** **

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WashingtonD.C.  20549**

 

**FORM 10-Q**

 

| **(Mark  One)**                                                                                                                                                                                                                 |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **ý****Quarterly Report Pursuant  to Section 13 or 15(d) of the Securities and Exchange Act of 1934**                                                                                                                      |
|                                                                                                                                                                                                                            |   |   |
| **For the quarterly period ended  March 31, 2003**                                                                                                                                                                              |
|                                                                                                                                                                                                                            |   |   |
| **o****Transition Report  Pursuant to 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 as specified in its charter)         |
|                                                            |
| **Washington**                                                  |
| (State or other  jurisdiction of incorporation or organization) |
|                                                            |
| **91-1691216**                                                  |
| (I.R.S. Employer  Identification No.)                           |
|                                                            |
| **1111 Third Avenue, Suite 250**                                |
| **Seattle, Washington**                                         |
| (Address of  principal executive offices)                       |
|                                                            |
| **98101**                                                       |
| (Zip Code)                                                      |
|                                                            |
| Registrant’s telephone  number including area code:        | **(206) 624-0600** |

 

Indicate by checkmark whether 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

 

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2of the Act).

YES ýNO o

 

As of April 29, 2003, 16,891,453 shares of common stock wereoutstanding with no par value.

 

 

----

 

**PACIFICNORTHWEST BANCORP**

 
| **INDEX**          |   |                                                                                                                 |
|--------------------|--------|----------------------------------------------------------------------------------------------------------------------|
|               |   |                                                                                                                 |
| **PART I.**        |   | **FINANCIAL INFORMATION**                                                                                            |
| **Item 1.**        |   | **Financial Statements**                                                                                             |
|               |   |                                                                                                                 |
|               |   | **Consolidated Statements  of Financial Condition as of March 31, 2003 and December 31, 2002**                       |
|               |   |                                                                                                                 |
|               |   | **Consolidated  Statements of Income for the three-month periods ended March 31, 2003 and  2002**                    |
|               |   |                                                                                                                 |
|               |   | **Consolidated  Statements of Shareholders’ Equity for the three-month periods ended March  31, 2003 and 2002** |
|               |   |                                                                                                                 |
|               |   | **Consolidated  Statements of Cash Flows for the three-month periods ended March 31, 2003 and  2002**                |
|               |   |                                                                                                                 |
|               |   | **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**                                                      |
|               |   |                                                                                                                 |
| **Item 4.**        |   | **Controls and Procedures**                                                                                          |
|               |   |                                                                                                                 |
| **PART II.**       |   | **OTHER INFORMATION**                                                                                                |
|               |   |                                                                                                                 |
| **Item 1.**        |   | **Legal Proceedings**                                                                                                |
|               |   |                                                                                                                 |
| **Item 6.**        |   | **Exhibits and Reports on Form 8-K**                                                                                 |
|               |   |                                                                                                                 |
| **SIGNATURES**     |
|               |   |                                                                                                                 |
| **CERTIFICATIONS** |
|                    |        |                                                                                                                      |  |  |

 

----

 

**PART I.FINANCIAL INFORMATION**

 

CONSOLIDATED STATEMENTSOF FINANCIAL CONDITION

 
| **Dollars in thousands**                                                                                            |   | **March 31,  2003** |      | **December  31, 2002** |   |
|---------------------------------------------------------------------------------------------------------------------|--------|---------------------|-----------|------------------------|--------|
|                                                                                                                |   | **(UNAUDITED)**     |      |                   |   |
|                                                                                                                |   |                |      |                   |   |
| *Assets*                                                                                                            |   |                |      |                   |   |
|                                                                                                                |   |                |      |                   |   |
| Cash  and due from banks                                                                                            |   |                |      |                   |   |
| Non-interest-bearing                                                                                                |   | $                   | 72,965    |                   | $      | 92,541 |   |
| Interest-bearing                                                                                                    |   | 10,785              |      | 7,461                  |   |
| Federal  funds sold and securities purchased under agreements to resell                                             |   | 15,620              |      | 950                    |   |
| Securities  available for sale                                                                                      |   | 787,308             |      | 788,546                |   |
| Loans  held for sale                                                                                                |   | 12,218              |      | 25,621                 |   |
| Loans  receivable                                                                                                   |   | 2,042,069           |      | 2,029,753              |   |
| Allowance  for losses on loans                                                                                      |   | (27,080             | )         | (26,940                | )      |
| Net  loans receivable                                                                                               |   | 2,014,989           |      | 2,002,813              |   |
|                                                                                                                |   |                |      |                   |   |
| Interest  receivable                                                                                                |   | 13,524              |      | 14,306                 |   |
| Other  real estate                                                                                                  |   | 6,548               |      | 7,152                  |   |
| Premises  and equipment                                                                                             |   | 45,071              |      | 48,082                 |   |
| Goodwill                                                                                                            |   | 67,732              |      | 67,732                 |   |
| Other  intangible assets                                                                                            |   | 10,090              |      | 10,505                 |   |
| Bank  owned life insurance                                                                                          |   | 57,581              |      | 56,995                 |   |
| Other  assets                                                                                                       |   | 4,676               |      | 4,305                  |   |
|                                                                                                                |   |                |      |                   |   |
| Total  assets                                                                                                       |   | $                   | 3,119,107 |                   | $      | 3,127,009 |   |
|                                                                                                                |   |                |      |                   |   |
| *Liabilities*                                                                                                       |   |                |      |                   |   |
|                                                                                                                |   |                |      |                   |   |
| Deposits:                                                                                                           |   |                |      |                   |   |
| Non-interest-bearing                                                                                                |   | $                   | 359,848   |                   | $      | 345,571 |   |
| Interest-bearing                                                                                                    |   | 1,717,245           |      | 1,708,739              |   |
| Total  deposits                                                                                                     |   | 2,077,093           |      | 2,054,310              |   |
|                                                                                                                |   |                |      |                   |   |
| Federal  Home Loan Bank (FHLB) advances                                                                             |   | 566,066             |      | 609,581                |   |
| Federal  funds purchased and securities sold under agreements to repurchase                                         |   | 121,627             |      | 120,706                |   |
| Guaranteed  preferred beneficial interests in subordinated debt                                                     |   | 52,000              |      | 48,000                 |   |
| Other  borrowings                                                                                                   |   | 10,067              |      | 10,072                 |   |
| Other  liabilities                                                                                                  |   | 25,796              |      | 22,727                 |   |
|                                                                                                                |   |                |      |                   |   |
| Total  liabilities                                                                                                  |   | 2,852,649           |      | 2,865,396              |   |
|                                                                                                                |   |                |      |                   |   |
| *Shareholders’  Equity*                                                                                        |   |                |      |                   |   |
|                                                                                                                |   |                |      |                   |   |
| Common  stock, no par value, authorized shares 30,000,000 issued and outstanding:  16,859,146 and 16,799,472 shares |   | —              |      | —-                |   |
| Paid-in-capital                                                                                                     |   | 65,818              |      | 64,995                 |   |
| Retained  earnings                                                                                                  |   | 198,967             |      | 192,942                |   |
| Accumulated other comprehensive income                                                                              |   | 1,673               |      | 3,676                  |   |
|                                                                                                                |   |                |      |                   |   |
| Total  shareholders’ equity                                                                                    |   | 266,458             |      | 261,613                |   |
|                                                                                                                |   |                |      |                   |   |
| Total  liabilities and shareholders’ equity                                                                    |   | $                   | 3,119,107 |                   | $      | 3,127,009 |   |

 

See accompanying notes toconsolidated financial statements.

 

1

----

 

CONSOLIDATED STATEMENTSOF INCOME (UNAUDITED)

 
|                                                            |   | **Three-month  periods ended March 31,** |   |
|-----------------------------------------------------------------|--------|------------------------------------------|--------|
| **Dollars in thousands, except per  share amounts**             |   | **2003**                                 |   | **2002** |   |
|                                                            |   |                                     |   |   |   |
| *Interest  Income*                                              |   |                                     |   |   |   |
| Loans  receivable and loans held for sale                       |   | $                                        | 34,570 |   | $ | 34,509 |   |
| Securities  available for sale                                  |   | 8,464                                    |   | 10,400 |   |
| Other                                                           |   | 19                                       |   | 7 |   |
|                                                            |   | 43,053                                   |   | 44,916 |   |
| *Interest  Expense*                                             |   |                                     |   |   |   |
| Deposits                                                        |   | 7,770                                    |   | 8,877 |   |
| FHLB  advances and other borrowings                             |   | 6,184                                    |   | 6,574 |   |
| Securities  sold under agreements to repurchase                 |   | 733                                      |   | 1,195 |   |
| Guaranteed  preferred beneficial interests in subordinated debt |   | 1,044                                    |   | 926 |   |
|                                                            |   | 15,731                                   |   | 17,572 |   |
|                                                            |   |                                     |   |   |   |
| Net  interest income                                            |   | 27,322                                   |   | 27,344 |   |
|                                                            |   |                                     |   |   |   |
| Provision  for losses on loans                                  |   | 1,250                                    |   | 1,700 |   |
|                                                            |   |                                     |   |   |   |
| Net  interest income after provision for losses on loans        |   | 26,072                                   |   | 25,644 |   |
|                                                            |   |                                     |   |   |   |
| *Non-interest  Income*                                          |   |                                     |   |   |   |
| Service  fees                                                   |   | 3,836                                    |   | 3,177 |   |
| Investment  product fees and insurance commissions              |   | 427                                      |   | 328 |   |
| Gain  on sale of loans                                          |   | 404                                      |   | 748 |   |
| Loss  on sale of securities available for sale                  |   | (2                                       | )      | — |   |
| Bank  owned life insurance income                               |   | 585                                      |   | — |   |
| Other                                                           |   | 260                                      |   | 332 |   |
|                                                            |   | 5,510                                    |   | 4,585 |   |
|                                                            |   |                                     |   |   |   |
| *Non-interest  Expense*                                         |   |                                     |   |   |   |
| Compensation  and employee benefits                             |   | 10,105                                   |   | 9,819 |   |
| General  and administrative                                     |   | 3,903                                    |   | 4,265 |   |
| Occupancy  and equipment                                        |   | 3,201                                    |   | 3,121 |   |
| Data  processing                                                |   | 1,454                                    |   | 1,385 |   |
| Severance  and employment agreements                            |   | 212                                      |   | — |   |
| Other  real estate owned                                        |   | 142                                      |   | 2 |   |
|                                                            |   | 19,017                                   |   | 18,592 |   |
|                                                            |   |                                     |   |   |   |
| Income  before income tax expense                               |   | 12,565                                   |   | 11,637 |   |
|                                                            |   |                                     |   |   |   |
| Income  tax expense                                             |   | 4,182                                    |   | 4,073 |   |
|                                                            |   |                                     |   |   |   |
| Net  income                                                     |   | $                                        | 8,383  |   | $ | 7,564 |   |
|                                                            |   |                                     |   |   |   |
| Basic  net income per share                                     |   | $                                        | 0.50   |   | $ | 0.49 |   |
|                                                            |   |                                     |   |   |   |
| Diluted  net income per share                                   |   | $                                        | 0.48   |   | $ | 0.48 |   |
|                                                            |   |                                     |   |   |   |
| Dividends  declared per share                                   |   | $                                        | 0.14   |   | $ | 0.14 |   |

 

See accompanying notes toconsolidated financial statements.

 

2

----

 

CONSOLIDATED STATEMENTSOF SHAREHOLDERS’ EQUITY (UNAUDITED)

 
| **Dollars in thousands, except  share data**                             |   | **Common  Stock,  no par value  Shares** |   | **Paid-in  Capital** |   | **Retained  Earnings** |    | **Accumulated  Other  Comprehensive  Income (Loss)** |   | **Debt  Related  To  ESOP** |   | **Total** |   |
|--------------------------------------------------------------------------|--------|------------------------------------------|--------|----------------------|--------|------------------------|---------|------------------------------------------------------|--------|-----------------------------|--------|-----------|--------|
| *January 1, 2002*                                                        |   | 15,595,204                               |   | $                    | 26,757 |                   | $       | 172,967                                              |   | $                           | 1,305  |      | $      | (543) |   | $ | 200,486 |   |
| Dividends  declared, $0.14 per share                                     |   |                                     |   |                 |   | (2,166                 | )       |                                                 |   |                        |   | (2,166    | )      |
| Issuance of  common stock:                                               |   |                                     |   |                 |   |                   |    |                                                 |   |                        |   |      |   |
| Stock option  plans                                                      |   | 56,566                                   |   | 604                  |   |                   |    |                                                 |   |                        |   | 604       |   |
| Purchase  and retirement of common stock                                 |   | (215,896                                 | )      | (5,117               | )      |                   |    |                                                 |   |                        |   | (5,117    | )      |
| ESOP  debt repayment                                                     |   | 17,707                                   |   |                 |   |                   |    |                                                 |   | 543                         |   | 543       |   |
| Comprehensive  income:                                                   |   |                                     |   |                 |   |                   |    |                                                 |   |                        |   |      |   |
| Net  income                                                              |   |                                     |   |                 |   | 7,564                  |    |                                                 |   |                        |   | 7,564     |   |
| Other  comprehensive income -                                            |   |                                     |   |                 |   |                   |    |                                                 |   |                        |   |      |   |
| Unrealized  loss on securities availablefor sale, net of taxes of $1,444 |   |                                     |   |                 |   |                   |    | (2,683                                               | )      |                        |   | (2,683    | )      |
| Total comprehensive  income                                              |   |                                     |   |                 |   |                   |    |                                                 |   |                        |   | 4,881     |   |
| March 31, 2002                                                           |   | 15,453,581                               |   | $                    | 22,244 |                   | $       | 178,365                                              |   | $                           | (1,378 | )         | $      | 0 |   | $ | 199,231 |   |
|                                                                     |   |                                     |   |                 |   |                   |    |                                                 |   |                        |   |      |   |
| January 1, 2003                                                          |   | 16,799,472                               |   | $                    | 64,995 |                   | $       | 192,942                                              |   | $                           | 3,676  |      | $      | 0 |   | $ | 261,613 |   |
| Dividends  declared, $0.14 per share                                     |   |                                     |   |                 |   | (2,358                 | )       |                                                 |   |                        |   | (2,358    | )      |
| Issuance  of common stock:                                               |   |                                     |   |                 |   |                   |    |                                                 |   |                        |   |      |   |
| Stock  option plans                                                      |   | 163,965                                  |   | 2,401                |   |                   |    |                                                 |   |                        |   | 2,401     |   |
| Tax  deduction on stock option exercises                                 |   |                                     |   | 1,192                |   |                   |    |                                                 |   |                        |   | 1,192     |   |
| Purchase  and retirement of common stock                                 |   | (104,291                                 | )      | (2,770               | )      |                   |    |                                                 |   |                        |   | (2,770    | )      |
| Comprehensive  income:                                                   |   |                                     |   |                 |   |                   |    |                                                 |   |                        |   |      |   |
| Net  income                                                              |   |                                     |   |                 |   | 8,383                  |    |                                                 |   |                        |   | 8,383     |   |
| Other  comprehensive income –                                       |   |                                     |   |                 |   |                   |    |                                                 |   |                        |   |      |   |
| Unrealized  loss on securities available forsale, net of taxes of $1,080 |   |                                     |   |                 |   |                   |    | (2,004                                               | )      |                        |   | (2,004    | )      |
| Reclass adjustment for  losses included innet income, net of tax of $1   |   |                                     |   |                 |   |                   |    | 1                                                    |   |                        |   | 1         |   |
| Total comprehensive  income                                              |   |                                     |   |                 |   |                   |    |                                                 |   |                        |   | 6,380     |   |
| March 31, 2003                                                           |   | 16,859,146                               |   | 65,818               |   | $                      | 198,967 |                                                 | $      | 1,673                       |   | $         | 0      |   | $ | 266,458 |   |

 

See accompanying notes toconsolidated financial statements.

 

3

----

 

CONSOLIDATED STATEMENTS OF CASH FLOWS(UNAUDITED)

 
|                                                                                     |   | **Three-month  periods ended March 31,** |    |
|------------------------------------------------------------------------------------------|--------|------------------------------------------|---------|
| **Dollars in thousands**                                                                 |   | **2003**                                 |    | **2002** |   |
|                                                                                     |   |                                     |    |   |   |
| *Operating  Activities*                                                                  |   |                                     |    |   |   |
|                                                                                     |   |                                     |    |   |   |
| Net  income                                                                              |   | $                                        | 8,383   |   | $ | 7,564 |   |
| Adjustments  to reconcile net income to net cash provided by operating activities:       |   |                                     |    |   |   |
| Depreciation                                                                             |   | 1,298                                    |    | 1,332 |   |
| Amortization  of intangible assets                                                       |   | 414                                      |    | 232 |   |
| Provision  for losses on loans                                                           |   | 1,250                                    |    | 1,700 |   |
| Amortization  of premiums and discounts, net                                             |   | 1,246                                    |    | 249 |   |
| Gain  on sale of loans and loan servicing                                                |   | (404                                     | )       | (748 | ) |
| Loss  on sale of securities available for sale                                           |   | 2                                        |    | — |   |
| (Gain)/Loss  on sale of other real estate                                                |   | 2                                        |    | (18 | ) |
| Write-downs  on other real estate                                                        |   | 50                                       |    | — |   |
| (Gain)/Loss  on disposal of premises and equipment                                       |   | (136                                     | )       | 82 |   |
| Income  from bank owned life insurance                                                   |   | (585                                     | )       | — |   |
| Loan  fees deferred, net of amortization                                                 |   | (123                                     | )       | 589 |   |
| FHLB  stock dividends                                                                    |   | (875                                     | )       | (682 | ) |
| Changes  in operating assets and liabilities:                                            |   |                                     |    |   |   |
| Decrease  in interest receivable                                                         |   | 776                                      |    | 706 |   |
| Increase  in other assets                                                                |   | (1,114                                   | )       | (3,760 | ) |
| Increase  in other liabilities                                                           |   | 5,680                                    |    | 4,973 |   |
|                                                                                     |   |                                     |    |   |   |
| Net  cash provided by operating activities                                               |   | $                                        | 15,864  |   | $ | 12,219 |   |
|                                                                                     |   |                                     |    |   |   |
| *Investing  Activities*                                                                  |   |                                     |    |   |   |
|                                                                                     |   |                                     |    |   |   |
| Purchases of securities available for sale                                               |   | (251,012                                 | )       | (92,774 | ) |
| Proceeds  from maturing and principal repayments on securities available for sale        |   | 138,210                                  |    | 113,140 |   |
| Proceeds  from sale of securities available for sale                                     |   | 110,614                                  |    | — |   |
| Proceeds  from sale of loans                                                             |   | 11,069                                   |    | 59,124 |   |
| Net increase in loans receivable                                                         |   | (11,665                                  | )       | (67,854 | ) |
| Proceeds  from sale of other real estate                                                 |   | 1,864                                    |    | 1,852 |   |
| Improvements capitalized to other real estate                                            |   | (213                                     | )       | (78 | ) |
| Purchases of premises and equipment                                                      |   | (1,388                                   | )       | (648 | ) |
| Proceeds from sales of premises and equipment                                            |   | 3,237                                    |    | 62 |   |
| Net  increase in federal funds sold and securities purchased under agreements to  resell |   | (14,670                                  | )       | (11,455 | ) |
|                                                                                     |   |                                     |    |   |   |
| Net  cash provided by (used in) investing activities                                     |   | $                                        | (13,954 | ) | $ | 1,369 |   |

 

See accompanying notes toconsolidated financial statements.

 

4

----

 

CONSOLIDATED STATEMENTSOF CASH FLOWS (UNAUDITED) continued

 
|                                                                                                |   | **Three-month  periods ended March 31,** |   |
|-----------------------------------------------------------------------------------------------------|--------|------------------------------------------|--------|
| **Dollars in thousands**                                                                            |   | **2003**                                 |   | **2002** |   |
|                                                                                                |   |                                     |   |   |   |
| *Financing  Activities*                                                                             |   |                                     |   |   |   |
|                                                                                                |   |                                     |   |   |   |
| Net  increase in deposits                                                                           |   | $                                        | 43,599 |   | $ | 53,589 |   |
| Net increase (decrease) in certificates of deposit                                                  |   | (20,816                                  | )      | 42,426 |   |
| Proceeds  from FHLB advances, securities sold under agreements to repurchase, and other  borrowings |   | 2,073,010                                |   | 1,201,554 |   |
| Repayment of  FHLB advances, securities sold under agreements to repurchase and other borrowings    |   | (2,115,608                               | )      | (1,302,920 | ) |
| Dividends paid to shareholders                                                                      |   | (2,352                                   | )      | (2,186 | ) |
| Proceeds from re-issuance of guaranteed subordinated  debt                                          |   | 4,373                                    |   | — |   |
| Purchase and retirement of common stock                                                             |   | (2,770                                   | )      | (5,117 | ) |
| Issuance  of common stock from exercise of stock options                                            |   | 2,402                                    |   | 604 |   |
|                                                                                                |   |                                     |   |   |   |
| Net  cash used in financing activities                                                              |   | (18,162                                  | )      | (12,050 | ) |
|                                                                                                |   |                                     |   |   |   |
| Net increase (decrease) in cash and due from banks                                                  |   | (16,252                                  | )      | 1,538 |   |
|                                                                                                |   |                                     |   |   |   |
| *Cash  and due from banks*                                                                          |   |                                     |   |   |   |
| Beginning  of period                                                                                |   | 100,002                                  |   | 58,625 |   |
|                                                                                                |   |                                     |   |   |   |
| End  of period                                                                                      |   | $                                        | 83,750 |   | $ | 60,163 |   |
|                                                                                                |   |                                     |   |   |   |
| *Supplemental  Disclosures of Cash Flow Information*                                                |   |                                     |   |   |   |
|                                                                                                |   |                                     |   |   |   |
| Cash  paid during the period for:                                                                   |   |                                     |   |   |   |
| Interest                                                                                            |   | $                                        | 15,214 |   | $ | 17,668 |   |
| Income  taxes                                                                                       |   | 95                                       |   | 2,500 |   |
| Non-cash  investing and financing activities:                                                       |   |                                     |   |   |   |
| Loans  receivable transferred to other real estate                                                  |   | 1,099                                    |   | 1,937 |   |
| ESOP  debt repayment                                                                                |   | —                                   |   | 543 |   |

 

See accompanying notes toconsolidated financial statements.

 

5

----

 

NOTES TO UNAUDITEDCONSOLIDATED FINANCIAL STATEMENTS

 

**NOTE A** BASIS OFPRESENTATION

 

Pacific Northwest Bancorp is a bank holding company incorporated in thestate of Washington.  Through itscommercial banking subsidiary, Pacific Northwest Bank, a wide range offinancial services is offered to businesses and individuals in its market areaincluding investment products available through its subsidiary, PacificNorthwest Financial Services, Inc. and insurance products available through itssubsidiary, Pacific Northwest Insurance Agency, Inc.  Pacific Northwest Bank operates 58 Financial Centers in thePacific Northwest, including the metropolitan areas of Seattle and Bellevue,Washington, and Portland, Oregon, and other areas of western and centralWashington.

 

The unaudited consolidated financial statements include the accounts ofPacific Northwest Bancorp and its wholly owned subsidiaries (collectivelyPNWB).  As of March 31, 2003, PacificNorthwest Bancorp’s wholly owned subsidiaries were Pacific Northwest Bank,InterWest Capital Trust I and Pacific Northwest Statutory Trust I.  All material inter-company transactions andbalances have been eliminated in consolidation.

 

The preparation ofthe consolidated financial statements in conformity with accounting principlesgenerally accepted in the United States requires management to make estimatesand assumptions that affect amounts reported in the consolidated financialstatements.  Changes in these estimatesand assumptions are considered reasonably possible and may have a materialimpact on the consolidated financial statements and thus actual results coulddiffer from the amounts reported and disclosed herein.

 

The unauditedconsolidated financial statements have been prepared in accordance withaccounting principles generally accepted in the United States for interimfinancial information and with the instructions to Form 10-Q and Rule 10-01 ofRegulation S-X.  Accordingly, they donot 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-month periods ended March 31, 2003 and 2002 are not necessarilyindicative of the operating results for the full year.  For further information, refer to theconsolidated financial statements and footnotes filed on the Form 10-K for themost recent annual period ended December 31, 2002.

 

**NOTE B**STOCK BASED COMPENSATION

 

PNWB accounts for stock-based employee compensation plan using theintrinsic value method prescribed in Accounting Principle Board Opinion (APB)No. 25, “Accounting for Stock Issued to Employees.”   No stock-based employee compensation cost is reflected in netincome, as all stock options are granted at exercise prices not less than thefair value of common stock on the date of grant.  PNWB has elected to apply the disclosure only provisions of Statementof Financial Accounting Standards (SFAS) No. 148, “Accounting for Stock-BasedCompensation.”  The following tableillustrates the effect on net income and earnings per share if PNWB had appliedthe fair value recognition provisions of FASB Statement No. 148 to stock-basedemployee compensation.

 
|                                                |                                                                                                                                         | **Three-months  ended** |   |
|-----------------------------------------------------|----------------------------------------------------------------------------------------------------------------------------------------------|-------------------------|--------|
| **Dollars in thousands, except per  share amounts** |                                                                                                                                         | **March 31,  2003**     |   | **March 31,  2002** |   |
|                                                |                                                                                                                                         |                    |   |   |   |
| Net income, as  reported                            |                                                                                                                                         | $                       | 8,383  |   | $ | 7,564 |   |
| Less:                                               |   Total stock-based employee compensation  Expense determined under fair value based method for all awards, net of  related tax effects |                    | 263    |   | 394 |   |
| Pro  forma net income                               |                                                                                                                                         | $                       | 8,120  |   | $ | 7,170 |   |
|                                                |                                                                                                                                         |                    |   |   |   |
| Earnings per  share:                                |                                                                                                                                         |                    |   |   |   |
| Basic - as  reported                                |                                                                                                                                         | $                       | 0.50   |   | $ | 0.49 |   |
| Basic - pro forma                                   |                                                                                                                                         | $                       | 0.48   |   | $ | 0.46 |   |
|                                                |                                                                                                                                         |                    |   |   |   |
| Diluted - as reported                               |                                                                                                                                         | $                       | 0.48   |   | $ | 0.48 |   |
| Diluted - pro forma                                 |                                                                                                                                         | $                       | 0.46   |   | $ | 0.45 |   |
|                                                     |                                                                                                                                              |                         |        |  |  |  |  |  |

 

6

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**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-month periods ended March 31:

 
| **Dollars in thousands, except  share and per share amounts**                                                            |   | **2003**   |       | **2002**   |       |
|--------------------------------------------------------------------------------------------------------------------------|--------|------------|------------|------------|------------|
|                                                                                                                     |   |       |       |       |       |
| **Numerator:**                                                                                                           |   |       | ** ** |       | ** ** |
|                                                                                                                     |   |       |       |       |       |
| Net  income                                                                                                              |   | $          | 8,383      |       | $          | 7,564 |   |
|                                                                                                                     |   |       |       |       |       |
| **Denominator:**                                                                                                         |   |       |       |       |       |
|                                                                                                                     |   |       |       |       |       |
| Denominator  for basic net income per share-  Weighted average shares                                                    |   | 16,851,985 |       | 15,534,568 |       |
| Effect  of dilutive securities:                                                                                          |   |       |       |       |       |
| Stock  options                                                                                                           |   | 692,352    |       | 314,189    |       |
| Denominator  for diluted net income per share-  Weighted average shares and assumed conversion of dilutive stock options |   | 17,544,337 |       | 15,848,757 |       |
|                                                                                                                     |   |       |       |       |       |
| Basic  net income per share                                                                                              |   | $          | 0.50       |       | $          | 0.49 |   |
|                                                                                                                     |   |       |       |       |       |
| Diluted net income per share                                                                                             |   | $          | 0.48       |       | $          | 0.48 |   |

 

**NOTE D**BUSINESSSEGMENT INFORMATION

 

Between the period August 31, 1996 and October 1999, PNWB acquired sixcommercial banking institutions. Subsequent to the acquisitions of PacificNorthwest Bank, First National Bank of Port Orchard, Pioneer Bank and KittitasValley Bank in 1998, PNWB was managed at the individual subsidiary banklevel.  Each subsidiary bank had a Boardof Directors and an executive management team that was responsible for theoperation and performance of the respective subsidiary bank. During the yearended December 31, 2000, PNWB merged the subsidiary banks into one commercialbank.  In addition, PNWB consolidatedits executive management functions and implemented a new organizationalstructure, while converting separate banking systems into a single operatingsystem.

 

On November 13,2002, PNWB completed the acquisition of Bank of the Northwest (BKNW) and mergedBKNW into its commercial bank subsidiary, Pacific Northwest Bank.  BKNW operated five branch offices in themetropolitan Portland market area. On December 9, 2002, PNWB successfullycompleted the information systems and data conversion of BKNW and all of thefive BKNW branches were renamed Pacific Northwest Bank.

 

As a result of these organizational and system changes, the financialinformation that is used by the chief operating decision maker in allocatingresources and assessing performance is only provided for one reportable segmentfor the three-month periods ended March 31, 2003 and 2002.

 

7

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

 

PNWB has sold certain securities of the U.S. government and itsagencies and other approved investments under agreements to repurchase.  The securities sold were classified assecurities available for sale with an estimated fair value of $73.7 million and$82.2 million as of March 31, 2003 and December 31, 2002, respectively.

 

**NOTE F**OFF BALANCE SHEET LOAN COMMITTMENTS

 

As of March 31, 2003, PNWB had $237,957,000 in real estate loancommitments to extend credit.  Otherloan commitments to extend credit, which include commercial and consumer linesof credit, totaled $499,040,000as of March 31, 2003.  Outstandingcommitments to extend credit under standby letters of credit and commercialletters of credit totaled $63,645,000 and $17,290,000 as of March 31, 2003.

 

**NOTE G**ACCOUNTING CHANGES

 

In January 2003,the FASB issued SFAS No. 148 “Accounting for Stock-BasedCompensation-Transition and Disclosure”. SFAS No. 148 amends FASB Statement No.123 “**Accounting for Stock-Based Compensation” and**providesalternative methods of transition for a voluntary change to the fair valuebased method of accounting for stock-based compensation. In addition, SFAS No.148 amends the disclosure requirements of Statement 123 to require moreprominent and quarterly disclosures in financial statements about the effectsof stock-based compensation.  SFAS No.148 became effective immediately for fiscal years ending after December 15,2002.  The adoption of this statementaffected the disclosures in PNWB’s consolidated financial statements; however,it had no material impact on PNWB’s financial condition or results ofoperations.

 

In July 2002, theFASB issued SFAS No. 146 “Accounting for Costs Associated with Exit or DisposalActivities”.  SFAS No. 146 addressesfinancial accounting and reporting for costs associated with exit or disposalactivities and nullifies EITF Issue No. 94-3 “Liability Recognition for CertainEmployee Termination Benefits and Other Costs to Exit an Activity (including CertainCosts Incurred in a Restructuring)”. SFAS No. 146 requires that a liability for a cost associated with anexit or disposal activity be recognized when the liability is incurred asopposed to when a plan is developed as required by EITF Issue No. 94-3.  SFAS No. 146 became effective on January 1,2003.  The adoption of SFAS No. 146 hadno material impact on PNWB’s financial condition or results of operations.

 

8

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**Item 2.    MANAGEMENT DISCUSSION AN****D ANALYSIS OF FINANCIAL CONDITION AND RESULTS OFOPERATIONS**

 

**FORWARD-LOOKING STATEMENTS**

 

*This document, including informationincluded with or incorporated by reference in this document, containsforward-looking statements within the meaning of the Private SecuritiesLitigation Reform Act of 1995.  Thesestatements are not guarantees of future performance and involve certain risks,uncertainties and assumptions that are difficult to predict.  Actual outcomes and results may differmaterially from those expressed in, or implied by, our forward-lookingstatements.  Words such as “expects,”“anticipates,” “believes,” “estimates,” “intends,” “strategy,” other similarexpressions or future or conditional verbs such as “will,” “may,” “should,”“would,” and “could” are intended to identify such forward-lookingstatements.  Readers should not relysolely on the forward-looking statements and should consider all uncertaintiesand risks throughout this document.  Thestatements are representative only as of the date they are made, and PNWBundertakes no obligation to update any forward-looking statement.*

 

*Possible events or factors thatcould cause results or performance to differ materially from those expressed inour forward-looking statements include, but are not limited to, thefollowing:  changes in general economicconditions and economic conditions in the geographic areas in which PNWBoperates which may affect, among other things, the level of nonperformingloans, charge-offs, and provision expense; changes in the interest rateenvironment which may reduce interest margins and impact funding sources;litigation liabilities, including costs, expenses, settlements and judgments; changes in tax laws, rules andregulations as well as Internal Revenue Service (IRS) or other governmentalagencies’ interpretations thereof; legislative, regulatory and accountingchanges affecting the banking and financial services industry; competition withother local, regional and national banks, thrifts, credit unions and othernon-bank financial institutions; ability to grow core businesses; ability todevelop and introduce new banking-related products, services and enhancementsand gain market acceptance of such products; mergers and acquisitions and theirintegration into PNWB; and management’s ability to manage these and otherrisks.*

 

**OVERVIEW**

 

Headquartered in Seattle, WA, Pacific Northwest Bancorp is a Washingtonbased bank holding company providing financial services through its commercialbanking subsidiary, Pacific Northwest Bank. Pacific Northwest Bank operates 58 Financial Centers in the PacificNorthwest, including the metropolitan areas of Seattle and Bellevue,Washington, and Portland, Oregon, and other areas of western and centralWashington. Pacific Northwest Bank offers a wide range of financial services tobusinesses and individuals in its market area, including investment productsavailable through its subsidiary, Pacific Northwest Financial Services, Inc.and insurance products available through its subsidiary, Pacific NorthwestInsurance Agency, Inc. As part of the migration to a commercial bank, PNWB hasmade significant progress in restructuring its balance sheet since mid-2000 sothat it is more reflective of a commercial bank.

 

A source of future growth may be through mergers and acquisitions.  PNWB’s management believes that many otherfinancial institutions are considering selling their institutions for a varietyof reasons, including lack of shareholder liquidity, management successionissues, technology challenges, and increasing competition. PNWB activelyreviews proposals for various acquisition opportunities.  PNWB has a due diligence review process toevaluate potential acquisitions and has established parameters for potentialacquisitions relating to market factors, financial performance and certainnon-financial factors.  Successfulcompletion of acquisitions by PNWB depends on several factors such as theavailability of suitable acquisition candidates, necessary regulatory andshareholder approval and compliance with applicable capital requirements.  No assurance can be made that acquisitionactivity will continue in the future.

 

9

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**RESULTS OF OPERATIONS**

 

PNWB had netincome of $8.4 million for the three-month period ended March 31, 2003,compared to $7.6 million for the three-month period ended March 31, 2002.  Diluted net income per share was $0.48 forthe three-month periods ended March 31, 2003 and 2002. PNWB’s return on averageshareholders’ equity was 12.64 percent for the three-month period ended March31, 2003, compared to 15.06 percent for the three-month period ended March 31,2002.  PNWB’s return on average assetswas 1.08 percent for the three-month period ended March 31, 2003, compared to1.11 percent for the three-month period ended March 31, 2002.

 

The following tablesummarizes net income, net income per share and key financial ratios for thethree-month periods ended March 31:

 
| **Dollars in thousands, except per  share amounts** |   | **2003** |   | **2002** |   |
|-----------------------------------------------------|--------|----------|--------|----------|--------|
|                                                |   |     |   |     |   |
| Net  income                                         |   | $        | 8,383  |     | $      | 7,564 |   |
|                                                |   |     |   |     |   |
| Basic  net income per share                         |   | $        | 0.50   |     | $      | 0.49 |   |
|                                                |   |     |   |     |   |
| Diluted  net income per share                       |   | $        | 0.48   |     | $      | 0.48 |   |
|                                                |   |     |   |     |   |
| Return  on average shareholders’ equity        |   | 12.64%   |   | 15.06%   |   |
|                                                |   |     |   |     |   |
| Return  on average assets                           |   | 1.08%    |   | 1.11%    |   |
|                                                |   |     |   |     |   |
| Net  interest margin                                |   | 3.88%    |   | 4.26%    |   |
|                                                |   |     |   |     |   |
| Efficiency  ratio                                   |   | 57.92%   |   | 58.23%   |   |

 

*Net Interest Income*  |PNWB’s net income is significantly affectedby changes in net interest income, which is the interest income received onloans receivable and other interest-earning assets less the interest expense ondeposits and borrowings. PNWB’s net interest income is sensitive to changes ininterest rates.  Net interest incomebefore the provision for losses on loans were $27.3 million for both thethree-month periods ended March 31, 2003 and March 31, 2002.

 

Net interest margin, which is net interest income divided by averageinterest-earning assets, was 3.88 percent for the three-month period endedMarch 31, 2003, compared to 4.26 percent for the three-month period ended March31, 2002. Net interest margin decreased as a result of PNWB’s asset sensitiveposition in the low and decreasing interest rate environment during the pastyear.  Loans repriced at lower rates andthe proceeds from investments that matured, were called or prepaid werereinvested at lower yields.  Thedecrease in net interest margin was also a result of management’simplementation of the bank owned life insurance (BOLI) strategy in April of2002.

 

Interest income was $43.1 million for the three-month period endedMarch 31, 2003, compared to $44.9 million for the three-month period endedMarch 31, 2002. This decrease was primarily due to lower yields earned on loansand securities, partially offset by increases in volume from the first quarterof 2002. The yield on interest-earning assets was 6.11 percent and 7.00 percentfor the three-month periods ended March 31, 2003 and, 2002, respectively.

 

Interest expensewas $15.7 million for the three-month period ended March 31, 2003, compared to$17.6 million for the three-month period ended March 31, 2002.  The decrease in interest expense wasprimarily due to a decrease in the cost of funds as a result of reductions ofmarket interest rates and management’s restructuring of the funding base.  The average balances of lower-costingdeposits increased while the higher-costing borrowings decreased from the firstquarter of 2003.  The cost of funds was2.55 percent for the three-month period ended March 31, 2003, compared to 3.13percent for the same period in 2002.

 

*Average Rates and Balances*| The following table indicates the average balance and average interest ratesearned or paid, interest rate spread and net interest margin for thethree-month periods ended March 31:

 

10

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|                                                                                |   | **2003**             |      | **2002** |   |
|-------------------------------------------------------------------------------------|--------|----------------------|-----------|----------|--------|
| **Dollars in thousands**                                                            |   | **Average  Balance** |      | **Rate** |   | **Average  Balance** |   | **Rate** |   |
|                                                                                |   |                 |      |     |   |   |   |   |   |
| Loans  receivable and loans held for sale                                           |   | $                    | 2,028,899 |     | 6.86   | % | $ | 1,839,789 |   | 7.56 | % |
| Securities  held to maturity and other interest-earning assets                      |   | 805,164              |      | 4.21     | %      | 742,558 |   | 5.61 | % |
| Total  interest-earning assets                                                      |   | 2,834,063            |      | 6.11     | %      | 2,582,347 |   | 7.00 | % |
|                                                                                |   |                 |      |     |   |   |   |   |   |
| Interest-bearing  deposits                                                          |   | 1,680,221            |      | 1.88     | %      | 1,387,649 |   | 2.59 | % |
| FHLB  advances, securities sold under agreements to repurchase and other borrowings |   | 826,399              |      | 3.91     | %      | 887,330 |   | 3.97 | % |
|                                                                                |   |                 |      |     |   |   |   |   |   |
| Total  interest-bearing liabilities                                                 |   | 2,506,620            |      | 2.55     | %      | 2,274,979 |   | 3.13 | % |
|                                                                                |   |                 |      |     |   |   |   |   |   |
| Non-interest-bearing  deposits                                                      |   | $                    | 302,717   |     |   |   | $ | 226,639 |   |   |   |
|                                                                                |   |                 |      |     |   |   |   |   |   |
| Net  interest spread                                                                |   |                 |      | 3.56     | %      |   |   | 3.87 | % |
| Net  interest margin                                                                |   |                 |      | 3.88     | %      |   |   | 4.26 | % |

 

The followingtable provides information on changes in net interest income for the periodsthat are attributable to changes in interest rates and changes in volume:

 

Three-month periods March 31, 2003 to 2002

Increase  (Decrease)

Due to changes in
|                                                                                           |   |
|------------------------------------------------------------------------------------------------|--------|
|                                                                                           |   |   |   |   |   |   |   |
| **Dollars in thousands**                                                                       |   | **Rate** |   | **Volume** |   | **Total** |   |
|                                                                                           |   |   |   |   |   |   |   |
| *Interest-earning  assets*                                                                     |   |   |   |   |   |   |   |
|                                                                                           |   |   |   |   |   |   |   |
| Loans  receivable and loans held for sale                                                      |   | $ | (3,355 | ) | $ | 3,416 |   | $ | 61 |   |
|                                                                                           |   |   |   |   |   |   |   |
| Securities  available for sale, securities held to maturity and other interest-earning  assets |   | (2,748 | ) | 824 |   | (1,924 | ) |
|                                                                                           |   |   |   |   |   |   |   |
| Total  net change in income on interest-earning assets                                         |   | (6,103 | ) | 4,240 |   | (1,863 | ) |
|                                                                                           |   |   |   |   |   |   |   |
| *Interest-bearing  liabilities*                                                                |   |   |   |   |   |   |   |
|                                                                                           |   |   |   |   |   |   |   |
| Interest-bearing  deposits                                                                     |   | 2,793 |   | (1,686 | ) | 1,107 |   |
|                                                                                           |   |   |   |   |   |   |   |
| FHLB  advances, securities sold under agreement to repurchase and other borrowings             |   | 138 |   | 596 |   | 734 |   |
|                                                                                           |   |   |   |   |   |   |   |
| Total  net change in expense on interest-bearing liabilities                                   |   | 2,931 |   | (1,090 | ) | 1,841 |   |
|                                                                                           |   |   |   |   |   |   |   |
| Net  change in net interest income                                                             |   | $ | (3,172 | ) | $ | 3,150 |   | $ | (22 | ) |

 

11

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*Provision for losses on loans* | The provision for losses on loanswas $1.3 million for the three-month period ended March 31, 2003, compared to$1.7 million for the three-month period ended March 31, 2002. The level of theprovision was based on management’s evaluation about the current PacificNorthwest regional economy and its resulting impact on the loan portfolio. Thelevel of provision was lower than the first quarter of 2002 as a result of ourquarterly assessment of the risk inherent within our loan portfolio inconsideration with the level of the allowance for losses on loans. Management continuesto assess the level of the provision for loan losses based on the known andinherent risk characteristics in the loan portfolio.  These risk characteristics include changes in the size andcomposition of the loan portfolio, delinquency levels, actual loan lossexperience, detailed analysis of individual loans for which full collectibilitymay not be assured, and current economic conditions in PNWB’s market area.

 

*Non-interest Income*| Non-interest income was $5.5 million for the three-month period ended March31, 2003, compared to $4.6 million for the three-month period ended March 31,2002.  The increase was primarily due toincome from BOLI that management obtained in April 2002, and higher servicefees, partially offset by decreased gain on sale of loans.

 

During the secondquarter of 2002, PNWB implemented the financial strategy to purchase $50.0million of BOLI on certain key employees. PNWB is the beneficiary of these BOLIcontracts and the proceeds from the death benefit payments will be used tooffset the cost of employee benefits. In addition, PNWB added another $5.3million of BOLI through the BKNW acquisition in November 2002. BOLI income was$585,000 for the first quarter of 2003, which represented tax-exempt incomefrom BOLI during that period.

 

Service feesincreased to $3.8 million from $3.2 million for the same quarter in 2002primarily as a result of the Bank of the Northwest acquisition completedNovember 13, 2002.  The increase innon-interest income was partially offset by a decrease in gain on sale ofloans. This decrease was due to the outsourcing of the residential mortgagelending function beginning in the first quarter of 2003. This was done toreduce mortgage banking business risk and improve operational efficiencies.  As a result, PNWB expects gain on sale ofloans to decrease further for the remainder of 2003.

 

*Non-interest Expense* | Non-interest expense was $19.0million for the three-month period ended March 31, 2003, compared to $18.6million for the three-month period ended March 31, 2002. The increase fromprior periods were primarily due to higher compensation expense as a result ofthe Bank of the Northwest acquisition and increased expenses related toseverance and employment agreements, partially offset by lower mortgage bankingrelated expenses.

 

General andadministrative expenses was $3.9 million for the quarter ended March 31, 2003,compared to $4.3 million for the quarter ended March 31, 2002. The decreasefrom the first quarter of 2002 was primarily due to lower mortgage bankingrelated expenses and management’s initiatives to increase operationalefficiencies.

 

The efficiency ratio is computed by dividing total operating expensesby net interest income and non-interest income.  An increase in the efficiency ratio indicates that more resourcesare being utililized to generate the same volume of income while a decreasewould indicate a more efficient allocation of resources.  The efficiency ratio for the three-monthperiod ended March 31, 2003 was 57.9 percent, compared to 58.2 percent for thethree-month period ended March 31, 2002.

 

*Income Tax Expense*|Income tax expense was $4.2 million for the three-month period ended March 31,2003, compared to $4.1 million for the three-month period ended March 31,2002.  The effective tax rate was 33.3percent and 35.0 percent for the three-month periods ended March 31, 2003 and2002, respectively.  The decrease ineffective tax rate from 2002 was primarily due to the increase in tax-exemptincome from BOLI.

 

12

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**REVIEW OF FINANCIAL CONDITION**

 

PNWB’sconsolidated assets were $3.12 billion as of March 31, 2003, compared to $3.13billion as of December 31, 2002.

 

*Securities*| As of March 31, 2003, PNWB had $787.3 million of securitiesavailable for sale, compared to $788.5 million as of December 31, 2002.

 

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 (net of income taxes) reported in accumulatedother comprehensive income, a separate component of shareholders’ equity.Periodically management assesses the gross unrealized losses in the securitiesportfolio and determines whether the losses were temporary or other thantemporary. During this process, PNWB considers (1) recent performance of thesecurity, (2) the credit rating of the security, (3) the amount of creditsupport available for the security, if any, (4) circumstances contributing tothe decline in value, (5) the length of time and extent to which the fair valuehas been less than cost or carrying value, and (6) the intent and ability ofPWNB to retain the investment for a period of time sufficient to allow foranticipated recovery.   In considerationof the above factors, management deems the gross unrealized losses in PNWB’ssecurities portfolio as of March 31, 2003 to be temporary.

 

*Loans Held for Sale*| Loans held for sale totaled $12.2 million as of March 31, 2003 compared to$25.6 million as of December 31, 2002. Loans held for sale are primarily single-family mortgage loans,construction loans and, to a much less extent, loans originated under the SmallBusiness Administration program.  Loansheld for sale are carried at the lower of cost or estimated fair value in aggregate.  Loans held for sale are typically sold toother financial institutions. The significant decrease from December 31, 2002is due to loans sold during the first quarter of 2003 and more resources beingfocused on the transition of single-family mortgage loan origination to anoutsourcing model.

 

*Net Loans Receivable*| Net loans receivable were $2.01 billion as of March 31, 2003, compared to$2.00 billion as of December 31, 2002. We continue to experience moderate growth in the commercial loanportfolio despite the sluggish economic conditions in our market area.

 

Total commercial loansoutstanding were $1.44 billion or 70.2 percent of the loan portfolio as ofMarch 31, 2003, compared to $1.39 billion or 68.3 percent as of December 31,2002. The first quarter growth in the commercial loan portfolio was primarilyin the commercial real estate loan category.

 

Single-family residentialmortgage loans outstanding totaled $201.5 million as of March 31, 2003 comparedto $231.2 million as of December 31, 2002. The decrease was primarily due to early payoffs associated with thecurrent interest rate environment and management’s decision not to retainsingle-family mortgage loans in our loan portfolio.

 

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

 
| **Dollars in thousands**          |   | **March 31,  2003** |      | **December  31, 2002** |   |
|-----------------------------------|--------|---------------------|-----------|------------------------|--------|
|                              |   |                |      |                   |   |
| Commercial loans:                 |   |                |      |                   |   |
| Commercial                        |   | $                   | 555,232   |                   | $      | 571,283 |   |
| Commercial  real estate           |   | 835,322             |      | 770,413                |   |
| Agriculture                       |   | 50,053              |      | 51,653                 |   |
| Total commercial loans:           |   | 1,440,607           |      | 1,393,349              |   |
|                              |   |                |      |                   |   |
| Single-family  residential        |   | 201,522             |      | 231,232                |   |
| Real  estate construction         |   | 274,828             |      | 274,581                |   |
| Consumer  loans                   |   | 134,103             |      | 139,784                |   |
|                              |   | 2,051,060           |      | 2,038,946              |   |
| Less:                             |   |                |      |                   |   |
| Allowance  for losses on loans    |   | 27,080              |      | 26,940                 |   |
| Deferred  loan fees and discounts |   | 9,025               |      | 9,193                  |   |
| Net  loans receivable             |   | $                   | 2,014,955 |                   | $      | 2,002,813 |   |

 

13

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*Non-performing Assets*| Loans are generally placed on non-accrual when they become past due over 90days, or 120 days if they are single-family mortgage loans, or when thecollection of interest or principal is considered unlikely.  Loans past due over 90 or 120 days that arenot on non-accrual status must be well-secured by tangible collateral and inthe process of collection.  PNWB doesnot return a loan to accrual status until it is brought current with respect toboth principal and interest and future principal payments are no longer indoubt.  When a loan is placed onnon-accrual status, any previously accrued and uncollected interest is reversedfrom interest income.  PNWB performs areview of its loan portfolio for weaknesses in credit quality on an ongoingbasis to identify problem loans.  Thisreview results in internal loan classifications based on risk characteristicsand loan performance.  The overallobjective of this review process is to identify trends in the credit quality ofthe loan portfolio and to determine the level of loss exposure to evaluate theneed for an adjustment to the allowance for losses on loans.

 

Non-accrual loans totaled $12.2 million as of March 31, 2003 comparedto $11.9 million as of December 31, 2002. Other real estate was $6.5 million asof March 31, 2003 compared to $7.2 million as of December 31, 2002. Totalnon-performing assets, including non-accrual loans and other real estate,totaled $18.7 million or 0.60 percent of consolidated assets as of March 31,2003, compared to $19.1 million or 0.61 percent of consolidated assets as ofDecember 31, 2002.

 

The followingtable summarizes non-performing assets as of the dates indicated:

 
| **Dollars in thousands**     |   | **March 31,  2003** |   | **December  31, 2002** |   |
|------------------------------|--------|---------------------|--------|------------------------|--------|
|                         |   |                |   |                   |   |
| *Non-accrual loans*          |   |                |   |                   |   |
|                         |   |                |   |                   |   |
| Commercial loans:            |   |                |   |                   |   |
| Commercial                   |   | $                   | 5,924  |                   | $      | 5,562 |   |
| Commercial  real estate      |   | 755                 |   | 657                    |   |
| Agriculture                  |   | 1,103               |   | 1,658                  |   |
| Total commercial loans:      |   | 7,782               |   | 7,877                  |   |
|                         |   |                |   |                   |   |
| Single-family  residential   |   | 3,825               |   | 3,733                  |   |
| Real  estate construction    |   | 363                 |   | 130                    |   |
| Consumer  loans              |   | 190                 |   | 173                    |   |
|                         |   |                |   |                   |   |
| Total  non-accrual loans     |   | 12,160              |   | 11,913                 |   |
|                         |   |                |   |                   |   |
| Other  real estate           |   | 6,548               |   | 7,152                  |   |
|                         |   |                |   |                   |   |
| Total  non-performing assets |   | $                   | 18,708 |                   | $      | 19,065 |   |

 

*Allowance for Losses on Loans*| The allowance for losses on loans was $27.1 million or 1.33 percent of loansreceivable as of March 31, 2003, compared to $26.9 million or 1.33 percent ofloans receivable as of December 31, 2002. Net loan charge-offs were $1.1 million or 0.22 percent (annualized) ofthe average balance of loans outstanding for the three-month period ended March31, 2003, compared to $783,000 or 0.16 percent (annualized) of the averagebalance of loans outstanding for the three-month period ended December 31,2002.

 

When available information confirms that specific loans, or portionsthereof, are uncollectible, these amounts are charged off against the allowancefor losses on loans. The existence of some or all of the following criteriawill generally confirm that a loss has been incurred: the loan is significantlydelinquent and the borrower has not evidenced the ability or intent to bringthe loan current; there is no recourse to the borrower, or if there isrecourse, the borrower has insufficient assets to pay the debt; the fair valueof the loan collateral is significantly below the current loan balance, andthere is little or no near-term prospect for improvement.  A provision for losses on loans, which is acharge against income, is added to the allowance for losses on loans based onongoing assessments of credit risk in the loan portfolio.

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The allowance for losses on loans is maintained at an amount tosufficiently provide for estimated losses based on evaluating known andinherent risks in the loan portfolio. Management analyzes certain factors underlying the quality of the loanportfolio.  These factors includechanges in the size and composition of the loan portfolio, delinquency levels,actual loan loss experience, detailed analysis of individual loans for whichfull collectibility may not be assured, and current economic conditions inPNWB’s market area.  Management hasassessed the impact of the Pacific Northwest regional economy on the creditrisk in the loan portfolio.  To date,delinquency trends and classified loan levels relative to comparable periods donot indicate any material deterioration in the loan portfolio.  Management continues to closely monitorPNWB’s credit quality and focus on identifying potential problem credits andany loss exposure in a timely manner. Industry concentration and related limits will also be subject to on-goingassessment.

 

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

 

PNWB’s allowancefor losses on loans is allocated to specific loans, certain loan categoriesbased on the relative risk characteristics, asset classifications and actualloss experience of the loan portfolio. Although the allocation of the allowance for losses on loans is animportant credit management tool, the entire allowance for losses on loans isavailable for the entire loan portfolio. Management reviewed the allocations in the various loan categories andbelieves the allowance for losses on loans was adequate as of March 31, 2003.

 

The followingtables summarize the activity in allowance for losses on loans during thethree-month periods ended March 31:

 
| **Dollars in thousands**             |   | **2003** |   | **2002** |   |
|--------------------------------------|--------|----------|--------|----------|--------|
|                                 |   |     |   |     |   |
| Allowance  as of beginning of period |   | $        | 26,940 |     | $      | 20,123 |   |
|                                 |   |     |   |     |   |
| Provision  for losses on loans       |   | 1,250    |   | 1,700    |   |
|                                 |   |     |   |     |   |
| Recoveries                           |   | 142      |   | 129      |   |
|                                 |   |     |   |     |   |
| Charge-offs                          |   | (1,252   | )      | (853     | )      |
|                                 |   |     |   |     |   |
| Allowance  as of end of period       |   | $        | 27,080 |     | $      | 21,099 |   |

 

*Goodwilland Other Intangible Assets*| Goodwill and other intangibleassets totaled $77.8 million or 2.50 percent of total assets and 29.2 percentof total shareholder’s equity as of March 31, 2003. Goodwill and otherintangible assets totaled $78.2 million or 2.50 percent of total assets and 29.9percent of total shareholder’s equity as of December 31, 2002. The decrease ingoodwill and other intangible assets is due to amortization of mortgageservicing intangibles and core deposit intangibles.

 

Goodwill arising from acquisitions represents the excess of thepurchase price over the estimated fair value of net assets acquired. Prior to2002, goodwill was amortized using the straight-line method over periods notexceeding twenty years.  EffectiveJanuary 1, 2002, upon adoption of SFAS No. 142 “Accounting for Goodwill andOther Intangible Assets”, PNWB no longer amortizes its goodwill. PNWB reviewsits goodwill for impairment annually or more frequently if impairmentindicators arise.

 

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Other intangibleassets consist of core deposit intangibles and mortgage servicing rights, andare amortized using straight-line and accelerated methods over periods notexceeding twenty years.  Mortgageservicing rights are capitalized when acquired either through the purchase ororigination of loans that are subsequently sold or securitized with theservicing rights retained.  Theestimated fair value of mortgage servicing rights at the date of the sale ofloans is determined based on the discounted present value of expected futurecash flows using key assumptions for servicing income and costs and prepaymentrates on the underlying loans. The estimated fair value is periodicallyevaluated for impairment by comparing actual cash flows and estimated futurecash flows from the servicing assets to those estimated at the time servicingassets were originated.  Mortgageservicing rights are amortized as an offset to service fees in proportion toand over the period of estimated net servicing income.

 

Goodwill and other intangible assets consisted of the following as ofthe dates indicated:

 
| **Dollars in thousands**        |   | **March 31,  2003** |   | **December  31, 2002** |   |
|---------------------------------|--------|---------------------|--------|------------------------|--------|
|                            |   |                |   |                   |   |
| Goodwill                        |   | $                   | 67,732 |                   | $      | 67,732 |   |
| Mortgage  servicing intangibles |   | 703                 |   | 836                    |   |
| Core deposit intangibles        |   | 9,387               |   | 9,669                  |   |
|                            |   | $                   | 77,822 |                   | $      | 78,237 |   |

 

*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 retaining and generating new customer relationships.  We emphasize developing total clientrelationships in order to increase our core deposit base.

 

Non-interest-bearingdeposits were $359.8 million as of March 31, 2003 compared to $345.6 million asof December 31, 2002. Non-interest-bearing deposits represented 17.3 percent and 16.8 percentof total deposits as of March 31, 2003 and December 31, 2002,respectively.  Interest-bearing transactionaccounts (which include interest-bearing checking, money market and savingsaccounts) totaled $933.3 million as of March 31, 2003 compared to $904.0million as of December 31, 2002. Interest-bearing transaction accounts represented 44.9 percent of totaldeposits as of March 31, 2003, compared to 44.0 percent as of December 31,2002.

 

Certificates of deposit totaled $783.9 million as of March 31, 2003,compared to $804.7 million as of December 31, 2002.  Certificates of deposit represented 37.7 percent of totaldeposits as of March 31, 2003, compared to 39.2 percent as of December 31,2002. The increase in the core deposit balances (which include non-interestbearing and non-interest bearing transactional accounts) and the decrease incertificate of deposit balance reflect management’s efforts to restructure thedeposit portfolio as a means to reduce the costs of funds.

 

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

 
| **Dollars in thousands**            |   | **March 31,  2003** |      | **December  31, 2002** |   |
|-------------------------------------|--------|---------------------|-----------|------------------------|--------|
|                                |   |                |      |                   |   |
| Non-interest-bearing  deposits      |   | $                   | 359,848   |                   | $      | 345,571 |   |
| Interest-bearing  checking accounts |   | 267,803             |      | 263,591                |   |
| Money  market accounts              |   | 554,826             |      | 531,698                |   |
| Savings  accounts                   |   | 110,703             |      | 108,721                |   |
| Certificates  of deposit            |   | 783,913             |      | 804,729                |   |
|                                |   |                |      |                   |   |
| Total                               |   | $                   | 2,077,093 |                   | $      | 2,054,310 |   |

 

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*FHLB Advances and Securities SoldUnder Agreements to Repurchase* | PNWB borrows throughadvances from the Federal Home Loan Bank (FHLB) and securities sold underagreements to repurchase with third parties. These borrowing sources totaled$687.7 million as of March 31, 2003 compared to $730.3 million as of December31, 2002.  The need for this type ofborrowings decreased primarily as a combined result of the increase in deposits.

 

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

 

*Other borrowings ** ***| Otherborrowings were $10.1 million as of March 31, 2003 and 2002.  The balances were comprised primarily ofnotes from another financial institution. This borrowing qualifies as Tier IIcapital under the capital guidelines of the Federal Reserve Board.

 

*Guaranteed Preferred BeneficialInterests in Subordinated Debt*  | On September 26, 2002, $12 million of Capital Securities wereissued by Pacific Northwest Statutory Trust I (the Trust).  The Trust is a business trust organized inSeptember 2002, and Bancorp owns 100 percent of the common equity of theTrust.  The proceeds of the offeringwere invested by the Trust in junior subordinated debentures of PacificNorthwest Bancorp.  The debentures heldby the Trust are the sole assets of Pacific Northwest Statutory Trust I.  The Capital Securities are subject tomandatory redemption, in whole or in part, upon repayment of thedebentures.  The debentures will notmature earlier than September 26, 2007, and not later than September 26, 2012.The interest rate on the Capital Securities is based upon three-month LIBORplus 3.55 percent and adjusts on a quarterly basis.  As of March 31, 2003, the interest rate on the Capital Securitieswas 4.84 percent.  Pacific NorthwestBancorp entered into agreements which, taken collectively, fully andunconditionally guarantee the capital securities subject to the terms of eachof the guarantees.  The CapitalSecurities qualify as Tier I capital under the capital guidelines of theFederal Reserve Board.

 

On November 15,1999, $40,000,000 of 9.875 percent Capital Securities were issued by InterWestCapital Trust I (the Trust I).  TheTrust I is a business trust organized in November 1999, and Bancorp owns 100percent of the common equity of the Trust I. The proceeds of the offering were invested by the Trust I in juniorsubordinated debentures of Bancorp.  Thedebentures held by the Trust I are the sole assets of the Trust I. At theBancorp’s option, the debentures will not mature earlier than November 15,2009, and not later than November 15, 2029. After November 15, 2019, the debentures can be redeemed at par value.Distributions on the capital securities issued by the Trust I are payablesemiannually at 9.875 percent per annum, which is equal to the interest ratebeing earned by the Trust I on the debentures it held.  The capital securities are subject tomandatory redemption, in whole or in part, upon repayment of the debentures.Bancorp has entered into agreements which, taken collectively, fully andunconditionally guarantee the capital securities subject to the terms of eachof the guarantees. The capital securities qualify as Tier I capital under thecapital guidelines of the Federal Reserve Board.  Pacific Northwest Bancorp purchased $4.0 million of the capitalsecurities (guaranteed subordinated debt) during 2002 and the $4.0 millioncapital securities were subsequently reissued at a premium of $372,500 duringthe first quarter of 2003.  The premiumwill be amortized using the straight-line method through November 9, 2009.

 

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

 

On January 28, 2003, the Board of Directors of Pacific NorthwestBancorp authorized the purchase of up to five percent of Pacific NorthwestBancorp’s outstanding shares of common stock over the next twelve months.  As of March 31, 2003 PNWB repurchased, onthe open market, a total of 104,291 shares at an average price of $27.56.

 

 

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There were 15,453,581 shares of common stock outstanding at March 31,2002. At December 31, 2002 there were 16,799,472 shares of common stockoutstanding. During the fourth quarter of 2002, Bancorp issued approximately1.7 million shares of Bancorp common stock as part of the Northwest mergerconsideration and this increased Bancorp’s shareholders’ equity byapproximately $57.0 million. There was an additional 217,000 shares issuedduring 2002 related to stock option plans. These increases were partiallyoffset by stock repurchases of approximately 781,000 shares during 2002.

 

PNWB’s total shareholders’ equity was $266.5 million as of March 31,2003, compared to $261.6 million as of December 31, 2002.  The increase in shareholders’ equity duringthe first three months of 2003 was primarily due to net income of $8.3 million,stock issued under stock option plans of $2.4 million, a tax deduction on stockoption exercises of $1.2 million, offset by the decrease in the estimated fairvalue of securities available for sale of $2.0 million (net of tax), cashdividends declared of $0.14 per share or $2.4 million, and repurchases ofcommon stock totaling $2.8 million. Book value per share was $15.80 as of March 31, 2003, compared to $15.57as of December 31, 2002.

 

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

 

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

 

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

 

The regulations define the relevant capital levels for the fivecategories.  In general terms, thecapital definitions are as follows:

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

 

18

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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, andexcludes the equity impact of adjusting securities available for sale toestimated fair value. Total capital is Tier I capital, the allowance for losseson loans and certain long-term debt that qualifies for inclusion as regulatorycapital.  The FRB’s risk-based capitalrules have been supplemented by a leverage capital ratio, defined as Tier I capitalto adjusted quarterly average total assets. As of March 31, 2003, under the FRB’s capital guidelines, PNWB’s levelsof consolidated regulatory capital exceeded the FRB’s well-capitalizedrequirements.  The capital amounts andratios for Pacific Northwest Bancorp and Pacific Northwest Bank as of March 31,2003 and December 31, 2002, are presented in the following table:

 

**CAPITAL RATIOS**

 
|                                      |   | **Amount** |    | **For  Capital  Adequacy Purposes** |   | **To Be Well  Capitalized Under  Prompt Corrective  Action Provisions** |   |
|-------------------------------------------|--------|------------|---------|-------------------------------------|--------|-------------------------------------------------------------------------|--------|
| **Dollars in thousands**                  |   | **Amount** |    | **Ratio**                           |   | **Amount**                                                              |   | **Ratio** |   | **Amount** |   | **Ratio** |   |
|                                      |   |       |    |                                |   |                                                                    |   |   |   |   |   |   |   |
| **March  31, 2003**-                      |   |       |    |                                |   |                                                                    |   |   |   |   |   |   |   |
|                                      |   |       |    |                                |   |                                                                    |   |   |   |   |   |   |   |
| **Pacific  Northwest Bancorp:**           |   |       |    |                                |   |                                                                    |   |   |   |   |   |   |   |
| Total capital  (to risk-weighted assets)  |   | $          | 274,826 |                                | 11.31% |                                                                    | $      | 194,349 |   | 8.0% |   | $ | 242,937 |   | 10.0% |   |
| Tier I capital  (to risk-weighted assets) |   | 237,360    |    | 9.77%                               |   | 97,175                                                                  |   | 4.0% |   | 145,762 |   | 6.0% |   |
| Tier I capital  (to average assets)       |   | 237,360    |    | 7.85%                               |   | 120,908                                                                 |   | 4.0% |   | 151,135 |   | 5.0% |   |
|                                      |   |       |    |                                |   |                                                                    |   |   |   |   |   |   |   |
| **Pacific  Northwest Bank:**              |   |       |    |                                |   |                                                                    |   |   |   |   |   |   |   |
| Total capital  (to risk-weighted assets)  |   | $          | 267,321 |                                | 11.09% |                                                                    | $      | 192,762 |   | 8.0% |   | $ | 240,953 |   | 10.0% |   |
| Tier I capital  (to risk-weighted assets) |   | 239,850    |    | 9.95%                               |   | 96,381                                                                  |   | 4.0% |   | 144,572 |   | 6.0% |   |
| Tier I capital  (to average assets)       |   | 239,850    |    | 7.94%                               |   | 120,791                                                                 |   | 4.0% |   | 150,988 |   | 5.0% |   |
|                                      |   |       |    |                                |   |                                                                    |   |   |   |   |   |   |   |
| **December  31, 2002**                    |   |       |    |                                |   |                                                                    |   |   |   |   |   |   |   |
|                                      |   |       |    |                                |   |                                                                    |   |   |   |   |   |   |   |
| **Pacific  Northwest Bancorp:**           |   |       |    |                                |   |                                                                    |   |   |   |   |   |   |   |
| Total capital  (to risk-weighted assets)  |   | $          | 264,965 |                                | 11.03% |                                                                    | $      | 192,262 |   | 8.0% |   | $ | 240,328 |   | 10.0% |   |
| Tier I capital  (to risk-weighted assets) |   | 227,653    |    | 9.47%                               |   | 96,131                                                                  |   | 4.0% |   | 144,197 |   | 6.0% |   |
| Tier I capital  (to average assets)       |   | 227,653    |    | 7.77%                               |   | 117,201                                                                 |   | 4.0% |   | 146,502 |   | 5.0% |   |
|                                      |   |       |    |                                |   |                                                                    |   |   |   |   |   |   |   |
| **Pacific  Northwest Bank:**              |   |       |    |                                |   |                                                                    |   |   |   |   |   |   |   |
| Total capital  (to risk-weighted assets)  |   | $          | 257,462 |                                | 10.80% |                                                                    | $      | 190,747 |   | 8.0% |   | $ | 238,434 |   | 10.0% |   |
| Tier I capital  (to risk-weighted assets) |   | 230,150    |    | 9.65%                               |   | 95,374                                                                  |   | 4.0% |   | 143,060 |   | 6.0% |   |
| Tier I capital  (to average assets)       |   | 230,150    |    | 7.87%                               |   |  116,902                                                           |   | 4.0% |   | 146,128 |   | 5.0% |   |

 

As of March 31, 2003, Pacific Northwest Bancorp and Pacific NorthwestBank were in compliance with well-capitalized capital requirements. Managementbelieves that under the current regulations the Bank and the Bancorp willcontinue to meet well-capitalized capital requirements in the foreseeablefuture.  However, events beyond thecontrol of the Bank and Bancorp, such as a downturn in the economy in areaswhere Pacific 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.

 

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Management manages the balance sheet to meet these needs. PNWB desiresto attract and retain business and retail customer relationships with a focuson transaction accounts and commercial and consumer lending.  PNWB also uses wholesale funds throughadvances from the FHLB and the sale of securities under agreements torepurchase to fund asset growth and meet liquidity needs. PNWB also useswholesale and brokered certificates of deposit to supplement wholesaleborrowings.  Other sources of funds forliquidity include loan repayments, loan sales, security sales and mortgage-backedand related security repayments. Repayments on loans and mortgage-backed andrelated securities and deposit inflows and outflows are affected by changes ininterest rates.

 

PNWB has the capacity to borrow funds from the FHLB through pre-approvedcredit lines.  These credit lines havepledge requirements whereby PNWB must maintain unencumbered collateral with avalue at least equal to the outstanding balance. PNWB also uses the securitiesmarket as a vehicle for borrowing by utilizing its securities available forsale as collateral.  If the estimatedfair value of the securities were to decline as a result of an increase ininterest rates or other factors, PNWB would be required to pledge additionalsecurities or cash as collateral. In addition, PNWB has the ability to borrowfunds from the Federal Reserve.

 

The analysis of liquidity also includes a review of PNWB’s consolidatedstatement of cash flows for the three-month period ended March 31, 2003.  The consolidated statement of cash flowsdetails PNWB’s operating, investing and financing activities during theperiod.  The most significant itemsunder operating activities include net income of $8.4 million for thethree-month period ended March 31, 2003, an increase in other assets of $1.1million, and an increase in accrued expenses and other liabilities of $5.7million.  Also included in operatingactivities are the add-back of non-cash depreciation, amortization ofintangible assets, provision for losses of loans, and amortization of premiumon investments totaling $4.2 million. Investing activities included purchasesof securities available for sale of $251.0 million, proceeds from maturing andprincipal repayments on securities available for sale of $138.2 million, andproceeds from sale of securities available for sale of $110.6 million. Duringthe period, financing activities included $42.6 million in borrowingrepayments, net of borrowing proceeds, a $22.8 million net increase indeposits, $4.4 million of cash proceeds from re-issuance of guaranteedsubordinated debt, and $2.4 million paid in cash dividends to shareholders.

 

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**Item3.  QUANTITATIVE AN****D QUALITATIVEDISCLOSURES ABOUT MARKET RISK**

 

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

 

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

 

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

 

Management usessimulation 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.

 

For furtherinformation on interest rate risk, reference is made to the sections “Net InterestIncome” and “Average Rates and Balances” in Item 2. Management Discussion andAnalysis of Financial Condition and Results of Operations contained in thisquarterly report on Form 10-Q. Information regarding the expected maturities of financial assets andfinancial liabilities has not changed materially from disclosures made in theAnnual Report on Form 10-K for the year ended December 31, 2002.

 

**Item 4.  CONTROLS AN****D PROCEDURES**

 

**Evaluation of Disclosure Controls andProcedures**

 

PNWB, under the supervisionand with the participation of its management, including its Chief ExecutiveOfficer and Chief Financial Officer, carried out an evaluation of theeffectiveness of the design and operation of the Company’s disclosure controlsand procedures as of March 31, 2003 (the “Evaluation Date”).  Based upon this evaluation, the ChiefExecutive Officer and Chief Financial Officer concluded as of the EvaluationDate that PNWB’s disclosure controls and procedures were effective for purposesof recording, processing, summarizing and timely reporting material informationrequired to be disclosed in reports filed by the Company under the SecuritiesExchange Act of 1934.

 

**Changes in Internal Controls**

 

There were no significantchanges in PNWB’s internal controls or in other factors that couldsignificantly affect these controls subsequent to the Evaluation Date.  PNWB did not implement any correctiveactions with regard to any significant deficiency or material weakness in itsinternal controls.

 

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**PART II. OTHER INF****ORMATION**

 

### **Item1.  Legal** Proceedings

 

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

 

**Items 2, 3, 4 and 5 are notapplicable and have been omitted.**

 

# **Item 6        Exhibitsa**nd 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  September 30, 2001).                               |
|  10    |   | Material contracts of  Pacific Northwest Bancorp (incorporated by reference to Exhibits 10.1 through  10.29 to the Registrant’s Annual Report on Form 10-K for the year ended  December 31, 2002).                            |
|  10.30 |   | First Amendment to  Employment Agreement entered into between Pacific Northwest Bancorp and Kim  S. Brace is filed with this report.                                                                                               |
|  10.31 |   | Severance/Change of  Control Agreement entered into between Pacific Northwest Bancorp and Joseph  H. Ward is filed with this report.                                                                                               |
|  10.32 |   | Pacific Northwest  Bancorp 2003 Long-Term Stock Incentive Plan is filed with this report.                                                                                                                                          |
|  10.33 |   | Amendment to Severance  Pay and Change in Control Agreement entered into between Pacific Northwest  Bancorp and Bette J. Floray.                                                                                                   |
|  10.34 |   | Amendment to Severance  Pay and Change in Control Agreement entered into between Pacific Northwest  Bancorp and David H. Straus                                                                                                    |
|  99.1  |   | Certifications of  Patrick M. Fahey, Chief Executive Officer, and Bette J. Floray, Chief  Financial Officer, pursuant to 18 U.S.C. Section 1350, as adopted, pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002. |
|        |   |                                                                                                                                                                                                                               |

**(b)****                                  Reportson Form 8-K**

 

PNWB filed a currentreport on Form 8-K on January 24, 2003. The report included under Items 5 and 7of Form 8-K a press release announcing PNWB’s 2002 financial results andunaudited consolidated financial statements for the three- and twelve-monthperiods ended December 31, 2002.

 

PNWB filed a currentreport on Form 8-K on January 30, 2003. The report included under Item 5 ofForm 8-K a press release announcing that the Board of Directors of PacificNorthwest Bancorp authorized the purchase in the open market, over the nexttwelve months, of up to 5 percent of its outstanding shares of common stock.

 

PNWB filed a currentreport on Form 8-K on March 3, 2003. The report included under Item 5 of Form8-K announcing executive management changes including the appointment of DavidH. Straus to the position of President and Chief Operating Officer of PacificNorthwest Bancorp’s principal subsidiary Pacific Northwest Bank. Mr. Fahey willcontinue as the Chairman and Chief Executive Officer of the Bank.

 

PNWB filed a currentreport on Form 8-K on March 27, 2003. The report included under Item 5 of Form8-K announcing that on April 18, 2003 Stephen M. Walden will step down asChairman of the Board of Pacific Northwest Bancorp, but will continue as aDirector. Meanwhile, the Board appointed Patrick M. Fahey to the role ofChairman of the Board of Pacific Northwest Bancorp.

 

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**SIGNATURES**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the Registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 

 
|   | PACIFIC NORTHWEST  BANCORP |
|--------|----------------------------|
|   |                       |   |   |
|   |                       |   |   |
|   |                       | By: | /s/ Patrick M. Fahey |   |
|   |                       |   | Patrick M. Fahey |
|   |                       |   | President and Chief  Executive Officer |
|   |                       |   |   |
|   |                       |   |   |
|   |                       |   | /s/ Bette J. Floray |   |
|   |                       |   | Bette J. Floray |
|   |                       |   | Executive Vice  President and Chief Financial Officer |
|   |                       |   |   |
|   |                       |   |   |
|   | Dated:  May 7, 2003   |   |   |
|        |                            |  |  |  |  |  |

 

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**CERTIFICATIONS**

 

**CERTIFICATION OF QUARTERLY REPORT ON FORM 10-Q**

**PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002**

 

I, Patrick M. Fahey, certify that:

 

1.                     I havereviewed this quarterly report on Form 10-Q of Pacific Northwest Bancorp;

 

2.                     Based on myknowledge, this quarterly report does not contain any untrue statement of amaterial fact or omit to state a material fact necessary to make the statementsmade, in light of the circumstances under which such statements were made, notmisleading with respect to the period covered by this quarterly report;

 

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

 

4.                     Theregistrant’s other certifying officers and I are responsible for establishingand maintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the registrant and we have:

 

a)        designed such disclosurecontrols and procedures to ensure that material information relating to theregistrant, including its consolidated subsidiaries, is made known to us byothers within those entities, particularly during the period in which thisquarterly report is being prepared;

 

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

 

c)        presented in thisquarterly report our conclusions about the effectiveness of the disclosurecontrols and procedures based on our evaluation as of the Evaluation Date;

 

5.                     Theregistrant’s other certifying officers and I have disclosed, based on our mostrecent evaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalentfunction):

 

a)        all significantdeficiencies in the design or operation of internal controls which couldadversely affect the registrant’s ability to record, process, summarize andreport financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

b)       any fraud, whether or notmaterial, that involves management or other employees who have a significantrole in the registrant’s internal controls;

 

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

 

 
|   | Date: May 7, 2003                     |   |
|--------|---------------------------------------|--------|
|   |                                  |
|   |                                  |
|   |  /s/  Patrick M. Fahey      |   |
|   | Patrick M. Fahey,                     |
|   | President and Chief Executive Officer |

 

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**CERTIFICATION OF QUARTERLY REPORT ON FORM 10-Q**

**PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002**

 

I, Bette J. Floray, certify that:

 

1.     I have reviewed this quarterly report on Form 10-Q of PacificNorthwest Bancorp;

 

2.               Based on myknowledge, this quarterly report does not contain any untrue statement of amaterial fact or omit to state a material fact necessary to make the statementsmade, in light of the circumstances under which such statements were made, notmisleading with respect to the period covered by this quarterly report;

 

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

 

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

 

a)              designed suchdisclosure controls and procedures to ensure that material information relatingto the registrant, including its consolidated subsidiaries, is made known to usby others within those entities, particularly during the period in which thisquarterly report is being prepared;

 

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

 

c)              presented in thisquarterly report our conclusions about the effectiveness of the disclosurecontrols and procedures based on our evaluation as of the Evaluation Date;

 

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

 

a)              all significantdeficiencies in the design or operation of internal controls which couldadversely affect the registrant’s ability to record, process, summarize andreport financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

b)             any fraud, whether ornot material, that involves management or other employees who have asignificant role in the registrant’s internal controls;

 

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

 

 
|   | Date: May 7, 2003                  |   |
|--------|------------------------------------|--------|
|   |                               |
|   |                               |
|   |  /s/  Bette J. Floray    |   |
|   | Bette J. Floray,                   |
|   | Executive Vice President and Chief |
|   | Financial Officer                  |

 

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