2002 and 2001 was $9,145 and $14,335,  respectively. |
|---|---------------------------------------------------------------------------------------------------------------------|

 

See accompanying notes to consolidatedfinancial statements.

 

3

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CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

** **
|                                                                                                |   | **Nine-month periods ended September 30,** |       |
|-----------------------------------------------------------------------------------------------------|--------|--------------------------------------------|------------|
| ***Dollars in thousands***                                                                          |   | **2002**                                   | ** ** | **2001** | ** ** |
|                                                                                                |   |                                       | ** ** |   | ** ** |
| *Operating  Activities*                                                                             |   |                                       |       |   |   |
|                                                                                                |   |                                       |       |   |   |
| Net income                                                                                          |   | $                                          | 23,429     |   | $ | 15,104 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities:                  |   |                                       |       |   |   |
| Depreciation                                                                                        |   | 3,935                                      |       | 4,763 |   |
| Amortization of  intangible assets                                                                  |   | 718                                        |       | 1,908 |   |
| Provision for  losses on loans                                                                      |   | 5,100                                      |       | 4,350 |   |
| Amortization  (accretion) of premiums and discounts, net                                            |   | 1,837                                      |       | (214 | ) |
| Gain on sale of  mortgage banking assets                                                            |   | (1,907                                     | )          | (1,556 | ) |
| Gain on sale of  securities available for sale                                                      |   | (40                                        | )          | (1,658 | ) |
| (Gain) loss on  sale of other real estate                                                           |   | 52                                         |       | (523 | ) |
| Write-downs on  other real estate                                                                   |   | 388                                        |       | 542 |   |
| Loss on  disposal of premises and equipment                                                         |   | 85                                         |       | — |   |
| Income from  bank owned life insurance                                                              |   | (1,039                                     | )          | — |   |
| Loan fees  deferred, net of amortization                                                            |   | 564                                        |       | 1,752 |   |
| FHLB stock  dividends                                                                               |   | (2,099                                     | )          | (2,220 | ) |
| Changes in  operating assets and liabilities:                                                       |   |                                       |       |   |   |
| Decrease in  interest receivable                                                                    |   | 1,121                                      |       | 2,879 |   |
| Increase in  other assets                                                                           |   | (5,673                                     | )          | (16,215 | ) |
| Increase  (decrease) in other liabilities                                                           |   | 959                                        |       | (6,444 | ) |
|                                                                                                |   |                                       |       |   |   |
| Net cash  provided by operating activities                                                          |   | $                                          | 27,430     |   | $ | 2,468 |   |
|                                                                                                |   |                                       | ** ** |   | ** ** |
| *Investing  Activities*                                                                             |   |                                       | ** ** |   | ** ** |
|                                                                                                |   |                                       |       |   |   |
| Purchases of securities  available for sale                                                         |   | (337,540                                   | )          | (282,995 | ) |
| Proceeds from  maturing and principal repayments on securities available for sale                   |   | 303,729                                    |       | 356,556 |   |
| Proceeds from  sale of securities available for sale                                                |   | 2,040                                      |       | 67,350 |   |
| Proceeds from  sale of mortgage banking assets                                                      |   | 134,429                                    |       | 104,256 |   |
| Net increase in loans  receivable                                                                   |   | (128,489                                   | )          | (167,958 | ) |
| Proceeds from  sale of other real estate                                                            |   | 5,484                                      |       | 8,527 |   |
| Improvements capitalized to  other real estate                                                      |   | (575                                       | )          | (1,136 | ) |
| Purchases of premises and  equipment                                                                |   | (1,997                                     | )          | (4,442 | ) |
| Proceeds from sales of  premises and equipment                                                      |   | 62                                         |       | 5,200 |   |
| Purchase of bank owned life  insurance                                                              |   | (50,000                                    | )          | — |   |
| Net increase in federal funds sold and  securities purchased under agreements to resell             |   | (5,150                                     | )          | 2,367 |   |
|                                                                                                |   |                                       |       |   |   |
| Net cash provided  by (used in) investing activities                                                |   | $                                          | (78,007    | ) | $ | 87,725 |   |
|                                                                                                |   |                                       |       |   |   |
| *Financing  Activities*                                                                             |   |                                       |       |   |   |
|                                                                                                |   |                                       |       |   |   |
| Net increase in  deposits                                                                           |   | $                                          | 160,265    |   | $ | 28,260 |   |
| Net increase (decrease) in  certificates of deposit                                                 |   | 55,162                                     |       | (62,172 | ) |
| Proceeds from  FHLB advances, securities sold under agreements to repurchase, and other  borrowings |   | 3,709,578                                  |       | 2,241,045 |   |
| Repayment of FHLB advances,  securities sold under agreements to repurchase and other borrowings    |   | (3,855,749                                 | )          | (2,309,916 | ) |
| Purchase of Interwest Capital  Trust I – capital securities                                    |   | (1,500                                     | )          | (1,500 | ) |
| Issuance of Pacific Northwest  Statutory Trust I - capital securities                               |   | 12,000                                     |       | — |   |
| Dividends paid to shareholders                                                                      |   | (6,533                                     | )          | (6,525 | ) |
| Purchase and retirement of  common stock                                                            |   | (21,695                                    | )          | — |   |
| Issuance of  common stock from exercise of stock options                                            |   | 1,992                                      |       | 722 |   |
|                                                                                                |   |                                       | ** ** |   | ** ** |
| Net cash  provided by (used in) financing activities                                                |   | 53,520                                     |       | (110,086 | ) |
|                                                                                                |   |                                       |       |   |   |
| Net increase (decrease) in  cash and due from banks                                                 |   | 2,943                                      |       | (19,893 | ) |
|                                                                                                |   |                                       | ** ** |   | ** ** |
| *Cash and due from  banks*                                                                          |   |                                       |       |   |   |
| Beginning of  period                                                                                |   | 58,625                                     |       | 78,861 |   |
|                                                                                                |   |                                       |       |   |   |
| End of period                                                                                       |   | $                                          | 61,568     |   | $ | 58,968 |   |
|                                                                                                |   |                                       |       |   |   |
| *Supplemental  Disclosures of Cash Flow Information*                                                |   |                                       | * *   |   | * * |
|                                                                                                |   |                                       |       |   |   |
| Cash paid  during the period for:                                                                   |   |                                       |       |   |   |
| Interest                                                                                            |   | $                                          | 55,980     |   | $ | 88,020 |   |
| Income taxes                                                                                        |   | 14,500                                     |       | 7,800 |   |
| Non-cash  investing and financing activities:                                                       |   |                                       |       |   |   |
| Loans  receivable transferred to other real estate                                                  |   | 7,065                                      |       | 4,440 |   |
| Premises and  equipment transferred to other real estate                                            |   | —                                     |       | 923 |   |
| Transfer of  securities from held to maturity  To available for sale                                |   | —                                     |       | 64,741 |   |
| ESOP debt  repayment                                                                                |   | 543                                        |       | 854 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

4

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NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

 

**NOTEA** BASIS OF PRESENTATION

 

Pacific Northwest Bancorp is a bank holdingcompany incorporated in the State of Washington.  Through its commercial bank subsidiary, Pacific Northwest Bank, awide range of financial services is offered to businesses and individualsthroughout western and central Washington State.  Financial services of Pacific Northwest Bank include the bankingactivities of accepting deposits from businesses and individuals andoriginating commercial and commercial real estate loans, residential loans andconsumer loans.

 

The unaudited consolidated financialstatements include the accounts of Pacific Northwest Bancorp and its whollyowned subsidiaries (collectively PNWB). As of September 30, 2002, Pacific Northwest Bancorp’s wholly ownedsubsidiaries were Pacific Northwest Bank and InterWest Capital Trust I andPacific Northwest Statutory Trust I. All material inter-company transactions and balances have beeneliminated in consolidation.

 

The preparation of the consolidated financialstatements in conformity with accounting principles generally accepted in theUnited States requires management to make estimates and assumptions that affectamounts reported in the consolidated financial statements.  Changes in these estimates and assumptionsare considered reasonably possible and may have a material impact on theconsolidated financial statements and thus actual results could differ from theamounts reported and disclosed herein.

 

The unaudited consolidated financialstatements have been prepared in accordance with accounting principlesgenerally accepted in the United States for interim financial information andwith the instructions to Form 10-Q and Rule 10-01 of Regulation S-X.  Accordingly, they do not include all of theinformation and footnotes required by accounting principles generally acceptedin the United States for complete financial statements.  In the opinion of management, alladjustments necessary for a fair presentation are reflected in the unauditedinterim consolidated financial statements. The consolidated statements of income for the three- and nine-monthperiods ended September 30, 2002 and 2001 are not necessarily indicative of theoperating results for the full year. For further information, refer to the consolidated financial statementsand footnotes filed on the Form 10-K for the most recent annual period endedDecember 31, 2001.

 

**NOTEB**  RECLASSIFICATIONS

 

Certain reclassifications have been made toprior financial statements to conform to current presentation.  The effects of the reclassifications are notconsidered material.

 

**NOTE****C** NET INCOME PER SHARE

 

Basic net income per share is calculated by dividing net income by theweighted average number of common shares outstanding during the period.  Diluted net income per share is calculatedby dividing net income by diluted weighted average shares outstanding, whichincludes common stock equivalent shares outstanding using the treasury stockmethod, unless such shares are anti-dilutive. Common stock equivalents include shares issuable upon exercise of stockoptions.  Unallocated shares relating tothe employee stock ownership plan debt obligation are deducted in thecalculation of weighted average shares outstanding.

 

5

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The following table presents the computation of basic and diluted netincome per share for the three- and nine-month periods ended September 30:

 
|                                                                                                                      |   | **Three  months** |       | **Nine  months** |       |
|---------------------------------------------------------------------------------------------------------------------------|--------|-------------------|------------|------------------|------------|
| ***Dollars in thousands, except share and per share amounts***                                                            |   | **2002**          | ** ** | **2001**         | ** ** | **2002** | ** ** | **2001** | ** ** |
|                                                                                                                      |   |              | ** ** |             | ** ** |   | ** ** |   | ** ** |
| **Numerator:**                                                                                                            |   |              | ** ** |             | ** ** |   | ** ** |   | ** ** |
|                                                                                                                      |   |              | ** ** |             | ** ** |   | ** ** |   | ** ** |
| Net income                                                                                                                |   | $                 | 7,953      |             | $          | 6,107 |   | $ | 23,429 |   | $ | 15,104 |   |
|                                                                                                                      |   |              | ** ** |             | ** ** |   | ** ** |   | ** ** |
| **Denominator:**                                                                                                          |   |              | ** ** |             | ** ** |   | ** ** |   | ** ** |
|                                                                                                                      |   |              | ** ** |             | ** ** |   | ** ** |   | ** ** |
| Denominator for  basic net income per share -  Weighted average shares                                                    |   | 15,104,147        |       | 15,583,115       |       | 15,329,286 |   | 15,543,215 |   |
| Effect of  dilutive securities:                                                                                           |   |              |       |             |       |   |   |   |   |
| Stock options                                                                                                             |   | 448,939           |       | 167,660          |       | 416,844 |   | 154,077 |   |
| Denominator for  diluted net income per share -  Weighted average shares and assumed conversion of dilutive stock options |   | 15,553,086        |       | 15,750,775       |       | 15,746,130 |   | 15,697,292 |   |
|                                                                                                                      |   |              |       |             |       |   |   |   |   |
| Basic net  income per share                                                                                               |   | $                 | 0.53       |             | $          | 0.39 |   | $ | 1.53 |   | $ | 0.97 |   |
|                                                                                                                      |   |              |       |             |       |   |   |   |   |
| Diluted net income per share                                                                                              |   | $                 | 0.51       |             | $          | 0.39 |   | $ | 1.49 |   | $ | 0.96 |   |

 

**NOTE D**CONVERSION AND INTEGRATION EXPENSES

 

During theyear ended December 31, 2000, PNWB initiated the process of converting itsvarious subsidiary bank operating systems to a single enhanced operatingsystem.  The conversion was completed onApril 9, 2001.  Conversion andintegration expenses were expensed as incurred.  Total expenses associated with conversion and integration effortswere $0 and $1.3 million during the three- and nine-month periods endedSeptember 30, 2001, respectively.   Noconversion and integration expenses were incurred in 2002.

 

**NOTE E**BUSINESS SEGMENT INFORMATION

 

Between the period August 31,1996 and October 1999, PNWB acquired six commercial banking institutions.Subsequent to the acquisitions of Pacific Northwest Bank, First National Bankof Port Orchard, Pioneer Bank and Kittitas Valley Bank in 1998, PNWB wasmanaged at the individual subsidiary bank level.  Each subsidiary bank had a Board of Directors and an executivemanagement team that was responsible for the operation and performance of the respectivesubsidiary bank.

 

During theyear ended December 31, 2000, PNWB merged the subsidiary banks into onecommercial bank.  In addition, PNWBconsolidated its executive management functions and implemented a neworganizational structure, while converting separate banking systems into a singleoperating system.  As a result of theseorganizational and system changes, the financial information that is used bythe chief operating decision maker in allocating resources and assessingperformance is only provided for one reportable segment for the three- andnine-month periods ended September 30, 2002 and 2001.

 

**NOTE F** SECURITIESPLEDGED UNDER AGREEMENTS TO REPURCHASE

 

PNWB has sold certainsecurities of the U.S. government and its agencies and other approvedinvestments under agreements to repurchase. The securities sold were classified as securities available for salewith an estimated fair value of $91.3 million and $147.9 million as ofSeptember 30, 2002 and December 31, 2001, respectively.

 

6

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**NOTE G** ACCOUNTINGCHANGES

 

In July 2002, the FASB issued SFAS No. 146“Accounting for Costs Associated with Exit or Disposal Activities”.  SFAS No. 146 addresses financial accountingand reporting for costs associated with exit or disposal activities and nullifiesEITF Issue No. 94-3 “Liability Recognition for Certain Employee TerminationBenefits and Other Costs to Exit an Activity (including Certain Costs Incurredin a Restructuring)”.  SFAS No. 146requires that a liability for a cost associated with an exit or disposalactivity be recognized when the liability is incurred as opposed to when a planis developed as required by EITF Issue No. 94-3.  SFAS No. 146 will become effective on January 1, 2003.  Management does not expect the adoption ofSFAS No. 146 to have a material impact on PNWB’s financial condition or resultsof operations.

 

In April 2002, the FASB issued SFAS No. 145“Rescission of FASB Statements No. 4, 44, and 62, Amendment of FASB StatementNo. 13, and Technical Corrections”. SFAS No. 145 rescinds the classification of extinguishment of debt asextraordinary as previously required under SFAS No. 4 and establishes newcriteria for the classification of gains and losses on extinguishment ofdebt.  SFAS No. 145 also amends SFAS No.13 to require certain modifications to capital leases be treated as asale-leaseback and modifies the accounting for sub-leases when the originallessee remains a secondary obligor. SFAS No. 145 becomes effective on January1, 2003 with the exception of the amendment and technical corrections relatedto SFAS No. 13, which were effective on May 15, 2002.  Management does not expect the adoption of SFAS No. 145 to have amaterial impact on PNWB’s financial condition or results of operations.

 

In October 2001, the FASB issued SFAS No. 144“Accounting for the Impairment or Disposal of Long-Lived Assets”. SFAS No. 144supersedes SFAS No. 121, “Accounting for the Impairment of Long-Lived Assetsand for Long-Lived Assets to Be Disposed Of”. This statement, which excludes goodwill, provides a single accountingmodel for recognition and impairment of long-lived assets to be held for saleor disposed of.  SFAS No. 144 retainsmany of the fundamental recognition and measurement provisions of SFAS No. 121;however, it significantly changes the criteria that would have to be met toclassify an asset as either held-for-sale or to be disposed of. SFAS No. 144became effective on January 1, 2002. The adoption of this statement did not have a material impact on PNWB’sfinancial condition or results of operations.

 

In July 2001, the FASB issuedSFAS No. 142 “Accounting for Goodwill and Other Intangible Assets”.  Under SFAS No. 142, goodwill and indefinitelived intangible assets are no longer amortized but are reviewed annually forimpairment or more frequently if impairment indicators arise.  Separable intangible assets that are notdeemed to have an indefinite life will continue to be amortized over theiruseful lives.  This Statement becameeffective on January 1, 2002.  PNWBperformed the transitional impairment assessment of its goodwill as of January1, 2002 and noted that such assessment did not indicate any impairment ofgoodwill.  The adoption of SFAS No. 142is expected to reduce PNWB’s goodwill amortization expense by approximately$1.1 million on an annual basis.  Areconciliation of reported net income to net income adjusted to excludegoodwill amortization for the three- and nine- month periods ended September30, 2002 and 2001 is as follows:

 

7

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|                                                |   | **Three-month  periods** |       | **Nine-month  periods** |       |
|-----------------------------------------------------|--------|--------------------------|------------|-------------------------|------------|
| ***Dollars in thousands, except per share amount*** |   | **2002**                 | ** ** | **2001**                | ** ** | **2002** | ** ** | **2001** | ** ** |
|                                                |   |                     | ** ** |                    | ** ** |   | ** ** |   | ** ** |
| Income  statement:                                  |   |                     |       |                    |       |   |   |   |   |
| Reported net  income                                |   | $                        | 7,953      |                    | $          | 6,107 |   | $ | 23,429 |   | $ | 15,104 |   |
| Adjustment for  goodwill amortization               |   | —                   |       | 280                     |       | — |   | 840 |   |
| Adjusted net  income                                |   | $                        | 7,953      |                    | $          | 6,387 |   | $ | 23,429 |   | 15,944 |   |
|                                                |   |                     |       |                    |       |   |   |   |   |
| Basic net  income per share:                        |   |                     |       |                    |       |   |   |   |   |
| Reported basic  net income per share                |   | $                        | 0.53       |                    | $          | 0.39 |   | $ | 1.53 |   | 0.97 |   |
| Adjustment for  goodwill amortization               |   | —                   |       | 0.02                    |       | — |   | 0.06 |   |
| Adjusted basic  net income per share                |   | $                        | 0.53       |                    | $          | 0.41 |   | $ | 1.53 |   | 1.03 |   |
|                                                |   |                     |       |                    |       |   |   |   |   |
| Diluted net income per share:                       |   |                     |       |                    |       |   |   |   |   |
| Reported diluted net income  per share              |   | $                        | 0.51       |                    | $          | 0.39 |   | $ | 1.49 |   | $ | 0.96 |   |
| Adjustment for  goodwill amortization               |   | —                   |       | 0.02                    |       | — |   | 0.06 |   |
| Adjusted diluted net income  per share              |   | $                        | 0.51       |                    | $          | 0.41 |   | $ | 1.49 |   | $ | 1.02 |   |

## ** **

## **NOTEH**  SUBSEQUENT EVENT

## ** **

On July 22, 2002, PNWB enteredinto a definitive agreement to acquire Bank of the Northwest of Portland,Oregon.   On October 29, 2002, PNWBreceived all required regulatory approvals and approval by Bank of theNorthwest shareholders for the acquisition. The acquisition is schedule to close on November 13, 2002 subject tocontingencies set forth in the merger agreement.  PNWB will issue approximately 1.75 million shares of common stockand pay $25.8 million of cash in a transaction in which Bank of the Northwestshareholders will have an opportunity to choose between common stock and cashconsideration.  The transaction isvalued at approximately $85.0 million based on PNWB’s stock price on July 22,2002, and the allocation of the purchase price will be approximately 65 percentcommon stock and 35 percent cash.  Thefinal merger consideration will be determined based on the average of theclosing prices for PNWB common stock during the ten consecutive trading daysending November 8, 2002 assuming a November 13, 2002 closing.  As of September 30, 2002, Bank of theNorthwest had total assets of $385.4 million and stockholders’ equity of $29.5million.  Bank of the Northwest operatesfive branch offices in the metropolitan Portland, Oregon market area.

## ** **

## **On November 1, 2002, PNWBannounced that it would outsource its residential mortgage lending operationsand discontinue its internal mortgage loan operations effective January 1,2003.  As a result, PNWB estimates thatit will recognize a one-time charge of approximately $1.2 million during thefourth quarter of 2002.  The charge willinclude costs related to severance, outplacement services, fixed-assetwrite-offs and miscellaneous other items.**

 

8

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**Item 2****.****           MANAGEMENT DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OFOPERATIONS**

 

The following discussion is provided for the unaudited consolidatedfinancial condition and results of operations of Pacific Northwest Bancorp,which includes its wholly owned subsidiaries (collectively PNWB).  As of September 30, 2002, Pacific NorthwestBancorp’s wholly owned subsidiaries were Pacific Northwest Bank, InterWestCapital Trust I and Pacific Northwest Statutory Trust I.  The purpose of this discussion is to focuson significant factors concerning PNWB’s financial condition and results ofoperations.  This discussion should beread along with the unaudited consolidated financial statements for anunderstanding of the following discussion and analysis. Certainreclassifications have been made to prior period balances to conform to currentpresentation.  The effects of suchreclassifications are not considered material.

 

Headquartered in Seattle, WA,Pacific Northwest Bancorp is a bank holding company incorporated in the Stateof Washington.  PNWB is a financialservices company providing a variety of products and services for both businessand individual customers.  Financialservices of PNWB include the banking activities of accepting deposits frombusinesses and individuals and originating commercial and commercial realestate loans, residential loans, and consumer loans.  As part of the migration to a commercial bank, PNWB has madesignificant progress in restructuring its balance sheet since mid-2000 so thatit is more reflective of a commercial bank.

 

On July 22, 2002, PNWB enteredinto a definitive agreement to acquire Bank of the Northwest headquartered inPortland, Oregon.   On October 29, 2002,PNWB received all required regulatory approvals and approval by Bank of theNorthwest shareholders for the acquisition. The acquisition is scheduled to close on November 13, 2002 subject tocontingencies set forth in the definitive agreement.  PNWB will issue approximately 1.75 million shares of common stockand pay $25.8 million of cash as consideration for its acquistion of Bank ofthe Northwest.  Bank of the Northwestshareholders will have an opportunity to choose between common stock and/orcash consideration.  The transaction isvalued at approximately $85.0 million based on PNWB’s stock price on July 22,2002, and the allocation of the purchase price will be approximately 65 percentcommon stock and 35 percent cash.  Thefinal merger consideration will be determined based on the average of theclosing prices for PNWB common stock during the ten consecutive trading days endingNovember 8, 2002 assuming a November 13, 2002 closing.  As of September 30, 2002, Bank of theNorthwest had total assets of $385.4 million and stockholders’ equity of $29.5million.  Bank of the Northwest operatesfive branch offices in the metropolitan Portland, Oregon market area.  This acquisition provides PNWB an entry intoPortland, Oregon and is consistent with management’s strategy to expand alongthe I-5 corridor.  This acquisition willbe accounted for using the purchase method of accounting in accordance withaccounting principles generally accepted in the United States.

 

A source of future growth maybe through mergers and acquisitions. PNWB’s management believes that many other financial institutions areconsidering selling their institutions for a variety of reasons, including lackof shareholder liquidity, management succession issues, technology challenges,and increasing competition. PNWB actively reviews proposals for variousacquisition opportunities.  PNWB has adue diligence review process to evaluate potential acquisitions and hasestablished parameters for potential acquisitions relating to market factors,financial performance and certain non-financial factors.  Successful completion of acquisitions byPNWB depends on several factors such as the availability of suitableacquisition candidates, necessary regulatory and shareholder approval andcompliance with applicable capital requirements.  No assurance can be made that acquisition activity will continuein the future.

 

Upon the completion of the Bankof the Northwest acquisition, Pacific Northwest Bank will operate 59 FinancialCenters in western and central Washington, and the metropolitan area ofPortland, Oregon. Investments are available through Pacific Northwest FinancialServices and insurance products are available through Pacific NorthwestInsurance Agency, both wholly owned subsidiaries of Pacific Northwest Bank.

 

9

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RESULTS OF OPERATIONS

 

PNWB had net income of $8.0 million for the three-month period endedSeptember 30, 2002, compared to $6.1 million for the three-month period endedSeptember 30, 2001.  Diluted net incomeper share was $0.51 for the three-month period ended September 30, 2002,compared to $0.39 for the three-month period ended September 30, 2001. PNWB’sreturn on average shareholders’ equity was 15.81 percent for the three-monthperiod ended September 30, 2002, compared to 12.83 percent for the three-monthperiod ended September 30, 2001.  PNWB’sreturn on average assets was 1.13 percent for the three-month period endedSeptember 30, 2002, compared to 0.88 percent for the three-month period endedSeptember 30, 2001.

 

PNWB had net income of $23.4 million for the nine-month period endedSeptember 30, 2002 compared to $15.1 million for the nine-month period endedSeptember 30, 2001.  Diluted net incomeper share was $1.49 for the nine-month period ended September 30, 2002,compared to $0.96 for the nine-month period ended September 30, 2001.  PNWB’s return on average shareholders’equity was 15.50 percent for the nine-month period ended September 30, 2002,compared to 10.81 percent for the nine-month period ended September 30, 2001.PNWB’s return on average assets was 1.12 percent for the nine-month periodended September 30, 2002, compared to 0.71 percent for the nine-month periodended September 30, 2001.

 

The following table summarizes net income, net income per share and keyfinancial ratios for the three- and nine-month periods ended September 30:

 
|                                                 |   | **Three months** |       | **Nine months** |       |
|------------------------------------------------------|--------|------------------|------------|-----------------|------------|
| ***Dollars in thousands, except per share amounts*** |   | **2002**         | ** ** | **2001**        | ** ** | **2002** | ** ** | **2001** | ** ** |
|                                                 |   |             | ** ** |            | ** ** |   | ** ** |   | ** ** |
| Net income                                           |   | $                | 7,953      |            | $          | 6,107 |   | $ | 23,429 |   | $ | 15,104 |   |
|                                                 |   |             | ** ** |            | ** ** |   | ** ** |   | ** ** |
| Basic net  income per share                          |   | $                | 0.53       |            | $          | 0.39 |   | $ | 1.53 |   | $ | 0.97 |   |
|                                                 |   |             |       |            |       |   |   |   |   |
| Diluted net  income per share                        |   | $                | 0.51       |            | $          | 0.39 |   | $ | 1.49 |   | $ | 0.96 |   |
|                                                 |   |             |       |            |       |   |   |   |   |
| Return on  average shareholders’ equity         |   | 15.81            | %          | 12.83           | %          | 15.50 | % | 10.81 | % |
|                                                 |   |             |       |            |       |   |   |   |   |
| Return on  average assets                            |   | 1.13             | %          | 0.88            | %          | 1.12 | % | 0.71 | % |
|                                                 |   |             |       |            |       |   |   |   |   |
| Net interest  margin                                 |   | 4.10             | %          | 4.04            | %          | 4.16 | % | 3.67 | % |
|                                                 |   |             | ** ** |            | ** ** |   | ** ** |   | ** ** |
| Efficiency  ratio                                    |   | 57.31            | %          | 64.37           | %          | 57.77 | % | 67.86 | % |

 

*NetInterest Income* |PNWB’s net income is significantly affected by changes in net interest income,which is the interest income received on loans receivable and otherinterest-earning assets less the interest expense on deposits andborrowings.  Net interest income was$26.9 million for the three-month period ended September 30, 2002, compared to$26.6 million for the three-month period ended September 30, 2001.  Net interest income was $81.3 million and$72.7 million for the nine-month periods ended September 30, 2002 and 2001,respectively.  PNWB’s net interestincome is sensitive to changes in interest rates.  The decreases in market interest rates throughout 2001 had apositive impact on PNWB’s net interest income due to PNWB’s liability sensitiveposition at that time. When interest rates decreased, PNWB experienced agreater reduction in funding costs in comparison to reduction in earnings onloans and investments.  During the firstquarter of 2002, PNWB completed initiatives related to the interest rate riskposition of the company. As of September 30, 2002, PNWB was in a slightlyasset sensitive position. As such, management does not expect net interestincome to improve in 2002 as a result of decreases in market interest rates.

 

Interestincome was $44.2 million for the three-month period ended September 30, 2002,compared to $50.7 million for the three-month period ended September 30, 2001.Interest income was $134.1 million for the nine-month period ended September30, 2002, compared to $157.5 million for the nine-month period ended September30, 2001.  The decreases for the three-and nine-month periods ended September 30, 2002 were due to the balances andlower yields earned on both loans receivable and investment securities as aresult of lower market

 

10

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interestrates.  The yields on interest-earningassets were 6.73 percent and 6.86 percent for the three- and nine-month periodsended September 30, 2002, compared to 7.69 percent and 7.95 percent for thesame periods in 2001.  However, thedecreases in interest income were partially offset by increases in the averagebalance of loans receivable and changes in the composition of average loansreceivable with a greater percentage comprised of commercial and commercialreal estate loans compared to single-family residential mortgage loans.

 

Interest expense was $17.3 million for thethree-month period ended September 30, 2002, compared to $24.0 million for thethree-month period ended September 30, 2001. The decrease in interest expense for the three-month period endedSeptember 30, 2002 was primarily due to a decrease in the cost of funds as aresult of reductions of market interest rates and management’s restructuring ofthe funding base.  The cost of funds was2.92 percent for the three-month period ended September 30, 2002, compared to4.07 percent for the same period in 2001. During the past year, certificates of deposit repriced according tomaturity schedules and borrowings matured and were replaced with borrowingswith relatively lower interest rates. In addition, cost of funds decreased due to management’s restructuringof the funding base with a greater percentage comprised of lower-costingdeposits.

 

Interest expense was $52.8 million for thenine-month period ended September 30, 2002, compared to $84.7 million for thenine-month period ended September 30, 2001. This decrease was primarily due to decreases in both the cost of fundsand the average balances of interest-bearing liabilities.  The cost of funds for the nine-month periodended September 30, 2002 was 3.03 percent, compared to 4.76 percent for thesame period in 2001 primarily due to lower market interest rates.  Average balances of interest-bearingliabilities for the first nine months of 2002 decreased $46.6 million comparedto the same period in 2001.

 

Net interest margin, which is net interestincome divided by average interest-earning assets, was 4.10 percent for thethree-month period ended September 30, 2002, compared to 4.04 percent for thethree-month period ended September 30, 2001. Net interest margin was 4.16 percent for the nine-month period endedSeptember 30, 2002, compared to 3.67 percent for the same period in 2001.  The increases in net interest margin for thethree- and nine-month periods ended September 30, 2002 were due to changes inthe mix of earning assets and decreases in cost of funds which resulted from reductionsin market interest rates and the restructuring of the funding base.  The increases in net interest margin werepartially offset by implementation of the bank owned life insurance (BOLI)initiative in early April 2002.  Thefunding of BOLI contracts increased average interest-bearing liabilities andinterest expense, while the income from BOLI, representing a tax-exemptincrease in cash surrender value of these contracts, was classified within“non-interest income”.

 

11

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*Average Rates and Balances*| The following table indicates the average balance and average interest ratesearned or paid, interest rate spread and net interest margin for thethree-month periods ended September 30:

** **
|                                                                                           |   | **2002**             |       | **2001** |       |
|------------------------------------------------------------------------------------------------|--------|----------------------|------------|----------|------------|
| ***Dollars in thousands***                                                                     |   | **Average  Balance** | ** ** | **Rate** | ** ** | **Average  Balance** | ** ** | **Rate** | ** ** |
|                                                                                           |   |                 | ** ** |     | ** ** |   | ** ** |   | ** ** |
| Loans  receivable and loans held for sale                                                      |   | $                    | 1,833,291  |     | 7.41       | % | $ | 1,822,369 |   | 8.38 | % |
| Securities  available for sale, securities held to maturity and other interest-earning  assets |   | 784,108              |       | 5.14     | %          | 803,699 |   | 6.13 | % |
| Total  interest-earning assets                                                                 |   | 2,617,399            |       | 6.73     | %          | 2,626,068 |   | 7.69 | % |
|                                                                                           |   |                 |       |     |       |   |   |   |   |
| Interest-bearing  deposits                                                                     |   | 1,581,163            |       | 2.35     | %          | 1,455,181 |   | 3.72 | % |
| FHLB advances,  securities sold under agreements to repurchase and other borrowings            |   | 765,508              |       | 4.08     | %          | 888,959 |   | 4.64 | % |
|                                                                                           |   |                 |       |     |       |   |   |   |   |
| Total  interest-bearing liabilities                                                            |   | 2,346,671            |       | 2.92     | %          | 2,344,140 |   | 4.07 | % |
|                                                                                           |   |                 |       |     |       |   |   |   |   |
| Non-interest-bearing  deposits                                                                 |   | $                    | 236,066    |     |       |   | $ | 226,947 |   |   |   |
|                                                                                           |   |                 |       |     |       |   |   |   |   |
| Net interest  spread                                                                           |   |                 |       | 3.81     | %          |   |   | 3.62 | % |
| Net interest margin                                                                            |   |                 |       | 4.10     | %          |   |   | 4.04 | % |

 

The following table indicates the averagebalance and average interest rates earned or paid, interest rate spread and netinterest margin for the nine-month periods ended September 30:

 
|                                                                                           |   | **2002**             |      | **2001** |   |
|------------------------------------------------------------------------------------------------|--------|----------------------|-----------|----------|--------|
| ***Dollars in thousands***                                                                     |   | **Average  Balance** |      | **Rate** |   | **Average  Balance** |   | **Rate** |   |
|                                                                                           |   |                 |      |     |   |   |   |   |   |
| Loans  receivable and loans held for sale                                                      |   | $                    | 1,842,677 |     | 7.48   | % | $ | 1,808,652 |   | 8.67 | % |
| Securities  available for sale, securities held to maturity and other interest-earning  assets |   | 765,821              |      | 5.39     | %      | 836,749 |   | 6.38 | % |
| Total  interest-earning assets                                                                 |   | 2,608,498            |      | 6.87     | %      | 2,645,401 |   | 7.95 | % |
|                                                                                           |   |                 |      |     |   |   |   |   |   |
| Interest-bearing  deposits                                                                     |   | 1,512,772            |      | 2.47     | %      | 1,482,733 |   | 4.30 | % |
| FHLB advances,  securities sold under agreements to repurchase and other borrowings            |   | 820,511              |      | 4.04     | %      | 897,124 |   | 5.53 | % |
|                                                                                           |   |                 |      |     |   |   |   |   |   |
| Total  interest-bearing liabilities                                                            |   | 2,333,283            |      | 3.03     | %      | 2,379,857 |   | 4.76 | % |
|                                                                                           |   |                 |      |     |   |   |   |   |   |
| Non-interest-bearing  deposits                                                                 |   | $                    | 229,136   |     |   |   | $ | 229,079 |   |   |   |
|                                                                                           |   |                 |      |     |   |   |   |   |   |
| Net interest  spread                                                                           |   |                 |      | 3.84     | %      |   |   | 3.19 | % |
| Net interest  margin                                                                           |   |                 |      | 4.16     | %      |   |   | 3.67 | % |

 

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The following table providesinformation on changes in net interest income for the periods that areattributable to changes in interest rates and changes in volume:

 
|                                                                                           |   | **Three-month periods Sept. 30, 2002 vs. 2001  Increase  (Decrease)  Due to changes in** |       | **Nine-month periods Sept. 30, 2002 vs. 2001  Increase (Decrease)  Due to changes in** |       |
|------------------------------------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------|------------|
| ***Dollars in thousands***                                                                     |   | **Rate**                                                                                      | ** ** | **Volume**                                                                             | ** ** | **Total** | ** ** | **Rate** | ** ** | **Volume** | ** ** | **Total** | ** ** |
|                                                                                           |   |                                                                                          | ** ** |                                                                                   | ** ** |   | ** ** |   | ** ** |   | ** ** |   | ** ** |
| *Interest-earning  assets*                                                                     |   |                                                                                          |       |                                                                                   |       |   |   |   |   |   |   |   |   |
|                                                                                           |   |                                                                                          |       |                                                                                   |       |   |   |   |   |   |   |   |   |
| Loans  receivable and loans held for sale                                                      |   | $                                                                                             | (4,465     | )                                                                                      | $          | 226 |   | $ | (4,239 | ) | $ | (16,461 | ) | $ | 2,176 |   | $ | (14,285 | ) |
|                                                                                           |   |                                                                                          |       |                                                                                   |       |   |   |   |   |   |   |   |   |
| Securities  available for sale, securities held to maturity and other interest-earning  assets |   | (1,935                                                                                        | )          | (294                                                                                   | )          | (2,229 | ) | (5,883 | ) | (3,205 | ) | (9,088 | ) |
|                                                                                           |   |                                                                                          |       |                                                                                   |       |   |   |   |   |   |   |   |   |
| Total net  change in income on interest-earning assets                                         |   | (6,400                                                                                        | )          | (68                                                                                    | )          | (6,468 | ) | (22,344 | ) | (1,029 | ) | (23,373 | ) |
|                                                                                           |   |                                                                                          |       |                                                                                   |       |   |   |   |   |   |   |   |   |
| *Interest-bearing  liabilities*                                                                |   |                                                                                          |       |                                                                                   |       |   |   |   |   |   |   |   |   |
|                                                                                           |   |                                                                                          |       |                                                                                   |       |   |   |   |   |   |   |   |   |
| Interest-bearing  deposits                                                                     |   | 5,370                                                                                         |       | (1,099                                                                                 | )          | 4,271 |   | 20,612 |   | (947 | ) | 19,665 |   |
|                                                                                           |   |                                                                                          |       |                                                                                   |       |   |   |   |   |   |   |   |   |
| FHLB advances,  securities sold under agreement to repurchase and other borrowings             |   | 1,163                                                                                         |       | 1,350                                                                                  |       | 2,513 |   | 9,324 |   | 2,961 |   | 12,285 |   |
|                                                                                           |   |                                                                                          |       |                                                                                   |       |   |   |   |   |   |   |   |   |
| Total net  change in expense on interest-bearing liabilities                                   |   | 6,533                                                                                         |       | 251                                                                                    |       | 6,784 |   | 29,936 |   | 2,014 |   | 31,950 |   |
|                                                                                           |   |                                                                                          |       |                                                                                   |       |   |   |   |   |   |   |   |   |
| Net change in  net interest income                                                             |   | $                                                                                             | 133        |                                                                                   | $          | 183 |   | $ | 316 |   | $ | 7,592 |   | $ | 985 |   | $ | 8,577 |   |

 

*Provisionfor losses on loans |*The provision for losses on loans was $1.7 million for the three-month periodended September 30, 2002, compared to $1.6 million for the three-month periodended September 30, 2001.  The provisionfor losses on loans was $5.1 million for the nine-month period ended September30, 2002, compared to $4.4 million for the same period in 2001.  The provision was at a higher level for thethree- and nine-month periods ended September 30, 2002 compared to the same periodsin the prior year in part due to management’s evaluation about the currentPacific Northwest regional economy and its resulting impact on the loanportfolio, the change in the loan mix, and management’s review of the loanportfolio.  Management continues toassess the level of the provision for loan losses based on the known andinherent risk characteristics in the loan portfolio.  These risk characteristics include changes in the size andcomposition of the loan portfolio, delinquency levels, actual loan lossexperience, detailed analysis of individual loans for which full collectibilitymay not be assured, and current economic conditions in PNWB’s market area.  

 

*Non-interest Income* | Non-interest income was $5.2 million for thethree-month period ended September 30, 2002, compared to $5.1 million for thethree-month period ended September 30, 2001. This increase was primarily due to income from bank owned life insurance(BOLI) during the third quarter of 2002, higher service fees, partially offset bythe lower gains on securities available for sale.  Non-interest income was $15.1 million for the nine-month periodended September 30, 2002, compared to $15.9 million for the same period endedSeptember 30, 2001.  This

 

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decrease was primarily due tolower gain on sale of securities available for sale, a one-time gain on sale ofthe equity interest in a partnership during the first quarter of 2001,partially offset by higher service fees, higher mortgage banking revenue andBOLI income.  The gains on securitiesavailable for sale during the three- and nine-month period ended September 30,2001 were primarily from the sale of mortgage-backed securities that were securitizedfrom PNWB’s single-family mortgage loan portfolio in prior periods.

 

During the second quarter 2002, PNWBimplemented the financial strategy to purchase $50.0 million of BOLI on certainkey employees. PNWB is the beneficiary of these BOLI contracts and the proceedsfrom the death benefit payments will be used to offset the cost of employeebenefits.  The $540,000 and $1.0 millionof income from BOLI represented tax-exempt increases in the cash surrendervalue of BOLI contracts for the three- and nine-month period ended September30, 2002, respectively.

 

Service fees were $3.3 million for thethree-month period ended September 30, 2002 compared to $2.8 million for thethree-month period ended September 30, 2001. Service fees were $9.8 million for the nine-month period ended September30, 2002 compared to $8.5 million for the nine-month period ended September 30,2001. The increases were primarily due to increases in fees received on depositaccounts and fees from commercial loan commitments.

 

Consistent with management’s expectation,mortgage banking revenue was $452,000 for the three-month period endedSeptember 30, 2002, compared to $584,000 for the three-month period endedSeptember 30, 2001.  Mortgage bankingrevenue was negatively impacted by a decrease in single-family mortgage productionvolume (especially from mortgage refinancing) as a result of the increase inmortgage rates during second quarter and first half of third quarter of2002.  Mortgage banking revenue was $1.9million for the nine-month period ended September 30, 2002 compared to $1.6million for the nine-month period ended September 30, 2001.

 

*Non-interest Expense* | Non-interest expense was $18.4 million for thethree-month period ended September 30, 2002, compared to $20.1 million for thethree-month period ended September 30, 2001 (excluding $280,000 of goodwillamortization expense).  Non-interestexpense was $55.7 million for the nine-month period ended September 30, 2002,compared to $57.8 million for the nine-month period ended September 30, 2001(excluding $1.5 million conversion and severance expenses and $840,000 goodwillamortization expense).

 

Generaland administrative expenses were $4.2 million for the three-month period endedSeptember 30, 2002, compared to $5.5 million for the three-month period endedSeptember 30, 2001 (excluding $280,000 of goodwill amortization expense).  General and administrative expenses were$12.7 million for the nine-month period ended September 30, 2002, compared to$15.3 million for the nine-month period ended September 30, 2001 (excluding$840,000 goodwill amortization expense. Apart from the elimination of goodwill amortization expense as a resultof the adoption of SFAS No. 142 “Accounting For Goodwill and Other IntangibleAssets”, the decreases in general and administrative expenses were primarilythe result of operational efficiencies and cost reduction initiativesimplemented by management in 2002.

 

Theefficiency ratio is computed by dividing total operating expenses by netinterest income and non-interest income. An increase in the efficiency ratio indicates that more resources arebeing utililized to generate the same volume of income while a decrease wouldindicate a more efficient allocation of resources.  The efficiency ratio for the three-month period ended September30, 2002 was 57.3 percent, compared to 64.4 percent for the three-month periodended September 30, 2001.  Theefficiency ratio for the nine-month period ended September 30, 2002 was 57.8percent, compared to 67.9 percent for the nine-month period ended September 30,2001.  Excluding the conversion andseverance expenses and goodwill amortization expense incurred in 2001, theefficiency ratios were 63.5 percent and 65.2 percent for the three- andnine-month periods ended September 30, 2001, respectively.

 

*Income Tax Expense*| Income tax expense was $4.1 million for thethree-month period ended September 30, 2002, compared to $3.7 million for thethree-month period ended September 30, 2001. Income tax expense was $12.2 million for the nine-month period ended September30, 2002, compared to $9.0 million for the nine-month period ended September30, 2001. The increases in income tax expense from 2001 were primarily due tothe

 

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higher income before taxes.  The effective tax rate was 33.8 percent and34.2 percent for the three- and nine-month periods ended September 30, 2002,compared to 37.4 percent for both the three- and nine-month periods endedSeptember 30, 2001.  The decreases ineffective tax rate from 2001 were primarily due to the elimination of non-taxdeductible goodwill amortization expense arising from the adoption of SFAS No.142 “Accounting For Goodwill and Other Intangible Assets” as well as thetax-exempt BOLI income in 2002.

 

## **REVIEW OF FINANCIAL CONDITION**

 

PNWB’s consolidated assets were$2.83 billion as of September 30, 2002, compared to $2.74 billion as ofDecember 31, 2001.

 

*Securities*| As of September 30, 2002, PNWB had $795.3million of securities available for sale, compared to $757.0 million as ofDecember 31, 2001. The increase was primarily due to investment of theadditional funds from deposit growth.

 

PNWB maintains liquidity inaccordance with an internal liquidity policy. Liquidity levels may be increased or decreased depending upon the yieldson investment alternatives, management’s judgment as to the attractiveness ofthe yields then available in relation to other opportunities, and management’sexpectation of the yield that will be available in the future.  Management’s projections as to theshort-term demand for funds to be used for loan originations and otheractivities can also affect liquidity levels.

 

Securitiesclassified as available for sale are reported at estimated fair value, withunrealized gains (net of income taxes) reported in accumulated othercomprehensive income, a separate component of shareholders’ equity.

 

*Net Loans Receivable* | Net loans receivable were $1.79 billionas of September 30, 2002, compared to $1.79 billion as of December 31, 2001.

 

Total commercial loans outstanding were $1.17 billion or 64.4 percentof the loan portfolio as of September 30, 2002, compared to $1.06 billion or58.4 percent as of December 31, 2001. This increase in total commercial loansoutstanding was primarily due the growth of commercial real estate loans.  To date, the growth in the commercial loanportfolio was consistent with management’s expectations.   However, due to the current condition ofthe Pacific Northwest regional economy and its slow recovery, commercial loansmay not grow at the same rate for the remainder of 2002.

 

Single-family residential mortgage loans outstanding totaled $248.4million as of September 30, 2002 compared to $321.2 million as of December 31,2001.  The decrease was primarily due toearly payoffs associated with the current interest rate environment and thechange to the mortgage banking model of origination and sale of single-familymortgages.

 

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Thefollowing table sets forth the composition of PNWB’s loan portfolio by type asof the dates indicated:

 
| ***Dollars in thousands***        |   | **September 30, 2002** |       | **December 31, 2001** |       |
|-----------------------------------|--------|------------------------|------------|-----------------------|------------|
|                              |   |                   | ** ** |                  | ** ** |
| Commercial  loans:                |   |                   |       |                  |       |
| Commercial                        |   | $                      | 584,853    |                  | $          | 591,663 |   |
| Commercial real  estate           |   | 589,605                |       | 470,408               |       |
| Total commercial loans:           |   | 1,174,458              |       | 1,062,071             |       |
|                              |   |                   |       |                  |       |
| Single-family  residential        |   | 248,410                |       | 321,246               |       |
| Real estate  construction         |   | 281,945                |       | 319,228               |       |
| Consumer loans                    |   | 120,084                |       | 115,440               |       |
|                              |   | 1,824,897              |       | 1,817,985             |       |
| Less:                             |   |                   |       |                  |       |
| Allowance for  losses on loans    |   | 22,785                 |       | 20,123                |       |
| Deferred loan  fees and discounts |   | 8,851                  |       | 9,430                 |       |
| Net loans  receivable             |   | $                      | 1,793,261  |                  | $          | 1,788,432 |   |

 

*Loans Held for Sale* | Loans held for sale totaled $22.2million as of September 30, 2002 compared to $43.8 million as of December 31,2001.  Loans held for sale are primarilysingle-family mortgage loans and, to a much less extent, loans originated undera Small Business Administration program. Loans held for sale are carried at the lower of cost or estimated fair valuein aggregate.  Loans held for sale aretypically sold to other financial institutions.

 

*Non-performing Assets* | Loans are generally placed on non-accrual whenthey become past due over 90 days, or 120 days if they are single-familymortgage loans, or when the collection of interest or principal is consideredunlikely.  Loans past due over 90 or 120days that are not on non-accrual status must be well secured by tangiblecollateral and in the process of collection. PNWB does not return a loan to accrual status until it is broughtcurrent with respect to both principal and interest and future principalpayments are no longer in doubt.  When aloan is placed on non-accrual status, any previously accrued and uncollectedinterest is reversed from interest income. PNWB performs a review of its loan portfolio for weaknesses in creditquality on an ongoing basis to identify problem loans.  This review results in internal loanclassifications based on risk characteristics and loan performance.  The overall objective of this review processis to identify trends in the credit quality of the loan portfolio and todetermine the level of loss exposure to evaluate the need for an adjustment tothe allowance for losses on loans.

 

Non-accrual loans totaled $10.9million as of September 30, 2002 compared to $16.1 million as of December 31,2001. This decrease was primarily due to decreases in construction loans andsingle family mortgage loans that were over 90 or 120 days past due as ofSeptember 30, 2002, respectively, as a result of payoffs or being brought currentduring 2002.  In addition, non-accrualcommercial loans decreased primarily due to the foreclosure and relatedtransfer to other real estate of a $1.5 million non-accrual commercial loan andthe payoff of a $950,000 commercial loan during the third quarter of 2002.  Other real estate was $7.5 million as ofSeptember 30, 2002 compared to $5.8 million as of December 31, 2001.  The increase was primarily due to theforeclosure of the $1.5 million non-accrual commercial loan previouslydiscussed. Total non-performing assets, including non-accrual loans and otherreal estate, totaled $18.4 million or 0.65 percent of consolidated assets as ofSeptember 30, 2002, compared to $21.9 million or 0.80 percent of consolidatedassets as of December 31, 2001.

 

16

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The following table summarizes non-performingassets as of the dates indicated:

 
| ***Dollars in thousands***   |   | **September 30, 2002** |         | **December 31, 2001** |         |
|------------------------------|--------|------------------------|--------------|-----------------------|--------------|
|                         |   |                   | *** *** |                  | *** *** |
| *Non-accrual loans*          |   |                   |         |                  |         |
|                         |   |                   |         |                  |         |
| Commercial  loans:           |   |                   |         |                  |         |
| Commercial                   |   | $                      | 5,806        |                  | $            | 8,119 |   |
| Commercial real  estate      |   | 1,157                  |         | 1,100                 |         |
| Total commercial loans:      |   | 6,963                  |         | 9,219                 |         |
|                         |   |                   |         |                  |         |
| Single-family  residential   |   | 3,284                  |         | 5,425                 |         |
| Real estate  construction    |   | 323                    |         | 1,199                 |         |
| Consumer loans               |   | 356                    |         | 245                   |         |
|                         |   |                   |         |                  |         |
| Total  non-accrual loans     |   | 10,926                 |         | 16,088                |         |
|                         |   |                   |         |                  |         |
| Other real  estate           |   | 7,478                  |         | 5,762                 |         |
|                         |   |                   |         |                  |         |
| Total  non-performing assets |   | $                      | 18,404       |                  | $            | 21,850 |   |

 

*Allowancefor Losses on Loans*| The allowance for losses on loans was $22.8 million or 1.25 percent of loansreceivable as of September 30, 2002, compared to $20.1 million or 1.11 percentof loans receivable as of December 31, 2001. Net loan charge-offs were $2.4 million or 0.18 percent (annualized) ofthe average balance of loans outstanding for the nine-month period endedSeptember 30, 2002, compared to $2.3 million or 0.17 percent (annualized) ofthe average balance of loans outstanding for the nine-month period endedSeptember 30, 2001.

 

When available informationconfirms that specific loans, or portions thereof, are uncollectible, theseamounts are charged off against the allowance for losses on loans. Theexistence of some or all of the following criteria will generally confirm thata loss has been incurred: the loan is significantly delinquent and the borrowerhas not evidenced the ability or intent to bring the loan current; there is norecourse to the borrower, or if there is recourse, the borrower hasinsufficient assets to pay the debt; the fair value of the loan collateral issignificantly below the current loan balance, and there is little or nonear-term prospect for improvement.  Aprovision for losses on loans, which is a charge against income, is added tothe allowance for losses on loans based on ongoing assessments of credit riskin the loan portfolio.

 

The allowance for losses onloans is maintained at an amount to sufficiently provide for estimated lossesbased on evaluating known and inherent risks in the loan portfolio.  Management analyzes certain factors underlyingthe quality of the loan portfolio. These factors include changes in the size and composition of the loanportfolio, delinquency levels, actual loan loss experience, detailed analysisof individual loans for which full collectibility may not be assured, andcurrent economic conditions in PNWB’s market area.  Management has assessed the impact of the Pacific Northwestregional economy on the credit risk in the loan portfolio.  To date, delinquency trends and classifiedloan levels relative to comparable periods do not indicate any materialdeterioration in the loan portfolio. Management continues to closely monitor PNWB’s credit quality and focuson identifying potential problem credits and any loss exposure in a timelymanner.  Industry concentration andrelated limits will also be subject to on-going assessment.

 

PNWB has established itsallowance for losses on loans in accordance with accounting principlesgenerally accepted in the United States. However, there can be no assurance that in the future, regulators, whenreviewing PNWB’s loan portfolio, will not request PNWB to increase itsallowance for losses on loans, thereby affecting PNWB’s financial condition andresults of operations.  Substantialincreases may be necessary should the quality of loans deteriorate as a resultof the factors discussed above.

 

17

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PNWB’sallowance for losses on loans is allocated to specific loans, certain loancategories based on the relative risk characteristics, asset classificationsand actual loss experience of the loan portfolio.  Although the allocation of the allowance for losses on loans isan important credit management tool, the entire allowance for losses on loansis available for the entire loan portfolio. Management reviewed the allocations in the various loan categories andbelieves the allowance for losses on loans was adequate as of September 30,2002.

 

Thefollowing tables summarize the activity in allowance for losses on loans duringthe three- and nine-month periods ended September 30: 
|                                 |   | **Three months** |       | **Nine months** |       |
|--------------------------------------|--------|------------------|------------|-----------------|------------|
| ***Dollars in thousands***           |   | **2002**         | ** ** | **2001**        | ** ** | **2002** | ** ** | **2001** | ** ** |
|                                 |   |             | ** ** |            | ** ** |   | ** ** |   | ** ** |
| Allowance as of  beginning of period |   | $                | 21,928     |            | $          | 18,916 |   | $ | 20,123 |   | $ | 17,561 |   |
|                                 |   |             |       |            |       |   |   |   |   |
| Provision for  losses on loans       |   | 1,700            |       | 1,550           |       | 5,100 |   | 4,350 |   |
|                                 |   |             |       |            |       |   |   |   |   |
| Recoveries                           |   | 81               |       | 535             |       | 326 |   | 1,023 |   |
|                                 |   |             |       |            |       |   |   |   |   |
| Charge-offs                          |   | (924             | )          | (1,383          | )          | (2,763 | ) | (3,316 | ) |
|                                 |   |             |       |            |       |   |   |   |   |
| Allowance as of  end of period       |   | $                | 22,785     |            | $          | 19,618 |   | $ | 22,785 |   | $ | 19,618 |   |

 

*Goodwill and Other Intangible Assets*|Goodwill arising from acquisitions represents the excess of the purchase priceover the estimated fair value of net assets acquired. Prior to 2002, goodwillwas amortized using the straight-line method over periods not exceeding twentyyears.  Effective January 1, 2002, uponadoption of SFAS No. 142 “Accounting for Goodwill and Other Intangible Assets”,PNWB no longer amortizes its goodwill, and as such, expects annual goodwillamortization expense to reduce by approximately $1.1 million starting in 2002.  PNWB reviews its goodwill for impairmentannually or more frequently if impairment indicators arise.  During the first quarter of 2002, PNWBperformed the transitional impairment assessment of its goodwill as of January1, 2002 and noted that such assessment did not indicate any impairment ofgoodwill.  A reconciliation of reportednet income to net income adjusted to exclude goodwill amortization for thethree- and nine-month periods as of September 30, 2002 and 2001 is as follows:

 
|                                                |   | **Three-month  periods** |       | **Nine-month  periods** |       |
|-----------------------------------------------------|--------|--------------------------|------------|-------------------------|------------|
| ***Dollars in thousands, except per share amount*** |   | **2002**                 | ** ** | **2001**                | ** ** | **2002** | ** ** | **2001** | ** ** |
|                                                |   |                     | ** ** |                    | ** ** |   | ** ** |   | ** ** |
| Income  statement:                                  |   |                     |       |                    |       |   |   |   |   |
| Reported net  income                                |   | $                        | 7,953      |                    | $          | 6,107 |   | $ | 23,429 |   | $ | 15,104 |   |
| Adjustment for  goodwill amortization               |   | —                   |       | 280                     |       | — |   | 840 |   |
| Adjusted net  income                                |   | $                        | 7,953      |                    | $          | 6,387 |   | $ | 23,429 |   | 15,944 |   |
|                                                |   |                     |       |                    |       |   |   |   |   |
| Basic net  income per share:                        |   |                     |       |                    |       |   |   |   |   |
| Reported basic  net income per share                |   | $                        | 0.53       |                    | $          | 0.39 |   | $ | 1.53 |   | 0.97 |   |
| Adjustment for  goodwill amortization               |   | —                   |       | 0.02                    |       | — |   | 0.06 |   |
| Adjusted basic  net income per share                |   | $                        | 0.53       |                    | $          | 0.41 |   | $ | 1.53 |   | 1.03 |   |
|                                                |   |                     |       |                    |       |   |   |   |   |
| Diluted net income per share:                       |   |                     |       |                    |       |   |   |   |   |
| Reported diluted net income  per share              |   | $                        | 0.51       |                    | $          | 0.39 |   | $ | 1.49 |   | $ | 0.96 |   |
| Adjustment for  goodwill amortization               |   | —                   |       | 0.02                    |       | — |   | 0.06 |   |
| Adjusted diluted net income  per share              |   | $                        | 0.51       |                    | $          | 0.41 |   | $ | 1.49 |   | $ | 1.02 |   |

 

Otherintangible assets consist of mortgage servicing intangibles and core depositintangibles.  Mortgage servicingintangibles are capitalized when acquired either through the purchase ororigination of loans that are subsequently sold or securitized with theservicing rights retained. The estimated fair value of mortgage servicingintangibles at the date of the sale of loans is determined based on thediscounted present value of expected future cash flows using key assumptionsfor servicing income and costs and prepayment rates on the underlying loans.The estimated fair value is periodically evaluated for impairment by comparingactual cash

 

18

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flows andestimated future cash flows from servicing assets to those estimated at thetime servicing assets were originated. Mortgage servicing intangibles are amortized using the acceleratedmethods as an offset to service fees in proportion to and over the period ofestimated net servicing income.  Sincemid-2000, PNWB has changed its strategy with regards to the origination andretention of single-family mortgage loans and the majority of those loans arenow sold to the secondary market with servicing rights released.

 

Goodwill andother intangible assets consisted of the following as of the dates indicated:

 
| ***Dollars in thousands***      |   | **September 30, 2002** |       | **December 31, 2001** |       |
|---------------------------------|--------|------------------------|------------|-----------------------|------------|
|                            |   |                   | ** ** |                  | ** ** |
| Goodwill                        |   | $                      | 16,137     |                  | $          | 16,137 |   |
| Mortgage servicing  intangibles |   | 975                    |       | 1,562                 |       |
| Core deposit  intangibles       |   | 292                    |       | 423                   |       |
|                            |   | $                      | 17,404     |                  | $          | 18,122 |   |

 

*Deposits* | PNWB offers various types ofdeposit accounts, including checking accounts, savings accounts, money marketaccounts and certificate of deposit accounts. Deposit accounts vary as to terms; the principal differences are theminimum balance required, the time period the funds must remain on deposit, theinterest rate, and the deposit or withdrawal option.  PNWB relies on generating deposits through a marketing strategythat employs a sales staff responsible for retaining and generating newcustomer relationships.  We emphasizedeveloping total client relationships in order to increase our core depositbase.

 

Non-interest-bearing deposits were $253.6 million as of September 30,2002 compared to $241.7 million as of December 31, 2001.  Non-interest-bearing deposits represented13.9 percent and 15.1 percent of total deposits as of September 30, 2002 andDecember 31, 2001, respectively. Interest-bearing transaction accounts (which include interest-bearingchecking, money market and savings accounts) totaled $780.4 million as ofSeptember 30, 2002 compared to $632.0 million as of December 31, 2001.  Interest-bearing transaction accountsrepresented 42.9 percent of total deposits as of September 30, 2002, comparedto 39.4 percent as of December 31, 2001. The increase in interest-bearingtransaction accounts were partly due to the increase in money market accountsas a result of short-term deposits of business customers.  The balance of the money market accountdeposits may not remain at the same level in the near future due to theshort-term nature of these deposits.

 

Certificatesof deposit totaled $786.3 million as of September 30, 2002, compared to $731.1million as of December 31, 2001. Certificates of deposit represented 43.2 percent of total deposits as ofSeptember 30, 2002, compared to 45.6 percent as of December 31, 2001. Theincrease in the balance of certificates of deposit was driven by a sales campaignthat was completed during the second quarter 2002 as a result of management’sinitiative to create more of an interest rate neutral position of the balancesheet.

 

The following table sets forth the balances of deposits by account typeas of the dates indicated:

 
| ***Dollars in thousands***          |   | **September 30, 2002** |       | **December 31, 2001** |       |
|-------------------------------------|--------|------------------------|------------|-----------------------|------------|
|                                |   |                   | ** ** |                  | ** ** |
| Non-interest-bearing  deposits      |   | $                      | 253,569    |                  | $          | 241,674 |   |
| Interest-bearing  checking accounts |   | 232,202                |       | 214,098               |       |
| Money market  accounts              |   | 443,425                |       | 322,554               |       |
| Savings  accounts                   |   | 104,785                |       | 95,390                |       |
| Certificates of  deposit            |   | 786,302                |       | 731,139               |       |
|                                |   |                   |       |                  |       |
| Total                               |   | $                      | 1,820,283  |                  | $          | 1,604,855 |   |

 

*FHLBAdvances and Securities Sold Under Agreements to Repurchase* | PNWB borrows through advances from the FederalHome Loan Bank (FHLB) and securities sold under agreements to repurchase withthird parties. These borrowing sources totaled $717.9 million as of September30, 2002 compared to $864.0 million as of December 31, 2001.  The need for this type of borrowingsdecreased primarily as a result of the increase in deposits.

 

19

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The FHLB provides credit for member financialinstitutions.  As members, financialinstitutions are required to own capital stock in the FHLB, and are authorizedto apply for advances on the security of such stock, certain home mortgages andother assets (principally securities that are obligations of, or guaranteed by,the United States).  Advances are madeto member financial institutions pursuant to several different programs.  These programs are generally designed tomeet the financial institution’s need while still reflecting market terms andconditions.  PNWB uses advances from theFHLB to supplement funds available to lend and to meet liquidityguidelines.  Interest rates on theseadvances vary in response to general economic conditions.  PNWB also uses the securities market forborrowings by utilizing its securities available for sale as collateral. Theseborrowings are collateralized by securities with an estimated fair valueexceeding the face value of the borrowings.

 

*Other borrowings*****| Other borrowings were $12.1 million as ofSeptember 30, 2002, compared to $12.6 million as of December 31, 2001.  They were primarily notes from anotherfinancial institution. This borrowing qualifies as Tier II capital under thecapital guidelines of the Federal Reserve Board.  The decrease from December 31, 2001 was due to the payoff of aloan by Pacific Northwest Bancorp Employee Stock Ownership Plan that PacificNorthwest Bancorp guaranteed.

 

*Guaranteed Preferred Beneficial Interests inSubordinated Debt*  | OnNovember 15, 1999, $40 million of 9.875 percent Capital Securities were issuedby InterWest Capital Trust I.  Theproceeds of the offering were invested by the Trust in junior subordinateddebentures of Pacific Northwest Bancorp. The debentures held by the Trust are the sole assets of InterwestCapital Trust.  The capital securitiesare subject to mandatory redemption, in whole or in part, upon repayment of thedebentures.  The debentures will notmature earlier than November 15, 2009, and not later than November 15,2029.  Pacific Northwest Bancorp enteredinto agreements which, taken collectively, fully and unconditionally guaranteethe capital securities subject to the terms of each of the guarantees.  The capital securities qualify as Tier Icapital under the capital guidelines of the Federal Reserve Board.  To date, Pacific Northwest Bancorp haspurchased $4.0 million of the capital securities since they were issued.

 

On September 26, 2002, $12million of Capital Securities were issued by Pacific Northwest Statutory TrustI through the Keefe, Bruyette, & Woods, Inc. Trust Preferred Pool Offering,Preferred Term Securities VII, LTD.  Theproceeds of the offering were invested by the Trust in junior subordinateddebentures of Pacific Northwest Bancorp. The debentures held by the Trust are the sole assets of PacificNorthwest Statutory Trust I.  TheCapital Securities are subject to mandatory redemption, in whole or in part, uponrepayment of the debentures.  Thedebentures will not mature earlier than September 26, 2007, and not later thanSeptember 26, 2012. The interest rate on the Capital Securities is based uponThree-Month LIBOR plus 3.55 percent and adjusts on a quarterly basis.  As of September 30, 2002, the interest rateon the Capital Securities was 5.37 percent. Pacific Northwest Bancorp entered into agreements which, takencollectively, fully and unconditionally guarantee the capital securitiessubject to the terms of each of the guarantees.  The Capital Securities qualify as Tier I capital under thecapital guidelines of the Federal Reserve Board.

 

*Shareholders’ Equity*| PNWB is committed to managing capital for maximum shareholder benefit andmaintaining strong protection for depositors and creditors.  PNWB manages various capital levels at boththe holding company and subsidiary bank level to maintain adequate capitalratios and levels in accordance with external regulations and capitalguidelines established by the Board of Directors.

 

On January 22, 2002, the Boardof Directors approved a stock repurchase plan of up to five percent of PacificNorthwest Bancorp’s outstanding shares of common stock over the next twelvemonths.  On September 16, 2002, PacificNorthwest Bancorp completed the stock repurchase plan.  Under this plan, PNWB repurchased, on theopen market, a total of 780,825 shares at an average price of $27.85.

 

PNWB’s total shareholders’equity was $202.3 million as of September 30, 2002, compared to $200.5 millionas of December 31, 2001.  The increasein shareholders’ equity during the first nine months of 2002 was primarily dueto net income of $23.4 million, an increase in the estimated fair value ofsecurities available for sale of $4.0 million (net of tax), stock issued understock option plans of $2.0 million, partially offset by stock repurchase of$21.7 million and cash dividends declared of $0.42 per share or $6.4million.  Book value per share was$13.51 as of September 30, 2002, compared to $12.86 as of December 31, 2001.

 

20

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### **SUPERVISION AND REGULATION**

 

PacificNorthwest Bancorp is a registered bank holding company under the Bank HoldingCompany Act of 1956 (BHCA) and is subject to the supervision of, and regulationby, the Board of Governors of the Federal Reserve System  (FRB). Under the BHCA, Pacific Northwest Bancorp files with the FRB annualreports of operations and such additional information as the FRB mayrequire.  Under the BHCA, a bank holdingcompany may engage in banking, managing or controlling banks, furnishing orperforming services for banks it controls, and conducting activities that theFRB has determined to be closely related to banking.

 

Pacific Northwest Bank is amember of the Federal Deposit Insurance Corporation (FDIC), and as such, issubject to examination thereby.  PacificNorthwest Bank is a state-chartered commercial bank subject to regulation andsupervision by the Washington Department of Financial Institutions, Division ofBanks.  In practice, the primaryregulator makes regular examinations of the subsidiary bank subject to itsregulatory review or participates in joint examinations with other regulators.  Areas subject to regulation by federal orstate authorities include the allowance for losses on loans, investments,loans, mergers and acquisitions, issuance of securities, payment of dividends,establishment of branches and other aspects of operations.

 

The enforcement powersavailable to banking regulators are substantial and include, among otherthings, the ability to assess civil monetary penalties, to issuecease-and-desist or removal orders and to initiate injunctive actions againstbanking organizations and institution-affiliated parties, as defined.  In general, enforcement actions must beinitiated for violations of laws and regulations and unsafe or unsoundpractices. Other actions, or inactions, may provide the basis for enforcementaction, including misleading or untimely reports filed with regulatory authorities.  Applicable law also requires publicdisclosure of final enforcement actions.

 

Pacific Northwest Bancorp andPacific Northwest Bank are subject to risk-based capital guidelines requiringminimum capital levels based on the credit risk of assets.  Failure to meet minimum capital requirementscan initiate certain mandatory and possibly additional discretionary, actionsby regulators that, if undertaken, could have a material effect on PNWB’sconsolidated financial statements. Under capital adequacy guidelines and the regulatory framework forprompt corrective action, Pacific Northwest Bancorp and Pacific Northwest Bankmust meet specific capital guidelines that involve quantitative measures ofassets, liabilities and certain off-balance-sheet items as calculated underregulatory accounting practices. Capital classifications are also subject to qualitative judgments by theregulators about components, risk weightings and other factors.

 

The regulations define therelevant capital levels for the five categories.  In general terms, the capital definitions are as follows:

 
|                           |   | **Total  Capital  (to Risk  Weighted Assets)** |   | **Tier 1  (to Risk  Weighted Assets)** |   | **Tier 1  (to Average  Assets)** |   |
|--------------------------------|--------|------------------------------------------------|--------|----------------------------------------|--------|----------------------------------|--------|
| Well capitalized               |   | 10                                             | %      | 6                                      | %      | 5                                | %      |
| Adequately capitalized         |   | 8                                              | %      | 4                                      | %      | 4                                | %      |
| Undercapitalized               |   | Below 8                                        | %      | Below 4                                | %      | Below 4                          | %      |
| Significantly undercapitalized |   | Below 6                                        | %      | Below 3                                | %      | Below 3                          | %      |
| Critically undercapitalized    |   | —                                         |   | —                                 |   | 2% or less                       |   |

 

Pacific Northwest Bancorpissubjecttorisk-basedcapital guidelinesissuedbytheFRB,which establish a risk-adjusted ratio relating capital to different categoriesof assets.  Tier I capital is comprisedof shareholders’ equity and guaranteed preferred beneficial interests insubordinated debt less certain intangibles, and excludes the equity impact of adjustingsecurities available for sale to estimated fair value. Total capital is Tier Icapital, the allowance for losses on loans and certain long-term debt thatqualifies for inclusion as regulatory capital. The FRB’s risk-based capital rules have been supplemented by a leveragecapital ratio, defined as Tier I capital to adjusted quarterly average totalassets.  As of September 30, 2002, underthe FRB’s capital guidelines, PNWB’s levels of consolidated regulatory capitalexceeded the FRB’s well-capitalized requirements.  The capital amounts and ratios for Pacific Northwest Bancorp andPacific Northwest Bank as of September 30,

 

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2002 and December 31, 2001, arepresented in the following table:

 

**CAPITALRATIOS**

 
|                                           |   | **Amount** | ** ** | **For Capital  Adequacy Purposes** | ** ** | **To Be Well  Capitalized Under  Prompt Corrective  Action Provisions** | ** ** |
|------------------------------------------------|--------|------------|------------|------------------------------------|------------|-------------------------------------------------------------------------|------------|
| ***Dollars in thousands***                     |   | **Amount** | ** ** | **Ratio**                          | ** ** | **Amount**                                                              | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
|                                           |   |       |       |                               |       |                                                                    |       |   |   |   |   |   |   |
| **September 30, 2002**                         |   |       | ** ** |                               | ** ** |                                                                    | ** ** |   | ** ** |   | ** ** |   | ** ** |
|                                           |   |       | ** ** |                               | ** ** |                                                                    | ** ** |   | ** ** |   | ** ** |   | ** ** |
| **Pacific Northwest Bancorp:**                 |   |       |       |                               |       |                                                                    |       |   |   |   |   |   |   |
| Total capital (to risk-weighted assets)        |   | $          | 263,461    |                               | 12.37      | %                                                                       | $          |  170,340 |   | 8.0 | % | $ |  212,925 |   | 10.0 | % |
| Tier I capital (to risk-weighted assets)       |   | 228,491    |       | 10.73                              | %          | 85,170                                                                  |       | 4.0 | % | 127,755 |   | 6.0 | % |
| Tier I capital (to average assets)             |   | 228,491    |       | 8.18                               | %          | 111,736                                                                 |       | 4.0 | % | 139,669 |   | 5.0 | % |
|                                           |   |       | * *   |                               | * *   |                                                                    | * *   |   | * * |   | * * |   | * * |
| **Pacific Northwest Bank:**                    |   |       |       |                               |       |                                                                    |       |   |   |   |   |   |   |
| Total capital (to risk-weighted assets)        |   | $          | 248,381    |                               | 11.80      | %                                                                       | $          |  168,428 |   |   | 8.0 | % | $ | 210,535 |   | 10.0 | % |
| Tier I capital (to risk-weighted assets)       |   | 225,411    |       | 10.71                              | %          | 84,214                                                                  |       | 4.0 | % | 126,321 |   | 6.0 | % |
| Tier I capital (to average assets)             |   | 225,411    |       | 8.09                               | %          | 111,436                                                                 |       | 4.0 | % | 139,296 |   | 5.0 | % |
|                                           |   |       |       |                               |       |                                                                    |       |   |   |   |   |   |   |
| **December 31, 2001**                          |   |       | ** ** |                               | ** ** |                                                                    | ** ** |   | ** ** |   | ** ** |   | ** ** |
|                                           |   |       | ** ** |                               | ** ** |                                                                    | ** ** |   | ** ** |   | ** ** |   | ** ** |
| **Pacific Northwest Bancorp:**                 |   |       | ** ** |                               |       |                                                                    |       |   |   |   | ** ** |   | ** ** |
| Total capital (to risk-weighted  assets)  |   | $          | 252,089    |                               | 12.09      | %                                                                       | $          | 166,802 |   | 8.0 | % | $ |  208,502 |   | 10.0 | % |
| Tier I capital (to risk-weighted assets)       |   | 219,966    |       | 10.55                              | %          | 83,401                                                                  |       | 4.0 | % | 125,101 |   | 6.0 | % |
| Tier I capital (to average assets)             |   | 219,966    |       | 8.02                               | %          | 109,692                                                                 |       | 4.0 | % | 137,115 |   | 5.0 | % |
|                                           |   |       |       |                               |       |                                                                    |       |   |   |   |   |   |   |
| **Pacific Northwest Bank:**                    |   |       | ** ** |                               |       |                                                                    |       |   | ** ** |   | ** ** |   | ** ** |
| Total capital (to risk-weighted assets)        |   | $          | 248,486    |                               | 11.96      | %                                                                       | $          |  166,274 |   | 8.0 | % | $ |  207,842 |   | 10.0 | % |
| Tier I capital (to risk-weighted assets)       |   | 228,363    |       | 10.99                              | %          | 83,137                                                                  |       | 4.0 | % | 124,705 |   | 6.0 | % |
| Tier I capital (to average assets)             |   | 228,363    |       | 8.35                               | %          | 109,427                                                                 |       | 4.0 | % | 136,783 |   | 5.0 | % |
|                                                |        |            |            |                                    |            |                                                                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

As of September 30, 2002,Pacific Northwest Bank was in compliance with well-capitalized capitalrequirements. Management believes that under the current regulations PacificNorthwest Bank will continue to meet well-capitalized capital requirements inthe foreseeable future.  However, eventsbeyond the control of Pacific Northwest Bank, such as a downturn in the economyin areas where Pacific Northwest Bank has most of its loans, could adverselyaffect future earnings and, consequently, the ability of Pacific Northwest Bankto meet future well-capitalized capital requirements.

# ** **

# **LIQUIDITYRESOURCES**

 

Liquidity management focuses onthe need to meet both short-term funding requirements and PNWB’s long-termstrategies and goals. Specifically, the objective of liquidity management is toensure the continuous availability of funds to meet the demands of depositors,creditors and borrowers. Management manages the balance sheet to meet theseneeds. PNWB desires to attract and retain business and retail customerrelationships with a focus on transaction accounts and commercial and consumerlending.  PNWB also uses wholesale fundsthrough advances from the FHLB and the sale of securities under agreements torepurchase to fund asset growth and meet liquidity needs. PNWB also useswholesale and brokered certificates of deposit to supplement wholesaleborrowings.  Other sources of funds forliquidity include loan repayments, loan sales, security sales andmortgage-backed and related security repayments. Repayments on loans andmortgage-backed and related securities and deposit inflows and outflows areaffected by changes in interest rates.

 

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PNWB has the capacity to borrowfunds from the FHLB through pre-approved credit lines.  These credit lines have pledge requirementswhereby PNWB must maintain unencumbered collateral with a value at least equalto the outstanding balance. PNWB also uses the securities market as a vehiclefor borrowing by utilizing its securities available for sale ascollateral.  These borrowings arecollateralized by securities with an estimated fair value exceeding the facevalue of the borrowings. If the estimated fair value of the securities were todecline as a result of an increase in interest rates or other factors, PNWBwould be required to pledge additional securities or cash as collateral. Inaddition, PNWB has the ability to borrow funds from the Federal Reserve.

 

The analysis of liquidity alsoincludes a review of PNWB’s consolidated statement of cash flows for thenine-month period ended September 30, 2002. The consolidated statement of cash flows details PNWB’s operating,investing and financing activities during the period.  The most significant items under operating activities include netincome of $23.4 million for the nine-month period ended September 30, 2002 andan increase in other assets of $5.9 million. Also included in operating activities are the add back of non-cashdepreciation, amortization of intangible assets and the provision for losses ofloans totaling $9.8 million. Investing activities included proceeds frommaturing and principal repayments on securities available for sale of $303.7million, purchases of securities available for sale of $337.5 million.Investing activities also included a $128.5 million increase in loansreceivable, $134.4 million of proceeds from mortgage banking activities and a$5.5 million proceeds from the sale of other real estate. During the period,financing activities included $146.2 million in borrowing repayments, net ofborrowing proceeds, a $55.2 million increase in certificates of deposit, a$160.3 million increase in deposits, $21.7 million of cash used for thepurchase and retirement of common stock, $12.0 million of cash proceeds fromissuance of Pacific Northwest Statutory Trust I capital securities, and $6.5million paid in cash dividends to shareholders.

 

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**Item3****.  QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

PNWB’s results of operationsare largely dependent upon its ability to manage interest rate risk. Managementconsiders interest rate risk to be a significant market risk that could have amaterial effect on PNWB’s financial condition and results of operations.

 

PNWB is sensitive to potentialchanges in interest rates and the resulting impact on net interest income.  It is an objective of management to reducethis sensitivity through the use of adjustable rate loans and short-termcommercial and consumer loans.  Thisenables PNWB to better match the duration of its deposit base with these typesof assets.

 

In addition to adjustable rateloans and short-term commercial and consumer loans, PNWB uses a number of otherstrategies to minimize the impact of significant interest rate changes on netincome. The strategies utilized by PNWB include sales of long-term, fixed-ratemortgage loans, emphasis on growth in non-interest-bearing deposits andadjustable rate commercial lending.

 

Management uses simulation analysis to measure PNWB’s interestsensitivity position.  This simulationanalysis is used to evaluate the effects of potential interest rate movementson net interest income.  The simulationanalysis model is dynamic in nature, and incorporates management’s currentbalance sheet strategy. Management develops assumptions regarding interest ratespreads, projected balances, expected maturities, cash flows and prepaymentassumptions under different interest rate scenarios.  Actual results may differ from simulated results due to timing,magnitude, and frequency of interest rate changes and changes in marketconditions and management strategies, among other factors.

 

For further information on interest rate risk, reference is made to thesections “Net Interest Income” and “Average Rates and Balances” in Item 2.Management Discussion and Analysis of Financial Condition and Results ofOperations contained in this quarterly report on Form 10-Q.  Information regarding the expectedmaturities of financial assets and financial liabilities has not changedmaterially from disclosures made in the Annual Report on Form 10-K for the yearended December 31, 2001.

 

**Item4****.  CONTROLS ANDPROCEDURES**

 

**Evaluationof Disclosure Controls and Procedures**

 

PNWB, under the supervision and with the participation of itsmanagement, including its Chief Executive Officer and Chief Financial Officer,carried out an evaluation of the effectiveness of the design and operation ofthe Company’s disclosure controls and procedures as of September 30, 2002 (the“Evaluation Date”).  Based upon thisevaluation, the Chief Executive Officer and Chief Financial Officer concludedas of the Evaluation Date that PNWB’s disclosure controls and procedures wereeffective for purposes of recording, processing, summarizing and timelyreporting material information required to be disclosed in reports filed by theCompany under the Securities Exchange Act of 1934.

 

**Changesin Internal Controls**

 

There were no significant changes in PNWB’s internal controls or inother factors that could significantly affect these controls subsequent to theEvaluation Date.  PNWB did not implementany corrective actions with regard to any significant deficiency or materialweakness in its internal controls.

 

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**FORWARD-LOOKINGSTATEMENTS**

 

In this quarterly report on Form 10-Q, PNWBhas included certain “forward-looking statements” concerning its futureoperations.  Sentences containing wordssuch as “may,” “will,” “expect,” “anticipate,” “believe,” “estimate,” “should,”“projected,” or similar words may constitute forward-looking statements.  Although PNWB believes that the expectationsexpressed in these forward-looking statements are based on reasonableassumptions within the bounds of its knowledge of its business and operations,it is possible that actual results may differ materially from theseexpectations.  The following items areamong the factors that could cause actual results to differ materially from theforward-looking statements: general economic conditions, including their impacton capital expenditures; business conditions in the banking industry; recentworld events and their impact on interest rates, businesses and customers; theregulatory environment; new legislation; vendor quality and efficiency;employee retention factors; rapidly changing technology and evolving bankingindustry standards; competitive standards; competitive factors, includingincreased competition with community, regional and national financialinstitutions; fluctuating interest rate environments; higher than expected loandelinquencies; and similar matters. These factors should be considered in evaluating the forward-lookingstatements and undue reliance should not be placed on such statements.

 

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**PARTII****. OTHER INFORMATION**

 

**Item 1****.****                  Legal Proceedings**

 

PNWB faces ordinary routine litigationarising in the normal course of business. In the opinion of management, liabilities (if any) arising from suchclaims will not have a material effect upon the business, results of operationsor financial condition of PNWB.

 

**Items 2, 3 and 4 are not applicable and havebeen omitted.**

 

**Item 5****.****                  Other Information**

 

In accord with Section 10A(I)(2) of theSecurities Exchange Act of 1934, as added by Section 202 of the Sarbanes-OxleyAct of 2002, PNWB is responsible for listing the non-audit services approved inthe third quarter by PNWB’s Audit Committee to be performed by Ernst &Young, PNWB’s independent auditor.  Non-audit services are defined in the law as services other than thoseprovided in connection with an audit or a review of the consolidated financialstatements of PNWB. During the third quarter of 2002, the Audit Committeeapproved additional engagements of Ernst & Young for the followingnon-audit services: (1) services to support SEC filings related to the Bank ofthe Northwest acquisition; (2) accounting matter consultations in connectionwith potential transactions for which fees do not exceed $10,000;  (3) other non-audit services for which fees,in aggregate and on an annual basis, do not exceed 20 percent of annual auditfees.

 

**Item 6****.                  Exhibitsand Reports on Form 8-K**

 

**(a) Exhibits**

 
| 3.1 |   | Articles of Incorporation of Pacific  Northwest Bancorp (incorporated by reference to Exhibit 3.1 to the  Registrant’s Annual Report on Form 10-K for the year ended December 31,  2000).                                                                                                                                       |
|-----|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.2 |   | Bylaws of Pacific Northwest Bancorp  (incorporated by reference to Exhibit 3.2 to the Registrant’s Annual Report  on Form 10-K for the year ended December 31, 2000).                                                                                                                                                           |
| 3.3 |   | Amendment to the Bylaws of Pacific  Northwest Bancorp (incorporated by reference to Exhibit 3.21 to the  Registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30,  2001).                                                                                                                                      |
| 10  |   | Material contracts of Pacific Northwest  Bancorp (incorporated by reference to Exhibits 10.1 through 10.22 to the  Registrant’s Annual Report on Form 10-K for the year ended December 31, 2001  and Exhibits 10.23 through 10.25 to the Registrant’s quarterly Report on Form  10-Q for the quarter ended June 30, 2002). |

 

**(b) Reports on Form 8-K**

 

PNWB filed a current report on Form 8-K onOctober 18, 2002. The report included under Item 5 of Form 8-K a press releaseannouncing PNWB’s third quarter 2002financial results and unaudited consolidated financial statements for thethree- and nine-month periods ended September 30, 2002.

 

PNWB filed a current report on Form 8-K on October 18, 2002 under item 5announcing that on October 16, 2002, Fitch Ratings upgraded the senior debtratings of Pacific Northwest Bancorp and its banking subsidiary, PacificNorthwest Bank.

 

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PNWB filed a current report on Form 8-K onNovember 5, 2002 under item 5 announcing that commencing January 1, 2003, itwill outsource its residential mortgage lending operations.

 

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**SIGNATURES**

 

Pursuant to the requirements ofthe Securities Exchange Act of 1934, the Registrant has duly caused this reportto be signed on its behalf by the undersigned thereunto duly authorized.

 

 
|                           |   | PACIFIC NORTHWEST BANCORP |
|--------------------------------|--------|---------------------------|
|                           |   |                      |   |   |
|                           |   |                      |   |   |
|                           |   |                      | By: | /s/ Patrick M. Fahey |   |
|                           |   |                      |   | Patrick M. Fahey |
|                           |   |                      |   | President and Chief Executive Officer |
|                           |   |                      |   |   |   |
|                           |   |                      |   |   |   |
|                           |   |                      |   | /s/ Bette J. Floray |   |
|                           |   |                      |   | Bette J. Floray |
|                           |   |                      |   | Executive Vice President and Chief  Financial Officer |
|                           |   |                      |   |   |
| Dated:   November 7, 2002 |   |                      |   |   |
|                                |        |                           |  |  |  |  |

 

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**CERTIFICATIONS**

 

**CERTIFICATION OFQUARTERLY REPORT ON FORM 10-Q**

**PURSUANT TO SECTION302 OF THE SARBANES-OXLEY ACT OF 2002**

 

I, Patrick M.Fahey, certify that:

 

1.             I have reviewedthis quarterly report on Form 10-Q of Pacific Northwest Bancorp;

 

2.             Based on my knowledge, thisquarterly report does not contain any untrue statement of a material fact oromit to state a material fact necessary to make the statements made, in lightof the circumstances under which such statements were made, not misleading withrespect to the period covered by this quarterly report;

 

3.             Based on myknowledge, the financial statements, and other financial information includedin this quarterly report, fairly present in all material respects the financialcondition, results of operations and cash flows of the registrant as of, andfor, the periods presented in this quarterly report;

 

4.             The registrant’sother certifying officers and I are responsible for establishing andmaintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the registrant and we have:

 

a)      designedsuch disclosure controls and procedures to ensure that material informationrelating to the registrant, including its consolidated subsidiaries, is madeknown to us by others within those entities, particularly during the period inwhich this quarterly report is being prepared;

 

b)      evaluatedthe effectiveness of the registrant’s disclosure controls and procedures as ofa date within 90 days prior to the filing date of this quarterly report (the“Evaluation Date”); and

 

c)      presentedin this quarterly report our conclusions about the effectiveness of thedisclosure controls and procedures based on our evaluation as of the EvaluationDate;

 

5.             The registrant’sother certifying officers and I have disclosed, based on our most recentevaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalentfunction):

 

a)      allsignificant deficiencies in the design or operation of internal controls whichcould adversely affect the registrant’s ability to record, process, summarizeand report financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

b)      anyfraud, whether or not material, that involves management or other employees whohave a significant role in the registrant’s internal controls; and

 

6.             The registrant’sother certifying officers and I have indicated in this quarterly report whetheror not there were significant changes in internal controls or in other factorsthat could significantly affect internal controls subsequent to the date of ourmost recent evaluation, including any corrective actions with regard tosignificant deficiencies and material weaknesses.

 

 
|   | Date:  November 7, 2002                |   |
|--------|----------------------------------------|--------|
|   |                                   |
|   |                                   |
|   |   /s/  Patrick M. Fahey |   |
|   | Patrick M.  Fahey,                     |   |
|   | President  and Chief Executive Officer |   |
|        |                                        |        |  |  |

 

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**CERTIFICATION OFQUARTERLY REPORT ON FORM 10-Q**

**PURSUANT TO SECTION302 OF THE SARBANES-OXLEY ACT OF 2002**

 

I, Bette J.Floray, certify that:

 

1.             I have reviewed this quarterlyreport on Form 10-Q of Pacific Northwest Bancorp;

 

2.             Based on my knowledge, thisquarterly report does not contain any untrue statement of a material fact oromit to state a material fact necessary to make the statements made, in lightof the circumstances under which such statements were made, not misleading withrespect to the period covered by this quarterly report;

 

3.             Based on my knowledge, the financialstatements, and other financial information included in this quarterly report,fairly present in all material respects the financial condition, results ofoperations and cash flows of the registrant as of, and for, the periodspresented in this quarterly report;

 

4.             The registrant’s other certifyingofficers and I are responsible for establishing and maintaining disclosurecontrols and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14)for the registrant and we have:

 

a)      designedsuch disclosure controls and procedures to ensure that material informationrelating to the registrant, including its consolidated subsidiaries, is madeknown to us by others within those entities, particularly during the period inwhich this quarterly report is being prepared;

 

b)      evaluatedthe effectiveness of the registrant’s disclosure controls and procedures as ofa date within 90 days prior to the filing date of this quarterly report (the“Evaluation Date”); and

 

c)      presentedin this quarterly report our conclusions about the effectiveness of thedisclosure controls and procedures based on our evaluation as of the EvaluationDate;

 

5.             The registrant’s other certifyingofficers and I have disclosed, based on our most recent evaluation, to theregistrant’s auditors and the audit committee of registrant’s board ofdirectors (or persons performing the equivalent function):

 

a)      allsignificant deficiencies in the design or operation of internal controls whichcould adversely affect the registrant’s ability to record, process, summarizeand report financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

b)      anyfraud, whether or not material, that involves management or other employees whohave a significant role in the registrant’s internal controls; and

 

6.             The registrant’s other certifyingofficers and I have indicated in this quarterly report whether or not therewere significant changes in internal controls or in other factors that couldsignificantly affect internal controls subsequent to the date of our mostrecent evaluation, including any corrective actions with regard to significantdeficiencies and material weaknesses.

 

 
|   | Date:  November 7, 2002                                |   |
|--------|--------------------------------------------------------|--------|
|   |                                                   |
|   |                                                   |
|   |   /s/  Bette J. Floray                  |   |
|   | Bette J.  Floray,                                      |   |
|   | Executive  Vice President and Chief  Financial Officer |   |
|        |                                                        |        |  |  |

 

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**CERTIFICATION OFQUARTERLY REPORT ON FORM 10-Q**

**PURSUANT TO SECTION906 OF THE SARBANES-OXLEY ACT OF 2002**

 

Theundersigned are the Chief Executive Officer and the Chief Financial Officer ofPacific Northwest Bancorp (the “Registrant”). This Certification is made pursuant to Section 906 of the Sarbanes-OxleyAct of 2002.  This Certificationaccompanies the Quarterly Report on Form 10-Q of the Registrant for thequarterly period ended September 30, 2002.

 

We certifythat such Quarterly Report on Form 10-Q fully complies with the requirements ofSection 13(a) or 15(d) of the Securities Exchange Act of 1934 and that theinformation contained in such 10-Q Report fairly presents, in all materialrespects, the financial condition and the results of operations of theRegistrant.

 

 
| Date:  November 7, 2002 |                                                  |
|-------------------------|-------------------------------------------------------|
|                    |                                                  |
|                    |                                                  |
|                    | /s/ Patrick  M. Fahey                                 |   |
|                    | Patrick M.  Fahey, President and CEO                  |   |
|                    |                                                  |   |
|                    |                                                  |   |
|                    | /s/ Bette J.  Floray                                  |   |
|                    | Bette J. Floray,                                      |   |
|                    | Executive  Vice President and Chief Financial Officer |   |

 

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