**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WashingtonD.C.  20549**

 

**FORM 10-Q**

 

**(MarkOne)**

| **ý****  Quarterly Report Pursuant to Section 13 or 15(d) of the  Securities and Exchange Act of 1934** |
|-------------------------------------------------------------------------------------------------------------------|

 

**For thequarterly period ended March 31, 2002**

 

| **o****  Transition Report Pursuant to Section 13 or 15(d) of the  Securities Exchange Act of 1934** |
|-----------------------------------------------------------------------------------------------------------|

 

**For the transitionperiod                fromto                **

 

**Commission filenumber   0-26632**

 

**Pacific Northwest Bancorp**

(Exact name of registrant as specified 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** |

 

Indicateby check mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.

 

YES  ý NO  o

 

As of May 9, 2002, 15,405,291shares of common 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 March 31, 2002 and December 31, 2001**                       |
|           |   |                                                                                                                 |
|           |   | **Consolidated  Statements of Income for the three-month periods ended March 31, 2002 and  2001**                    |
|           |   |                                                                                                                 |
|           |   | **Consolidated  Statements of Shareholders’ Equity for the three-month periods ended March  31, 2002 and 2001** |
|           |   |                                                                                                                 |
|           |   | **Consolidated  Statements of Cash Flows for the three-month periods ended March 31, 2002 and  2001**                |
|           |   |                                                                                                                 |
|           |   | **Notes  to Unaudited Consolidated Financial Statements**                                                            |
|           |   |                                                                                                                 |
| **Item  2.**   |   | **Management  Discussion and Analysis of Financial Condition and Results of Operations**                             |
|           |   |                                                                                                                 |
| **Item  3.**   |   | **Quantitative  and Qualitative Disclosures About Market Risk**                                                      |
|           |   |                                                                                                                 |
| **PART II.**   |   | **OTHER INFORMATION**                                                                                                |
|           |   |                                                                                                                 |
| **Item 1.**    |   | **Legal Proceedings**                                                                                                |
|           |   |                                                                                                                 |
| **Item 6.**    |   | **Exhibits and  Reports on Form 8-K**                                                                                |
|           |   |                                                                                                                 |
| **SIGNATURES** |   |                                                                                                                 |

 

----

 

CONSOLIDATED STATEMENTS OFFINANCIAL CONDITION (UNAUDITED)

 
| ***Dollars in thousands***                                                  |   | **March 31, 2002** |      | **December 31, 2001** |   |
|-----------------------------------------------------------------------------|--------|--------------------|-----------|-----------------------|--------|
|                                                                        |   |               |      |                  |   |
| *Assets*                                                                    |   |               |      |                  |   |
|                                                                        |   |               |      |                  |   |
| Cash and due from banks                                                     |   |               |      |                  |   |
| Non-interest-bearing                                                        |   | $                  | 60,097    |                  | $      | 58,134 |   |
| Interest-bearing                                                            |   | 66                 |      | 491                   |   |
| Federal funds sold and securities purchased under agreements to resell      |   | 11,455             |      | —                |   |
| Securities available for sale                                               |   | 732,959            |      | 757,018               |   |
| Loans receivable                                                            |   | 1,824,264          |      | 1,808,555             |   |
| Allowance for losses on loans                                               |   | (21,099            | )         | (20,123               | )      |
| Net loans receivable                                                        |   | 1,803,165          |      | 1,788,432             |   |
|                                                                        |   |               |      |                  |   |
| Loans held for sale                                                         |   | 34,277             |      | 43,757                |   |
| Interest receivable                                                         |   | 14,193             |      | 14,808                |   |
| Other real estate                                                           |   | 5,943              |      | 5,762                 |   |
| Premises and equipment                                                      |   | 50,008             |      | 50,837                |   |
| Goodwill                                                                    |   | 16,137             |      | 16,137                |   |
| Other intangible assets                                                     |   | 1,752              |      | 1,985                 |   |
| Other assets                                                                |   | 7,723              |      | 4,147                 |   |
|                                                                        |   |               |      |                  |   |
| Total assets                                                                |   | $                  | 2,737,775 |                  | $      | 2,741,508 |   |
|                                                                        |   |               |      |                  |   |
| *Liabilities*                                                               |   |               |      |                  |   |
|                                                                        |   |               |      |                  |   |
| Deposits:                                                                   |   |               |      |                  |   |
| Non-interest-bearing                                                        |   | $                  | 263,459   |                  | $      | 241,674 |   |
| Interest-bearing                                                            |   | 1,437,412          |      | 1,363,181             |   |
| Total deposits                                                              |   | 1,700,871          |      | 1,604,855             |   |
|                                                                        |   |               |      |                  |   |
| Federal Home Loan Bank (FHLB) advances                                      |   | 647,035            |      | 714,526               |   |
| Federal funds purchased and securities sold under agreements to  repurchase |   | 115,629            |      | 149,504               |   |
| Guaranteed preferred beneficial interests in subordinated debt              |   | 37,500             |      | 37,500                |   |
| Other borrowings                                                            |   | 12,077             |      | 12,621                |   |
| Other liabilities                                                           |   | 25,432             |      | 22,016                |   |
|                                                                        |   |               |      |                  |   |
| Total liabilities                                                           |   | 2,538,544          |      | 2,541,022             |   |
|                                                                        |   |               |      |                  |   |
| *Shareholders’  Equity*                                                |   |               |      |                  |   |
|                                                                        |   |               |      |                  |   |
| Common stock, no par value                                                  |   |               |      |                  |   |
| Authorized shares 30,000,000                                                |   |               |      |                  |   |
| Issued and outstanding: 15,453,581 and 15,595,204 shares                    |   | —             |      | —                |   |
| Paid-in-capital                                                             |   | 22,244             |      | 26,757                |   |
| Retained earnings                                                           |   | 178,365            |      | 172,967               |   |
| Accumulated  other comprehensive income (loss)                              |   | (1,378             | )         | 1,305                 |   |
| Debt related to employee stock ownership plan (ESOP)                        |   | —             |      | (543                  | )      |
|                                                                        |   |               |      |                  |   |
| Total shareholders’ equity                                             |   | 199,231            |      | 200,486               |   |
|                                                                        |   |               |      |                  |   |
| Total liabilities and shareholders’ equity                             |   | $                  | 2,737,775 |                  | $      | 2,741,508 |   |

 

See accompanying notes to consolidated financial statements.

 

1

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CONSOLIDATED STATEMENTS OF INCOME(UNAUDITED)

 
|                                                           |   | **Three-month periods ended March 31,** |   |
|----------------------------------------------------------------|--------|-----------------------------------------|--------|
| ***Dollars in thousands, except per share amounts***           |   | **2002**                                |   | **2001** |   |
|                                                           |   |                                    |   |   |   |
| *Interest  Income*                                             |   |                                    |   |   |   |
| Loans receivable and loans held for sale                       |   | $                                       | 34,509 |   | $ | 39,735 |   |
| Securities available for sale                                  |   | 10,400                                  |   | 13,981 |   |
| Other                                                          |   | 7                                       |   | 331 |   |
|                                                           |   | 44,916                                  |   | 54,047 |   |
| *Interest  Expense*                                            |   |                                    |   |   |   |
| Deposits                                                       |   | 8,877                                   |   | 17,890 |   |
| FHLB advances and other borrowings                             |   | 6,574                                   |   | 9,288 |   |
| Securities sold under agreements to repurchase                 |   | 1,195                                   |   | 4,278 |   |
| Guaranteed preferred beneficial interests in subordinated debt |   | 926                                     |   | 987 |   |
|                                                           |   | 17,572                                  |   | 32,443 |   |
|                                                           |   |                                    |   |   |   |
| Net interest income                                            |   | 27,344                                  |   | 21,604 |   |
|                                                           |   |                                    |   |   |   |
| Provision for losses on loans                                  |   | 1,700                                   |   | 1,400 |   |
|                                                           |   |                                    |   |   |   |
| Net interest income after provision for losses on loans        |   | 25,644                                  |   | 20,204 |   |
|                                                           |   |                                    |   |   |   |
| *Non-interest  Income*                                         |   |                                    |   |   |   |
| Service fees                                                   |   | 3,177                                   |   | 2,802 |   |
| Investment product fees and insurance commissions              |   | 328                                     |   | 575 |   |
| Mortgage banking revenue                                       |   | 748                                     |   | 453 |   |
| Gain on sale of securities available for sale                  |   | —                                  |   | 698 |   |
| Gain on sale of partnership                                    |   | —                                  |   | 574 |   |
| Other                                                          |   | 332                                     |   | 540 |   |
|                                                           |   | 4,585                                   |   | 5,642 |   |
| *Non-interest  Expense*                                        |   |                                    |   |   |   |
| Compensation and employee benefits                             |   | 9,819                                   |   | 9,418 |   |
| General and administrative                                     |   | 4,267                                   |   | 4,539 |   |
| Occupancy and equipment                                        |   | 3,121                                   |   | 2,976 |   |
| Data processing                                                |   | 1,385                                   |   | 1,479 |   |
| Conversion and integration                                     |   | —                                  |   | 856 |   |
|                                                           |   | 18,592                                  |   | 19,268 |   |
|                                                           |   |                                    |   |   |   |
| Income before income tax expense                               |   | 11,637                                  |   | 6,578 |   |
|                                                           |   |                                    |   |   |   |
| Income tax expense                                             |   | 4,073                                   |   | 2,457 |   |
|                                                           |   |                                    |   |   |   |
| Net income                                                     |   | $                                       | 7,564  |   | $ | 4,121 |   |
|                                                           |   |                                    |   |   |   |
| Basic net income per share                                     |   | $                                       | 0.49   |   | $ | 0.27 |   |
|                                                           |   |                                    |   |   |   |
| Diluted net income per share                                   |   | $                                       | 0.48   |   | $ | 0.26 |   |
|                                                           |   |                                    |   |   |   |
| Dividends declared per share                                   |   | $                                       | 0.14   |   | $ | 0.14 |   |

 

See accompanying notes to consolidated financial statements.

 

2

----

 

CONSOLIDATED STATEMENTS OFSHAREHOLDERS’ 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, $0.14 per share                                                                    |   |                                      |   |                 |   | (2,179                   | )      |                                                 |   |                        |   | (2,179    | )      |
|                                                                                                   |   |                                      |   |                 |   |                     |   |                                                 |   |                        |   |      |   |
| Issuance of common stock:                                                                              |   |                                      |   |                 |   |                     |   |                                                 |   |                        |   |      |   |
| Stock option plans                                                                                     |   | 19,011                                    |   | 175                  |   |                     |   |                                                 |   |                        |   | 175       |   |
|                                                                                                   |   |                                      |   |                 |   |                     |   |                                                 |   |                        |   |      |   |
| ESOP debt repayment                                                                                    |   | 10,754                                    |   |                 |   |                     |   |                                                 |   | 328                         |   | 328       |   |
|                                                                                                   |   |                                      |   |                 |   |                     |   |                                                 |   |                        |   |      |   |
| Comprehensive income:                                                                                  |   |                                      |   |                 |   |                     |   |                                                 |   |                        |   |      |   |
|                                                                                                   |   |                                      |   |                 |   |                     |   |                                                 |   |                        |   |      |   |
| Net income                                                                                             |   |                                      |   |                 |   | 4,121                    |   |                                                 |   |                        |   | 4,121     |   |
|                                                                                                   |   |                                      |   |                 |   |                     |   |                                                 |   |                        |   |      |   |
| Other comprehensive income (loss) 3⁄4                                                               |   |                                      |   |                 |   |                     |   |                                                 |   |                        |   |      |   |
|                                                                                                   |   |                                      |   |                 |   |                     |   |                                                 |   |                        |   |      |   |
| Reclassification of securities held tomaturity to securities available  for sale, net of taxes of $321 |   |                                      |   |                 |   |                     |   | (597                                                 | )      |                        |   | (597      | )      |
|                                                                                                   |   |                                      |   |                 |   |                     |   |                                                 |   |                        |   |      |   |
| Unrealized gain on securities available for sale, net of taxes of  $2,684                              |   |                                      |   |                 |   |                     |   | 4,985                                                |   |                        |   | 4,985     |   |
|                                                                                                   |   |                                      |   |                 |   |                     |   |                                                 |   |                        |   |      |   |
| Reclassification adjustment for gains included in net income, net of  taxes of $244                    |   |                                      |   |                 |   |                     |   | (454                                                 | )      |                        |   | (454      | )      |
|                                                                                                   |   |                                      |   |                 |   |                     |   |                                                 |   |                        |   |      |   |
| Total comprehensive income                                                                             |   |                                      |   |                 |   |                     |   |                                                 |   |                        |   | 8,055     |   |
| March 31, 2001                                                                                         |   | 15,524,122                                |   | $                    | 26,466 |                     | $      | 161,555                                              |   | $                           | (1,566 | )         | $      | (1,340 | ) | $ | 185,115 |   |
|                                                                                                   |   |                                      |   |                 |   |                     |   |                                                 |   |                        |   |      |   |
| January 1, 2002                                                                                        |   | 15,595,204                                |   | $                    | 26,757 |                     | $      | 172,967                                              |   | $                           | 1,305  |      | $      | (543 | ) | $ | 200,486 |   |
|                                                                                                   |   |                                      |   |                 |   |                     |   |                                                 |   |                        |   |      |   |
| Dividends declared, $0.14 per share                                                                    |   |                                      |   |                 |   | (2,166                   | )      |                                                 |   |                        |   | (2,166    | )      |
|                                                                                                   |   |                                      |   |                 |   |                     |   |                                                 |   |                        |   |      |   |
| Issuance of common stock:                                                                              |   |                                      |   |                 |   |                     |   |                                                 |   |                        |   |      |   |
| Stock option plans                                                                                     |   | 56,566                                    |   | 604                  |   |                     |   |                                                 |   |                        |   | 604       |   |
|                                                                                                   |   |                                      |   |                 |   |                     |   |                                                 |   |                        |   |      |   |
| Purchase and retirement of common stock                                                                |   | (215,896                                  | )      | (5,117               | )      |                     |   |                                                 |   |                        |   | (5,117    | )      |
|                                                                                                   |   |                                      |   |                 |   |                     |   |                                                 |   |                        |   |      |   |
| ESOP debt repayment                                                                                    |   | 17,707                                    |   |                 |   |                     |   |                                                 |   | 543                         |   | 543       |   |
|                                                                                                   |   |                                      |   |                 |   |                     |   |                                                 |   |                        |   |      |   |
| Comprehensive income:                                                                                  |   |                                      |   |                 |   |                     |   |                                                 |   |                        |   |      |   |
|                                                                                                   |   |                                      |   |                 |   |                     |   |                                                 |   |                        |   |      |   |
| Net income                                                                                             |   |                                      |   |                 |   | 7,564                    |   |                                                 |   |                        |   | 7,564     |   |
|                                                                                                   |   |                                      |   |                 |   |                     |   |                                                 |   |                        |   |      |   |
| Other comprehensive loss 3⁄4                                                                        |   |                                      |   |                 |   |                     |   |                                                 |   |                        |   |      |   |
|                                                                                                   |   |                                      |   |                 |   |                     |   |                                                 |   |                        |   |      |   |
| Unrealized loss on securities available for sale, net of taxes of  $1,444                              |   |                                      |   |                 |   |                     |   | (2,683                                               | )      |                        |   | (2,683    | )      |
|                                                                                                   |   |                                      |   |                 |   |                     |   |                                                 |   |                        |   |      |   |
| Total comprehensive income                                                                             |   |                                      |   |                 |   |                     |   |                                                 |   |                        |   | 4,881     |   |
| March 31, 2002                                                                                         |   | 15,453,581                                |   | $                    | 22,244 |                     | $      | 178,365                                              |   | $                           | (1,378 | )         | $      | 0 |   | $ | 199,231 |   |

 

See accompanying notes to consolidated financial statements.

 

3

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CONSOLIDATED STATEMENTS OF CASHFLOWS (UNAUDITED)

** **
|                                                                                                |   | **Three-month periods ended March 31,** |   |
|-----------------------------------------------------------------------------------------------------|--------|-----------------------------------------|--------|
| ***Dollars in thousands***                                                                          |   | **2002**                                |   | **2001** |   |
|                                                                                                |   |                                    |   |   |   |
| *Operating  Activities*                                                                             |   |                                    |   |   |   |
|                                                                                                |   |                                    |   |   |   |
| Net income                                                                                          |   | $                                       | 7,564  |   | $ | 4,121 |   |
| Adjustments to reconcile net income to net cash provided by operating  activities:                  |   |                                    |   |   |   |
| Depreciation                                                                                        |   | 1,332                                   |   | 1,580 |   |
| Amortization of intangible assets                                                                   |   | 232                                     |   | 567 |   |
| Provision for losses on loans                                                                       |   | 1,700                                   |   | 1,400 |   |
| Amortization (accretion) of premiums and discounts, net                                             |   | 249                                     |   | (246 | ) |
| Gain on sale of mortgage banking assets                                                             |   | (748                                    | )      | (453 | ) |
| Gain on sale of securities available for sale                                                       |   | —                                  |   | (698 | ) |
| Gain on sale of other real estate                                                                   |   | (18                                     | )      | (12 | ) |
| Loss on disposal of premises and equipment                                                          |   | 82                                      |   | — |   |
| Loan fees deferred, net of amortization                                                             |   | 589                                     |   | 549 |   |
| FHLB stock dividends                                                                                |   | (682                                    | )      | (672 | ) |
| Changes in operating assets and liabilities:                                                        |   |                                    |   |   |   |
| Decrease in interest receivable                                                                     |   | 706                                     |   | 2,084 |   |
| (Increase) decrease in other assets                                                                 |   | (3,760                                  | )      | 3,348 |   |
| Increase (decrease) in other liabilities                                                            |   | 4,973                                   |   | (3,828 | ) |
|                                                                                                |   |                                    |   |   |   |
| Net cash provided by operating activities                                                           |   | $                                       | 12,219 |   | $ | 7,740 |   |
|                                                                                                |   |                                    |   |   |   |
| *Investing  Activities*                                                                             |   |                                    |   |   |   |
|                                                                                                |   |                                    |   |   |   |
| Purchases  of securities available for sale                                                         |   | (92,774                                 | )      | (94,820 | ) |
| Proceeds from maturing and principal repayments on securities  available for sale                   |   | 113,140                                 |   | 160,017 |   |
| Proceeds from sale of securities available for sale                                                 |   | —                                  |   | 11,698 |   |
| Proceeds from sale of mortgage banking assets                                                       |   | 59,124                                  |   | 26,433 |   |
| Net  increase in loans receivable                                                                   |   | (67,854                                 | )      | (54,861 | ) |
| Proceeds from sale of other real estate                                                             |   | 1,852                                   |   | 1,592 |   |
| Improvements  capitalized to other real estate                                                      |   | (78                                     | )      | (478 | ) |
| Purchases  of premises and equipment                                                                |   | (648                                    | )      | (2,634 | ) |
| Proceeds  from sales of premises and equipment                                                      |   | 62                                      |   | — |   |
| Net increase in  federal funds sold and securities purchased under agreements to resell             |   | (11,455                                 | )      | (30,683 | ) |
|                                                                                                |   |                                    |   |   |   |
| Net cash provided by investing activities                                                           |   | $                                       | 1,369  |   | $ | 16,264 |   |
|                                                                                                |   |                                    |   |   |   |
| *Financing  Activities*                                                                             |   |                                    |   |   |   |
|                                                                                                |   |                                    |   |   |   |
| Net  increase in deposits                                                                           |   | $                                       | 53,589 |   | $ | 19,180 |   |
| Net  increase in certificates of deposit                                                            |   | 42,426                                  |   | 37,039 |   |
| Proceeds  from FHLB advances, securities sold under agreements to repurchase, and other  borrowings |   | 1,201,554                               |   | 443,262 |   |
| Repayment  of FHLB advances, securities sold under agreements to repurchase and other  borrowings   |   | (1,302,920                              | )      | (526,652 | ) |
| Dividends  paid to shareholders                                                                     |   | (2,186                                  | )      | (2,174 | ) |
| Purchase  and retirement of common stock                                                            |   | (5,117                                  | )      | — |   |
| Issuance  of common stock from exercise of stock options                                            |   | 604                                     |   | 175 |   |
|                                                                                                |   |                                    |   |   |   |
| Net cash used in financing activities                                                               |   | (12,050                                 | )      | (29,170 | ) |
|                                                                                                |   |                                    |   |   |   |
| Net  increase (decrease) in cash and due from banks                                                 |   | 1,538                                   |   | (5,166 | ) |
|                                                                                                |   |                                    |   |   |   |
| *Cash and due  from banks*                                                                          |   |                                    |   |   |   |
| Beginning  of period                                                                                |   | 58,625                                  |   | 78,861 |   |
|                                                                                                |   |                                    |   |   |   |
| End  of period                                                                                      |   | $                                       | 60,163 |   | $ | 73,695 |   |
|                                                                                                |   |                                    |   |   |   |
| *Supplemental  Disclosures of Cash Flow Information*                                                |   |                                    |   |   |   |
|                                                                                                |   |                                    |   |   |   |
| Cash  paid during the period for:                                                                   |   |                                    |   |   |   |
| Interest                                                                                            |   | $                                       | 17,668 |   | $ | 30,672 |   |
| Income taxes                                                                                        |   | 2,500                                   |   | 1,000 |   |
| Non-cash  investing and financing activities:                                                       |   |                                    |   |   |   |
| Loans receivable transferred to other real estate                                                   |   | 1,937                                   |   | 1,633 |   |
| ESOP debt repayment                                                                                 |   | 543                                     |   | 328 |   |

 

See accompanying notes to consolidated financial statements.

 

4

----

 

NOTES TO UNAUDITED CONSOLIDATEDFINANCIAL STATEMENTS

 

**NOTE A** BASIS OFPRESENTATION

 

Pacific Northwest Bancorp is a bank holding company incorporated in theState of Washington.  Through itscommercial bank subsidiary, Pacific Northwest Bank, a wide range of financialservices is offered to businesses and individuals throughout western andcentral Washington State.  Financialservices of Pacific Northwest Bank include the banking activities of acceptingdeposits from businesses and individuals and originating commercial andcommercial real estate loans, residential loans and consumer loans.

 

The unaudited consolidated financial statements include the accounts ofPacific Northwest Bancorp and its wholly owned subsidiaries (collectivelyPNWB).  As of March 31, 2002, PacificNorthwest Bancorp’s wholly owned subsidiaries were Pacific Northwest Bank andInterWest Capital Trust I.  All materialinter-company transactions and balances have been eliminated in consolidation.

 

The preparation of the consolidated financial statements in conformitywith accounting principles generally accepted in the United States requiresmanagement to make estimates and assumptions that affect amounts reported inthe consolidated financial statements. Changes in these estimates and assumptions are considered reasonablypossible and may have a material impact on the consolidated financialstatements and thus actual results could differ from the amounts reported anddisclosed herein.

 

The unaudited consolidated financial statements have been prepared inaccordance with accounting principles generally accepted in the United Statesfor interim financial information and with the instructions to Form 10-Q andRule 10-01 of Regulation S-X.  Accordingly, they do not include all of the information andfootnotes required by accounting principles generally accepted in the UnitedStates for complete financial statements. In the opinion of management, all adjustments necessary for a fairpresentation are reflected in the unaudited interim consolidated financialstatements.  The consolidated statementsof income for the three-month periods ended March 31, 2002 and 2001 are notnecessarily indicative of the operating results for the full year.  For further information, refer to theconsolidated financial statements and footnotes filed on the Form 10-K for themost recent annual period ended December 31, 2001.

 

**NOTE B** RECLASSIFICATIONS

 

Certain reclassifications have been made to prior financial statementsto conform to current presentation.  Theeffects of the reclassifications are not considered material.

 

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

 

Basic net incomeper share is calculated by dividing net income by the weighted average numberof common shares outstanding during the period.  Diluted net income per share is calculated by dividing net incomeby diluted weighted average shares outstanding, which includes common stockequivalent shares outstanding using the treasury stock method, unless suchshares are anti-dilutive.  Common stockequivalents include shares issuable upon exercise of stock options.  Unallocated shares relating to the employeestock ownership plan debt obligation are deducted in the calculation ofweighted average shares outstanding.

 

5

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The followingtable presents the computation of basic and diluted net income per share forthe three-month periods ended March 31:

 
| ***Dollars in thousands, except share and per share amounts***            |   | **2002**   |   | **2001**   |   |
|---------------------------------------------------------------------------|--------|------------|--------|------------|--------|
|                                                                      |   |       |   |       |   |
| **Numerator:**                                                            |   |       |   |       |   |
|                                                                      |   |       |   |       |   |
| Net income                                                                |   | $          | 7,564  |       | $      | 4,121 |   |
|                                                                      |   |       |   |       |   |
| **Denominator:**                                                          |   |       |   |       |   |
|                                                                      |   |       |   |       |   |
| Denominator for basic net income per share3⁄4                          |   |       |   |       |   |
| Weighted average shares                                                   |   | 15,534,568 |   | 15,511,258 |   |
| Effect of dilutive securities:                                            |   |       |   |       |   |
| Stock options                                                             |   | 314,189    |   | 110,520    |   |
| Denominator for diluted net income per share3⁄4                        |   |       |   |       |   |
| Weighted average shares and assumed conversion of dilutive stock  options |   | 15,848,757 |   | 15,621,778 |   |
|                                                                      |   |       |   |       |   |
| Basic net income per share                                                |   | $          | 0.49   |       | $      | 0.27 |   |
|                                                                      |   |       |   |       |   |
| Diluted  net income per share                                             |   | $          | 0.48   |       | $      | 0.26 |   |

 

**NOTE D **CONVERSION ANDINTEGRATION EXPENSES

 

During the year ended December31, 2000, PNWB initiated the process of converting its various subsidiary bankoperating systems to a single enhanced operating system.  The conversion was completed on April 9,2001.  Conversion and integrationexpenses were expensed as incurred. Total expenses associated with conversion and integration efforts were$0 and $0.9 million during the three-month periods ended March 31, 2002 and 2001,respectively.

 

**NOTE E **BUSINESS SEGMENTINFORMATION

 

Between the period August 31, 1996 and October 1999,PNWB acquired six commercial banking institutions. Subsequent to theseacquisitions, PNWB was managed at the individual subsidiary bank level.  Each subsidiary bank had a Board ofDirectors and an executive management team that was responsible for theoperation and performance of the respective subsidiary bank.

 

During the year ended December 31, 2000, PNWBmerged the subsidiary banks into one commercial bank.  In addition, PNWB consolidated its executive management functionsand implemented a new organizational structure, while converting separatebanking systems into a single operating system.  As a result of these organizational and system changes, thefinancial information that is used by the chief operating decision maker inallocating resources and assessing performance is only provided for onereportable segment for the three-month periods ended March 31, 2002 and 2001.

 

**NOTE F**  SECURITIES PLEDGED UNDER AGREEMENTS TOREPURCHASE

 

PNWB has sold certain securities of the U.S. government and itsagencies and other approved investments under agreements to repurchase.  The securities sold were classified assecurities available for sale with an estimated fair value of $93.9 million and$147.9 million as of March 31, 2002 and December 31, 2001, respectively.

 

6

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**NOTE G**  ACCOUNTING CHANGES

 

In October 2001, the FASBissued SFAS No. 144 “Accounting for the Impairment or Disposal of Long-LivedAssets”. SFAS No. 144 supersedes SFAS No. 121, “Accounting for the Impairmentof Long-Lived Assets and for Long-Lived Assets to Be Disposed Of”.  This statement, which excludes goodwill,provides a single accounting model for recognition and impairment of long-livedassets to be held for sale or disposed of. SFAS No. 144 retains many of the fundamental recognition and measurementprovisions of SFAS No. 121; however, it significantly changes the criteria thatwould have to be met to classify an asset as either held-for-sale or to bedisposed of. SFAS No. 144 became effective on January 1, 2002.  The adoption of this statement did not havematerial impact on PNWB’s financial condition or results of operations.

 

In July 2001, the FASB issued SFAS No. 142 “Accounting for Goodwill andOther Intangible Assets”.  Under SFASNo. 142, goodwill and indefinite lived intangible assets are no longeramortized but are reviewed annually for impairment or more frequently ifimpairment indicators arise.  Separableintangible assets that are not deemed to have an indefinite life will continueto be amortized over their useful lives. This Statement became effective on January 1, 2002.  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.  The adoption of SFAS No. 142is expected to reduce PNWB’s goodwill amortization expense by approximately $1.1million on an annual basis.  Areconciliation of reported net income to net income adjusted to excludegoodwill amortization follows:

 
|                                                 |   | **Three-month periods ended March 31,** |   |
|------------------------------------------------------|--------|-----------------------------------------|--------|
| ***Dollars in thousands, except per share amounts*** |   | **2002**                                |   | **2001** |   |
|                                                 |   |                                    |   |   |   |
| Income statement:                                    |   |                                    |   |   |   |
| Reported net income                                  |   | $                                       | 7,564  |   | $ | 4,121 |   |
| Adjustment for goodwill amortization                 |   | —                                  |   | 280 |   |
| Adjusted net income                                  |   | $                                       | 7,564  |   | $ | 4,401 |   |
|                                                 |   |                                    |   |   |   |
| Basic net income per shares:                         |   |                                    |   |   |   |
| Reported basic net income per share                  |   | $                                       | 0.49   |   | $ | 0.27 |   |
| Adjustment for goodwill amortization                 |   | —                                  |   | 0.01 |   |
| Adjusted basic net income per share                  |   | $                                       | 0.49   |   | $ | 0.28 |   |
|                                                 |   |                                    |   |   |   |
| Diluted  net income per share                        |   |                                    |   |   |   |
| Reported  diluted net income per share               |   | $                                       | 0.48   |   | $ | 0.26 |   |
| Adjustment for goodwill amortization                 |   | —                                  |   | 0.02 |   |
| Adjusted  diluted net income per share               |   | $                                       | 0.48   |   | $ | 0.28 |   |

 

7

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## **Item 2.    MANAGEMENT DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

The followingdiscussion is provided for the unaudited consolidated financial condition andresults of operations of Pacific Northwest Bancorp, which includes its whollyowned subsidiaries (collectively PNWB). As of March 31, 2002, Pacific Northwest Bancorp’s wholly ownedsubsidiaries were Pacific Northwest Bank and InterWest Capital 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. Certain reclassifications have been made to prior period balances toconform to current presentation.  Theeffects of such reclassifications are not considered material.

 

Pacific Northwest Bancorp is a bank holding company incorporated in theState of Washington.  PNWB is afinancial services company providing a variety of products and services forboth business and individual customers. Financial services of PNWB include the banking activities of acceptingdeposits from businesses and individuals and originating commercial andcommercial real estate loans, residential loans, and consumer loans.  As part of the migration to a commercialbank, PNWB has made significant progress in restructuring its balance sheetsince mid-2000 so that it is more reflective of a commercial bank.

 

A source of futuregrowth may be through mergers and acquisitions.  PNWB’s management believes that many other financial institutionsare considering selling their institutions for a variety of reasons, includinglack of shareholder liquidity, management succession issues, technologychallenges, and increasing competition. PNWB actively reviews proposals forvarious acquisition opportunities.  PNWBhas a due 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 occur inthe future.

 

Currently, PNWB conducts its business through 55financial centers in western and central Washington State. Investments areavailable through Pacific Northwest Financial Services and insurance productsare available through Pacific Northwest Insurance Agency, both wholly ownedsubsidiaries of Pacific Northwest Bank.

 

8

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**RESULTS OFOPERATIONS**

 

PNWB had net income of $7.6 million for the three-month period endedMarch 31, 2002, compared to $4.1 million for the three-month period ended March31, 2001.  Diluted net income per sharewas $0.48 for the three-month period ended March 31, 2002, compared to $0.26for the three-month period ended March 31, 2001. PNWB’s return on averageshareholders’ equity was 15.06 percent for the three-month period ended March31, 2002, compared to 9.10 percent for the three-month period ended March 31,2001.  PNWB’s return on average assetswas 1.11 percent for the three-month period ended March 31, 2002, compared to0.58 percent for the three-month period ended March 31, 2001.

 

The following table summarizesnet income, net income per share and key financial ratios for the three-monthperiods ended March 31:

 
| ***Dollars in thousands, except per share amounts*** |   | **2002** |   | **2001** |   |
|------------------------------------------------------|--------|----------|--------|----------|--------|
|                                                 |   |     |   |     |   |
| Net income                                           |   | $        | 7,564  |     | $      | 4,121 |   |
|                                                 |   |     |   |     |   |
| Basic net income per share                           |   | $        | 0.49   |     | $      | 0.27 |   |
|                                                 |   |     |   |     |   |
| Diluted net income per share                         |   | $        | 0.48   |     | $      | 0.26 |   |
|                                                 |   |     |   |     |   |
| Return on average shareholders’ equity          |   | 15.06    | %      | 9.10     | %      |
|                                                 |   |     |   |     |   |
| Return on average assets                             |   | 1.11     | %      | 0.58     | %      |
|                                                 |   |     |   |     |   |
| Net interest margin                                  |   | 4.26     | %      | 3.26     | %      |
|                                                 |   |     |   |     |   |
| Efficiency ratio                                     |   | 58.23    | %      | 70.72    | %      |

 

*Net InterestIncome* | PNWB’s net incomeis significantly affected by changes in net interest income, which is thedifference between interest income received on loans receivable and otherinterest-earning assets and interest expense on deposits and borrowings.  Net interest income was $27.3 million forthe three-month period ended March 31, 2002, compared to $21.6 million for thethree-month period ended March 31, 2001. PNWB’s net interest income is sensitive to changes in interestrates.  The decrease in market interestrates over the past year had a positive impact on PNWB’s net interest incomedue to PNWB’s liability sensitive position. When interest rates decreased, PNWBexperienced a greater reduction in funding costs in comparison to reduction inearnings on loans and investments. During the first quarter of 2002, PNWB completed initiatives to createan interest rate neutral position to minimize the impact on net interest incomefrom future interest rate changes.  Assuch, Management does not expect net interest income and net interest margin tocontinue to improve at the same rate in 2002 as in 2001, if at all.

 

Interest income was $44.9 million for the three-month period ended March31, 2002, compared to $54.0 million for the three-month period ended March 31,2001.  The decrease for the three-monthperiod ended March 31, 2002 was due to lower yields earned on both loansreceivable and investment securities as a result of lower market interestrates.  The yield on interest-earningassets was 7.00 percent for the three-month period ended March 31, 2002,compared to 8.16 percent for the same period in 2001.  However, the decrease from lower yields was partially offset byincreases in the average balance of loans receivable and changes in thecomposition of average loans receivable with a greater percentage comprised ofcommercial and commercial real estate loans compared to single-familyresidential mortgage loans.

 

9

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Interest expense was $17.6 million for the three-month period endedMarch 31, 2002, compared to $32.4 million for the three-month period endedMarch 31, 2001.  The decrease in netinterest expense for the three-month period ended March 31, 2002 was due to adecrease in both the cost of funds as a result of reductions of market interestrates and the average balance of interest-bearing liabilities.  The cost of funds was 3.13 percent for thethree-month period ended March 31, 2002, compared to 5.45 percent for the sameperiod in 2001.  During this period,certificates of deposit repriced according to maturity schedules and borrowingsmatured and were replaced with borrowings with relatively lower interestrates.  In addition, the cost of fundsdeclined due to a shift from higher cost certificates of deposit to lower costnon-interest-bearing and interest-bearing deposits and money market accounts.

 

Net interest margin, which is net interest income divided by average interest-earningassets, was 4.26 percent for the three-month period ended March 31, 2002,compared to 3.26 percent for the three-month period ended March 31, 2001.  The increase in net interest margin for thethree-month period ended March 31, 2002 was due to changes in the mix ofearning assets and decreases in cost of funds which resulted from reductions inmarket interest rates and the restructuring of the funding base.

 

*Average Ratesand Balances* | Thefollowing table indicates the average balances and average interest ratesearned or expensed, net interest spread and net interest margin for thethree-month periods ended March 31:

 
|                                                                                          |   | **2002**             |      | **2001** |   |
|-----------------------------------------------------------------------------------------------|--------|----------------------|-----------|----------|--------|
| ***Dollars i******n thousands***                                                              |   | **Average  Balance** |      | **Rate** |   | **Average  Balance** |   | **Rate** |   |
|                                                                                          |   |                 |      |     |   |   |   |   |   |   |   |
| Loans receivable and loans held for sale                                                      |   | $                    | 1,839,789 |     | 7.56   | % | $ | 1,796,362 |   | 8.93 | % |
| Securities available for sale, securities held to maturity and other  interest-earning assets |   | 742,558              |      | 5.61     | %      | 870,514 |   | 6.58 | % |
| Total interest-earning assets                                                                 |   | 2,582,347            |      | 7.00     | %      | 2,666,876 |   | 8.16 | % |
|                                                                                          |   |                 |      |     |   |   |   |   |   |
| Interest-bearing deposits                                                                     |   | 1,387,649            |      | 2.59     | %      | 1,502,536 |   | 4.83 | % |
| FHLB advances, securities sold under agreements to repurchase and  other borrowings           |   | 887,330              |      | 3.97     | %      | 912,051 |   | 6.47 | % |
|                                                                                          |   |                 |      |     |   |   |   |   |   |
| Total interest-bearing liabilities                                                            |   | 2,274,979            |      | 3.13     | %      | 2,414,587 |   | 5.45 | % |
|                                                                                          |   |                 |      |     |   |   |   |   |   |
| Non-interest-bearing deposits                                                                 |   | $                    | 263,459   |     |   |   | $ | 225,824 |   |   |   |
|                                                                                          |   |                 |      |     |   |   |   |   |   |
| Net interest spread                                                                           |   |                 |      | 3.87     | %      |   |   | 2.71 | % |
| Net interest margin                                                                           |   |                 |      | 4.26     | %      |   |   | 3.26 | % |

 

10

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The following table provides information on changes in net interestincome for the periods that are attributable to changes in interest rates andchanges in volume:

 
|                                                                                          |   | **Three-month periods March 31, 2001 to 2002  Increase  (Decrease)  Due to changes in** |   |
|-----------------------------------------------------------------------------------------------|--------|----------------------------------------------------------------------------------------------|--------|
| ***Dollars in thousands***                                                                    |   | **Rate**                                                                                     |   | **Volume** |   | **Total** |   |
|                                                                                          |   |                                                                                         |   |   |   |   |   |
| *Interest-earning  assets*                                                                    |   |                                                                                         |   |   |   |   |   |
|                                                                                          |   |                                                                                         |   |   |   |   |   |
| Loans receivable and loans held for sale                                                      |   | $                                                                                            | (6,191 | ) | $ | 965 |   | $ | (5,226 | ) |
|                                                                                          |   |                                                                                         |   |   |   |   |   |
| Securities available for sale, securities held to maturity and other  interest-earning assets |   | (1,956                                                                                       | )      | (1,949 | ) | (3,905 | ) |
|                                                                                          |   |                                                                                         |   |   |   |   |   |
| Total net change in income on interest-earning assets                                         |   | (8,147                                                                                       | )      | (984 | ) | (9,131 | ) |
|                                                                                          |   |                                                                                         |   |   |   |   |   |
| *Interest-bearing  liabilities*                                                               |   |                                                                                         |   |   |   |   |   |
|                                                                                          |   |                                                                                         |   |   |   |   |   |
| Interest-bearing deposits                                                                     |   | 7,734                                                                                        |   | 1,279 |   | 9,013 |   |
|                                                                                          |   |                                                                                         |   |   |   |   |   |
| FHLB advances, securities sold under agreement to repurchase and other  borrowings            |   | 5,474                                                                                        |   | 384 |   | 5,858 |   |
|                                                                                          |   |                                                                                         |   |   |   |   |   |
| Total net change in expense on interest-bearing liabilities                                   |   | 13,208                                                                                       |   | 1,663 |   | 14,871 |   |
|                                                                                          |   |                                                                                         |   |   |   |   |   |
| Net change in net interest income                                                             |   | $                                                                                            | 5,061  |   | $ | 679 |   | $ | 5,740 |   |

 

*Provision forlosses on loans* | The provision for losseson loans was $1.7 million for the three-month period ended March 31, 2002,compared to $1.4 million for the three-month period ended March 31, 2001.  The provision was at a higher level for thethree-month period ended March 31, 2002 compared to the same quarter last yeardue to management’s concern about the deterioration of the Pacific Northwesteconomy and the resulting impact on known and inherent risk characteristics inthe loan portfolio.  These riskcharacteristics include changes in the size and composition of the loanportfolio, delinquency levels, actual loan loss experience, current economicconditions, and detailed analysis of individual loans for which fullcollectibility may not be assured.  

 

*Non-interestIncome* | Non-interestincome was $4.6 million for the three-month period ended March 31, 2002,compared to $5.6 million for the three-month period ended March 31, 2001.  This decrease was primarily due to a gain onsecurities available for sale and a one-time gain on the sale of an equityinterest in a partnership during the first quarter of 2001, partially offset byincreases in service fees and mortgage banking revenue in 2002.  The gains on securities available for saleduring the three-month period ended March 31, 2001 were primarily from the saleof mortgage-backed securities that were securitized from PNWB’s single-familymortgage loan portfolio in prior periods.

 

11

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Service fees were$3.2 million for the three-month period ended March 31, 2002 compared to $2.8million for the three-month period ended March 31, 2001. This increase isprimarily due to increases in fees received on deposit accounts and fees fromcommercial loan commitments.

 

Mortgage bankingrevenue was $748,000 for the three-month period ended March 31, 2002 comparedto $453,000 for the three-month period ended March 31, 2001. As part of PNWB’stransition to a commercial bank starting in mid-2000, management changed itsstrategy on the origination and retention of single-family residential mortgageloans.  As a result, the majority ofPNWB’s single-family mortgage loan production is now channeled directly to thesecondary market.  During the past year,the decline in long-term interest rates resulted in an increase in fixed-ratesingle-family mortgage loan refinances and opportunities to sell these loans onthe secondary market for a fee.  Inaddition to the lower interest rate environment, the increase in mortgagebanking revenue in the first quarter of 2002 was also due to PNWB’s focus oninitiatives to improve the mortgage banking activities.

 

*Non-interest Expense* | Non-interest expense was $18.6 million for thethree-month period ended March 31, 2002, compared to $19.3 million for thethree-month period ended March 31, 2001. Non-interest expense for the three-month period ended March 31, 2001included conversion and integration expenses of $856,000 as a result of theconversion process that was completed in April 2001 and $280,000 goodwillamortization expense.  During thethree-month period ended March 31, 2002, no such expenses were incurred.

 

Compensation and employee benefits were $9.8million for the three-month period ended March 31, 2002, compared to $9.4million for the three-month period ended March 31, 2001.  This increase in compensation and employeebenefits was primarily due to higher variable compensation expense related toperformance based bonus plans.

 

The efficiency ratio is computed by dividing totaloperating expenses by net interest income and non-interest income.  An increase in the efficiency ratioindicates that more resources are being utililized to generate the same (orgreater) volume of income while a decrease would indicate a more efficientallocation of resources.  The efficiencyratio for the three-month period ended March 31, 2002 was 58.2 percent,compared to 70.7 percent for the three-month period ended March 31, 2001.  Excluding the $856,000 conversion andintegration expenses and $280,000 goodwill amortization expense incurred duringthe first quarter of 2001, the efficiency ratios were 58.2 percent  and 66.6 percent for the three-month periodended March 31, 2002 and 2001, respectively.

 

*Income Tax Expense*| Income tax expense was $4.1 million for thethree-month period ended March 31, 2002, compared to $2.5 million for thethree-month period ended March 31, 2001. The increase in income tax expense wasprimarily due to the higher income before taxes.  The increase was partially offset by a decrease in effective taxrate from 37.4 percent for the first quarter of 2001 to 35.0 percent for thesame period in 2002 primarily due to the elimination of non-tax deductiblegoodwill amortization expense as a result of the adoption of SFAS No. 142“Accounting For Goodwill and Other Intangible Assets”.

 

**REVIEW OF FINANCIAL CONDITION**

 

PNWB’sconsolidated assets were $2.74 billion as of March 31, 2002 and December 31,2001.

 

*Securities*| As of March 31, 2002, PNWB had $733.0 million ofsecurities available for sale, compared to $757.0 million as of December 31,2001.  The decreases were due to salesand maturities of investment securities.

 

PNWB maintains liquidityin accordance with an internal liquidity policy.  Liquidity levels may be increased or decreased depending upon theyields on investment alternatives, management’s judgment as to theattractiveness of the yields then available in relation to other opportunities,and management’s expectation of the yield that will be available in thefuture.  Management’s projections as tothe short-term demand for funds to be used for loan originations and otheractivities can also affect liquidity levels.

 

12

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Securities classified as available for sale arereported at estimated fair value, with unrealized gains and losses (net ofincome taxes) reported in accumulated other comprehensive income (loss), aseparate component of shareholders’ equity.

 

*Net Loans Receivable* | Net loans receivable were $1.80 billionas of March 31, 2002, compared to $1.79 billion as of December 31, 2001.

 

Commercial loans outstanding totaled $593.1 million asof March 31, 2002, an increase of $1.4 million from December 31, 2001.  Commercial real estate mortgage loansoutstanding totaled $523.0 million as of March 31, 2002, an increase of $52.6million from December 31, 2001. Commercial and commercial real estate loans outstanding represented 60.9percent of total gross loans as of March 31, 2002, an increase from 58.4percent of total gross loans as of December 31, 2001.  Growth in commercial lending should shorten duration risk andincrease net interest margin.

 

Single-family residential mortgage loans outstandingtotaled $293.8 million as of March 31, 2002 compared to $321.2 million as ofDecember 31, 2001.  As part of the transition to a commercial bank, PNWBchanged its strategy with regard to the origination and retention ofsingle-family mortgage loans in mid-2000. The majority of PNWB’s single-family mortgage loan production is nowbeing sold in the secondary market with servicing rights released.

 

The following table sets forththe composition of PNWB’s loan portfolio by type as of the dates indicated:

 
| ***Dollars in thousands***       |   | **March 31, 2002** |      | **December 31, 2001** |   |
|----------------------------------|--------|--------------------|-----------|-----------------------|--------|
|                             |   |               |      |                  |   |
| Commercial loans:                |   |               |      |                  |   |
| Commercial                       |   | $                  | 593,065   |                  | $      | 591,663 |   |
| Commercial real estate           |   | 522,982            |      | 470,408               |   |
| Total  commercial loans:         |   | 1,116,047          |      | 1,062,071             |   |
|                             |   |               |      |                  |   |
| Single-family residential        |   | 293,770            |      | 321,246               |   |
| Real estate construction         |   | 309,348            |      | 319,228               |   |
| Consumer loans                   |   | 114,456            |      | 115,440               |   |
|                             |   | 1,833,621          |      | 1,817,985             |   |
| Less:                            |   |               |      |                  |   |
| Allowance for losses on loans    |   | 21,099             |      | 20,123                |   |
| Deferred loan fees and discounts |   | 9,357              |      | 9,430                 |   |
| Net loans receivable             |   | $                  | 1,803,165 |                  | $      | 1,788,432 |   |

 

*Loans Held for Sale* | Loans held for sale totaled $34.3million as of March 31, 2002 compared to $43.8 million as of December 31,2001.  Loans held for sale are generallysingle-family mortgage loans and loans originated under a Small Business Administrationprogram.  Loans held for sale arecarried at the lower of cost or estimated fair value in aggregate.  Loans held for sale are typically sold toother financial institutions.

 

*Non-performingAssets* | Loans aregenerally placed on non-accrual when they become past due over 90 days, or 120days if they are single-family mortgage loans, or when the collection ofinterest or principal is considered unlikely. Loans past due over 90 or 120 days that are not on non-accrual statusmust be well secured by tangible collateral and in the process ofcollection.  PNWB does not return a loanto accrual status until it is brought current with respect to both principaland interest and future principal payments are no longer in doubt.  When a loan is placed on non-accrual status,any previously accrued and uncollected interest is reversed from interestincome.  PNWB performs a review of itsloan portfolio for weaknesses in credit quality on an ongoing basis to identifyproblem loans.  This review results ininternal loan classifications based on risk characteristics and loanperformance.  The overall objective ofthis review process is to identify trends in the credit quality of the loanportfolio and to determine the level of loss exposure to evaluate the need foran adjustment to the allowance for losses on loans.

 

13

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Non-accrual loans totaled $16.8 million as of March 31, 2002 compared to$16.1 million as of December 31, 2001. This increase was primarily due to anincrease in single-family mortgage loans that were over 120 days past due as ofMarch 31, 2002, partially offset by a few construction loans being broughtcurrent during the first quarter of 2002. Other real estate was $5.9 million as of March 31, 2002 compared to $5.8million as of December 31, 2001.  Totalnon-performing assets, including non-accrual loans and other real estate,totaled $22.7 million or 0.83 percent of consolidated assets as of March 31,2002, compared to $21.9 million or 0.80 percent of consolidated assets as ofDecember 31, 2001.

 

The following table summarizes non-performing assets as of the datesindicated:

 
| ***Dollars in thousands***  |   | **March 31, 2002** |   | **December 31, 2001** |   |
|-----------------------------|--------|--------------------|--------|-----------------------|--------|
|                        |   |               |   |                  |   |
| *Non-accrual  loans*        |   |               |   |                  |   |
|                        |   |               |   |                  |   |
| Commercial loans:           |   |               |   |                  |   |
| Commercial                  |   | $                  | 8,258  |                  | $      | 8,119 |   |
| Commercial real estate      |   | 1,013              |   | 1,100                 |   |
| Total  commercial loans:    |   | 9,271              |   | 9,219                 |   |
|                        |   |               |   |                  |   |
| Single-family residential   |   | 6,712              |   | 5,425                 |   |
| Real estate construction    |   | 663                |   | 1,199                 |   |
| Consumer loans              |   | 135                |   | 245                   |   |
|                        |   |               |   |                  |   |
| Total non-accrual loans     |   | 16,781             |   | 16,088                |   |
|                        |   |               |   |                  |   |
| Other real estate           |   | 5,943              |   | 5,762                 |   |
|                        |   |               |   |                  |   |
| Total non-performing assets |   | $                  | 22,724 |                  | $      | 21,850 |   |

 

*Allowance forLosses on Loans* | Theallowance for losses on loans was $21.1 million or 1.16 percent of loans receivableas of March 31, 2002, compared to $20.1 million or 1.11 percent of loansreceivable as of December 31, 2001.  Netloan charge-offs were $0.7 million or 0.16 percent of the average balance ofloans outstanding for the three-month period ended March 31, 2002, compared to$0.7 million or 0.15 percent of the average balance of loans outstanding forthe three-month period ended March 31, 2001.

 

When availableinformation confirms that specific loans, or portions thereof, areuncollectible, these amounts are charged off against the allowance for losseson loans. The existence of some or all of the following criteria will generallyconfirm that a loss has been incurred: the loan is significantly delinquent andthe borrower has not evidenced the ability or intent to bring the loan current;there is no recourse 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 forlosses on loans is maintained at an amount to sufficiently provide forestimated losses based on evaluating known and inherent risks in the loanportfolio.  Management analyzes certainfactors underlying the quality of the loan portfolio.  These factors include changes in the size and composition of theloan portfolio, delinquency levels, actual loan loss experience, currenteconomic conditions, and detailed analysis of individual loans for which fullcollectibility may not be assured. Management has assessed the impact of the Pacific Northwest regionaleconomy on the credit risk in the loan portfolio.  To date, delinquency trends and classified loan levels relativeto comparable periods do not indicate any material deterioration in the loanportfolio.  Currently, management is notaware of any unusually large loan concentrations in industries impacted by theeconomy. Management continues to closely monitor PNWB’s credit quality andfocus on identifying potential problem credits and any loss exposure in atimely manner.  Industry concentrationand related limits will also be subject to on-going assessment.

 

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PNWB believes it hasestablished its allowance for losses on loans in accordance with accountingprinciples generally accepted in the United States.  However, there can be no assurance that in the future,regulators, when reviewing PNWB’s loan portfolio, will not request PNWB toincrease its allowance for losses on loans, thereby affecting PNWB’s financialcondition and results of operations. Substantial increases may be necessary should the quality of loansdeteriorate as a result of the factors discussed above.

 

PNWB’s allowance for losses on loans is allocated to specific loans,certain loan categories based on the relative risk characteristics, assetclassifications and actual loss experience of the loan portfolio.  Although the allocation of the allowance forlosses on loans is an important credit management tool, the entire allowancefor losses on loans is available for the entire loan portfolio.  Management reviewed the allocations in thevarious loan categories and believes the allowance for losses on loans wasadequate as of March 31, 2002.

 

The following tables summarize the activity in allowance for losses onloans during the three-month periods ended March 31:

 
| ***Dollars in thousands***          |   | **2002** |   | **2001** |   |
|-------------------------------------|--------|----------|--------|----------|--------|
|                                |   |     |   |     |   |
| Allowance as of beginning of period |   | $        | 20,123 |     | $      | 17,561 |   |
|                                |   |     |   |     |   |
| Provision for losses on loans       |   | 1,700    |   | 1,400    |   |
|                                |   |     |   |     |   |
| Recoveries                          |   | 129      |   | 296      |   |
|                                |   |     |   |     |   |
| Charge-offs                         |   | (853     | )      | (954     | )      |
|                                |   |     |   |     |   |
| Allowance as of end of period       |   | $        | 21,099 |     | $      | 18,303 |   |

 

*Goodwilland Other Intangible Assets*| Goodwill arising from acquisitions represents theexcess of the purchase price over the estimated fair value of net assets acquired.Prior to 2002, goodwill was amortized using the straight-line methods overperiods not exceeding twenty years. Effective January 1, 2002, upon adoption of SFAS No. 142 “Accounting forGoodwill and Other Intangible Assets”, PNWB no longer amortizes its goodwill,and as such, expects annual goodwill amortization expense to reduce byapproximately $1.1 million starting in 2002. PNWB reviews its goodwill for impairment annually or more frequently ifimpairment indicators arise.  During thefirst quarter of 2002, PNWB performed the transitional impairment assessment ofits goodwill as of January 1, 2002 and noted that such assessment did notindicate any impairment of goodwill.  Areconciliation of reported net income to net income adjusted to exclude goodwillamortization follows:

 
|                                                 |   | **Three-month periods ended March 31,** |   |
|------------------------------------------------------|--------|-----------------------------------------|--------|
| ***Dollars in thousands, except per share amounts*** |   | **2002**                                |   | **2001** |   |
|                                                 |   |                                    |   |   |   |
| Income statement:                                    |   |                                    |   |   |   |
| Reported net income                                  |   | $                                       | 7,564  |   | $ | 4,121 |   |
| Adjustment for goodwill amortization                 |   | —                                  |   | 280 |   |
| Adjusted net income                                  |   | $                                       | 7,564  |   | $ | 4,401 |   |
|                                                 |   |                                    |   |   |   |
| Basic net income per shares:                         |   |                                    |   |   |   |
| Reported basic net income per share                  |   | $                                       | 0.49   |   | $ | 0.27 |   |
| Adjustment for goodwill amortization                 |   | —                                  |   | 0.01 |   |
| Adjusted basic net income per share                  |   | $                                       | 0.49   |   | $ | 0.28 |   |
|                                                 |   |                                    |   |   |   |
| Diluted  net income per share                        |   |                                    |   |   |   |
| Reported  diluted net income per share               |   | $                                       | 0.48   |   | $ | 0.26 |   |
| Adjustment for goodwill amortization                 |   | —                                  |   | 0.02 |   |
| Adjusted  diluted net income per share               |   | $                                       | 0.48   |   | $ | 0.28 |   |

 

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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 flows and estimated future cash flows from servicing assets tothose estimated at the time servicing assets were originated.  Mortgage servicing intangibles are amortizedusing the accelerated methods as an offset to service fees in proportion to andover the period of estimated net servicing income.

 

Goodwilland other intangible assets consisted of the following as of the datesindicated:

 
| ***Dollars in  thousands***    |   | **March 31, 2002** |   | **December 31, 2001** |   |
|--------------------------------|--------|--------------------|--------|-----------------------|--------|
|                           |   |               |   |                  |   |
| Goodwill                       |   | $                  | 16,137 |                  | $      | 16,137 |   |
| Mortgage servicing intangibles |   | 1,374              |   | 1,562                 |   |
| Core deposit intangibles       |   | 378                |   | 423                   |   |
|                           |   | $                  | 17,889 |                  | $      | 18,122 |   |

 

*Deposits*| PNWB offers various types of deposit accounts, including checking accounts,savings accounts, money market accounts and certificate of depositaccounts.  Deposit accounts vary as toterms; the principal differences are the minimum balance required, the time periodthe funds must remain on deposit, the interest rate, and the deposit orwithdrawal option.  PNWB relies ongenerating deposits through a marketing strategy that employs a sales staffresponsible for retaining and generating new customer relationships.  We emphasize developing total clientrelationships in order to increase our core deposit base.

 

Non-interest-bearing deposits were $263.5 million asof March 31, 2002 compared to $241.7 million as of December 31, 2001.  Non-interest-bearing deposits represented15.5 percent and 15.1 percent of total deposits as of March 31, 2002 andDecember 31, 2001, respectively. Interest-bearing transaction accounts (which include interest-bearingchecking, money market and savings accounts) totaled $663.8 million as of March31, 2002 compared to $632.0 million as of December 31, 2001.  Interest-bearing transaction accountsrepresented 39.0 percent of total deposits as of March 31, 2002, compared to39.4 percent as of December 31, 2001.

 

Certificatesof deposit totaled $773.6 million as of March 31, 2002, compared to $731.1million as of December 31, 2001. Certificates of deposit represented 45.5 percent of total deposits as ofMarch 31, 2002, compared to 45.6 percent as of December 31, 2001.

 

The following table sets forth the balances of depositsby account type as of the dates indicated:

 
| ***Dollars in  thousands***        |   | **March 31, 2002** |      | **December 31, 2001** |   |
|------------------------------------|--------|--------------------|-----------|-----------------------|--------|
|                               |   |               |      |                  |   |
| Non-interest-bearing deposits      |   | $                  | 263,459   |                  | $      | 241,674 |   |
| Interest-bearing checking accounts |   | 216,614            |      | 214,098               |   |
| Money market accounts              |   | 348,127            |      | 322,554               |   |
| Savings accounts                   |   | 99,106             |      | 95,390                |   |
| Certificates of deposit            |   | 773,565            |      | 731,139               |   |
|                               |   |               |      |                  |   |
| Total                              |   | $                  | 1,700,871 |                  | $      | 1,604,855 |   |

 

*FHLB Advancesand 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 $762.7 million as of March 31,2002 compared to $864.0 million as of December 31, 2001.  The need for this type of borrowingsdecreased primarily as a result of the overall decrease in assets and increasein deposits.

 

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The FHLB providescredit for member financial institutions. As members, financial institutions are required to own capital stock inthe FHLB, and are authorized to apply for advances on the security of suchstock, certain home mortgages and other assets (principally securities that areobligations of, or guaranteed by, the United States).  Advances are made to member financial institutions pursuant toseveral different programs.  Theseprograms are generally designed to meet the financial institution’s need whilestill reflecting market terms and conditions. PNWB uses advances from the FHLB to supplement funds available to lendand to meet liquidity guidelines. Interest rates on these advances vary in response to general economicconditions.  PNWB also uses the securitiesmarket for borrowings by utilizing its securities available for sale ascollateral. These borrowings are collateralized by securities with an estimatedfair value exceeding the face value of the borrowings.

 

*Otherborrowings*| Otherborrowings were $12.1 million as of March 31, 2002, compared to $12.6 millionas of December 31, 2001.  They wereprimarily notes from another financial institution. This borrowing qualifies asTier II capital under the capital guidelines of the Federal Reserve Board.  The decrease from December 31, 2001 was dueto the payoff of a loan by Pacific Northwest Bancorp Employee Stock OwnershipPlan that Pacific Northwest Bancorp guaranteed.

 

*GuaranteedPreferred Beneficial Interests in Subordinated Debt*  | On November 15, 1999, $40 million of 9.875 percentCapital Securities were issued by InterWest Capital Trust I (the Trust).  The proceeds of the offering were investedby the Trust in junior subordinated debentures of Pacific NorthwestBancorp.  The debentures held by the Trustare the sole assets of the Trust.  Thecapital securities are subject to mandatory redemption, in whole or in part,upon repayment of the debentures.  Thedebentures will not mature earlier than November 15, 2009, and not later thanNovember 15, 2029.  Pacific NorthwestBancorp entered into agreements which, taken collectively, fully andunconditionally guarantee the capital securities subject to the terms of eachof the guarantees.  The capitalsecurities qualify as Tier I capital under the capital guidelines of theFederal Reserve Board.  In 2001, PacificNorthwest Bancorp purchased $2.5 million of the capital securities.

 

*Shareholders’Equity* | PNWB is committed to managing capital for maximumshareholder benefit and maintaining strong protection for depositors andcreditors.  PNWB manages various capitallevels at both the holding company and subsidiary bank level to maintainadequate capital ratios and levels in accordance with external regulations andcapital guidelines established by the Board of Directors.

 

On January 22, 2002, the Board of Directors approved a stock repurchaseplan of up to five percent of Pacific Northwest Bancorp’s outstanding shares ofcommon stock over the next twelve months. During the three-month period ended March 31, 2002, PNWB repurchased, onthe open market, approximately 216,000 shares at a total price of $5.1 millionunder this repurchase plan.  Therepurchased common stock was acquired for an average price of $23.70 per commonshare.

 

PNWB’s total shareholders’ equity was $199.2 million as of March 31,2002, compared to $200.5 million as of December 31, 2001.  The decrease in shareholders’ equity duringthe first quarter of 2002 was primarily due to stock repurchase of $5.1million, first quarter cash dividends declared of $0.14 per share or $2.2million, a decrease in the estimated fair value of securities available forsale of $2.7 million, partially offset by net income of $7.6 million.  Book value per share was $12.90 as of March31, 2002, compared to $12.86 as of December 31, 2001.

 

### **SUPERVISION ANDREGULATION**

 

Pacific Northwest Bancorp is a registered bankholding company under the Bank Holding Company Act of 1956 (BHCA) and issubject to the supervision of, and regulation by, the Board of Governors of theFederal Reserve System  (FRB).  Under the BHCA, Pacific Northwest Bancorpfiles with the FRB annual reports of operations and such additional informationas the FRB may require.  Under the BHCA,a bank holding company may engage in banking, managing or controlling banks,furnishing or performing services for banks it controls, and conducting activitiesthat the FRB has determined to be closely related to banking.

 

Pacific Northwest Bank isa member of the Federal Deposit Insurance Corporation (FDIC), and as such, issubject to examination thereby.  PacificNorthwest Bank is a state-chartered commercial bank subject to

 

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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 otherregulators.  Areas subject to regulationby federal or state authorities include the allowance for losses on loans,investments, loans, mergers and acquisitions, issuance of securities, paymentof 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 regulatoryauthorities.  Applicable law alsorequires public disclosure of final enforcement actions.

 

Pacific Northwest Bancorp and Pacific Northwest Bank are subject torisk-based capital guidelines requiring minimum capital levels based on thecredit risk of assets.  Failure to meetminimum capital requirements can initiate certain mandatory and possiblyadditional discretionary, actions by regulators that, if undertaken, could havea material effect on PNWB’s consolidated financial statements.  Under capital adequacy guidelines and theregulatory framework for prompt corrective action, Pacific Northwest Bancorpand Pacific Northwest Bank must meet specific capital guidelines that involvequantitative measures of assets, liabilities and certain off-balance-sheetitems as calculated under regulatory accounting practices.  Capital classifications are also subject toqualitative judgments by the regulators about components, risk weightings andother factors.

 

The regulations define the relevant capital levels for the fivecategories.  In general terms, thecapital 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-basedcapitalguidelinesissuedbytheFRB, which establish a risk-adjusted ratiorelating capital to different categories of assets.  Tier I capital is comprised of shareholders’ equity andguaranteed preferred beneficial interests in subordinated debt less certainintangibles, and excludes the equity impact of adjusting securities availablefor sale to estimated fair value. Total capital is Tier I capital, theallowance for losses on loans and certain long-term debt that qualifies forinclusion as regulatory capital.  TheFRB’s risk-based capital rules have been supplemented by a leverage capitalratio, defined as Tier I capital to adjusted quarterly average totalassets.  As of March 31, 2002, under theFRB’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 March 31, 2002 and December 31, 2001, arepresented in the following table:

 

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**CAPITALRATIOS**

 
|                                           |   | **Amount** |    | **For  Capital  Adequacy Purposes** |   | **To Be Well  Capitalized Under  Prompt Corrective  Action Provisions** |   |
|------------------------------------------------|--------|------------|---------|-------------------------------------|--------|-------------------------------------------------------------------------|--------|
| ***Dollars in thousands***                     |   | **Amount** |    | **Ratio**                           |   | **Amount**                                                              |   | **Ratio** |   | **Amount** |   | **Ratio** |   |
|                                           |   |       |    |                                |   |                                                                    |   |   |   |   |   |   |   |
| **March 31, 2002**                             |   |       |    |                                |   |                                                                    |   |   |   |   |   |   |   |
|                                           |   |       |    |                                |   |                                                                    |   |   |   |   |   |   |   |
| **Pacific Northwest Bancorp**                  |   |       |    |                                |   |                                                                    |   |   |   |   |   |   |   |
| Total capital  (to risk-weighted assets)  |   | $          | 254,687 |                                | 12.49  | %                                                                       | $      | 163,121 |   | 8.0 | % | $ | 203,901 |   | 10.0 | % |
| Tier I capital  (to risk-weighted assets)      |   | 221,483    |    | 10.86                               | %      | 81,561                                                                  |   | 4.0 | % | 122,341 |   | 6.0 | % |
| Tier I capital  (to average assets)            |   | 221,483    |    | 8.18                                | %      | 108,263                                                                 |   | 4.0 | % | 135,329 |   | 5.0 | % |
|                                           |   |       |    |                                |   |                                                                    |   |   |   |   |   |   |   |
| **Pacific Northwest Bank:**                    |   |       |    |                                |   |                                                                    |   |   |   |   |   |   |   |
| Total capital  (to risk-weighted assets)       |   | $          | 253,156 |                                | 12.46  | %                                                                       | $      | 162,533 |   | 8.0 | % | $ | 203,166 |   | 10.0 | % |
| Tier I capital  (to risk-weighted assets)      |   | 231,952    |    | 11.42                               | %      | 81,267                                                                  |   | 4.0 | % | 121,900 |   | 6.0 | % |
| Tier I capital  (to average assets)            |   | 231,952    |    | 8.59                                | %      | 108,017                                                                 |   | 4.0 | % | 135,021 |   | 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 March 31, 2002, Pacific Northwest Bank was in compliance withwell-capitalized capital requirements. Management believes that under thecurrent regulations Pacific Northwest Bank will continue to meetwell-capitalized capital requirements in the foreseeable future.  However, events beyond the control ofPacific Northwest Bank, such as a downturn in the economy in areas wherePacific Northwest Bank has most of its loans, could adversely affect futureearnings and, consequently, the ability of Pacific Northwest Bank to meetfuture well-capitalized capital requirements.

 

# **LIQUIDITY RESOURCES**

 

Liquidity management focuses on the need to meet both short-termfunding requirements and PNWB’s long-term strategies and goals. Specifically,the objective of liquidity management is to ensure the continuous availabilityof funds to meet the demands of depositors, creditors and borrowers. Managementmanages the balance sheet to meet these needs. PNWB desires to attract andretain business and retail customer relationships with a focus on transactionaccounts and commercial and consumer lending. PNWB also uses wholesale funds through advances from the FHLB and thesale of securities under agreements to repurchase to fund asset growth and meetliquidity needs. PNWB also uses wholesale and brokered certificates of depositto supplement wholesale borrowings. Other sources of funds for liquidity include loan repayments, loansales, security sales and mortgage-backed and related security repayments.Repayments on loans and mortgage-backed and related securities and depositinflows and outflows are affected by changes in interest rates.

 

PNWB has the capacity to borrow funds from the FHLB throughpre-approved credit lines.  These creditlines have pledge requirements whereby PNWB must maintain unencumberedcollateral with a value at least equal to the outstanding balance. PNWB alsouses the securities market as a vehicle for borrowing by utilizing itssecurities available for sale as collateral. These borrowings are collateralized by securities with an estimated

 

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fair value exceeding the face value of the borrowings. If the estimatedfair value of the securities were to decline as a result of an increase in interestrates or other factors, PNWB would be required to pledge additional securitiesor cash as collateral. In addition, PNWB has the ability to borrow funds fromthe Federal Reserve.

 

The analysis of liquidity also includes a review of PNWB’s consolidatedstatement of cash flows for the three-month period ended March 31, 2002.  The consolidated statement of cash flowsdetails PNWB’s operating, investing and financing activities during the period.  The most significant items under operatingactivities include net income of $7.6 million for the three-month period endedMarch 31, 2002 and a decrease in other liabilities of $5.0 million and anincrease of other assets of $3.8 million. Also included in operating activities are the add back of non-cashdepreciation, amortization of intangible assets and the provision for losses ofloans totaling $3.3 million. Investing activities included proceeds frommaturing and principal repayments on securities available for sale of $113.1million, purchases of securities available for sale of $92.8 million. Investingactivities also included a $67.9 million increase in loans receivable, $59.1million of proceeds from mortgage banking activities and a $1.7 millionproceeds from the sale of other real estate. During the period, financingactivities included $101.4 million in borrowing repayments, net of borrowingproceeds, a $42.4 million increase in certificates of deposit, a $53.6 millionincrease in deposits and a total of $2.2 million paid in cash dividends toshareholders.

 

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**Item3.  QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK**

 

PNWB’s results of operations are largely dependent upon its ability tomanage interest rate risk. Management considers interest rate risk to be asignificant market risk that could have a material effect on PNWB’s financialcondition and results of operations.

 

PNWB is sensitive to potential changes in interest rates and theresulting impact on net interest income. It is an objective of management to reduce this sensitivity through theuse of adjustable rate loans and short-term commercial and consumer loans.  This enables PNWB to better match theduration of its deposit base with these types of assets.

 

In addition to adjustable rate loans and short-term commercial andconsumer loans, PNWB uses a number of other strategies to minimize the impactof significant interest rate changes on net income. The strategies utilized byPNWB include sales of long-term, fixed-rate mortgage loans, emphasis on growthin non-interest-bearing deposits and adjustable rate commercial lending.

 

Management uses simulationanalysis to measure PNWB’s interest sensitivity position.  This simulation analysis is used to evaluatethe effects of potential interest rate movements on net interest income.  The simulation analysis model is dynamic innature, and incorporates management’s current balance sheet strategy.Management develops assumptions regarding interest rate spreads, projectedbalances, expected maturities, cash flows and prepayment assumptions underdifferent 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 oninterest rate risk, reference is made to the sections “Net Interest Income” and“Average Rates and Balances” in Item 2. Management Discussion and Analysis ofFinancial Condition and Results of Operations contained in this quarterlyreport on Form 10-Q.  Informationregarding the expected maturities of financial assets and financial liabilitieshas not changed materially from disclosures made in the Annual Report on Form10-K for the year ended December 31, 2001.

 

**FORWARD-LOOKINGSTATEMENTS**

 

In this quarterlyreport on Form 10-Q, PNWB has included certain “forward-looking statements”concerning its future operations. Sentences containing words such as “may,” “will,” “expect,”“anticipate,” “believe,” “estimate,” “should,” “projected,” or similar wordsmay constitute forward-looking statements. Although PNWB believes that the expectations expressed in theseforward-looking statements are based on reasonable assumptions within thebounds of its knowledge of its business and operations, it is possible thatactual results may differ materially from these expectations.  The following items are among the factorsthat could cause actual results to differ materially from the forward-lookingstatements: general economic conditions, including their impact on capitalexpenditures; business conditions in the banking industry; recent world eventsand their impact on interest rates, businesses and customers; the regulatoryenvironment; new legislation; vendor quality and efficiency; employee retentionfactors; rapidly changing technology and evolving banking industry standards;competitive standards; competitive factors, including increased competitionwith community, regional and national financial institutions; fluctuatinginterest rate environments; higher than expected loan delinquencies; andsimilar matters.  These factors shouldbe considered in evaluating the forward-looking statements and undue relianceshould not be placed on such statements.

 

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**PART II. OTHER INFORMATION**

 

**Item 1.                    LegalProceedings**

 

PNWB faces ordinary routine litigation arising in the normal course ofbusiness.  In the opinion of management,liabilities (if any) arising from such claims will not have a material effectupon the business, results of operations or financial condition of PNWB.

 

**Item 2, 3, 4, 5are not applicable and have been omitted.**

 

**Item 6****.                    Exhibits and Reports on Form8-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). |

 

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

 

On January 24, 2002, PNWBreported items 5 and 7 in a Current Report on Form 8-K in connection with theissuance of a press release announcing PNWB’s plan to repurchase up to fivepercent of its outstanding shares of common stock over the next twelve months.

 

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**SIGNATURES**

 

Pursuant to the requirements of the Securities Exchange Act of 1934, theRegistrant has duly caused this report to be signed on its behalf by theundersigned 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: | May 13, 2002 |                                                  |   |   |
|        |              |                                                       |        |  |  |  |

 

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