** **

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington D.C.  20549**

 

**FORM 10-Q**

 

**(MarkOne)**

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

** **

 

**Forthe quarterly period ended September 30, 2001**

 

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

** **

**For the transition period________ from to ________**

** **

**Commission file number 0-26632**

 

**Pacific Northwest Bancorp**

(Exact name of registrant asspecified in its charter)

 

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

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.

 

YES ý NO o

 

Asof October 30, 2001, 15,600,428 shares of common stock were outstanding with nopar value.

 

 

**PACIFIC NORTHWEST BANCORP**

 
| **INDEX**      |                                                                                                                    |
|----------------|-------------------------------------------------------------------------------------------------------------------------|
|           |                                                                                                                    |
| **PART I.**    | **FINANCIAL INFORMATION**                                                                                               |
|           |                                                                                                                    |
| **Item 1.**    | **Financial Statements**                                                                                                |
|           |                                                                                                                    |
|           | **Consolidated  Statements of Financial Condition as of September 30, 2001 and December 31,  2000**                     |
|           |                                                                                                                    |
|           | **Consolidated  Statements of Income for the three and nine month periods ended September 30,  2001 and 2000**          |
|           |                                                                                                                    |
|           | **Consolidated  Statements of Shareholders’ Equity for the nine-month periods ended September  30, 2001 and 2000** |
|           |                                                                                                                    |
|           | **Consolidated  Statements of Cash Flows for the nine-month periods ended September 30, 2001  and 2000**                |
|           |                                                                                                                    |
|           | **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** |                                                                                                                    |

 

CONSOLIDATEDSTATEMENTS OF FINANCIAL CONDITION (UNAUDITED)

 
| *Dollars in thousands*                                                  |   | **September 30,  2001** |      | **December 31,  2000** |   |
|-------------------------------------------------------------------------|--------|-------------------------|-----------|------------------------|--------|
| *Assets*                                                                |   |                    |      |                   |   |
| Cash and due from banks                                                 |   |                    |      |                   |   |
| Non-interest-bearing                                                    |   | $                       | 58,880    |                   | $      | 70,566 |   |
| Interest-bearing                                                        |   | 88                      |      | 8,295                  |   |
| Federal funds sold and securities purchased under  agreements to resell |   | 5,100                   |      | 7,467                  |   |
| Securities available for sale                                           |   | 784,947                 |      | 840,489                |   |
| Securities held to maturity                                             |   | --                      |      | 64,741                 |   |
| Loans receivable                                                        |   | 1,808,428               |      | 1,776,108              |   |
| Allowance for losses on loans                                           |   | (19,618                 | )         | (17,561                | )      |
| Net loans receivable                                                    |   | 1,788,810               |      | 1,758,547              |   |
| Loans held for sale                                                     |   | 38,640                  |      | 14,187                 |   |
| Interest receivable                                                     |   | 16,883                  |      | 19,762                 |   |
| Other real estate                                                       |   | 7,861                   |      | 9,909                  |   |
| Premises and equipment                                                  |   | 52,023                  |      | 58,466                 |   |
| Goodwill and other intangible assets                                    |   | 18,792                  |      | 20,701                 |   |
| Other assets                                                            |   | 25,904                  |      | 9,740                  |   |
| Total assets                                                            |   | $                       | 2,797,928 |                   | $      | 2,882,870 |   |
| *Liabilities*                                                           |   |                    |      |                   |   |
| Deposits:                                                               |   |                    |      |                   |   |
| Non-interest-bearing                                                    |   | $                       | 233,054   |                   | $      | 244,100 |   |
| Interest-bearing                                                        |   | 1,450,142               |      | 1,473,008              |   |
| Total deposits                                                          |   | 1,683,196               |      | 1,717,108              |   |
| Federal Home Loan Bank (FHLB) advances                                  |   | 684,300                 |      | 643,200                |   |
| Securities sold under agreements to repurchase                          |   | 152,953                 |      | 274,920                |   |
| Guaranteed preferred beneficial  interests in subordinated debt         |   | 38,500                  |      | 40,000                 |   |
| Other borrowings                                                        |   | 12,894                  |      | 1,753                  |   |
| Other liabilities                                                       |   | 26,458                  |      | 27,153                 |   |
| Total liabilities                                                       |   | 2,598,301               |      | 2,704,134              |   |
| *Shareholders’ Equity*                                             |   |                    |      |                   |   |
| Common stock, no par value                                              |   |                    |      |                   |   |
| Authorized shares 30,000,000                                            |   |                    |      |                   |   |
| Issued and outstanding:  15,596,136 and 15,494,357 shares               |   | --                      |      | --                     |   |
| Paid-in-capital                                                         |   | 27,013                  |      | 26,291                 |   |
| Retained earnings                                                       |   | 168,180                 |      | 159,613                |   |
| Accumulated other comprehensive  gain (loss)                            |   | 5,248                   |      | (5,500                 | )      |
| Debt related to employee stock ownership plan (ESOP)                    |   | (814                    | )         | (1,668                 | )      |
| Total shareholders' equity                                              |   | 199,627                 |      | 178,736                |   |
| Total liabilities and shareholders’ equity                         |   | $                       | 2,797,928 |                   | $      | 2,882,870 |   |

 

CONSOLIDATED STATEMENTS OF INCOME(UNAUDITED)

For the three and nine monthperiods ended September 30, 2001 and 2000

** **
| *Dollars in thousands, except per  share amounts*               |     | **Three-month  periods** |     | **Nine-month  periods** |     |
|-----------------------------------------------------------------|----------|--------------------------|----------|-------------------------|----------|
|                                                            | **2001** | *** ***             | **2000** | ** **              | **2001** | ** ** | **2000** | ** ** |
| *Interest Income*                                               |     |                     |     |                    |     |   |   |   |   |
| Loans receivable and loans held  for sale                       |     | $                        | 38,354   |                    | $        | 41,431 |   | $ | 117,457 |   | $ | 120,034 |   |
| Securities available for sale                                   |     | 12,166                   |     | 12,121                  |     | 39,452 |   | 37,944 |   |
| Securities held to maturity                                     |     | --                       |     | 1,105                   |     | -- |   | 3,281 |   |
| Other                                                           |     | 143                      |     | 366                     |     | 580 |   | 1,246 |   |
|                                                            |     | 50,663                   |     | 55,023                  |     | 157,489 |   | 162,505 |   |
| *Interest Expense*                                              |     |                     |     |                    |     |   |   |   |   |
| Deposits                                                        |     | 13,652                   |     | 16,637                  |     | 47,665 |   | 45,532 |   |
| FHLB advances and other borrowings                              |     | 7,231                    |     | 11,088                  |     | 24,804 |   | 32,766 |   |
| Securities sold under agreements to repurchase                  |     | 2,168                    |     | 4,363                   |     | 9,314 |   | 13,057 |   |
| Guaranteed preferred beneficial interests in  subordinated debt |     | 987                      |     | 987                     |     | 2,963 |   | 2,962 |   |
|                                                            |     | 24,038                   |     | 33,075                  |     | 84,746 |   | 94,317 |   |
| Net interest income                                             |     | 26,625                   |     | 21,948                  |     | 72,743 |   | 68,188 |   |
| Provision for losses on loans                                   |     | 1,550                    |     | 1,400                   |     | 4,350 |   | 3,350 |   |
| Net interest income after  provision for losses on loans        |     | 25,075                   |     | 20,548                  |     | 68,393 |   | 64,838 |   |
| *Non-interest Income*                                           |     |                     |     |                    |     |   |   |   |   |
| Service fees                                                    |     | 3,174                    |     | 2,944                   |     | 9,307 |   | 8,708 |   |
| Investment product fees and insurance commissions               |     | 571                      |     | 734                     |     | 1,792 |   | 2,210 |   |
| Gain on sale of loans                                           |     | 584                      |     | 635                     |     | 1,556 |   | 668 |   |
| Gain (loss) on sale of securities available for sale            |     | 514                      |     | 5                       |     | 1,658 |   | (6,770 | ) |
| Gain on sale of partnership                                     |     | --                       |     | --                      |     | 574 |   | -- |   |
| Other                                                           |     | 596                      |     | 574                     |     | 1,747 |   | 1,897 |   |
|                                                            |     | 5,439                    |     | 4,892                   |     | 16,634 |   | 6,713 |   |
| *Non-interest Expense*                                          |     |                     |     |                    |     |   |   |   |   |
| Compensation and employee benefits                              |     | 9,732                    |     | 10,031                  |     | 28,812 |   | 29,877 |   |
| General and administrative                                      |     | 5,790                    |     | 4,320                   |     | 15,954 |   | 13,113 |   |
| Occupancy and equipment                                         |     | 3,120                    |     | 2,681                   |     | 8,924 |   | 7,674 |   |
| Data processing                                                 |     | 1,967                    |     | 1,381                   |     | 5,558 |   | 3,888 |   |
| Other Real Estate Owned                                         |     | 147                      |     | 11                      |     | 161 |   | 2,166 |   |
| Conversion and integration                                      |     | --                       |     | 1,827                   |     | 1,290 |   | 5,354 |   |
| Severance and employment agreements                             |     | --                       |     | 120                     |     | 200 |   | 3,325 |   |
| Impairment of goodwill                                          |     | --                       |     | --                      |     | -- |   | 748 |   |
|                                                            |     | 20,756                   |     | 20,371                  |     | 60,899 |   | 66,145 | ** ** |
| Income before income tax expense                                |     | 9,758                    |     | 5,069                   |     | 24,128 |   | 5,406 |   |
| Income tax expense                                              |     | 3,651                    |     | 1,861                   |     | 9,024 |   | 2,451 |   |
| Net income                                                      |     | $                        | 6,107    |                    | $        | 3,208 |   | $ | 15,104 |   | $ | 2,955 |   |
| Basic net income per share                                      |     | $                        | 0.39     |                    | $        | 0.21 |   | $ | 0.97 |   | $ | 0.19 |   |
| Diluted net income per share                                    |     | $                        | 0.39     |                    | $        | 0.21 |   | $ | 0.96 |   | $ | 0.19 |   |
| Dividends declared per share                                    |     | $                        | 0.14     |                    | $        | 0.14 |   | $ | 0.42 |   | $ | 0.42 |   |

 

CONSOLIDATEDSTATEMENTS OF SHAREHOLDERS' EQUITY (UNAUDITED)

 
| *Dollars in thousands, except  share data*                                                                |   | **Common Stock,  no par value Shares** |   | **Paid-in  Capital** |   | **Retained  Earnings** |   | **Accumulated  Other Comprehensive Gain (Loss)** |   | **Debt Related  To ESOP** |    | **Total** |   |
|-----------------------------------------------------------------------------------------------------------|--------|----------------------------------------|--------|----------------------|--------|------------------------|--------|--------------------------------------------------|--------|---------------------------|---------|-----------|--------|
| January 1, 2000                                                                                           |   | 15,800,377                             |   | $                    | 33,297 |                   | $      | 162,043                                          |   | $                         | (20,640 | )         | $      | (2,980 | ) | $ | 171,720 |   |
| Dividends declared, $0.42 per share                                                                       |   |                                   |   |                 |   | (6,522                 | )      |                                             |   |                      |    | (6,522    | )      |
| Issuance of common stock:                                                                                 |   |                                   |   |                 |   |                   |   |                                             |   |                      |    |      |   |
| Stock option plans and stock grants                                                                       |   | 104,897                                |   | 752                  |   |                   |   |                                             |   |                      |    | 752       |   |
| ESOP debt repayment                                                                                       |   | 36,227                                 |   |                 |   |                   |   |                                             |   | 984                       |    | 984       |   |
| Purchase and retirement of common stock                                                                   |   | (468,000                               | )      | (7,861               | )      |                   |   |                                             |   |                      |    | (7,861    | )      |
| Comprehensive income:                                                                                     |   |                                   |   |                 |   |                   |   |                                             |   |                      |    |      |   |
| Net income                                                                                                |   |                                   |   |                 |   | 2,955                  |   |                                             |   |                      |    | 2,955     |   |
| Other comprehensive income (loss) -                                                                       |   |                                   |   |                 |   |                   |   |                                             |   |                      |    |      |   |
| Unrealized loss on securities available for sale, net  of taxes of $(82)                                  |   |                                   |   |                 |   |                   |   | (152                                             | )      |                      |    | (152      | )      |
| Reclassification adjustment for losses included in net  income, net of taxes of $2,370                    |   |                                   |   |                 |   |                   |   | 4,400                                            |   |                      |    | 4,400     |   |
| Total comprehensive income *                                                                              |   |                                   |   |                 |   |                   |   |                                             |   |                      |    | 7,203     |   |
| September 30, 2000                                                                                        |   | 15,473,501                             |   | $                    | 26,188 |                   | $      | 158,476                                          |   | $                         | (16,392 | )         | $      | (1,996 | ) | $ | 166,276 |   |
|                                                                                                      |   |                                   |   |                 |   |                   |   |                                             |   |                      |    |      |   |
| January 1, 2001                                                                                           |   | 15,494,357                             |   | $                    | 26,291 |                   | $      | 159,613                                          |   | $                         | (5,500  | )         | $      | (1,668 | ) | $ | 178,736 |   |
| Dividends declared, $0.42 per share                                                                       |   |                                   |   |                 |   | (6,537                 | )      |                                             |   |                      |    | (6,537    | )      |
| Issuance of common stock:                                                                                 |   |                                   |   |                 |   |                   |   |                                             |   |                      |    |      |   |
| Stock option plans                                                                                        |   | 71,538                                 |   | 722                  |   |                   |   |                                             |   |                      |    | 722       |   |
| ESOP debt repayment                                                                                       |   | 30,241                                 |   |                 |   |                   |   |                                             |   | 854                       |    | 854       |   |
| Comprehensive income:                                                                                     |   |                                   |   |                 |   |                   |   |                                             |   |                      |    |      |   |
| Net income                                                                                                |   |                                   |   |                 |   | 15,104                 |   |                                             |   |                      |    | 15,104    |   |
| Other comprehensive income (loss) -                                                                       |   |                                   |   |                 |   |                   |   |                                             |   |                      |    |      |   |
| Reclassification of securities held to maturity to  securities available for sale, net of taxes of $(321) |   |                                   |   |                 |   |                   |   | (597                                             | )      |                      |    | (597      | )      |
| Unrealized gain on securities available for sale, net  of taxes of $6,690                                 |   |                                   |   |                 |   |                   |   | 12,423                                           |   |                      |    | 12,423    |   |
| Reclassification adjustment for gains included in net  income, net of taxes of $580                       |   |                                   |   |                 |   |                   |   | (1,078                                           | )      |                      |    | (1,078    | )      |
| Total comprehensive  income *                                                                             |   |                                   |   |                 |   |                   |   |                                             |   |                      |    | 25,852    |   |
| September 30, 2001                                                                                        |   | 15,596,136                             |   | $                    | 27,013 |                   | $      | 168,180                                          |   | $                         | 5,248   |      | $      | (814 | ) | $ | 199,627 |   |

 

----

* Comprehensive Income for the three months ended September 30, 2001 and2000 was $14,335 and $7,220, respectively.

 

CONSOLIDATEDSTATEMENTS OF CASH FLOWS (UNAUDITED)

** **
|                                                                                               | **Nine-month  periods ended September 30,** |
|----------------------------------------------------------------------------------------------------|---------------------------------------------|
| *Dollars in thousands*                                                                             | ** **                                  | **2001** | ** ** | **2000** |   |
| *Operating Activities*                                                                             |                                        |   |   |   |   |
| Net income                                                                                         |                                        | $ | 15,104 |   | $ | 2,955 |   |
| Adjustments to reconcile net income to net cash  provided by operating activities:                 |                                        |   |   |   |   |
| Depreciation                                                                                       |                                        | 4,763 |   | 4,227 |   |
| Amortization of intangible assets                                                                  |                                        | 1,908 |   | 1,458 |   |
| Impairment of goodwill                                                                             |                                        | -- |   | 748 |   |
| Provision for losses on loans                                                                      |                                        | 4,350 |   | 3,350 |   |
| Write-downs on other real estate                                                                   |                                        | 542 |   | 2,168 |   |
| Amortization (accretion) of premiums and discounts, net                                            |                                        | (214 | ) | 96 |   |
| Gain on sale of loans                                                                              |                                        | (1,556 | ) | (668 | ) |
| Loss (gain) on sale of securities available for sale                                               |                                        | (1,658 | ) | 6,770 |   |
| Gain on sale of other real estate                                                                  |                                        | (523 | ) | (141 | ) |
| Loan fees deferred, net of  amortization                                                           |                                        | 1,752 |   | 682 |   |
| FHLB stock dividends                                                                               |                                        | (2,220 | ) | (2,169 | ) |
| Changes in operating assets and liabilities:                                                       |                                        |   |   |   |   |
| (Increase) decrease in interest receivable                                                         |                                        | 2,879 |   | (2,300 | ) |
| (Increase) decrease in other assets                                                           |                                        | (16,215 | ) | (6,554 | ) |
| Increase (decrease) in other liabilities                                                           |                                        | (6,444 | ) | 28,651 |   |
| Net cash provided by operating  activities                                                         |                                        | $ | 2,468 |   | $ | 39,273 |   |
| *Investing Activities*                                                                             |                                        |   |   |   |   |
| Purchases of securities  available for sale                                                        |                                        | (282,995 | ) | (130,472 | ) |
| Proceeds from maturing and  principal repayments on securities available for sale                  |                                        | 356,556 |   | 59,895 |   |
| Proceeds from sale of securities available for sale                                                |                                        | 67,350 |   | 126,343 |   |
| Proceeds from maturing and  principal repayments on securities held to maturity                    |                                        | -- |   | 2,663 |   |
| Proceeds from sale of loans                                                                        |                                        | 104,256 |   | 147,089 |   |
| Net increase in loans  receivable                                                                  |                                        | (167,958 | ) | (289,998 | ) |
| Proceeds from sale of other real estate                                                            |                                        | 8,527 |   | 5,770 |   |
| Improvements capitalized to  other real estate                                                     |                                        | (1,136 | ) | (431 | ) |
| Purchases of premises and  equipment                                                               |                                        | (4,442 | ) | (8,057 | ) |
| Proceeds from sales of premises  and equipment                                                     |                                        | 5,200 |   | -- |   |
| Purchases  of FHLB stock                                                                           |                                        | -- |   | (770 | ) |
| Net (increase) decrease in federal funds sold and  securities purchased under agreements to resell |                                        | 2,367 |   | (1,100 | ) |
| Net cash provided by (used in)  investing activities                                               |                                        | $ | 87,725 | ** ** | $ | (89,068 | ) |

** **

 
| *Dollars in thousands*                                                                             | **Nine-month  periods ended September 30,** |
|----------------------------------------------------------------------------------------------------|---------------------------------------------|
|                                                                                               | **2001**                                    |   | **2000** |   |
| *Financing Activities*                                                                             |                                        |   |   |   |   |
| Net increase in deposits                                                                           |                                        | $ | 28,260 |   | $ | 24,865 |   |
| Net increase (decrease) in  certificates of deposit                                                |                                        | (62,172 | ) | 55,824 |   |
| Proceeds from FHLB advances,  securities sold under agreements to repurchase, and other borrowings |                                        | 2,241,045 |   | 1,319,995 |   |
| Repayment  of FHLB advances, securities sold under agreements to repurchase and other  borrowings  |                                        | (2,309,916 | ) | (1,366,082 | ) |
| Purchase of Interwest Capital  Trust I – capital securities                                   |                                        | (1,500 | ) | -- |   |
| Dividends  paid to shareholders                                                                    |                                        | (6,525 | ) | (6,595 | ) |
| Purchase and retirement of  common stock                                                           |                                        | -- |   | (7,861 | ) |
| Issuance of common stock from exercise of stock options                                            |                                        | 722 |   | 677 |   |
| Net cash provided by (used in)  financing activities                                               |                                        | (110,086 | ) | 20,823 |   |
| Net decrease in cash and due  from banks                                                           |                                        | (19,893 | ) | (28,972 | ) |
| *Cash and due from banks*                                                                          |                                        |   |   |   |   |
| Beginning of period                                                                                |                                        | 78,861 |   | 114,062 |   |
| End of period                                                                                      |                                        | $ | 58,968 |   | $ | 85,090 |   |
| *Supplemental Disclosures of Cash Flow Information*                                                |                                        |   |   |   |   |
| Cash paid during the period for:                                                                   |                                        |   |   |   |   |
| Interest                                                                                           |                                        | $ | 88,020 |   | $ | 88,342 |   |
| Income taxes                                                                                       |                                        | 7,800 |   | 9,630 |   |
| Non-cash investing and financing activities:                                                       |                                        |   |   |   |   |
| Loans receivable transferred to other real estate                                                  |                                        | 4,440 |   | 5,553 |   |
| Premises and equipment transferred to other real estate                                            |                                        | 923 |   | 279 |   |
| Loans receivable securitized as securities available  for sale                                     |                                        | -- |   | 120,169 |   |
| Transfer of securities from  held to maturity to available for sale                                |                                        | 64,741 |   | -- |   |
| ESOP debt repayment                                                                                |                                        | 854 |   | 984 |   |

 

NOTESTO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

 

**NOTE A** BASIS OF PRESENTATION

 

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 are 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, consumer loans, andagricultural loans.

 

The unaudited consolidated financial statements include the accounts ofPacific Northwest Bancorp and its wholly owned subsidiaries (collectivelyPNWB).  As of September 30, 2001,Pacific Northwest Bancorp’s wholly owned subsidiaries were Pacific NorthwestBank and InterWest Capital Trust I.  Allmaterial inter-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 and footnotes required by accountingprinciples generally accepted in the United States for complete financialstatements.  In the opinion ofmanagement, all adjustments necessary for a fair presentation are reflected inthe unaudited interim consolidated financial statements.  The consolidated statements of income forthe three and nine-month periods ended September 30, 2001 and 2000 are notnecessarily indicative of the operating results for the full year.  For further information, refer to theconsolidated financial statements and footnotes for the most recent annualperiod, December 31, 2000.

** **

**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.

 

The followingtable presents the computation of basic and diluted net income per share forthe three and nine-month periods ended September 30:

 
|                                                                      |   | **Three months** |   | **Nine months** |   |
|---------------------------------------------------------------------------|--------|------------------|--------|-----------------|--------|
| *Dollars in thousands, except share and per share amounts*                |   | **2001**         |   | **2000**        |   | **2001** |   | **2000** |   |
| **Numerator:**                                                            |   |             |   |            |   |   |   |   |   |
| Net income                                                                |   | $                | 6,107  |            | $      | 3,208 |   | $ | 15,104 |   | $ | 2,955 |   |
| **Denominator:**                                                          |   |             |   |            |   |   |   |   |   |
| Denominator for basic net income per share-                               |   |             |   |            |   |   |   |   |   |
| Weighted average shares                                                   |   | 15,583,115       |   | 15,450,317      |   | 15,543,215 |   | 15,512,081 |   |
| Effect of dilutive securities:                                            |   |             |   |            |   |   |   |   |   |
| Stock options                                                             |   | 167,660          |   | 83,360          |   | 154,077 |   | 121,887 |   |
| Denominator for diluted net income per share-                             |   |             |   |            |   |   |   |   |   |
| Weighted average shares and assumed conversion of  dilutive stock options |   | 15,750,775       |   | 15,533,677      |   | 15,697,292 |   | 15,633,968 |   |
| Basic net income per share                                                |   | $                | 0.39   |            | $      | 0.21 |   | $ | 0.97 |   | $ | 0.19 |   |
| Diluted net income per share                                              |   | $                | 0.39   |            | $      | 0.21 |   | $ | 0.96 |   | $ | 0.19 |   |

 

**NOTE D**CONVERSION AND INTEGRATION EXPENSES

** **

Duringthe year ended December 31, 2000, PNWB initiated the process of converting itsvarious subsidiary bank operating systems to a single enhanced operatingsystem.  The conversion was completed onApril 9, 2001.  Conversion andintegration expenses were expensed as incurred.  Total expenses associated with conversion and integration effortswere $0 and $1.8 million during the three-month periods ended September 30,2001 and 2000, respectively.  Conversionand integration expenses were $1.3 million and $5.4 million for the nine-monthperiods ended September 30, 2001 and 2000, respectively.

 

**NOTE E**SEVERANCE AND EMPLOYMENT AGREEMENT EXPENSES

 

In conjunction with executive management changes and elimination ofduplicate administrative functions, PNWB incurred $0 and $120,000 in severanceand employment agreement expenses during the three-month periods endedSeptember 30, 2001 and 2000, respectively. Such expenses were $200,000 and $3.3 million for the nine-month periodsended September 30, 2001 and 2000, respectively.  There are approximately a total of 40 employees affected by theseseverance and employment agreements. For the nine-month period ended September 30, 2001, $400,000 was paidout in accordance with the terms of the severance and employment agreements.  As of September 30, 2001, PNWB had anaccrued liability of $2.1 million related to these agreements that will be paidout in future periods.

** **

**NOTE F**BUSINESS SEGMENT INFORMATION

 

During the year endedDecember 31, 2000, PNWB consolidated its executive management functions andimplemented a new organizational structure while consolidating the subsidiarybanks into a single commercial bank using a single operating system.  Effective July 1, 2000, Pacific NorthwestBank and The Bank of Tukwila were merged into InterWest Bank.  EffectiveSeptember 1, 2000, InterWest Bank changed its name to Pacific NorthwestBank.  As a result of theseorganizational changes, the financial information that is used by the chiefoperating decision maker in allocating resources and assessing performance isonly provided for one reportable segment for the three and nine-month periodsended September 30, 2001 and 2000.

 

**NOTE G**SECURITIES PLEDGED UNDER AGREEMENTS TO REPURCHASE

 

Securities pledged under agreements to repurchase were $142.6 millionand $299.6 million as of September 30, 2001 and December 31, 2000,respectively, and are included in securities available for sale and securitiesheld to maturity in the consolidated statements of financial condition.  PNWB reclassified all securities held tomaturity to securities available for sale on January 1, 2001 upon adoption ofSFAS No. 133.

 

**NOTE H**ACCOUNTING CHANGES

 

In September 1998, the Financial Accounting and Standards Board (FASB)issued Statement of Financial Accounting Standards (SFAS) No. 133, “Accountingfor Derivative Instruments and Hedging Activities.” In September 2000, the FASBissued SFAS No. 138, which amended certain provisions of SFAS No. 133 toclarify specific areas presenting difficulties in implementation.  SFAS No. 133, as amended by SFAS No. 138,establishes accounting and reporting standards for derivative instruments,including certain derivative instruments imbedded in other contracts, and forhedging activities.  It requires therecognition of all derivatives as either assets or liabilities in the statementof financial condition and the measurement of those instruments at estimatedfair value.  In certain definedconditions, a derivative may be specifically designated as a hedge for aparticular exposure.  The accounting forderivatives depends on the intended use of the derivatives and the resultingdesignation.  This statement was adoptedby PNWB on January 1, 2001. The adoption of this statement did not have amaterial impact on PNWB’s financial condition or results of operations.  As permitted by the provisions of this statement,PNWB reclassified all securities held to maturity to securities available forsale on January 1, 2001.  Thisreclassification resulted in other comprehensive loss of $597,000, net ofincome taxes of $321,000.

 

In September 2000, the FASB issued SFAS No. 140 “Accounting forTransfers and Servicing of Financial Assets and Extinguishments ofLiabilities,” a replacement of SFAS No. 125. This statement revises the standards for accounting for securitizationsand other transfers of financial assets and collateral and requires certaindisclosures; however, it carries over most of SFAS No. 125’s provisions withoutreconsideration.  The standardsaddressed in this statement are based on consistent application of a financialcomponents approach that focuses on control. Under this approach, after a transfer of financial assets, an entityrecognizes the financial and servicing assets it controls and the liabilitiesit has incurred, derecognizes financial assets when control has beensurrendered, and derecognizes liabilities when extinguished.  This statement is effective for transfersand servicing of financial assets and extinguishment of liabilities occurringafter March 31, 2001.   This statementwas effective for recognition and reclassification of collateral and fordisclosures relating to securitization transactions and collateral for fiscalyear 2000.  The adoption of thisstatement affects the disclosures in PNWB’s financial statements; however, theadoption of this statement did not have a material impact on PNWB’s financialcondition or results of operations.

 

In July 2001, the FASB issued SFAS No. 141 “Accounting for BusinessCombinations”.  This statementeliminated pooling-of-interests method of accounting for business combinationsexcept for qualifying business combinations that were initiated prior to July1, 2001.  It further clarifies thecriteria for recognizing intangible assets separately from goodwill.  The requirements of Statement 141 areeffective for any business combination accounted for by the purchase methodthat is completed after June 30, 2001. The adoption of this statement did not have a material impact on PNWB’sfinancial condition or results of operations.

 

In July 2001, the FASB issued SFAS No. 142“Accounting for Goodwill and Other Intangible Assets”.  Under SFAS No. 142, goodwill and indefinitelived intangible assets are no longer amortized but are reviewed annually forimpairment or more frequently if impairment indicators arise.  Separable intangible assets that are notdeemed to have an indefinite life will continue to be amortized over theiruseful lives.  The amortizationprovisions of SFAS No. 142 become effective on January 1, 2002 for goodwill andintangible assets in existence prior to June 30, 2001, but apply immediately togoodwill and intangible assets created after June 30, 2001.  This Statement will become effective onJanuary 1, 2002.  The adoption ofSFAS No. 142 is expected to reduce PNWB’s goodwill amortization byapproximately $1.1 million ($729,000 after tax) on an annual basis beginning infiscal 2002.

 

In October 2001, the FASB issued SFAS No. 144 “Accounting for theImpairment or Disposal of Long-Lived Assets”. SFAS No. 144 supersedes SFAS No.121, “Accounting for the Impairment of Long-Lived Assets and for Long-LivedAssets to Be Disposed Of”.  Thisstatement, which excludes goodwill, provides a single accounting model forlong-lived assets to be disposed of.  It 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 will becomeeffective on January 1, 2002. Management is currently evaluating the potential impact on PNWB’s financialcondition or results of operations upon adoption of this statement.

 

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

 

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 September 30, 2001, 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 Bancorpis a bank holding company incorporated in the State of Washington.  PNWB is a financial services companyproviding a variety of products and services for both business and individualcustomers.  Financial services of PNWBinclude the banking activities of accepting deposits from businesses andindividuals and originating commercial and commercial real estate loans,residential loans, consumer loans and agricultural loans.  PNWB continues to change the composition ofthe loan portfolio and the deposit base as part of the migration to acommercial bank.  These changes aredesigned to have a positive impact on net interest income and service feerevenue while continuing to meet the needs of PNWB’s customers.

** **

Pacific Northwest Bancorp completed the acquisition of six commercialbanking institutions between 1996 and 1999, which added a total of $668 millionin assets as measured at the respective acquisition dates.  The following table summarizes pertinentinformation related to the completed acquisitions:

 
| **Acquisition**

**Date** |   | **Institution**                   |   | **Total Assets At Acquisition Date  (dollars in thousands)** |    | **Common Shares Issued** |      |
|---------------------------|--------|-----------------------------------|--------|--------------------------------------------------------------|---------|--------------------------|-----------|
| August 31, 1996           |   | Central Bancorporation (1)        |   | $                                                            | 206,093 |                     | 2,147,391 |   |
| January 15, 1998          |   | Puget Sound Bancorp, Inc.(1)      |   | 53,109                                                       |    | 586,420                  |      |
| September 15,  1998       |   | Pacific Northwest Bank (1)        |   | 200,219                                                      |    | 2,346,081                |      |
| September 16,  1998       |   | Pioneer Bancorp, Inc. (1)         |   | 108,399                                                      |    | 692,846                  |      |
| August 31, 1998           |   | Kittitas Valley Bancorp, Inc. (2) |   | 47,441                                                       |    | 229,831                  | *         |
| October 1, 1999           |   | NBT Northwest Bancorp (2)         |   | 53,018                                                       |    | 677,109                  |      |
|                           |        |                                   |        |                                                              |         |                          |           |  |

 

----

(1)    Pooling-of-interests method of accounting

(2)    Purchase method of accounting

 

* Additionally, $6.4 million in cash was paid to Kittitas shareholders.

 

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

 

Currently, PNWB conductsits business through 55 financial centers in western and central WashingtonState.  Investments are availablethrough Pacific Northwest Financial Services and insurance products areavailable through Pacific Northwest Insurance Agency, wholly owned subsidiariesof Pacific Northwest Bank.

 

**RESULTS OFOPERATIONS**

 

PNWB had net income of $6.1 million for the three-month period endedSeptember 30, 2001, compared to $3.2 million for the three-month period endedSeptember 30, 2000.  Diluted net incomeper share was $0.39 for the three-month period ended September 30, 2001,compared to $0.21 for the three-month period ended September 30, 2000.  PNWB’s return on average shareholders’ equitywas 12.83 percent for the three-month period ended September 30, 2001, comparedto 7.87 percent for the three-month period ended September 30, 2000.  PNWB’s return on average assets was 0.88percent for the three-month period ended September 30, 2001, compared to 0.46percent for the three-month period ended September 30, 2000.

 

PNWB had net income of $15.1 million for the nine-month period endedSeptember 30, 2001 compared to $3.0 million for the nine-month period endedSeptember 30, 2000.  Diluted net incomeper share was $0.96 for the nine-month period ended September 30, 2001,compared to $0.19 for the nine-month period ended September 30, 2000.  PNWB’s return on average shareholders’equity was 10.81 percent for the nine-month period ended September 30, 2001,compared to 2.37 percent for the nine-month period ended September 30, 2000.PNWB’s return on average assets was 0.71 percent for the nine-month periodended September 30, 2001, compared to 0.14 percent for the nine-month periodended September 30, 2000.

 

Thefollowing table summarizes net income , net income per share and key financialratios for the three and nine-month periods ended September 30:

 
|                                              |   | **Three months** |       | **Nine months** |       |
|---------------------------------------------------|--------|------------------|------------|-----------------|------------|
| *Dollars in thousands, except per  share amounts* |   | **2001**         | ** ** | **2000**        | ** ** | **2001** | ** ** | **2000** | ** ** |
| Net income                                        |   | $                | 6,107      |            | $          | 3,208 |   | $ | 15,104 |   | $ | 2,955 |   |
| Basic net income per share                        |   | $                | 0.39       |            | $          | 0.21 |   | $ | 0.97 |   | $ | 0.19 |   |
| Diluted net income per share                      |   | $                | 0.39       |            | $          | 0.21 |   | $ | 0.96 |   | $ | 0.19 |   |
| Return on average shareholders’  equity      |   | 12.83            | %          | 7.87            | %          | 10.81 | % | 2.37 | % |
| Return on average assets                          |   | 0.88             | %          | 0.46            | %          | 0.71 | % | 0.14 | % |
| Net interest margin                               |   | 4.04             | %          | 3.37            | %          | 3.67 | % | 3.49 | % |
| Efficiency ratio                                  |   | 64.73            | %          | 75.90           | %          | 68.14 | % | 88.31 | % |

* *

*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.  PNWB’s net interest income is sensitive tochanges in interest rates.  While interestrates began declining in the first quarter of 2001, the positive impact on netinterest income was delayed until the second and third quarters becauseshort-term borrowings and certificates of deposit reprice according to maturityschedules.  Furthermore, interestrate changes have a greater initial impact on loan yields than on the cost ofdeposits and borrowings as variable rate loans reprice immediately.  PNWBcontinues to change the composition of its balance sheet to reduce its interestrate sensitivity.  Management does notexpect that net interest income and net interest margin to continue to improveat the same rate for the rest of the year.

 

Net interest income was $26.7 million for the three-month period endedSeptember 30, 2001, compared to $21.9 million for the three-month period endedSeptember 30, 2000.  Net interest incomewas $72.7 million for the nine-month period ended September 30, 2001, comparedto $68.2 million for the nine-month period ended September 30, 2000.  The increases in net interest income forboth the three and nine-month periods ended September 30, 2001 were primarilydue to more significant decreases in the cost of funds as compared to decreasesin yield on earning assets.

 

Interest income was $50.7 million for the three-month period endedSeptember 30, 2001, compared to $55.0 million for the three-month period endedSeptember 30, 2000.  Interest income was$157.5 million for the nine-month period ended September 30, 2001, compared to$162.5 million for the nine-month period ended September 30, 2000.  The decreases for both the three andnine-month periods ended September 30, 2001 were due to lower yields earned onboth loans receivable and investment securities as a result of lower marketinterest rates.  The yield on interest-earningassets was 7.69 percent for the three-month period ended September 30, 2001,compared to 8.45 percent for the same period in 2000.  The yield on interest-earning assets was 7.95 percent for thenine-month period ended September 30, 2001, compared to 8.31 percent for thesame period in 2000.   However, thedecreases were partially offset by increases in the average balance of loansreceivable and changes in the composition of average loans receivable with agreater percentage comprised of commercial and commercial real estate loanscompared to single-family residential mortgage loans.

 

Interest expense was $24.0 million for the three-month period endedSeptember 30, 2001, compared to $33.1 million for the three-month period endedSeptember 30, 2000.  Interest expensewas $84.7 million for the nine-month period ended September 30, 2001, comparedto $94.3 million for the nine-month period ended September 30, 2000.  The decreases in net interest expense forboth the three and nine-month periods ended September 30, 2001 were due to adecrease in both the cost of funds and the average balance of interest-bearingliabilities.  The cost of funds was 4.07percent for the three-month period ended September 30, 2001, compared to 5.49percent for the three-month period ended September 30, 2000. The cost of fundsdecreased primarily due to reductions of market interest rates throughout thefirst nine months of 2001 during which certificates of deposits repricedaccording to maturity schedules and borrowings matured and were replaced withborrowings with relatively lower interest rates.  In addition, the cost of funds declined due to a shift fromhigher cost certificates of deposit to lower cost interest-bearing deposits andmoney market accounts.

 

Net interest margin, which is net interest income divided by averageinterest-earning assets, was 4.04 percent for the three-month period endedSeptember 30, 2001, compared to 3.37 percent for the three-month period endedSeptember 30, 2000.  Net interest marginwas 3.67 percent for the nine-month period ended September 30, 2001, comparedto 3.49 percent for the nine-month period ended September 30, 2000.  The increases in net interest margin forboth the three and nine-month periods ended September 30, 2001 were due to changesin the mix of earning assets and decreases in cost of funds which resulted fromreductions in market 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 September 30:

 
|                                                                                          |       | **2001**             |       | **2000** |             |
|-----------------------------------------------------------------------------------------------|------------|----------------------|------------|----------|------------------|
| *Dollars in thousands*                                                                        | ** ** | **Average  Balance** | ** ** | **Rate** | ** **  | **Average  Balance** | ** ** | **Rate** | ** ** |
| Loans receivable and loans held for sale                                                      |       | $                    | 1,822,369  |     | 8.38             | % | $ | 1,803,380 |   | 9.19 | % |
| Securities available for sale, securities held to  maturity and other interest-earning assets |       | 803,699              |       | 6.13     | %                | 801,017 |   | 6.79 | % |
| Total interest-earning assets                                                                 |       | 2,626,068            |       | 7.69     | %                | 2,604,397 |   | 8.45 | % |
| Interest-bearing deposits                                                                     |       | 1,455,181            |       | 3.72     | %                | 1,397,102 |   | 4.74 | % |
| FHLB advances, securities sold under agreements to  repurchase and other borrowings           |       | 888,959              |       | 4.64     | %                | 1,000,396 |   | 6.54 | % |
| Total interest-bearing liabilities                                                            |       | 2,344,140            |       | 4.07     | %                | 2,397,498 |   | 5.49 | % |
| Non-interest-bearing deposits                                                                 |       | $                    | 226,947    |     |             |   | $ | 218,942 |   |   |   |
| Net interest spread                                                                           |       |                 |       | 3.62     | %                |   |   | 2.96 | % |
| Net interest margin                                                                           |       |                 |       | 4.04     | %                |   |   | 3.37 | % |

 

The following table indicates the average balances and average interestrates earned or expensed, net interest spread and net interest margin for thenine-month periods ended September 30:

 
|                                                                                          |       | **2001**             |       | **2000** |       |
|-----------------------------------------------------------------------------------------------|------------|----------------------|------------|----------|------------|
| *Dollars in thousands*                                                                        | ** ** | **Average  Balance** | ** ** | **Rate** | ** ** | **Average  Balance** | ** ** | **Rate** | ** ** |
| Loans receivable and loans held for sale                                                      |       | $                    | 1,808,652  |     | 8.67       | % | $ | 1,767,790 |   | 9.05 | % |
| Securities available for sale, securities held to  maturity and other interest-earning assets |       | 836,749              |       | 6.38     | %          | 839,865 |   | 6.74 | % |
| Total interest-earning assets                                                                 |       | 2,645,401            |       | 7.95     | %          | 2,607,655 |   | 8.31 | % |
| Interest-bearing deposits                                                                     |       | 1,482,733            |       | 4.30     | %          | 1,364,282 |   | 4.46 | % |
| FHLB advances, securities sold under agreements to  repurchase and other borrowings           |       | 897,124              |       | 5.53     | %          | 1,039,862 |   | 6.27 | % |
| Total interest-bearing liabilities                                                            |       | 2,379,857            |       | 4.76     | %          | 2,404,144 |   | 5.24 | % |
| Non-interest-bearing deposits                                                                 |       | $                    | 229,079    |     |       |   | $ | 214,936 |   |   |   |
| Net interest spread                                                                           |       |                 |       | 3.19     | %          |   |   | 3.07 | % |
| Net interest margin                                                                           |       |                 |       | 3.67     | %          |   |   | 3.49 | % |

 

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 Sept. 30, 2001 vs. 2000** |                          | **Nine-month  periods Sept. 30, 2001 vs. 2000** |
|-----------------------------------------------------------------------------------------------|--------------------------------------------------|-------------------------------|-------------------------------------------------|
|                                                                                          |                                             | **Increase  (Decrease)** |                                            | **Increase  (Decrease)** |   |
|                                                                                          |                                             | **Due to changes  in **  | ** **                                      | **Due to changes  in  ** | ** ** |
| *Dollars in thousands*                                                                        |                                             | **Rate**                      |                                            | **Volume** |   | **Total** |   | **Rate** |   | **Volume** |   | **Total** |   |
| *Interest-earning assets*                                                                     |                                             |                          |                                            |   |   |   |   |   |   |   |   |   |   |
| Loans receivable and loans held for sale                                                      |                                             | $                             | (3,529                                          | ) | $ | 452 |   | $ | (3,077 | ) | $ | (5,058 | ) | $ | 2,481 |   | $ | (2,577 | ) |
| Securities available for sale, securities held to  maturity and other interest-earning assets |                                             | (1,328                        | )                                               | 45 |   | (1,283 | ) | (2,282 | ) | (157 | ) | (2,439 | ) |
| Total net change in income on interest-earning assets                                         |                                             | (4,857                        | )                                               | 497 |   | (4,360 | ) | (7,340 | ) | 2,324 |   | (5,016 | ) |
| *Interest-bearing liabilities*                                                                |                                             |                          |                                            |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing deposits                                                                     |                                             | 3,640                         |                                            | (655 | ) | 2,985 |   | 1,841 |   | (3,974 | ) | (2,133 | ) |
| FHLB advances, securities sold under agreement to  repurchase and other borrowings            |                                             | 4,368                         |                                            | 1,684 |   | 6,052 |   | 5,507 |   | 6,197 |   | 11,704 |   |
| Total net change in expense on interest-bearing  liabilities                                  |                                             | 8,008                         |                                            | 1,029 |   | 9,037 |   | 7,348 |   | 2,223 |   | 9,571 |   |
| Net change in net interest incomeinterest income                                              |                                             | $                             | 3,151                                           |   | $ | 1,526 |   | $ | 4,677 |   | $ | 8 |   | $ | 4,547 |   | $ | 4,555 |   |

* *

*Provision forlosses on loans* | The provision for losseson loans was $1.6 million for the three-month period ended September 30, 2001,compared to $1.4 million for the three-month period ended September 30, 2000.The provision for losses on loans was $4.4 million for the nine-month periodended September 30, 2001, compared to $3.4 million for the nine-month periodended September 30, 2000.  Managementincreased the provision for losses on loans during the three and nine-monthperiods ended September 30, 2000 as a result of management’s concern about thedeterioration of the Pacific Northwest economy and the resulting impact onknown and inherent risk characteristics in the loan portfolio.  These risk characteristics includechanges in the size and composition of the loan portfolio, delinquency levels,actual loan loss experience, current economic conditions, and detailed analysisof individual loans for which full collectibility may not be assured.  

 

*Non-interestIncome* | Non-interest income was $5.4 million for thethree-month period ended September 30, 2001, compared to $4.9 million for thethree-month period ended September 30, 2000. This increase was primarily due to an increase in gain on the sale ofsecurities during the third quarter of 2001. Non-interest income was $16.6 million for the nine-month period endedSeptember 30, 2001, compared to $6.7 million for the nine-month period endedSeptember 30, 2000.  This increase wasprimarily due to an increase in gains on sale of loans in 2001 and the $6.8million loss incurred on the sale of securities in the second quarter of 2000.

 

Gains on the saleof loans were $584,000 for the three-month period ended September 30, 2001compared to $635,000 for the three-month period ended September 30, 2000.  Gains on the sale of loans were $1.6 millionfor the nine-month period ended September 30, 2001 compared to $668,000 for thenine-month period ended September 30, 2000. As part of the transition to a commercial bank, PNWBchanged its strategy with regards to the origination and retention ofsingle-family mortgage loans during 2000. The majority of PNWB’s single-family mortgage loan production is channeledto the secondary market with less single-family mortgages retained in the loanportfolio.

 

Gains on the sale of securities available for sale were $514,000and $1.7 million for the three and nine-month period ended September 30, 2001,respectively, compared to a gain of $5,000 and a loss of $6.8 million for thethree and nine-month periods ended September 30, 2000.  The gains during the three andnine-month periods ended September 30, 2001 were primarily from the sale ofmortgage-backed securities that were securitized from PNWB’s single-familymortgage loan portfolio in prior periods. The loss during the first nine months of 2000 resulted fromrestructuring the company’s investment portfolio to better manage interest raterisk.

 

Service fees were $3.2million for the three-month period ended September 30, 2001 compared to $3.0million for the three-month period ended September 30, 2000.  Service fees were $9.3 million for thenine-month period ended September 30, 2001 compared to $8.7 million for thenine-month period ended September 30, 2000. This increase is primarily due to increased fees received on depositaccounts.

 

*Non-interestExpense* | Non-interest expense was $20.8 million for thethree-month period ended September 30, 2001, compared to $20.4 million for thethree-month period ended September 30, 2000. Non-interest expense was $60.9 million for the nine-month period endedSeptember 30, 2001, compared to $66.1 million for the nine-month period endedSeptember 30, 2000.  Non-interest expensefor the three and nine months ended September 30, 2000 included conversion andintegration expenses, costs associated with severance and employmentagreements, goodwill impairment and write-downs on other real estate.

 

Compensation and employee benefits were $9.7million for the three-month period ended September 30, 2001, compared to $10.0million for the three-month period ended September 30, 2000.  Compensation and employee benefits were$28.8 million for the nine-month period ended September 30, 2001, compared to$29.9 million for the nine-month period ended September 30, 2000.  This decrease in compensation and employeebenefits was primarily due to the consolidation of certain executive andadministrative functions.

 

Occupancyand equipment expense was $3.1 million and $8.9 million for the three andnine-month periods ended September 30, 2001, respectively, compared to $2.7million and $7.7 million for the three and nine-month periods ended September30, 2000.  Data processing expense was$2.0 million and $5.6 million for the three and nine-month periods endedSeptember 30, 2001, respectively, compared to $1.4 million and $3.9 million forthe three and nine-month periods ended September 30, 2000.  The increase in occupancy and equipment anddata processing expense reflects increased costs associated with PNWB’s newcommercial bank operating system.

 

*Income TaxExpense*| Income taxexpense was $3.7 million for the three-month period ended September 30, 2001,compared to $1.9 million for the three-month period ended September 30, 2000.Income tax expense was $9.0 million for the nine-month period ended September30, 2001, compared to $2.5 million for the nine-month period ended September30, 2000.  The increase in income taxexpenses was consistent with the higher income before taxes adjusted forpermanent differences for tax purposes.

** **

**REVIEW OFFINANCIAL CONDITION**

 

PNWB’s consolidated assets were $2.80 billion as of September 30, 2001,compared to $2.88 billion as of December 31, 2000.

 

*Securities*| As of September 30, 2001, PNWB had $784.9 million ofsecurities available for sale, compared to $840.5 million as of December 31,2000.  As permitted by the provisions ofSFAS No. 133, PNWB reclassified all securities held to maturity to securitiesavailable for sale effective January 1, 2001. As such, PNWB did not have any securities held to maturity as ofSeptember 30, 2001, compared to $64.7 million as of December 31, 2000.

 

PNWB maintains liquidity in accordance with an internal liquiditypolicy.  Liquidity levels may beincreased or decreased depending upon the yields on investment alternatives,management's judgment as to the attractiveness of the yields then available inrelation to other opportunities, and management's expectation of the yield thatwill be available in the future. Management's projections as to the short-term demand for funds to beused for loan originations and other activities can also affect liquiditylevels.

 

Securities classified as available for sale are reported at estimatedfair value, with unrealized gains and losses (net of income taxes) reported inaccumulated other comprehensive income (loss), a separate component ofshareholders' equity.

 

*LoansReceivable and Loans Held for Sale* | Net loans receivablewere $1.79 billion as of September 30, 2001, compared to $1.76 billion as ofDecember 31, 2000.  Growth in loansreceivable would have been more significant during the nine-month period endedSeptember 30, 2001; however, approximately $103.1 million of single-familymortgage loans were sold during the period and the balance of single-familymortgage loans outstanding decreased by $53.2 million from December 31, 2000 toSeptember 30, 2001.

 

Commercial loans outstanding totaled $548.2 million as of September 30,2001, an increase of $71.0 million from December 31, 2000.  Commercial real estate mortgage loansoutstanding totaled $456.7 million as of September 30, 2001, an increase of$81.0 million from December 31, 2000. Commercial and commercial real estate loans outstanding represented 54.1percent of total gross loans as of September 30, 2001, an increase from 47.4percent of total gross loans as of December 31, 2000.  Growth in commercial lending should shorten duration risk andincrease net interest margin.

 

Single-family residential mortgage loans outstanding totaled $376.0million as of September 30, 2001 compared to $429.3 million as of December 31,2000.  As part of the transition to acommercial bank, PNWB changed itsstrategy with regard to the origination and retention of single-family mortgageloans during 2000.  The majority ofPNWB’s single-family mortgage loan production is being channeled directly tothe secondary market with servicing rights released.

 

Real estate construction loans outstanding totaled $305.1 million as ofSeptember 30, 2001 compared to $330.3 million as of December 31, 2000.

 

Loans held for sale totaled $38.6 million as of September 30, 2001compared to $14.2 million as of December 31, 2000.  Loans held for sale are carried at the lower of cost or estimatedfair value in aggregate.  Loans held forsale are generally single-family mortgage loans and loans originated under aSmall Business Administration program. Loans held for sale are typically sold to other financial institutions.

 

The following table sets forth the composition of PNWB’s loan portfolioby type as of the dates indicated:

 
| *Dollars in thousands*                 |   | **September 30,  2001** |      | **December 31,  2000** |   |
|----------------------------------------|--------|-------------------------|-----------|------------------------|--------|
| Commercial loans                       |   | $                       | 548,182   |                   | $      | 477,224 |   |
| Real estate mortgage loans             |   |                    |      |                   |   |
| Single-family residential              |   | 376,035                 |      | 429,257                |   |
| Commercial                             |   | 456,688                 |      | 375,699                |   |
| Real estate construction               |   | 305,057                 |      | 330,267                |   |
| Consumer loans                         |   | 119,757                 |      | 129,379                |   |
| Agricultural loans                     |   | 50,834                  |      | 57,224                 |   |
|                                   |   | 1,856,553               |      | 1,799,050              |   |
| Less:                                  |   |                    |      |                   |   |
| Loans held for sale                    |   | 38,640                  |      | 14,187                 |   |
|  Allowance for losses on loans    |   | 19,618                  |      | 17,561                 |   |
|  Deferred loan fees and discounts |   | 9,485                   |      | 8,755                  |   |
| Net loans receivable                   |   | $                       | 1,788,810 |                   | $      | 1,758,547 |   |
|                                        |        |                         |           |                        |        |  |  |  |  |

* *

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

 

Non-accrual loans totaled $16.5 million as of September 30, 2001compared to $13.9 million as of December 31, 2000. This increase was primarilydue to the placement of a $3.4 million commercial loan on non-accrual statusduring the first quarter of 2001 and an increase in non-accrual agriculturalloans of $1.6 million, partially offset by a decrease in non-accrual realestate construction loans of $2.5 million. Non-accrual agricultural loans increased due to the weakness of the agriculturaleconomy in central Washington.  Otherreal estate was $7.9 million as of September 30, 2001 compared to $9.9 millionas of December 31, 2000.  This decreasewas due to increased sales of other real estate owned.  Total non-performing assets, includingnon-accrual loans and other real estate, totaled $24.3 million or 0.87 percentof consolidated assets as of September 30, 2001, compared to $23.8 million or0.83 percent of consolidated assets as of December 31, 2000.

 

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

 
| *Dollars in thousands*      |   | **September 30,  2001** |   | **December 31,  2000** |   |
|-----------------------------|--------|-------------------------|--------|------------------------|--------|
| *Non-accrual loans*         |   |                    |   |                   |   |
| Commercial loans            |   | $                       | 7,631  |                   | $      | 2,215 |   |
| Real estate mortgage loans  |   |                    |   |                   |   |
| Single-family residential   |   | 4,040                   |   | 5,020                  |   |
| Commercial                  |   | 657                     |   | 1,231                  |   |
| Real estate construction    |   | 1,434                   |   | 3,920                  |   |
| Consumer loans              |   | 234                     |   | 225                    |   |
| Agricultural loans          |   | 2,469                   |   | 1,272                  |   |
| Total non-accrual loans     |   | 16,465                  |   | 13,883                 |   |
| Other real estate           |   | 7,861                   |   | 9,909                  |   |
| Total non-performing assets |   | $                       | 24,326 |                   | $      | 23,792 |   |

 

*Allowancefor Losses on Loans* | The allowance for losses on loans was$19.6 million or 1.08 percent of loans receivable as of September 30, 2001,compared to $17.6 million or 0.99 percent of loans receivable as of December31, 2000.  Net loan charge-offs were$2.3 million or 0.17 percent of the average balance of loans outstanding forthe nine-month period ended September 30, 2001.  Net loan charge-offs were $2.0 million or 0.15 percent of theaverage balance of loans outstanding for the nine-month period ended September30, 2000.

 

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 on the credit risk in the loanportfolio as a result of the recent tragedies and layoffs announced locally andaround the country.  To date,delinquency trends and classified loan levels relative to comparable periods donot indicate any deterioration in the loan portfolio.  Currently, management is not aware of any unusually large loanconcentrations in industries impacted by the recent events.  However, management increased the provisionfor losses on loans by $150,000 during the quarter ended September 30, 2001based on concerns resulting from the inherent risk in the loan portfolioassociated with the deterioration of the economy. Management continues toassess the impact of recent events and focus on identifying potential problemcredits and any loss exposure in a timely manner.  Concentration and related limits will also be subject to on-goingassessment.

 

PNWB believes it has established its allowance forlosses on loans in accordance with accounting principles generally accepted inthe United States.  However, there canbe no assurance that in the future, regulators, when reviewing PNWB's loanportfolio, will not request PNWB to increase its allowance for losses on loans,thereby affecting PNWB's financial condition and results of operations.

 

PNWB’s allowance for losses on loans is allocated to significant 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 September 30, 2001.

 

The following tables summarize the activity in allowance for losses onloans during the three and nine-month periods ended September 30:
|                                |   | **Three months** |   | **Nine months** |   |
|-------------------------------------|--------|------------------|--------|-----------------|--------|
| *Dollars in thousands*              |   | **2001**         |   | **2000**        |   | **2001** |   | **2000** |   |
| Allowance as of beginning of period |   | $                | 18,916 |            | $      | 15,538 |   | $ | 17,561 |   | $ | 15,182 |   |
| Provision for losses on loans       |   | 1,550            |   | 1,400           |   | 4,350 |   | 3,350 |   |
| Recoveries                          |   | 535              |   | 194             |   | 1,023 |   | 373 |   |
| Charge-offs                         |   | (1,383           | )      | (539            | )      | (3,316 | ) | (2,312 | ) |
| Allowance as of end of period       |   | $                | 19,618 |            | $      | 16,593 |   | $ | 19,618 |   | $ | 16,593 |   |

* *

*Goodwill and Other Intangible Assets*| Goodwill arising from acquisitions represents the excess ofthe purchase price over the estimated fair value of net assets acquired.

 

Other intangibleassets consist primarily of loan servicing rights.  Loan servicing rights are capitalized when acquired eitherthrough the purchase or origination of loans that are subsequently sold orsecuritized with the servicing rights retained. The estimated fair value ofloan servicing rights at the date of the sale of loans is determined based onthe discounted present value of expected future cash flows using keyassumptions for servicing income and costs and prepayment rates on theunderlying loans. The estimated fair value is periodically evaluated forimpairment by comparing actual cash flows and estimated future cash flows fromservicing assets to those estimated at the time servicing assets wereoriginated.  Loan servicing rights areamortized as an offset to service fees in proportion to and over the period ofestimated net servicing income.

 

Goodwill and other intangible assets are amortizedusing the straight-line and accelerated methods over periods not exceedingtwenty years.

 

Goodwill and otherintangible assets consisted of the following as of the dates indicated:

 
| *Dollars in thousands*     |   | **September 30,  2001** |   | **December 31,  2000** |   |
|----------------------------|--------|-------------------------|--------|------------------------|--------|
| Goodwill                   |   | $                       | 16,416 |                   | $      | 17,242 |   |
| Loan servicing intangibles |   | 1,909                   |   | 2,861                  |   |
| Other                      |   | 467                     |   | 598                    |   |
|                       |   | $                       | 18,792 |                   | $      | 20,701 |   |

* *

*Deposits* | PNWBoffers various types of deposit accounts, including checking accounts, savingsaccounts, money market accounts and certificate of deposit accounts.  Deposit accounts vary as to terms; theprincipal differences are the minimum balance required, the time period thefunds must remain on deposit, the interest rate, and the deposit or withdrawaloption.  PNWB relies on generatingdeposits through a marketing strategy that employs a sales staff responsiblefor establishing new customer relationships.

 

Non-interest-bearingdeposits were $233.1 million as of September 30, 2001 compared to $244.1million as of December 31, 2000.  Non-interest-bearing deposits represented 13.9 percent and 14.2percent of total deposits as of September 30, 2001 and December 31, 2000,respectively.  Interest-bearing transactionaccounts (which include interest-bearing checking, money market and savingsaccounts) totaled $618.3 million as of September 30, 2001 compared to $569.7million as of December 31, 2000. Interest-bearing transaction accounts represented 36.7 percent of totaldeposits as of September 30, 2001, compared to 33.2 percent as of December 31,2000.

 

Certificates of deposit totaled $831.8 million as ofSeptember 30, 2001, compared to $903.4 million as of December 31, 2000.  Certificates of deposit represented 49.4percent of total deposits as of September 30, 2001, a decrease from 52.6 percentas of December 31, 2000.

 

The following table sets forththe balances of deposits by account type as of the dates indicated:

 
| *Dollars in thousands*             |   | **September 30,  2001** |      | **December 31,  2000** |   |
|------------------------------------|--------|-------------------------|-----------|------------------------|--------|
| Non-interest-bearing deposits      |   | $                       | 233,054   |                   | $      | 244,100 |   |
| Interest-bearing checking accounts |   | 211,222                 |      | 201,894                |   |
| Money market accounts              |   | 312,082                 |      | 266,933                |   |
| Savings accounts                   |   | 94,993                  |      | 100,831                |   |
| Certificates of deposit            |   | 831,845                 |      | 903,350                |   |
| Total                              |   | $                       | 1,683,196 |                   | $      | 1,717,108 |   |

 

*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 $837.3 million as of September30, 2001 compared to $918.1 million as of December 31, 2000.  The need for this type of borrowingsdecreased as a result of the overall decrease in assets and increase inshareholder’s equity, partially offset by decreases in deposits.

 

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 thesecurities market for borrowings by utilizing its securities available for saleas collateral. These borrowings are collateralized by securities with anestimated fair value exceeding the face value of the borrowings.

 

*Otherborrowings *| Otherborrowings were $12.9 million as of September 30, 2001 compared to $1.8 millionas of December 31, 2000.  This increaseis due to Pacific Northwest Bancorp borrowing $12 million from anotherfinancial institution during the nine-month period ended September 30, 2001.This borrowing qualifies as Tier II capital under the capital guidelines of theFederal Reserve Board.

 

*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 theTrust are the sole assets of the Trust. The capital securities are subject to mandatory redemption, in whole orin part, upon repayment of the debentures. The debentures will not mature earlier than November 15, 2009, and notlater than November 15, 2029.  PacificNorthwest Bancorp 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 September2001, Pacific Northwest Bancorp purchased $1.5 million of the capitalsecurities in an effort to reduce funding costs.

 

*Shareholders’ Equity* | PNWB is committedto managing capital for maximum shareholder benefit and maintaining strongprotection for depositors and creditors. PNWB manages various capital levels at both the holding company andsubsidiary bank level to maintain adequate capital ratios and levels inaccordance with external regulations and capital guidelines established by theBoard of Directors.

 

PNWB’s totalshareholders’ equity was $199.6 million as of September 30, 2001, an increaseof $20.9 million from $178.7 million as of December 31, 2000.  The increase in shareholders’ equity was dueto net income, other comprehensive income, the issuance of common stock understock option plans and repayments on the ESOP loan partially offset bydividends declared to shareholders. Book value per share was $12.80 as of September 30, 2001, compared to$11.54 as of December 31, 2000.  Duringthe nine-month period ended September 30, 2001, Pacific Northwest Bancorpdeclared cash dividends totaling $0.42 per share.

 

**SUPERVISION AND REGULATION**

 

Pacific Northwest Bancorp is a registered bank holding company underthe Bank Holding Company Act of 1956 (BHCA) and is subject to the supervisionof, and regulation by, the Board of Governors of the Federal ReserveSystem  (FRB).  Under the BHCA, Pacific Northwest Bancorp files with the FRBannual reports of operations and such additional information as the FRB mayrequire.  Under the BHCA, a bank holdingcompany may engage in banking, managing or controlling banks, furnishing orperforming services for banks it controls, and conducting activities that theFRB has determined to be closely related to banking.

 

Pacific Northwest Bank is a member of the Federal Deposit InsuranceCorporation (FDIC), and as such, is subject to examination thereby.  Pacific Northwest Bank is a state-charteredcommercial bank subject to regulation and supervision by the WashingtonDepartment of Financial Institutions, Division of Banks.  In practice, the primary regulator makesregular examinations of the subsidiary bank subject to its regulatory review orparticipates in joint examinations with other regulators.  Areas subject to regulation by federal orstate authorities include the allowance for losses on loans, investments,loans, mergers and acquisitions, issuance of securities, payment of dividends,establishment of branches and other aspects of operations.

 

The enforcement powers available to banking regulators are substantialand include, among other things, the ability to assess civil monetarypenalties, to issue cease-and-desist or removal orders and to initiateinjunctive actions against banking organizations and institution-affiliatedparties, as defined.  In general,enforcement actions must be initiated for violations of laws and regulationsand unsafe or unsound practices. Other actions, or inactions, may provide thebasis for enforcement action, including misleading or untimely reports filedwith regulatory authorities.  Applicablelaw also requires 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 Bancorp is subject to risk-based capital guidelinesissued by the FRB, which establish a risk-adjusted ratio relating capital todifferent categories of assets.  Tier Icapital is comprised of shareholders’ equity and guaranteed preferredbeneficial interests in subordinated debt less certain intangibles, and excludesthe equity impact of adjusting securities available for sale to estimated fairvalue. Total capital is Tier I capital, the allowance for losses on loans andcertain long-term debt that qualifies for inclusion as regulatory capital.  The FRB’s risk-based capital rules have beensupplemented by a leverage capital ratio, defined as Tier I capital to adjustedquarterly average total assets.  As ofSeptember 30, 2001, under the FRB’s capital guidelines, PNWB’s levels ofconsolidated regulatory capital exceeded the FRB’s well-capitalized requirements.  The capital amounts and ratios for PacificNorthwest Bancorp and Pacific Northwest Bank as of September 30, 2001 andDecember 31, 2000, are presented in the following table:

 
|                                           |   |           |       |      |       |                                     |       |      |       | **To Be  Well Capitalized Under  Prompt  Corrective   Action Provisions** |       |
|------------------------------------------------|--------|----------------|------------|-----------|------------|------------------------------------------|------------|-----------|------------|-------------------------------------------------------------------------------------|------------|
| **CAPITAL RATIOS**                             |   |           |       |      |       | **For  Capital  Adequacy Purposes** |       |      |
|                                           |   | **Amount**     |       |      |       |
| *Dollars in thousands*                         |   | **Amount**     | ** ** | **Ratio** |       | **Amount**                               | ** ** | **Ratio** |       | **Amount**                                                                          | ** ** | **Ratio** |   |
| **September 30, 2001**                         |   |           |       |      |       |                                     |       |      |       |                                                                                |       |   |   |
| **Pacific Northwest Bancorp**                  |   |           |       |      |       |                                     |       |      |       |                                                                                |       |   |   |
| Total capital  (to risk-weighted assets)  |   | $              | 247,423    |      | 11.76      | %                                        | $          | 168,347   |       | 8.0                                                                                 | %          | $ | 210,434 |   | 10.0 | % |
| Tier I capital  (to risk-weighted assets)      |   | 215,805        |       | 10.26     | %          | 84,174                                   |       | 4.0       | %          | 126,260                                                                             |       | 6.0 | % |
| Tier I capital  (to average assets)            |   | 215,805        |       | 7.71      | %          | 111,976                                  |       | 4.0       | %          | 139,970                                                                             |       | 5.0 | % |
| **Pacific Northwest Bank:**                    |   |           |       |      |       |                                     |       |      |       |                                                                                |       |   |   |
| Total capital  (to risk-weighted assets)  |   | $              | 245,020    |      | 11.72      | %                                        | $          | 167,320   |       | 8.0                                                                                 | %          | $ | 209,150 |   | 10.0 | % |
| Tier I capital  (to risk-weighted assets)      |   | 225,402        |       | 10.78     | %          | 83,660                                   |       | 4.0       | %          | 125,490                                                                             |       | 6.0 | % |
| Tier I capital  (to average assets)            |   | 225,402        |       | 8.07      | %          | 111,687                                  |       | 4.0       | %          | 139,609                                                                             |       | 5.0 | % |
| **December 31, 2000**                          |   |           | ** ** |      | ** ** |                                     | ** ** |      | ** ** |                                                                                | ** ** |   | ** ** |
| **Pacific Northwest Bancorp:**                 |   |           |       |      |       |                                     |       |      |       |                                                                                |       |   |   |
| Total capital  (to risk-weighted assets)       |   | $              | 223,657    |      | 11.05      | %                                        | $          | 161,912   |       | 8.0                                                                                 | %          | $ | 202,391 |   | 10.0 | % |
| Tier I capital  (to risk-weighted assets)      |   | 206,096        |       | 10.18     | %          | 80,956                                   |       | 4.0       | %          | 121,434                                                                             |       | 6.0 | % |
| Tier I capital  (to average assets)            |   | 206,096        |       | 7.23      | %          | 114,066                                  |       | 4.0       | %          | 142,583                                                                             |       | 5.0 | % |
| **Pacific Northwest Bank:**                    |   |           |       |      |       |                                     |       |      |       |                                                                                |       |   |   |
| Total capital  (to risk-weighted assets)       |   |  $221,312 |       | 10.96     | %          | $                                        | 161,548    |      | 8.0        | %                                                                                   | $          | 201,935 |   | 10.0 | % |
| Tier I capital  (to risk-weighted assets)      |   | 203,751        |       | 10.09     | %          | 80,774                                   |       | 4.0       | %          | 121,161                                                                             |       | 6.0 | % |
| Tier I capital (to  average assets)            |   | 203,751        |       | 7.30      | %          | 111,703                                  |       | 4.0       | %          | 139,629                                                                             |       | 5.0 | % |

 

As of September 30, 2001, 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 fairvalue exceeding the face value of the borrowings. If the estimated fair valueof the securities were to decline as a result of an increase in interest ratesor other factors, PNWB would be required to pledge additional securities orcash as collateral. In addition, PNWB has the ability to borrow funds from theFederal Reserve.

 

The analysis of liquidity also includes a review of PNWB’s consolidatedstatement of cash flows for the nine-month period ended September 30,2001.  The consolidated statement ofcash flows details PNWB’s operating, investing and financing activities duringthe period.  The most significant itemsunder operating activities include net income of $15.1 million for thenine-month period ended September 30, 2001 and a decrease in other liabilitiesof $6.4 million and an increase of other assets of $16.2 million.  Also included in operating activities arethe add back of non-cash depreciation, amortization of intangible assets andthe provision for losses of loans totaling $11.0 million.  Net cash provided by operating activities isalso adjusted for the gains on the sale of loans and securities available forsale totaling $3.2 million.  Investingactivities included proceeds from maturing and principal repayments onsecurities available for sale of $356.6 million, purchases of securitiesavailable for sale of $283.0 million and proceeds from the sale of securitiesavailable for sale of $67.4 million. Investing activities also included a $168.0 million increase in loansreceivable, $104.3 million of proceeds from the sale of loans and a $9.1million proceeds from the sale of other real estate. During the period,financing activities included $68.9 million in borrowing repayments, net ofborrowing proceeds, a $62.2 million decrease in certificates of deposit, a$28.3 million increase in deposits and a total of $6.5 million paid in cashdividends to shareholders.

** **

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

 

PNWB’s results ofoperations are largely dependent upon its ability to manage interest rate risk.Management considers interest rate risk to be a significant market risk thatcould have a material effect on PNWB’s financial condition and results ofoperations.

 

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

 

In addition to adjustablerate loans and short-term commercial and consumer loans, PNWB uses a number ofother strategies to minimize the impact on net income due to significantchanges in interest rates. The strategies utilized by PNWB include sales oflong-term, fixed-rate mortgage loans, emphasis on growth innon-interest-bearing deposits and adjustable rate commercial lending.

* *

Managementuses simulation analysis 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 will differ from simulated results due to timing,magnitude, and frequency of interest rate changes and changes in marketconditions and management strategies, among other factors.

 

For further information on interest rate risk, reference is made to thesections “Net Interest Income” and “Average Rates and Balances” in Item 2.Management Discussion and Analysis of Financial Condition and Results ofOperations contained in this quarterly report on Form 10-Q.  Information regarding the expectedmaturities of financial assets and financial liabilities has not changedmaterially from disclosures made in the Annual Report on Form 10-K for the yearended December 31, 2000.

* *

**FORWARD-LOOKING STATEMENTS**

* *

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.  PNWB has used these statements to describeexpectations and estimates in various areas, including, but not limited to:changes in the economy of the markets in which it operates; interest ratemovements; future acquisition and growth strategies; data processing systemconversions; the impact of competitive products, services and pricing; andlegislative, regulatory and accounting changes affecting the banking andfinancial services industry.  Actualresults could vary materially from the future results covered inforward-looking statements.  Factorssuch as interest rate trends and loan delinquency rates, as well as the generalstate of the economy in Washington State and the United States as a whole,could also cause actual results to vary materially from the future resultsanticipated in such forward-looking statements. These factors should beconsidered in evaluating the forward-looking statements and undue relianceshould not be placed on such statements.

 

**PART II. OTHERINFORMATION**

** **

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

** **

**(a)   Exhibits**

** **
| 3.1   | Articles  of Incorporation of Pacific Northwest Bancorp (incorporated by reference to  Exhibit 3.1 to the Registrant’s Annual Report on Form 10-K for the year ended  December 31, 2000).                                                                                                                                        |
|-------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.2   | Bylaws  of Pacific Northwest Bancorp (incorporated by reference to Exhibit 3.2 to the  Registrant’s Annual Report on Form 10-K for the year ended December 31,  2000).                                                                                                                                                           |
| 3.3   | Amendment  to the Bylaws of Pacific Northwest Bancorp (incorporated by reference to  Exhibit 3.21 to the Registrant’s Quarterly Report on Form 10-Q for the  quarter ended June 30, 2001).                                                                                                                                       |
| 10    | Material  contracts of Pacific Northwest Bancorp (incorporated by reference to Exhibits  10.1 through 10.14 to the Registrant’s Annual Report on Form 10-K for the  year ended December 31, 2000 and Exhibits 10.17 through 10.18 to the  Registrant’s quarterly Report on Form 10-Q for the quarter ended June 30,  2001). |
| 10.19 | Amended Pacific  Northwest Bancorp 1996 Outside Directors Stock Options-for-fees Plan proposed  in October 2001 is filed with this report.                                                                                                                                                                                            |
| 10.20 | Employment  Agreement entered into between Pacific Northwest Bancorp and Kim S. Brace is  filed with this report.                                                                                                                                                                                                                     |
| 10.21 | Severance  Pay Agreement entered into between Pacific Northwest Bancorp and Bette J.  Floray is filed with this report.                                                                                                                                                                                                               |
| 10.22 | Change  In Control Agreement entered into between Pacific Northwest Bancorp and Bette  J. Floray is filed with this report.                                                                                                                                                                                                           |

 

**(b) Reports onForm 8-K**

 

PNWB filed a CurrentReport on Form 8-K on August 23, 2001 under item 5 announcing the resignationof Barney R. Beeksma as a director of PNWB effective August 15, 2001.

 

**SIGNATURES**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the Registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 
|         | PACIFIC  NORTHWEST BANCORP |
|--------------|----------------------------|
|         |                       |   |   |
|         |                       |   |   |
|         |                       |   |   |
|         |                       |   |   |
|         |                       | By: | /s/  Patrick M. Fahey |
|         |                       |   | Patrick  M. Fahey, |
|         |                       |   | President and Chief Executive Officer |
|         |                       |   |   |
|         |                       |   |   |
|         |                       |   |   |
|         |                       |   | /s/  Bette J. Floray |
|         |                       |   | Bette  J. Floray |
|         |                       |   | Executive  Vice President and Chief Financial Officer |
|         |                       |   |   |
|         |                       |   |   |
| Dated:  | November  12, 2001         |   |   |   |
|              |                            |  |  |  |  |  |  |