**Exhibit 13**

**Management Discussion and Analysis andConsolidated Financial Statements included in 2001 Financial Information distributed to shareholders with the 2001 Annual Report**

 

 

 

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#### **MANAGEMENTDISCUSSION AND ANALYSIS**

 

The following discussion isprovided for the consolidated operations of Pacific Northwest Bancorp(Bancorp), which includes its wholly owned subsidiaries (collectivelyPNWB).  As of December 31, 2001,Bancorp’s wholly owned subsidiaries were Pacific Northwest Bank and InterWestCapital Trust I.  The purpose of thisdiscussion is to focus on significant factors concerning PNWB’s financialcondition and results of operations. This discussion should be read along with the consolidated financialstatements (including notes thereto) for an understanding of the followingdiscussion and analysis.

 

Bancorp is a bank holdingcompany incorporated in the State of Washington.  PNWB is a financial services company providing a variety ofproducts and services for both business and individual customers.  Financial services of PNWB include thebanking activities of accepting deposits from businesses and individuals andoriginating commercial and commercial real estate loans, residential loans,consumer loans, and agricultural loans.

 

On June 20, 2000, the Board ofDirectors approved a change of PNWB’s fiscal year end from September 30 toDecember 31, retroactively to January 1, 2000. Effective July 1, 2000, PNWB converted its subsidiary bank charter froma state savings bank to a state commercial bank.  In conjunction with the charter conversion, PNWB merged itsbanking subsidiaries into a single commercial bank.  Effective September 1, 2000, InterWest Bancorp, Inc. changed itsname to Pacific Northwest Bancorp and the company’s commercial bank subsidiary,InterWest Bank, changed its name to Pacific Northwest Bank.  In conjunction with the name changes, PNWBrelocated its corporate headquarters to Seattle and transitioned to a newexecutive management team experienced in commercial banking.

 

Following the changes in 2000,PNWB’s main focus in 2001 was to continue its transition from a thriftinstitution to a commercial bank. During 2001, PNWB made significant progress in restructuring its balancesheet so that it was more reflective of a commercial bank.  In the past year, PNWB increased thecommercial and commercial real estate loan balance by $169.1 million, whichrepresented 54.9 percent of total gross loans as of December 31, 2001 comparedto 47.4 percent as of December 31, 2000. Also, transaction deposits and money market account balances increasedwhile higher-cost certificates of deposit balances decreased compared to2000.  The implementation of balancesheet restructuring initiatives and lower interest rates contributed to theincrease in net interest income and net interest margin in 2001.  PNWB will continue to emphasize the changein the composition of the loan portfolio and the deposit base in 2002 in aneffort to positively manage net interest income and better manage interest raterisk.

 

On April 9, 2001, PNWBcompleted the process of converting to a single enhanced operating system forthe entire company.  The conversionprocess started in 2000, subsequent to a series of acquisitions of communitycommercial banks in prior years.  Thenew operating system increased the types of products and services offered tobusiness and retail customers.

 

A source of future growth may be through mergers andacquisitions.  PNWB’s managementbelieves that many other financial institutions are considering selling theirinstitutions for a variety of reasons, including lack of shareholder liquidity,management succession issues, technology challenges, and increasingcompetition. PNWB actively reviews proposals for various acquisitionopportunities.  PNWB has a due diligencereview process to evaluate potential acquisitions and has establishedparameters for potential acquisitions relating to market factors, financialperformance and certain non-financial factors. Successful completion of acquisitions by PNWB depends on several factorssuch as the availability of suitable acquisition candidates, necessaryregulatory and shareholder approval and compliance with applicable capitalrequirements.  No assurance can be madethat acquisition activity will continue in the future.

 

Currently, PNWB conducts its business through 55 financial centers inwestern and central Washington State. Investments are available through Pacific Northwest Financial Servicesand insurance products are available through Pacific Northwest InsuranceAgency, wholly owned subsidiaries of Pacific Northwest Bank.

 

Certainreclassifications have been made to prior year financial data to conform to2001 presentation.  The effects of thereclassifications are not considered material.

 

## **CRITICAL ACCOUNTING POLICIESAND ESTIMATES**

 

Our financial statements are based upon the selectionand application of significant accounting policies which require management tomake significant estimates and assumptions (see note 1 to the consolidatedfinancial statements).  We believe thatthe following is one of the more critical judgment areas in the application ofour accounting policies that currently affect our financial condition andresults of operations.

 

*ALLOWANCE FOR LOSSES ON LOANS*| The allowance for loan loss is established through a charge to the provisionfor loan losses.  Provisions are made toreserve for known and inherent risk characteristics within the loanportfolio.  The allowance is asignificant estimate and PNWB regularly evaluates it for adequacy by consideringfactors such as current loan grades, historical loss rates, change in thenature of the loan portfolio, overall portfolio quality, industryconcentrations, delinquency trends, current economic factors and estimatedimpact of current economic conditions that may effect a borrower’s ability topay.  The use of different estimates orassumptions could produce different provisions for loan loss.  In addition, the allowance for losses onloans is also subject to regulatory supervision and examination.

 

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#### ** **

#### **RESULTS OFOPERATIONS**

 

PNWB’s net income was $22.1million for the year ended December 31, 2001 compared to $6.3 million and $27.9million for the years ended December 31, 2000 and September 30, 1999.  Diluted net income per share was $1.40 forthe year ended December 31, 2001 compared to $0.40 and $1.74 for the yearsended December 31, 2000 and September 30, 1999.  Return on average assets was 0.79 percent for the year endedDecember 31, 2001 compared to 0.22 percent and 1.12 percent for the years endedDecember 31, 2000 and September 30, 1999. Return on average shareholders’ equity was 11.63 percent for the yearended December 31, 2001 compared to 3.74 percent and 16.00 percent for theyears ended December 31, 2000 and September 30, 1999.

 

*FIVE-YEARSELECTED CONSOLIDATED FINANCIAL DATA*

 

The following table summarizes financial informationfor the years ended December 31, 2001 and 2000, and the years ended September30, 1999, 1998 and 1997.  Historicalresults are not necessarily indicative of future results.

 
|                                                     |   | **As of and  for the year ended,**                            |       |
|----------------------------------------------------------|--------|---------------------------------------------------------------|------------|
|                                                     |   | **December  31,  2001(1)**                                    |       | **December  31,   2000(2)** |   | **September  30,   1999** |   | **September  30,  1998(3)** |   | **September  30,  1997** |   |
|                                                     |   | **Dollars  in thousands, except share and per share amounts** |       |
| **SUMMARY OF OPERATIONS**                                |   |                                                          |       |   |   |   |   |   |   |   |   |
| Interest income                                          |   | $                                                             | 205,653    |   | $ | 218,188 |   | $ | 179,659 |   | $ | 180,279 |   | $ | 165,206 |   |
| Interest expense                                         |   | 103,841                                                       |       | 128,655 |   | 95,480 |   | 101,483 |   | 91,081 |   |
| Net interest income                                      |   | 101,812                                                       |       | 89,533 |   | 84,179 |   | 78,796 |   | 74,125 |   |
| Provision for losses on loans                            |   | 6,050                                                         |       | 4,750 |   | 2,000 |   | 2,807 |   | 1,508 |   |
| Net interest income after provision for  losses on loans |   | 95,762                                                        |       | 84,783 |   | 82,179 |   | 75,989 |   | 72,617 |   |
| Gain (loss) on sale of securities available  for sale    |   | 1,709                                                         |       | (6,113 | ) | 72 |   | 813 |   | 587 |   |
| Other non-interest income                                |   | 18,976                                                        |       | 18,226 |   | 27,975 |   | 25,371 |   | 17,712 |   |
| Non-interest expense                                     |   | 81,152                                                        |       | 86,265 |   | 67,786 |   | 66,683 |   | 53,686 |   |
| Income tax expense                                       |   | 13,203                                                        |       | 4,362 |   | 14,585 |   | 12,848 |   | 12,681 |   |
| Net income                                               |   | $                                                             | 22,092     |   | $ | 6,269 |   | $ | 27,855 |   | $ | 22,642 |   | $ | 24,549 |   |
|                                                     |   |                                                          |       |   |   |   |   |   |   |   |   |
| Basic net income per share                               |   | $                                                             | 1.42       |   | $ | 0.40 |   | $ | 1.78 |   | $ | 1.45 |   | $ | 1.58 |   |
| Diluted net income per share                             |   | 1.40                                                          |       | 0.40 |   | 1.74 |   | 1.40 |   | 1.54 |   |
| Cash dividends declared per share                        |   | 0.56                                                          |       | 0.56 |   | 0.56 |   | 0.50 |   | 0.33 |   |
|                                                     |   |                                                          |       |   |   |   |   |   |   |   |   |
| **STATEMENT OF FINANCIAL CONDITION**                     |   |                                                          | ** ** |   | ** ** |   | ** ** |   | ** ** |   | ** ** |
| Total assets                                             |   | $                                                             | 2,741,508  |   | $ | 2,882,870 |   | $ | 2,579,539 |   | $ | 2,448,386 |   | $ | 2,402,928 |   |
| Loans receivable and loans held for sale                 |   | 1,832,189                                                     |       | 1,771,701 |   | 1,584,722 |   | 1,452,175 |   | 1,348,681 |   |
| Deposits                                                 |   | 1,604,855                                                     |       | 1,717,108 |   | 1,578,949 |   | 1,564,825 |   | 1,468,460 |   |
| Borrowings                                               |   | 914,151                                                       |       | 959,873 |   | 817,910 |   | 682,390 |   | 755,968 |   |
| Shareholders'  equity                                    |   |                                                          | 200,486    |   |   | 178,736 |   |   | 165,306 |   |   | 171,652 |   |   | 160,770 |   |
| Book  value per share                                    |   | $                                                             | 12.86      |   | $ | 11.54 |   | $ | 10.71 |   | $ | 10.97 |   | $ | 10.26 |   |
|                                                     |   |                                                          | ** ** |   | ** ** |   | ** ** |   | ** ** |   | ** ** |
| **KEY  OPERATING RATIOS**                                |   |                                                          | ** ** |   | ** ** |   | ** ** |   | ** ** |   | ** ** |
| Return on average assets                                 |   | 0.79                                                          | %          | 0.22 | % | 1.12 | % | 0.95 | % | 1.15 | % |
| Return on average shareholders’ equity              |   | 11.63                                                         | %          | 3.74 | % | 16.00 | % | 13.58 | % | 16.64 | % |
| Average shareholders’ equity to average  assets     |   | 6.77                                                          | %          | 5.92 | % | 7.02 | % | 6.99 | % | 6.89 | % |
| Net interest margin                                      |   | 3.86                                                          | %          | 3.41 | % | 3.64 | % | 3.52 | % | 3.70 | % |
| Ratio of non-performing assets to total  assets(4)       |   | 0.80                                                          | %          | 0.83 | % | 0.56 | % | 0.64 | % | 0.52 | % |
| Dividend payout ratio                                    |   | 39.55                                                         | %          | 138.76 | % | 31.62 | % | 33.98 | % | 21.35 | % |

 

 

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(1) 2001 results include conversion and integration expenses of $0.8 million(net of tax), and expenses for severance and employment agreements of $0.1million (net of tax).

 

(2) 2000 results include conversion and integration expenses of $4.8 million(net of tax), expenses for severance and employment agreements of $2.2 million(net of tax), and impairment of goodwill of $0.7 million.

 

(3) 1998 results include merger-related charges of $4.4 million (net of tax)and a merger-related provision for losses on loans of $0.7 million (net oftax).

 

(4) Non-performing assets consist of non-performing loans (includingnon-accrual loans and certain other delinquent loans at the discretion ofmanagement) and other real estate.

 

 

*NET INTEREST INCOME* |PNWB’s net income is significantly affected by changes in netinterest income, which is the difference between interest income received onloans receivable and other interest-earning assets and interest paid ondeposits and borrowings.  PNWB’soperations are sensitive to changes in interest rates and the resulting impacton net interest income.  Interest ratesdecreased in 2001 and resulted in a greater reduction in funding costs incomparison to reduction in earnings on loans and investments. During 2002, PNWBintends to continue the change in the composition of its balance sheet with afocus on growth in commercial loans and retail deposits to better manageinterest rate risk.  However, managementdoes not expect that net interest income and net interest margin to continue toimprove at the same rate in 2002 as it did in 2001.

 

Net interest income before the provision for losses onloans was $101.8 million for the year ended December 31, 2001 compared to $89.5million and $84.2 million for the years ended December 31, 2000 and September30, 1999. The increase in net interest income from 2000 to 2001 was primarilydue to lower funding costs and a change in the mix in loans and deposits.  The increase in net interest income from1999 to 2000 was due to growth in interest-earning assets and offset by adecrease in net interest margin.

 

Net interest margin, which is net interest incomedivided by average interest-earning assets, increased for the year endedDecember 31, 2001 compared to the year ended December 31, 2000.  Net interest margin was 3.86 percent in2001, compared to 3.41 percent in 2000. The increase in net interest marginfrom 2000 was primarily due to a decrease in cost of funds and a change in themix of earning assets. The cost of funds decreased due to reductions in marketinterest rates and the restructuring of the funding base.  The cost of funds was 4.40 percent for theyear ended December 31, 2001 compared to 5.33 percent for the year endedDecember 31, 2000.  The growth in higheryielding commercial loans, lower-cost checking and money market accountdeposits, as well as a decline in average balance of borrowings during 2001contributed to the improvement of net interest margin.  The improvement in net interest margin waspartially offset by a decrease in the yield earned on loans, securities andother interest-earning assets.  Theyield on interest-earning assets decreased from 8.32 percent for the year endedDecember 31, 2000 to 7.80 percent for the year ended December 31, 2001,primarily as a result of decreases in market interest rates in 2001.

 

Net interest margin was 3.41percent in 2000, compared to 3.64 percent in 1999.  This decrease was primarily the result of an increase in the costof funds.  The cost of funds was 5.33percent for the year ended December 31, 2000 compared to 4.57 percent for theyear ended September 30, 1999.  The costof funds increased due to overall interest rate increases and the resultingimpact on the interest rate paid on deposits and borrowings.  Borrowings increased in 2000 in order tofund asset growth as PNWB experienced limited interest-bearing depositgrowth.  The effect that the increase inthe cost of funds had on net interest margin in 2000 was partially offset by anincrease in the yield earned on loans, securities and other interest-earningassets as well as an increase in the average balance of non-interest-bearingdeposits. The yield earned increased both as a result of overall interest rateincreases and growth in higher yielding commercial loans.

 

Interest income was $205.7million for the year ended December 31, 2001, compared to $218.2 million and$179.7 million for the years ended December 31, 2000 and September 30,1999.  Interest income on interest-earningassets decreased in 2001 compared to 2000 due to a decrease in the yield earnedwhich was partially offset by an increase in volume.  Interest income increased in 2000 compared to 1999 due to anincrease in both the yield and the average balance of interest-earning assets.

 

Interest expense was $103.8 million for the year endedDecember 31, 2001, compared to $128.7 million and $95.5 million for the yearsended December 31, 2000 and September 30, 1999.  Interest expense decreased in 2001 compared to 2000 due to adecrease in both the cost of funds and the average balance of interest-bearingliabilities.  Interest expense increasedin 2000 compared to 1999 due to an increase in both the cost of funds and theaverage balance of interest-bearing liabilities.

 

The following table presents, for the periodsindicated, information regarding average balances of assets and liabilities aswell as the total amounts of interest income from average interest-earningassets and interest expense on average interest-bearing liabilities, resultingyield and cost ratios, interest rate spread, ratio of interest-earning assetsto interest-bearing liabilities and net interest margin for PNWB.

 

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|                                                                                |   | **Year ended**           |      |
|-------------------------------------------------------------------------------------|--------|--------------------------|-----------|
|                                                                                |   | **December  31,  2001**  |      | **December  31,  2000** |   | **September  30,  1999** |   |
|                                                                                |   | **Average  Balance**     |      | **Interest** |   | **Average  Yield/Cost** |   | **Average  Balance** |   | **Interest** |   | **Average  Yield/Cost** |   | **Average  Balance** |   | **Interest** |   | **Average  Yield/Cost** |   |
|                                                                                |   | **Dollars in thousands** |      |
| *Assets:*                                                                           |   |                     |      |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans receivable and loans held for sale (1)                                        |   | $                        | 1,812,352 |   | $ | 153,936 |   | 8.49 | % | $ | 1,755,144 |   | $ | 159,870 |   | 9.11 | % | $ | 1,432,273 |   | $ | 126,482 |   | 8.83 | % |
| Securities available for sale and securities held  to maturity                      |   | 816,240                  |      | 51,116 |   | 6.27 |   | 841,380 |   | 56,747 |   | 6.74 |   | 824,699 |   | 50,398 |   | 6.11 |   |
| Other interest-earning assets                                                       |   | 9,091                    |      | 601 |   | 6.61 |   | 25,971 |   | 1,571 |   | 6.05 |   | 56,886 |   | 2,779 |   | 4.89 |   |
| Total interest-earning assets                                                       |   | 2,637,683                |      | 205,653 |   | 7.80 |   | 2,622,495 |   | 218,188 |   | 8.32 |   | 2,313,858 |   | 179,659 |   | 7.76 |   |
|                                                                                |   |                     |      |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Non-interest-earning assets                                                         |   | 170,863                  |      |   |   |   |   | 204,196 |   |   |   |   |   | 165,963 |   |   |   |   |   |
|                                                                                |   |                     |      |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total assets                                                                        |   | $                        | 2,808,546 |   |   |   |   |   | $ | 2,826,691 |   |   |   |   |   | $ | 2,479,821 |   |   |   |   |   |
|                                                                                |   |                     |      |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| *Liabilities and Shareholders’ Equity:*                                        |   |                     |      |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Savings accounts and money market accounts                                          |   | $                        | 388,947   |   | $ | 10,978 |   | 2.82 | % | $ | 386,869 |   | $ | 13,285 |   | 3.43 | % | $ | 377,459 |   | $ | 11,229 |   | 2.97 | % |
| Checking accounts                                                                   |   | 199,856                  |      | 1,723 |   | 0.86 |   | 182,208 |   | 2,017 |   | 1.11 |   | 167,238 |   | 2,102 |   | 1.26 |   |
| Certificates of deposit                                                             |   | 879,021                  |      | 45,774 |   | 5.21 |   | 823,764 |   | 48,503 |   | 5.89 |   | 811,117 |   | 42,085 |   | 5.19 |   |
| Total interest-bearing deposits                                                     |   | 1,467,824                |      | 58,475 |   | 3.98 |   | 1,392,841 |   | 63,805 |   | 4.58 |   | 1,355,814 |   | 55,416 |   | 4.09 |   |
|                                                                                |   |                     |      |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| FHLB advances, securities sold under agreements to  repurchase and other borrowings |   | 892,786                  |      | 45,366 |   | 5.08 |   | 1,019,612 |   | 64,850 |   | 6.36 |   | 734,507 |   | 40,064 |   | 5.45 |   |
|                                                                                |   |                     |      |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total interest-bearing liabilities                                                  |   | 2,360,610                |      | 103,841 |   | 4.40 |   | 2,412,453 |   | 128,655 |   | 5.33 |   | 2,090,321 |   | 95,480 |   | 4.57 |   |
|                                                                                |   |                     |      |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Non-interest-bearing deposits                                                       |   | 230,131                  |      |   |   |   |   | 218,887 |   |   |   |   |   | 191,704 |   |   |   |   |   |
| Other non-interest-bearing liabilities                                              |   | 27,786                   |      |   |   |   |   | 27,871 |   |   |   |   |   | 23,653 |   |   |   |   |   |
| Total liabilities                                                                   |   | 2,618,527                |      |   |   |   |   | 2,659,211 |   |   |   |   |   | 2,305,678 |   |   |   |   |   |
|                                                                                |   |                     |      |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Shareholders’ equity                                                           |   | 190,019                  |      |   |   |   |   | 167,480 |   |   |   |   |   | 174,143 |   |   |   |   |   |
| Total liabilities and shareholders’ equity                                     |   | $                        | 2,808,546 |   |   |   |   |   | $ | 2,826,691 |   |   |   |   |   | $ | 2,479,821 |   |   |   |   |   |
|                                                                                |   |                     |      |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest income                                                                 |   |                     |      | $ | 101,812 |   |   |   |   |   | $ | 89,533 |   |   |   |   |   | $ | 84,179 |   |   |   |
| Interest rate spread                                                                |   |                     |      |   |   | 3.40 |   |   |   |   |   | 2.99 |   |   |   |   |   | 3.19 |   |
| Net interest margin                                                                 |   |                     |      |   |   | 3.86 |   |   |   |   |   | 3.41 |   |   |   |   |   | 3.64 |   |
|                                                                                |   |                     |      |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Ratio of average interest-earning assets to  average interest- bearing liabilities  |   |                     |      |   |   | 111.74 | % |   |   |   |   | 108.74 | % |   |   |   |   | 110.69 | % |
|                                                                                     |        |                          |           |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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(1) Average balances do not includenon-accrual loans.

 

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The following table provides information on changes innet interest income for the periods indicated that are attributable to changesin interest rates and changes in volume.

 
|                                                                                          |   | **December  31, 2000 to  December********31****,****2001********Increase****(****Decrease****)****Due********to********Changes********in** |    | **September  30, 1999 to  December********31****,****2000********Increase****(****Decrease****)****Due********to********Changes********in** |   |
|-----------------------------------------------------------------------------------------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------|---------|---------------------------------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                          |   | **Rate**                                                                                                                                   |    | **Volume**                                                                                                                                  |   | **Total** |   | **Rate** |   | **Volume** |   | **Total** |   |
|                                                                                          |   | **Dollars in thousands**                                                                                                                   |    |
| *Interest-Earning Assets*                                                                     |   |                                                                                                                                       |    |                                                                                                                                        |   |   |   |   |   |   |   |   |   |
|                                                                                          |   |                                                                                                                                       |    |                                                                                                                                        |   |   |   |   |   |   |   |   |   |
| Loans receivable and loans held for sale                                                      |   | $                                                                                                                                          | (10,746 | )                                                                                                                                           | $      | 4,812 |   | $ | (5,934 | ) | $ | 4,035 |   | $ | 29,353 |   | $ | 33,388 |   |
|                                                                                          |   |                                                                                                                                       |    |                                                                                                                                        |   |   |   |   |   |   |   |   |   |
| Securities available for sale, securities  held to maturity and other interest-earning assets |   | (3,856                                                                                                                                     | )       | (2,745                                                                                                                                      | )      | (6,601 | ) | 6,012 |   | (871 | ) | 5,141 |   |
| Total net change in interest income on  interest-earning assets                               |   | (14,602                                                                                                                                    | )       | 2,067                                                                                                                                       |   | (12,535 | ) | 10,047 |   | 28,482 |   | 38,529 |   |
|                                                                                          |   |                                                                                                                                       |    |                                                                                                                                        |   |   |   |   |   |   |   |   |   |
| *Interest-Bearing Liabilities*                                                                |   |                                                                                                                                       |    |                                                                                                                                        |   |   |   |   |   |   |   |   |   |
|                                                                                          |   |                                                                                                                                       |    |                                                                                                                                        |   |   |   |   |   |   |   |   |   |
| Interest-bearing deposits                                                                     |   | 8,681                                                                                                                                      |    | (3,351                                                                                                                                      | )      | 5,330 |   | (6,842 | ) | (1,547 | ) | (8,389 | ) |
|                                                                                          |   |                                                                                                                                       |    |                                                                                                                                        |   |   |   |   |   |   |   |   |   |
| FHLB advances, securities sold under  agreements to repurchase and other borrowings           |   | 12,085                                                                                                                                     |    | 7,399                                                                                                                                       |   | 19,484 |   | (7,426 | ) | (17,360 | ) | (24,786 | ) |
|                                                                                          |   |                                                                                                                                       |    |                                                                                                                                        |   |   |   |   |   |   |   |   |   |
| Total  net change in interest expense on interest-bearing liabilities                         |   | 20,766                                                                                                                                     |    | 4,048                                                                                                                                       |   | 24,814 |   | (14,268 | ) | (18,907 | ) | (33,175 | ) |
| Net change in net  interest income                                                            |   | $                                                                                                                                          | 6,164   |                                                                                                                                        | $      | 6,115 |   | $ | 12,279 |   | $ | (4,221 | ) | $ | 9,575 |   | $ | 5,354 |   |

 

*PROVISION FOR LOSSES ON LOANS*| The provision for losses on loans was $6.1 million for the year endedDecember 31, 2001 compared to $4.8 million and $2.0 million for the years endedDecember 31, 2000 and September 30, 1999. Management increased the provision for losses on loans during 2001 as aresult of its concern about the known and inherent risk characteristics in theloan portfolio in part resulting from the deterioration of the PacificNorthwest regional economy.  These riskcharacteristics include changes in the size and composition of the loan portfolio,delinquency levels, actual loan loss experience, detailed analysis ofindividual loans for which full collectibility may not be assured and currenteconomic conditions in the geographical area where we lend.   Management believes that the allowance forlosses on loans was adequate as of December 31, 2001.  However, based on current trends in the loan portfolio, it isanticipated that the provision for losses on loans will remain at higher levelsin 2002 compared to prior years.

 

*NON-INTEREST INCOME*| Non-interest income was $20.7 million for the year ended December 31, 2001,compared to $12.1 million and $28.0 million for the years ended December 31,2000 and September 30, 1999.  Theincrease in non-interest income in 2001 from 2000 was primarily due to a $1.4million increase in the gain on sale of loans in 2001 and a $6.8 million lossincurred on the sale of securities available for sale during the second quarterof 2000.  The loss in 2000 was due tothe restructuring the company’s investment portfolio to better manage interestrate risk.  The decrease in non-interestincome in 2000 from 1999 was primarily due to a decrease in the gain on sale ofloans and loan servicing rights and losses on the sale of securities availablefor sale in 2000.

 

Gains on the sale of loans were $2.3 millionfor the year ended December 31, 2001, compared to $0.9 million and $8.1 millionfor the years ended December 31, 2000 and September 30, 1999.  As part of PNWB’s transition to a commercialbank starting in mid-2000, management changed its strategy on the originationand retention of single-family residential mortgage loans.  As a result, the majority of PNWB’ssingle-family mortgage loan production is now channeled directly to thesecondary market.  During 2001, thedecline in long-term interest rates resulted in an increase in fixed-ratesingle-family mortgage loan refinances and opportunities to sell these loans onthe secondary market for a fee.  Inaddition to the lower interest rate environment, the increase in gains on saleof loans in 2001 was also due to PNWB’s focus on initiatives to improve themortgage banking activities.  Thedecrease in gains on sale of loans in 2000 from 1999 was primarily due to anincrease in long-term interest rates, which resulted in a decrease insingle-family mortgage loan origination and decline in sales of those loans.

 

PNWB sold the servicing rightsfor $530 million of fixed-rate single-family mortgage loans that resulted in again of $2.8 million during the year ended September 30, 1999.  These loan servicing rights were primarilyrelated to loans sold with servicing rights retained by PNWB during 1998 andthe first half of 1999.  The sale wasinitiated as a result of increasing long-term interest rates and decreasingloan prepayment rates, which increased the value of the servicingportfolio.   PNWB did not sell anyservicing rights during the years ended December 31, 2001 and 2000.

 

Gains on the sale of securities available forsale were $1.7 million for the year ended December 31, 2001, compared to lossesof $6.1 million and gains of $0.1 million for the years ended December 31, 2000and September 30, 1999.  As part of itsstrategic plan to become 

 

6

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a commercial bank, PNWBpartially restructured its investment portfolio by selling approximately $130million of securities available for sale during the first half of 2000, whichresulted in a $6.8 million loss. During the second half of 2000 PNWB soldapproximately $30 million of mortgage-backed securities available for sale at again of $0.7 million.  The gains during2001 and second half of 2000 were primarily from the sale of mortgage-backedsecurities that were securitized from PNWB’s single family mortgage loanportfolio in prior years.

 

*NON-INTEREST EXPENSE*| Non-interest expense was $81.2 million for the year ended December 31, 2001,compared to $86.3 million and $67.8 million for the years ended December 31,2000 and September 30, 1999.  Excludingcosts associated with conversion and integration activities, severance agreementsand goodwill impairment, non-interest expense was $79.7 million, $74.8 millionand $67.8 million for the years ended December 31, 2001 and 2000 and September30, 1999.

 

Compensation and employee benefits expense was $39.0 million for theyear ended December 31, 2001 compared to $39.4 million and $37.5 million forthe years ended December 31, 2000 and September 30, 1999.  The decrease in 2001 compared to 2000 wasthe result of consolidation of certain executive and administrationfunctions.  The increase from 1999 to2000 was due to improvement in compensation and benefits to meet competition,as well as an acquisition in 1999. Increases in base compensation from 1999 to 2000 were partially offsetby a decrease in variable compensation expense related to performance basedbonus plans.

 

The increase in general andadministrative, occupancy and equipment and data processing expenses for theyear ended December 31, 2001 compared to the year ended December 31, 2000 wasprimarily due to increased costs associated with operations as a commercialbank such as data services, supplies and courier expenses.  The increase for the year ended December 31,2000 compared to the year ended September 30, 1999 was primarily due to activitiesto develop the resources and infrastructure for commercial banking growth.  Key elements of commercial banking growthwere the development of credit administration and commercial lending support,the addition of commercial lending officers and several experienced commercialbanking management personnel.   Generaland administrative, occupancy and equipment and data processing expenses alsoincreased compared to 1999 due to an acquisition in late 1999 that wasaccounted for using the purchase method.

 

Expense from other real estateowned, net of gains from the sale of other real estate owned, was $0.2 millionfor the year ended December 31, 2001 compared to $2.3 million and $0.5 millionfor the years ended December 31, 2000 and September 30, 1999.  PNWB recorded write-downs of approximately $2.2million related to other real estate during the year ended December 31,2000.  These write-downs relateprimarily to one land development project and resulted primarily from newmanagement’s intent with regard to the development and sale of the project aswell as changing economic conditions.

 

The amortization of goodwilland core deposit intangible was $1.3 million for the year ended December 31,2001 compared to $1.3 million and $0.7 million for the years ended December 31,2000 and September 30, 1999.  Theincrease in 2001 and 2000 from 1999 was due to an acquisition in 1999.

 

In order to consolidate theindividual banking systems obtained through acquisitions in 1998 and 1999, PNWBbegan the process of converting to a single enhanced operating system for theentire company in 2000.  PNWB  contracted with a third party service bureauto provide data services and processing for the new operating system.  The contract term expires on December 31,2006.  The multiple-phased conversionproject was completed on April 9, 2001. Conversion and integration costs were expensed as incurred.  Total expenses associated with conversionand integration efforts were $1.3 million and $7.4 million for the years endedDecember 31, 2001 and 2000.  Theseexpenses included the buyout of previous data processing contracts, consultantfees, accelerated depreciation of equipment and other costs incurred inconjunction with conversion and integration initiatives.  Other costs included the preparation andmailing of customer notifications for the conversion of customer accounts andtraining expenses.  Except for the $0.4million related to the accelerated depreciation of equipment, PNWB paid out$2.1 million and $5.2 million of conversion and integration expenses during2001 and 2000.

 

Inconjunction with executive management changes, elimination of duplicateadministrative functions and consolidating operating systems, PNWB incurred$0.2 million and $3.3 million in expenses associated with severance andemployment agreements during the years ended December 31, 2001 and 2000.  There were approximately 40 employeesaffected by these severance and employment agreements.  $0.5 million and $1.2 million of suchexpenses were paid out during 2001 and 2000, respectively.  As of December 31, 2001, PNWB had an accruedliability of $1.4 million related to certain agreements that will be paid outin future periods.

 

As part ofthe transition to a commercial bank, PNWB consolidated and restructured itsmortgage loan origination functions and related processes.  This resulted in the impairment of $0.7million of goodwill previously recorded for the acquisition of a mortgagebrokerage subsidiary in 1996.  PNWBconsolidated its mortgage brokerage function into its wholesale lendingfunction and changed its strategy with regard to the origination and retentionof single-family mortgage loans.  Themajority of PNWB’s single-family mortgage loan production is now channeled forsale with servicing released directly to the secondary market.

 

*INCOME TAX EXPENSE* | Income tax expense was $13.2 million for theyear ended December 31, 2001, compared to $4.4 million and $14.6 million forthe years ended December 31, 2000 and September 30, 1999.  The decrease in income tax expense isconsistent with a decrease in income before income taxes.   The effective tax rates were 37.4 percentfor the year ended December 31, 2001, 41.0 percent 

 

7

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for the year ended December 31,2000 and 34.4 percent for the year ended September 30, 1999. The highereffective tax rate in 2001 and 2000 compared to 1999 was primarily due to anincrease in goodwill amortization and impairment expense that was notdeductible for federal income tax purposes. The rate in 2000 was higher also due to lower income before incometaxes.

 

### **REVIEW OFFINANCIAL CONDITION**

 

PNWB’s total consolidatedassets were $2.742 billion as of December 31, 2001 compared to $2.883 billionas of December 31, 2000.

 

*SECURITIES AND OTHER INTEREST-EARNING ASSETS* |Securities and other interest-earning assets, including securities availablefor sale, securities held to maturity, interest-bearing deposits in banks,federal funds sold and securities purchased under agreements to resell, were$757.5 million as of December 31, 2001, compared to $921.0 million as ofDecember 31, 2000.  On January 1, 2001,PNWB transferred all securities held to maturity to securities available forsale as permitted by the provisions of SFAS No. 133 “Accounting for DerivativeInstruments and Hedging Activities”.  Assuch, PNWB did not have any securities held to maturity as of December 31,2001, compared to $64.7 million as of December 31, 2000.  The transfer resulted in other comprehensiveloss of $0.6 million, net of income taxes of $0.3 million.

 

PNWB maintains liquidity in accordance with aninternal liquidity policy.  Liquiditylevels may be increased or decreased depending upon the yields on investmentalternatives, management’s judgment as to the attractiveness of the yields thenavailable in relation to other opportunities and management’s expectation ofthe yield that will be available in the future.  Management’s projections as to the short-term demand for funds tobe used for loan origination and other activities can also affect liquidity levels.

 

Securities classified as available for saleare reported at estimated fair value, with unrealized gains and losses (net ofincome taxes) reported as accumulated other comprehensive income, a separatecomponent of shareholders’ equity.

 

The following tablesets forth PNWB’s securities available for sale as of the dates indicated.

 
|                                              |   | **December  31, 2001**     |    | **December  31, 2000**     |   | **December  31, 1999**     |   | **September  30, 1999**    |   |
|---------------------------------------------------|--------|----------------------------|---------|----------------------------|--------|----------------------------|--------|----------------------------|--------|
|                                              |   | **Estimated  Fair  Value** |    | **Percent  of  Portfolio** |   | **Estimated  Fair  Value** |   | **Percent  of  Portfolio** |   | **Estimated  Fair  Value** |   | **Percent  of  Portfolio** |   | **Estimated  Fair  Value** |   | **Percent  of  Portfolio** |   |
|                                              |   | **Dollars in thousands**   |    |
| U.S. government and agency securities             |   | $                          | 291,994 |                       | 38.6   | %                          | $      | 510,916                    |   | 60.8 | % | $ | 362,528 |   | 45.8 | % | $ | 314,980 |   | 42.4 | % |
| FHLB stock                                        |   | 46,084                     |    | 6.1                        |   | 42,962                     |   | 5.1                        |   | 44,346 |   | 5.6 |   | 42,536 |   | 5.7 |   |
| Obligations of states and political  subdivisions |   | 1,161                      |    | 0.2                        |   | 1,187                      |   | 0.1                        |   | 1,107 |   | 0.1 |   | 1,413 |   | 0.2 |   |
| Private mortgage-backed and related  securities   |   | 374,437                    |    | 49.4                       |   | 242,062                    |   | 28.8                       |   | 345,521 |   | 43.6 |   | 359,997 |   | 48.4 |   |
| Other securities                                  |   | 43,342                     |    | 5.7                        |   | 43,362                     |   | 5.2                        |   | 38,827 |   | 4.9 |   | 24,160 |   | 3.3 |   |
| Total                                             |   | $                          | 757,018 |                       |   |                       | $      | 840,489                    |   |   |   | $ | 792,329 |   |   |   | $ | 743,086 |   |   |   |

 

The following table sets forth the contractual maturities and weightedaverage yields of PNWB’s securities available for sale as of December 31,2001.  Securities with no statedmaturity dates are reported as due within one year.

 
|                                             |   | **Less Than  One Year**    |   | **One to  Five Years** |   | **Five to  Ten Years**     |   | **Over Ten  Years** |   |
|--------------------------------------------------|--------|----------------------------|--------|------------------------|--------|----------------------------|--------|---------------------|--------|
|                                             |   | **Estimated  Fair  Value** |   | **Yield**              |   | **Estimated  Fair  Value** |   | **Yield**           |   | **Estimated  Fair  Value** |   | **Yield** |   | **Estimated  Fair  Value** |   | **Yield** |   |
|                                             |   | **Dollars in thousands**   |   |
| U.S. government and agency securities            |   | $                          | 25,318 |                   | 6.70   | %                          | $      | 54,280              |   | 4.84 | % | $ | 13,230 |   | 6.52  | % | $ | 199,166 |   | 6.34 | % |
| Obligations of states and political subdivisions |   | 221                        |   | 4.85                   |   | 835                        |   | 6.11                |   | 105 |   | 5.37 |   | — |   | — |   |
| Private mortgage-backed and related  securities  |   | 24,776                     |   | 5.72                   |   | 16,592                     |   | 5.49                |   | 54,931 |   | 6.04 |   | 278,138 |   | 6.18 |   |
| FHLB stock                                       |   | 46,084                     |   | —                 |   | —                     |   | —              |   | — |   | — |   | — |   | — |   |
| Other securities                                 |   | 254                        |   | —                 |   | —                     |   | —              |   | — |   | — |   | 43,088 |   | 7.62 |   |
| Total                                            |   | $                          | 96,653 |                   | 6.21   | %                          | $      | 71,707              |   | 5.01 | % | $ | 68,266 |   | 6.13 | % | $ | 520,392 |   | 6.36 | % |

 

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The following table sets forth amortized costand estimated fair values for PNWB’s securities held to maturity as of thedates indicated.

 
|                                              |   | **December  31, 2001**   |   | **December  31, 2000**     |   |
|---------------------------------------------------|--------|--------------------------|--------|----------------------------|--------|
|                                              |   | **Amortized  Cost**      |   | **Estimated  Fair  Value** |   | **Percent  of  Portfolio** |   | **Amortized  Cost** |   | **Estimated  Fair  Value** |   | **Percent  of  Portfolio** |   |
|                                              |   | **Dollars in thousands** |   |
| U.S. government and agency securities             |   | $                        | — |                       | $      | — |   |   |   | $ | 22,672  |   | $ | 22,530 |   | 35.0 | % |
| Obligations of states and political  subdivisions |   | —                   |   | —                     |   |   |   | 998 |   | 999 |   | 1.5 |   |
| Private mortgage-backed and related  securities   |   | —                   |   | —                     |   |   |   | 41,071 |   | 40,294 |   | 63.5 |   |
| Total                                             |   | $                        | — |                       | $      | — |   |   |   | $ | 64,741  |   | $ | 63,823 |   |   |   |

 
|                                              |   | **December  31,1999**    |   | **September  30, 1999**    |   |
|---------------------------------------------------|--------|--------------------------|--------|----------------------------|--------|
|                                              |   | **Amortized  Cost**      |   | **Estimated  Fair  Value** |   | **Percent  of  Portfolio** |   | **Amortized  Cost** |   | **Estimated  Fair  Value** |   | **Percent  of  Portfolio** |   |
|                                              |   | **Dollars in thousands** |   |
| U.S. government and agency securities             |   | $                        | 24,328 |                       | $      | 23,549 |   | 35.3 | % | $ | 24,878  |   | $ | 24,475 |   | 35.2 | % |
| Obligations of states and political  subdivisions |   | 1,625                    |   | 1,626                      |   | 2.4 |   | 2,397 |   | 2,396 |   | 3.4 |   |
| Private mortgage-backed and related  securities   |   | 42,943                   |   | 41,302                     |   | 62.3 |   | 43,417 |   | 42,338 |   | 61.4 |   |
| Total                                             |   | $                        | 68,896 |                       | $      | 66,477 |   |   |   | $ | 70,692  |   | $ | 69,209 |   |   |   |

 

*LOANS RECEIVABLE AND LOANS HELD FOR SALE*| Net loans receivable were $1.788 billion as of December 31, 2001, an increasefrom $1.758 billion as of December 31, 2000.

 

Subsequent to the acquisitionsof six commercial banks from 1996 to 1999, PNWB’s banking subsidiary changedits charter from a Washington state savings bank to a Washington statecommercial bank effective July 1, 2000. The acquisitions and charter conversion increased PNWB’s ability tooriginate commercial loans.  Sincemid-2000, management has been focusing on restructuring the loan portfolio sothat it is more reflective of a commercial bank.  The principal balance outstanding for commercial and commercialreal estate loans increased during the year ended December 31, 2001, whilesingle-family mortgage, real estate construction, consumer and agriculturalloans outstanding decreased.  Thechanges in the composition of PNWB’s loan portfolio during 2001 were consistentwith management’s expectation.

 

Commercial loans outstandingtotaled $539.2 million as of December 31, 2001, an increase of $62.0 millionfrom December 31, 2000, which represented an annual growth rate of 13.0percent. Commercial real estate loans outstanding totaled $482.8 million, anincrease of $107.1 million from December 31, 2000, which represented an annualgrowth rate of 28.5 percent.  Commercialand commercial real estate loans outstanding represented 54.9 percent of totalgross loans as of December 31, 2001, an increase from 47.4 percent of totalgross loans as of December 31, 2000.

 

Single-family mortgage loansoutstanding totaled $351.8 million, or 18.9 percent of total gross loans, as ofDecember 31, 2001, compared to $429.3 million, or 23.9 percent of total grossloans, as of December 31, 2000.  As part of the transition to a commercial bank,PNWB consolidated and restructured its mortgage loan origination functions andrelated processes in 2000.  PNWBconsolidated its mortgage brokerage function into a wholesale lending functionand changed its strategy with regards to the origination and retention ofsingle-family mortgage loans and related servicing.  The majority of PNWB’s single-family mortgage loan production isnow sold with servicing rights released to the secondary market; thus lesssingle-family mortgage loans are retained in the loan portfolio compared toprior years.  During the year endedDecember 31, 2001, PNWB sold ,with servicing rights released, approximately$141.2 million of single-family mortgage loans.  In addition, approximately $93.8 million of single-familymortgage loans were paid off during 2001 due to refinances or maturity of theloans.

 

Real estate construction loansoutstanding totaled $320.0 million, or 17.2 percent of total gross loans, as ofDecember 31, 2001 compared to $330.3 million, or 18.4 percent of total grossloans, as of December 31, 2000.

 

Consumer loans outstandingtotaled $115.4 million, or 6.2 percent of total gross loans, as of December 31,2001 compared to $128.3 million, or 7.1 percent of total gross loans, as ofDecember 31, 2000.

 

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The following table sets forth thecomposition of PNWB’s loan portfolio by type of loan as of the dates indicated.

 
|                             |   | **December  31,  2001**  |      | **December 31,  2000** |   | **December  31,  1999** |   | **September  30,  1999** |   | **September  30,  1998** |   | **September  30,  1997** |      |
|----------------------------------|--------|--------------------------|-----------|------------------------|--------|-------------------------|--------|--------------------------|--------|--------------------------|--------|--------------------------|-----------|
|                             |   | **Amount**               |      | **Percent**            |   | **Amount**              |   | **Percent**              |   | **Amount**               |   | **Percent**              |      | **Amount** |   | **Percent** |   | **Amount** |   | **Percent** |   | **Amount** |   | **Percent** |   |
|                             |   | **Dollars in thousands** |      |
| Commercial loans:                |   |                     |      |                   |   |                    |   |                     |   |                     |   |                     |      |   |   |   |   |   |   |   |   |   |   |   |   |
| Commercial                       |   | $                        | 539,241   |                   | 29.0   | %                       | $      | 477,223                  |   | 26.5                     | %      | $                        | 392,452   |   | 22.8 | % | $ | 365,853 |   | 22.7 | % | $ | 275,151 |   | 18.7 | % | $ | 206,408 |   | 15.1 | % |
| Commercial real estate (1)       |   | 482,829                  |      | 25.9                   |   | 375,699                 |   | 20.9                     |   | 377,976                  |   | 22.0                     |      | 339,013 |   | 21.1 |   | 240,132 |   | 16.3 |   | 198,636 |   | 14.5 |   |
| Total commercial loans           |   | 1,022,070                |      | 54.9                   |   | 852,922                 |   | 47.4                     |   | 770,428                  |   | 44.8                     |      | 704,865 |   | 43.8 |   | 515,283 |   | 35.0 |   | 405,044 |   | 29.6 |   |
|                             |   |                     |      |                   |   |                    |   |                     |   |                     |   |                     |      |   |   |   |   |   |   |   |   |   |   |   |   |
| Single-family residential (1)    |   | 351,828                  |      | 18.9                   |   | 429,258                 |   | 23.9                     |   | 471,624                  |   | 27.4                     |      | 456,271 |   | 28.4 |   | 634,710 |   | 43.0 |   | 708,828 |   | 51.7 |   |
| Real estate construction         |   | 319,982                  |      | 17.2                   |   | 330,267                 |   | 18.4                     |   | 318,957                  |   | 18.5                     |      | 298,134 |   | 18.5 |   | 197,182 |   | 13.4 |   | 151,777 |   | 11.1 |   |
| Consumer loans                   |   | 115,440                  |      | 6.2                    |   | 128,346                 |   | 7.1                      |   | 103,640                  |   | 6.0                      |      | 96,399 |   | 6.0 |   | 80,695 |   | 5.5 |   | 73,234 |   | 5.3 |   |
| Agricultural loans               |   | 52,422                   |      | 2.8                    |   | 57,224                  |   | 3.2                      |   | 55,385                   |   | 3.2                      |      | 53,190 |   | 3.3 |   | 46,763 |   | 3.2 |   | 31,538 |   | 2.3 |   |
| Total gross loans                |   | 1,861,742                |      |                   |   | 1,798,017               |   |                     |   | 1,720,034                |   |                     |      | 1,608,860 |   |   |   | 1,474,634 |   |   |   | 1,370,421 |   |   |   |
| Less:                            |   |                     |      |                   |   |                    |   |                     |   |                     |   |                     |      |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans held for sale              |   | (43,757                  | )         |                   |   | (14,187                 | )      |                     |   | (22,397                  | )      |                     |      | (23,138 | ) |   |   | (93,125 | )  |   |   | (10,230 | )  |   |   |
| Allowance for losses on loans    |   | (20,123                  | )         |                   |   | (17,561                 | )      |                     |   | (15,182                  | )      |                     |      | (14,123 | ) |   |   | (13,224 | ) |   |   | (11,104 | ) |   |   |
| Deferred loan fees and discounts |   | (9,430                   | )         |                   |   | (8,755                  | )      |                     |   | (10,140                  | )      |                     |      | (10,015 | ) |   |   | (9,235 | ) |   |   | (10,636 | ) |   |   |
| Net loans receivable             |   | $                        | 1,788,432 |                   |   |                    | $      | 1,757,514                |   |                     |   | $                        | 1,672,315 |   |   |   | $ | 1,561,584 |   |   |   | $ | 1,359,050 |   |   |   | $ | 1,338,451 |   |   |   |
|                                  |        |                          |           |                        |        |                         |        |                          |        |                          |        |                          |           |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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(1)          Includes construction loans converted topermanent loans.

 

The following table indicates the contractualmaturity of PNWB’s gross loans as of December 31, 2001. Loans having no statedschedule of repayments and no stated maturity are reported as due within oneyear.  Loan balances do not includedeferred loan fees and discounts and the allowance for losses on loans.  The table does not reflect any estimate ofprepayments, which significantly shorten the average life of all loans and willcause PNWB’s actual repayment experience to differ significantly from thatindicated below.

 
|                      |   | **Within  One  Year**     |    | **After One  Through  5 Years** |   | **After  5 Years** |   | **Total** |      |
|---------------------------|--------|---------------------------|---------|---------------------------------|--------|--------------------|--------|-----------|-----------|
|                      |   |                      |    |                            |   |
|                      |   |                      |    |                            |   |
|                      |   | **Dollars in  thousands** |    |
| Commercial loans:         |   |                      |    |                            |   |               |   |      |      |
| Commercial                |   | $                         | 211,925 |                            | $      | 131,006            |   | $         | 196,310   |   | $ | 539,241 |   |
| Commercial real estate    |   | 19,149                    |    | 68,034                          |   | 395,646            |   | 482,829   |      |
| Total commercial loans:   |   | 231,074                   |    | 199,040                         |   | 591,956            |   | 1,022,070 |      |
|                      |   |                      |    |                            |   |               |   |      |      |
| Single-family residential |   | 10,233                    |    | 42,381                          |   | 299,214            |   | 351,828   |      |
| Real estate construction  |   | 122,834                   |    | 88,499                          |   | 108,649            |   | 319,982   |      |
| Consumer loans            |   | 45,873                    |    | 25,236                          |   | 44,331             |   | 115,440   |      |
| Agricultural loans        |   | 28,545                    |    | 9,359                           |   | 14,518             |   | 52,422    |      |
| Total gross loans         |   | $                         | 438,559 |                            | $      | 364,515            |   | $         | 1,058,668 |   | $ | 1,861,742 |   |

 

The following table sets forth the dollar amount of the loanscontractually due after one year as of December 31, 2001 that have fixed and/orfloating or variable interest rates.

 
|                      |   | **Fixed  Rates**          |    | **Floating  or  Variable  Rates** |   |
|---------------------------|--------|---------------------------|---------|-----------------------------------|--------|
|                      |   |                      |    |
|                      |   |                      |    |
|                      |   | **Dollars in  thousands** |    |
| Commercial loans:         |   |                      |    |                              |   |
| Commercial                |   | $                         | 82,642  |                              | $      | 244,674 |   |
| Commercial real estate    |   | 86,000                    |    | 377,680                           |   |
| Total commercial loans:   |   | 168,642                   |    | 622,354                           |   |
|                      |   |                      |    |                              |   |
| Single-family residential |   | 133,542                   |    | 208,053                           |   |
| Real estate construction  |   | 60,574                    |    | 136,574                           |   |
| Consumer loans            |   | 52,210                    |    | 49,745                            |   |
| Agricultural loans        |   | 4,878                     |    | 19,000                            |   |
| Total                     |   | $                         | 419,846 |                              | $      | 1,035,726 |   |

 

10

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The principal lending activity of Pacific Northwest Bank is theorigination of commercial loans, commercial real estate mortgage loans,single-family residential mortgage loans, real estate construction loans,consumer loans and agricultural loans.

 

*Commercial loans* | Commercial loans include awide range of loan types to small and medium-sized businesses, including commerciallines of credit with variable rates and maturities of one year or less, andequipment and operational loans.  Theseloans are primarily secured by liens on real estate, capital assets, accountsreceivable and inventory, although certain loans are unsecured.  Commercial lending has increased risks as aresult of dependence on income production for future repayment, and in certaincircumstances, the lack of tangible collateral.   Commercial loans are underwritten based on the financialstrength and repayment ability of the borrower, as well as the value of anycollateral securing the loans. Commercial lending operations rely on a strong credit culture thatcombines prudent credit policies and individual lender accountability.

 

*Commercial real estate mortgage loans* | PNWBoriginates mortgage loans on commercial real estate properties with terms of upto 30 years in its primary market area. These loans are secured by property such as apartment buildings,condominium projects, office buildings, small commercial business properties,subdivision developments and shopping centers.

 

Commercial real estate mortgage loans generally have larger balancesoutstanding and involve greater risks than single-family residential mortgageloans because payments on loans secured by commercial properties are dependenton the successful operation or management of the properties. As a result,repayment of such loans may be subject to conditions in the real estate marketor the economy to a greater extent than single-family residential mortgageloans. These loans may involve large loan balances to single borrowers orgroups of related borrowers.

 

*Single-family residential mortgage loans* |PNWB presently originates both fixed-rate loans and adjustable-rate mortgageloans (“ARMs”) secured by single-family residential properties with loan termsof up to 30 years.  ARMs have interestrates that adjust based upon changes in a predetermined index for a periodmatching the repricing period of the loan. Borrowers’ demand for ARMs versus fixed-rate mortgage loans is afunction of the level of interest rates, the expectations of changes in thelevel of interest rates and the difference between the interest rates and loanfees offered for fixed-rate mortgage loans and the rates and loan fees forARMs.  Aspart of the transition to a commercial bank, PNWB consolidated and restructuredits mortgage loan origination functions and related processes.  PNWB consolidated its mortgagebrokerage function into a wholesale lending function and changed its strategywith regards to the origination and retention of single-family mortgage loans.The majority of PNWB’s single-family mortgage loan origination is now sold inthe secondary market; thus less single-family mortgage loans are retained inthe loan portfolio as compared to prior years.

 

*Real estate construction* | PNWB originatesreal estate construction loans to residential owner-occupants (customconstruction loans) and to contractors building residential properties forresale, as well as construction loans for condominiums, commercial real estateproperties and land development on properties located within its primary marketarea.  Construction loans toowner-occupants generally are converted to single-family residential mortgageloans.

 

Real estate construction loans may involve additional risks becauseloan funds are collateralized by the project under construction, which is ofuncertain value prior to completion. Delays may arise from labor problems, material shortages may beexperienced and other unpredictable contingencies may occur.  It is important to evaluate accurately thetotal loan funds required to complete a project and related loan–to–valueratios.  Because of these factors, theanalysis of prospective construction loan projects requires an expertise thatis different in significant respects from the expertise required for realestate mortgage lending.  Constructionlending is generally considered to involve a higher degree of collateral riskthan long-term financing of residential properties.  PNWB’s risk of loss on a construction loan is dependent largelyupon the accuracy of the initial estimate of the property’s value andmarketability at completion of construction or development and the estimatedcost (including interest) of construction. If the estimate of construction costs and the marketability of theproperty upon completion of the project prove to be inaccurate, PNWB may berequired to advance additional funds to complete development of theproject.  PNWB’s underwriting criteriaare designed to evaluate and minimize the risks of each real estateconstruction loan.  Among other things,PNWB considers evidence of the availability of permanent financing for theborrower, the reputation of the borrower, the amount of the borrower’s equityin the project, the independent appraisal and review of cost estimates, thepre-construction sale and leasing information, and the cash flow projections ofthe borrower.

 

*Consumer loans* | Consumer loans consist ofautomobile loans, home equity loans, credit card loans and loans for otherconsumer purposes.  Consumer loans alsoinclude both secured and unsecured personal lines of credit.  Consumer lending may involve special risks,including decreases in the value of collateral and transaction costs associatedwith foreclosure and repossession.

 

*Agricultural loans* | Agricultural loansinclude seasonal production loans secured by crops and equipment.  These loans generally have adjustable ratesthat are renewed annually.  Agriculturalloans also include loans secured by farmland. The majority of PNWB’s agricultural loans have terms of less than fiveyears and have variable interest rates.

 

 

11

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*Loans held for sale* | Loans held for saletotaled $43.8 million as of December 31, 2001 compared to $14.2 million as ofDecember 31, 2000.  Loans held for saleare carried at the lower of cost or estimated fair value in aggregate.  Net unrealized losses are recognized in avaluation allowance by charges to income. Loans held for sale are generally single-family residential mortgageloans and loans originated under a Small Business Administration program.  The loans are typically sold to FHLMC andother financial institutions.  Prior to2001, PNWB retained the right to service the loans in connection with loanssales, for which it generally receives a fee based on the difference betweenthe rate paid to the investor and that collected from the borrower.  PNWB capitalized loan-servicing rightseither through the purchase or origination of mortgage loans that weresubsequently sold or securitized with the servicing rights retained.  Loan servicing rights are included inintangible assets and are amortized as an offset to services fees in proportionto and over the period of servicing income, not to exceed 15 years.  Starting in 2001, PNWB released the right toservice the loans for all the single-family mortgage loans sold.  Periodically, PNWB has sold loan servicingrights.  During 1999, PNWB sold the loanservicing rights for $530 million of single-family mortgage loans resulting ina gain of $2.8 million.

 

*Non-performing loans* | Loans are generallyplaced on non-accrual when they become past due over 90 days, or 120 days ifthey are single-family mortgage loans, or when the collection of interest orprincipal is considered unlikely.  Loanspast due over 90 or 120 days that are not on non-accrual status must be wellsecured by tangible collateral and in the process of collection.  PNWB does not return a loan to accrual statusuntil it is brought current with respect to both principal and interest andfuture principal and interest payments are no longer in doubt.  When a loan is placed on non-accrual status,any previously accrued and uncollected interest is reversed from interestincome.  As of December 31, 2001, PNWBhad $16.1 million of loans on non-accrual status compared to $13.9 million asof December 31, 2000.  PNWB performs a review of its loan portfolio forweaknesses in credit quality on an ongoing basis to identify problemloans.  This review results in internalloan classifications based on risk characteristics and loan performance.  The overall objective of this review processis to identify trends in the credit quality of the loan portfolio and todetermine the level of loss exposure to evaluate the need for an adjustment tothe allowance for losses on loans.

 

*ALLOWANCE FOR LOSSES ON LOANS* | PNWB’sallowance for losses on loans was $20.1 million or 1.11 percent of loansreceivable as of December 31, 2001, compared to $17.6 million, or 0.99 percentof loans as of December 31, 2000.  Netloan charge-offs for the year ended December 31, 2001, were $3.5 million or0.19 percent of the average balance of loans outstanding for the year.  Net loan charge-offs were $2.4 million and$1.1 million for the years ended December 31, 2000 and September 30, 1999,respectively.  The increase in netcharge-offs in 2001 was primarily due to an increase in charge-offs related toforeclosed single-family residential loans.

 

When available informationconfirms that specific loans or portions thereof are uncollectible, theseamounts are charged off against the allowance for losses on loans.  The existence of some or all of thefollowing criteria will generally confirm that a loss has been incurred: theloan is significantly delinquent and the borrower has not evidenced the abilityor intent to bring the loan current; there is no recourse to the borrower, orif there is recourse, the borrower has insufficient assets to pay the debt; thefair value of the loan collateral is significantly below the current loanbalance, and there 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.

 

The allowance for losses on loans ismaintained at an amount to sufficiently provide for estimated losses based onevaluating known and inherent risks in the loan portfolio.  Management analyzes certain factorsunderlying the quality of the loan portfolio. These factors include changes in the size and composition of the loanportfolio, delinquency levels, actual loan loss experience, current economicconditions, and detailed analysis of individual loans for which fullcollectibility may not be assured.  Theappropriate level of the allowance for losses on loans is estimated based uponfactors and trends identified by management at the time financial statementsare prepared.

 

Management has assessed,and will continue to assess on an on-going basis, the impact of the recenttragedies and the slowing Washington state economy on the credit risk in theloan portfolio.  Currently, managementis not aware of any unusually large loan concentrations in industriesnegatively impacted by the recent events and the slowdown in the economy. As ofDecember 31, 2001, delinquency trends and classified loan levels relative tocomparable prior periods do not indicate any material deterioration in the loanportfolio.  However, managementincreased the provision for losses on loans by $450,000 during the second halfof 2001 in comparison to the first half of 2001 based on concerns resultingfrom the inherent risk in the loan portfolio, including the impact of the deteriorationof the Washington state economy. Management continues to closely monitor PNWB’scredit quality and focus on identifying potential problem credits and any lossexposure in a timely manner.  Industryconcentration and related limits will continue to be subject to on-goingassessments.

 

PNWB believes it 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.

 

12

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The following table sets forth activity in the allowance for losses onloans during the periods indicated.

 
|                                                                                        |   | **Year ended**           |   |
|---------------------------------------------------------------------------------------------|--------|--------------------------|--------|
|                                                                                        |   | **December  31,**        |   | **September  30,** |   |
|                                                                                        |   | **2001**                 |   | **2000** |   | **1999** |   | **1998** |   | **1997** |   |
|                                                                                        |   | **Dollars in thousands** |   |
| Allowance as of beginning of year                                                           |   | $                        | 17,561 |   | $ | 15,182 |   | $ | 13,224 |   | $ | 11,104 |   | $ | 10,235 |   |
| Provision for losses on loans                                                               |   | 6,050                    |   | 4,750 |   | 2,000 |   | 1,707 |   | 1,508 |   |
|                                                                                        |   |                     |   |   |   |   |   |   |   |   |   |
| *Merger and acquisition activity:*                                                          |   |                     |   |   |   |   |   |   |   |   |   |
| Provision pursuant to acquisition                                                           |   | —                   |   | — |   | — |   | 1,100 |   | — |   |
| Allowance acquired                                                                          |   | —                   |   | — |   | — |   | 295 |   | — |   |
| Pooling accounting adjustment                                                               |   | —                   |   | — |   | — |   | (76 | ) | — |   |
|                                                                                        |   |                     |   |   |   |   |   |   |   |   |   |
| *Charge-offs:*                                                                              |   |                     |   |   |   |   |   |   |   |   |   |
| Commercial loans                                                                            |   | 1,518                    |   | 1,300 |   | 405 |   | 194 |   | 246 |   |
| Commercial real estate                                                                      |   | 326                      |   | 5 |   | — |   | 119 |   | 234 |   |
| Single-family residential                                                                   |   | 1,723                    |   | 750 |   | 727 |   | 413 |   | 109 |   |
| Real estate construction                                                                    |   | 47                       |   | 283 |   | — |   | 134 |   | — |   |
| Consumer loans                                                                              |   | 922                      |   | 464 |   | 337 |   | 428 |   | 449 |   |
| Agricultural loans                                                                          |   | 210                      |   | 154 |   | 84 |   | 2 |   | 2 |   |
| Total charge-offs                                                                           |   | 4,746                    |   | 2,956 |   | 1,553 |   | 1,290 |   | 1,040 |   |
|                                                                                        |   |                     |   |   |   |   |   |   |   |   |   |
| *Recoveries:*                                                                               |   |                     |   |   |   |   |   |   |   |   |   |
| Commercial loans                                                                            |   | 629                      |   | 280 |   | 86 |   | 88 |   | 133 |   |
| Commercial real estate                                                                      |   | 126                      |   | 29 |   | 38 |   | 55 |   | 67 |   |
| Real estate mortgage loans:                                                                 |   |                     |   |   |   |   |   |   |   |   |   |
| Single-family residential                                                                   |   | 330                      |   | 175 |   | 245 |   | 61 |   | 39 |   |
| Consumer loans                                                                              |   | 173                      |   | 100 |   | 83 |   | 176 |   | 162 |   |
| Agricultural loans                                                                          |   | —                   |   | 1 |   | — |   | 4 |   | — |   |
| Total recoveries                                                                            |   | 1,258                    |   | 585 |   | 452 |   | 384 |   | 401 |   |
| Net charge-offs                                                                             |   | (3,488                   | )      | (2,371 | ) | (1,101 | ) | (906 | ) | (639 | ) |
| Allowance as of end of year                                                                 |   | $                        | 20,123 |   | $ | 17,561 |   | $ | 14,123 |   | $ | 13,224 |   | $ | 11,104 |   |
| Ratio of allowance for losses on loans to  total loans receivable as of the end of the year |   | 1.11                     | %      | 0.99 | % | 0.90 | % | 0.96 | % | 0.82 | % |
| Ratio of net charge-offs to average loans  outstanding during the year                      |   | 0.19                     | %      | 0.14 | % | 0.08 | % | 0.06 | % | 0.05 | % |

 

PNWB maintains an estimated allowance forlosses on loans based on the analyses conducted by management and creditpersonnel.  The allowance for losses onloans is allocated to certain loan categories based on the relative riskcharacteristics, asset classifications and actual loss experience of the loanportfolio.  Management has reviewed theallocations in the various loan categories and believes the allowance for losseson loans was adequate at all times during the five-year period ended December31, 2001.

 

PNWB updated its methodology for allocatingthe allowance for losses on loans during 2000, with a greater emphasis oncurrent risk characteristics and asset classifications and less emphasis onhistorical loss experience compared to years prior to 2000.  Management believes this approach is moreappropriate and reflective of the changing nature of the loan portfolio with a greateremphasis on commercial lending that is also expanding into new markets andproducts.  As such, portfolio riskcharacteristics and internal asset classification assessments are morereflective of the current loan portfolio than historical loss experience.

 

Theallocation of the allowance for losses on loans to commercial and commercialreal estate loans increased from prior years primarily due to growth incommercial loans and a greater emphasis on the current risk characteristicsinherent in the commercial and commercial real estate loan portfolio.

 

Theincreased allocation to real estate construction loans and agricultural loansin 2001 and 2000 compared to prior years is due to a greater emphasis on riskcharacteristics inherent in real estate construction lending and greateremphasis on internal asset classifications. Prior year allocations were based more heavily on historical lossexperience and PNWB had not experienced significant losses in the real estateconstruction and agricultural loan portfolios. The allocation to agricultural loanshas also increased due to an increase in non-performing and adverselyclassified agricultural loans based on the state of the agricultural economy incentral Washington.

 

The decreased allocationto single-family residential mortgage loans is primarily due to a decrease inthe balances outstanding in the portfolio compared to prior years.

 

The decreased allocationto the consumer loans in 2001 and 2000 compared to prior years is primarily dueto a decrease in the average life of consumer loans outstanding with a greateremphasis on originating shorter-term consumer loans and a decrease innon-performing 

 

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consumer loans.  The reduction in the allocation alsoreflects the change in the methodology of allocating the allowance for losseson loans to the consumer portfolio.  Theincrease in allocation to consumer loans in 2001 compared to 2000 was due to anincrease in historical loss experience in consumer loans.

 

Although theallocation of the allowance for losses on loans is an important creditmanagement tool, the entire allowance for losses on loans is available for theentire loan portfolio.  The followingtable sets forth the allocation of the allowance for losses on loans by loancategory as of the dates indicated.

 
|                      |   | **December  31,  2001**  |   | **December  31,  2000** |   | **December  31,  1999** |   | **September  30,  1999** |   | **September  30,  1998** |   | **September  30,  1997** |   |
|---------------------------|--------|--------------------------|--------|-------------------------|--------|-------------------------|--------|--------------------------|--------|--------------------------|--------|--------------------------|--------|
|                      |   | **Dollars in thousands** |   |
| Commercial loans:         |   |                     |   |                    |   |                    |   |                     |   |                     |   |                     |   |
| Commercial loans          |   | $                        | 6,105  |                    | $      | 4,448                   |   | $                        | 3,632  |                     | $      | 2,785                    |   | $ | 2,454 |   | 1,592 |   |
| Commercial real estate    |   | 3,265                    |   | 2,862                   |   | 1,342                   |   | 1,525                    |   | 1,878                    |   | 998                      |   |
| Total commercial loans:   |   | 9,370                    |   | 7,310                   |   | 4,974                   |   | 4,310                    |   | 4,332                    |   | 2,590                    |   |
|                      |   |                     |   |                    |   |                    |   |                     |   |                     |   |                     |   |
| Single-family residential |   | 1,798                    |   | 2,076                   |   | 3,265                   |   | 2,471                    |   | 3,288                    |   | 2,092                    |   |
| Real estate construction  |   | 2,752                    |   | 2,804                   |   | 301                     |   | 302                      |   | 424                      |   | 494                      |   |
| Consumer loans            |   | 448                      |   | 311                     |   | 1,376                   |   | 1,441                    |   | 996                      |   | 1,012                    |   |
| Agricultural loans        |   | 1,999                    |   | 1,921                   |   | 394                     |   | 334                      |   | 285                      |   | 59                       |   |
| Unallocated               |   | 3,756                    |   | 3,139                   |   | 4,872                   |   | 5,265                    |   | 3,899                    |   | 4,857                    |   |
|                      |   |                     |   |                    |   |                    |   |                     |   |                     |   |                     |   |
| Total                     |   | $                        | 20,123 |                    | $      | 17,561                  |   | $                        | 15,182 |                     | $      | 14,123                   |   | $ | 13,224 |   | $ | 11,104 |   |
|                           |        |                          |        |                         |        |                         |        |                          |        |                          |        |                          |        |  |  |  |  |  |  |

 

*OTHER REAL ESTATE* |Other real estate includes property acquired by PNWB through foreclosure andreal estate held for development.  Otherreal estate is carried at the lower of the estimated fair value or theprincipal balance of the foreclosed loans. The real estate held for developmentportfolio primarily consists of one land development project.  PNWB had other real estate totaling $5.8million as of December 31, 2001 compared to $9.9 million as of December 31,2000.

 

*NON-PERFORMING ASSETS |*PNWB’s non-performing assets as of December 31, 2001, consisting ofnon-performing loans and other real estate, totaled $21.9 million or 0.80percent of total assets.  This is adecrease from $23.8 million or 0.83 percent of total assets as of December 31,2000.  Non-performing loans increased to$16.1 million as of December 31, 2001 compared to $13.9 million as of December31, 2000, and $11.0 million as of September 30, 1999.  The increase in non-performing loans is primarily due to anincrease in non-performing commercial and agricultural loans offset by adecrease in real estate construction loans. The increase in non-performing commercial loans is primarily due to severalindividual commercial loans.  Theincrease in non-performing agricultural loans is primarily due to a weakagricultural economy in central Washington. Management believes that the allowance for losses on loans is adequateto provide for losses that may be incurred on non-performing loans.  Non-performing other real estate was $5.8million as of December 31, 2001, a decrease from $9.9 million as of December31, 2000.  The decrease was primarilydue to increased sales of other real estate owned compared to 2000 as a resultof management’s continued emphasis on selling other real estate owned in atimely manner. The following table presents information with respect to PNWB’snon-performing assets and restructured loans as of the dates indicated.

 
|                                            |   | **December  31,  2001**  |   | **December  31,  2000** |   | **December  31,  1999** |   | **September  30,  1999** |   | **September  30,  1998** |   | **September  30,  1997** |   |
|-------------------------------------------------|--------|--------------------------|--------|-------------------------|--------|-------------------------|--------|--------------------------|--------|--------------------------|--------|--------------------------|--------|
|                                            |   | **Dollars in thousands** |   |
| Non-performing loans:                           |   |                     |   |                    |   |                    |   |                     |   |                     |   |                     |   |
| Commercial loans:                               |   |                     |   |                    |   |                    |   |                     |   |                     |   |                     |   |
| Commercial                                      |   | $                        | 5,434  |                    | $      | 2,455                   |   | $                        | 5,038  |                     | $      | 3,943                    |   | $ | 1,682 |   | $ | 343 |   |
| Commercial real estate                          |   | 1,100                    |   | 991                     |   | 1,371                   |   | 792                      |   | 557                      |   | 1,212                    |   |
| Total Commercial Loans                          |   | 6,534                    |   | 3,446                   |   | 6,409                   |   | 4,735                    |   | 2,239                    |   | 1,555                    |   |
|                                            |   |                     |   |                    |   |                    |   |                     |   |                     |   |                     |   |
| Single-family residential                       |   | 5,425                    |   | 5,020                   |   | 3,207                   |   | 4,125                    |   | 5,036                    |   | 3,181                    |   |
| Real estate construction                        |   | 1,199                    |   | 3,920                   |   | 880                     |   | 880                      |   | 634                      |   | 234                      |   |
| Consumer loans                                  |   | 245                      |   | 225                     |   | 366                     |   | 507                      |   | 174                      |   | 417                      |   |
| Agricultural loans                              |   | 2,685                    |   | 1,272                   |   | 88                      |   | 652                      |   | 127                      |   | 78                       |   |
| Total                                           |   | 16,088                   |   | 13,883                  |   | 10,950                  |   | 10,899                   |   | 8,210                    |   | 5,465                    |   |
| Other real estate                               |   | 5,762                    |   | 9,909                   |   | 4,313                   |   | 3,560                    |   | 7,553                    |   | 6,945                    |   |
| Total non-performing assets                     |   | $                        | 21,850 |                    | $      | 23,792                  |   | $                        | 15,263 |                     | $      | 14,459                   |   | $ | 15,763 |   | $ | 12,410 |   |
|                                            |   |                     |   |                    |   |                    |   |                     |   |                     |   |                     |   |
| Restructured loans                              |   | $                        | 570    |                    | $      | 687                     |   | $                        | 777    |                     | $      | 798                      |   | $ | 883 |   | $ | 1,403 |   |
| Total non-performing loans to loans  receivable |   | 0.90                     | %      | 0.79                    | %      | 0.65                    | %      | 0.70                     | %      | 0.60                     | %      | 0.41                     | %      |
| Total non-performing loans to total assets      |   | 0.59                     | %      | 0.48                    | %      | 0.39                    | %      | 0.42                     | %      | 0.34                     | %      | 0.21                     | %      |
| Total non-performing assets to total assets     |   | 0.80                     | %      | 0.83                    | %      | 0.55                    | %      | 0.56                     | %      | 0.64                     | %      | 0.52                     | %      |

 

 

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The level of non-performing loans relative toloans receivable has increased since 1996. This trend may continue as PNWB expands its commercial lendingactivities and expands into new geographic and product markets.  Interest income that would have beenrecognized as of December 31, 2001, had non-accrual loans been current inaccordance with their contractual terms amounted to $2.0 million.

 

*Goodwill and Other Intangible Assets*|Goodwill and other intangible assets totaled $18.1 million, or 0.66 percent oftotal assets and 9.04 percent of total shareholders’ equity as of December 31,2001.   Goodwill and other intangibleassets totaled $20.7 million, or 0.72 percent of total assets and 11.58 percentof total shareholders’ equity as of December 31, 2001.  This decrease in the balance of goodwill andother intangible assets was due to amortization in 2001.

 

Goodwill arising fromacquisitions represents the excess of the purchase price over the estimatedfair value of net assets acquired. Goodwill was amortized using the straight-line methods 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, and as such,expects annual goodwill amortization expense to reduce by approximately $1.1million starting in 2002.  On the otherhand, PNWB reviews its goodwill for impairment on an annual basis or morefrequently if impairment indicators arise. PNWB is currently performing the first of the required impairmentassessments of goodwill in accordance with SFAS No. 142 and does not expect theresult of assessment to have material impact on PNWB’s financial condition orresults of operations.

 

Other intangible assets consistof core deposit intangibles and mortgage servicing rights, amortized using thestraight-line and accelerated methods over periods not exceeding twentyyears.  Mortgage servicing rights arecapitalized when acquired either through the purchase or origination of loansthat are subsequently sold or securitized with the servicing rightsretained.  The estimated fair value ofmortgage servicing rights at the date of the sale of loans is determined basedon the discounted present value of expected future cash flows using keyassumptions for servicing income and costs and prepayment rates on theunderlying loans. The estimated fair value is periodically evaluated forimpairment by comparing actual cash flows and estimated future cash flows fromthe servicing assets to those estimated at the time servicing assets wereoriginated.  Mortgage servicing rightsare amortized as an offset to service fees in proportion to and over the periodof estimated net servicing income.  Theamortization and write-down of mortgage servicing rights was $1.3 million, $0.8million and $1.4 million for the years ended December 31, 2001 and 2000, andthe year ended September 30, 1999.  Thehigher amortization and write-down level during 2001 and 1999 compared to 2000was primarily due to decreases in interest rates, which resulted in higherprepayment rates on the underlying loans.

 

*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.

 

Non-interest-bearing depositswere $241.7 million as of December 31, 2001, compared to $244.1 million as ofDecember 31, 2000.  Non-interest-bearingdeposits represented 15.1 percent of total deposits as of December 31, 2001,compared to 14.2 percent as of December 31, 2000.  Interest-bearing transaction accounts, which includesinterest-bearing checking, money market and savings accounts, totaled $632.0million as of December 31, 2001 compared to $569.7 million as of December 31,2000.  Interest-bearing transactionaccounts represented 39.4 percent of total deposits as of December 31, 2001,compared to 33.2 percent as of December 31, 2000.

 

Certificates of deposit were$731.1 million as of December 31, 2001, compared to $903.4 million as ofDecember 31, 2000.  Certificates ofdeposit represented 45.6 percent of total deposits as of December 31, 2001,compared to 52.6 percent as of December 31, 2000.

 

During 2001, management focusedon initiatives to restructure the deposit portfolio in an effort to decreasefunding costs and better manage interest rate risk while building customerrelationships.  As of December 31, 2001,54.4 percent of total deposits were transaction accounts, compared to 47.4percent as of December 31, 2000.  Theincrease in the percentage of non-interest-bearing deposits andinterest-bearing transaction deposits relative to certificates of depositreflected the progress made on those initiatives.   It is management’s intention to continue to increase transactionaccounts as a percentage of the total deposit portfolio in the future.

 

The following table indicatesthe amount of PNWB’s certificates of deposit with balances equal to or greaterthan $100,000 classified by time remaining until maturity as of December 31,2001.

 

| **Maturity  Period**       |   | **Amount**               | ** ** |
|----------------------------|--------|--------------------------|------------|
|                       |   | **Dollars in thousands** |       |
| Three months or less       |   | $                        | 187,166    |   |
| Three through six months   |   | 59,175                   |       |
| Six through twelve months  |   | 88,412                   |       |
| Greater than twelve months |   | 59,077                   |       |
| Total                      |   | $                        | 393,830    |   |

 

15

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

 
|                               |   | **December  31, 2001**   |      | **December  31, 2000**  |   | **December  31, 1999** |   | **September  30, 1999** |   |
|------------------------------------|--------|--------------------------|-----------|-------------------------|--------|------------------------|--------|-------------------------|--------|
|                               |   | **Amount**               |      | **Percent   of  Total** |   | **Amount**             |   | **Percent   of  Total** |   | **Amount** |   | **Percent   of  Total** |   | **Amount** |   | **Percent   of  Total** |   |
|                               |   | **Dollars in thousands** |      |
| Non-interest-bearing deposits      |   | $                        | 241,674   |                    | 15.1   | %                      | $      | 244,100                 |   | 14.2 | % | $ | 212,880 |   | 13.3 | % | $ | 197,732 |   | 12.5 | % |
| Interest-bearing checking accounts |   | 214,098                  |      | 13.3                    |   | 201,894                |   | 11.8                    |   | 173,751 |   | 10.9 |   | 171,578 |   | 10.9 |   |
| Money market accounts              |   | 322,552                  |      | 20.1                    |   | 266,933                |   | 15.5                    |   | 300,267 |   | 18.8 |   | 273,537 |   | 17.3 |   |
| Savings accounts                   |   | 95,390                   |      | 5.9                     |   | 100,831                |   | 5.9                     |   | 97,035 |   | 6.1 |   | 103,306 |   | 6.6 |   |
| Certificates of deposit            |   | 731,141                  |      | 45.6                    |   | 903,350                |   | 52.6                    |   | 814,257 |   | 50.9 |   | 832,796 |   | 52.7 |   |
|                               |   |                     |      |                    |   |                   |   |                    |   |   |   |   |   |   |   |   |   |
| Total                              |   | $                        | 1,604,855 |                    | 100.0  | %                      | $      | 1,717,108               |   | 100.0 | % | $ | 1,598,190 |   | 100.0 | % | $ | 1,578,949 |   | 100.0 | % |

 

*FHLB ADVANCES AND SECURITIES SOLD UNDERAGREEMENT 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 $864.0 million as of December 31, 2001compared to $918.1 million as of December 31, 2000.  The need for this type of borrowings decreased as a result of theoverall decrease in assets and increase in shareholder’s equity, partiallyoffset by decreases in deposits.

 

The FHLB provides credit formember financial institutions.  Asmembers, financial institutions are required to own capital stock in the FHLB,and are authorized to apply for advances on the security of such stock, certainhome mortgages, commercial real estate loans and other assets such assecurities that are obligations of, or guaranteed by, the United States.  Advances are made to member financialinstitutions pursuant to several different programs.  These programs are generally designed to meet the financialinstitution’s needs while still reflecting market terms and conditions.  Interest rates on these advances vary inresponse to general economic conditions.

 

PNWB also uses the securitiesmarket for borrowings by utilizing its securities available for sale ascollateral.  These borrowings arecollateralized by securities with an estimated fair value exceeding the facevalue of the borrowings.

 

The following table sets forthcertain information with respect to FHLB advances and securities sold underagreements to repurchase during the periods indicated:

 
|                                                            |   | **As of or  for the period ended** |    |
|-----------------------------------------------------------------|--------|------------------------------------|---------|
|                                                            |   | **December  31,  2001**            |    | **December  31,  2000** |   | **December  31,  1999** |   | **September  30,  1999** |   |
|                                                            |   | **Dollars in thousands**           |    |
| Maximum amount outstanding at any month end  during the period: |   |                               |    |   |   |   |   |   |   |
| FHLB advances                                                   |   | $                                  | 721,200 |   | $ | 787,526 |   | $ | 696,587 |   | $ | 718,709 |   |
| Securities sold under agreements to  repurchase                 |   | 279,176                            |    | 286,807 |   | 282,655 |   | 133,992 |   |
|                                                            |   |                               |    |   |   |   |   |   |   |
| Approximate average amount outstanding  during the period:      |   |                               |    |   |   |   |   |   |   |
| FHLB advances                                                   |   | 651,824                            |    | 707,814 |   | 680,928 |   | 601,931 |   |
| Securities sold under agreements to  repurchase                 |   | 193,607                            |    | 267,570 |   | 165,612 |   | 131,723 |   |
|                                                            |   |                               |    |   |   |   |   |   |   |
| Balance outstanding at end of period:                           |   |                               |    |   |   |   |   |   |   |
| FHLB advances                                                   |   | 714,526                            |    | 643,200 |   | 670,234 |   | 682,238 |   |
| Securities sold under agreements to  repurchase                 |   | 149,504                            |    | 274,920 |   | 282,655 |   | 131,972 |   |
|                                                            |   |                               |    |   |   |   |   |   |   |
| Weighted average rate paid during the  period:                  |   |                               |    |   |   |   |   |   |   |
| FHLB advances                                                   |   | 4.63                               | %       | 6.07 | % | 5.55 | % | 5.38 | % |
| Securities sold under agreements to  repurchase                 |   | 5.49                               |    | 6.66 |   | 5.86 |   | 5.77 |   |
|                                                            |   |                               |    |   |   |   |   |   |   |
| Weighted average rate paid at end of  period:                   |   |                               |    |   |   |   |   |   |   |
| FHLB advances                                                   |   | 3.23                               |    | 6.37 |   | 5.59 |   | 5.41 |   |
| Securities sold under agreements to  repurchase                 |   | 3.63                               |    | 6.88 |   | 5.96 |   | 5.70 |   |
|                                                                 |        |                                    |         |  |  |  |  |  |  |  |  |  |  |

 

*GUARANTEED PREFERREDBENEFICIAL INTERESTS IN SUBORDINATED DEBT*  |On November 15, 1999, $40 million of 9.875 percent Capital Securities wereissued by InterWest Capital Trust I (the Trust).  The Trust is a business trust organized in November 1999, andPacific Northwest Bancorp owns 100 percent of the common equity of the Trust.

 

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 the Trust. Distributions on the capital securities issued by the Trust are payablesemi-annually at 

16

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9.875 percent per annum, whichis equal to the interest rate being earned by the Trust on the debentures heldby the Trust.  The capital securitiesare subject to mandatory redemption, in whole or in part, upon repayment of thedebentures.  The debentures will notmature earlier than November 15, 2009, and not later than November 15,2029.  Pacific Northwest Bancorp enteredinto agreements which, taken collectively, fully and unconditionally guaranteethe capital securities subject to the terms of each of the guarantees.

 

PNWB used the proceeds forgeneral corporate purposes including stock repurchases and investment in thesubsidiary bank.  The capital securitiesqualify as Tier I capital under the capital guidelines of the Federal ReserveBoard.  During 2001, Pacific NorthwestBancorp purchased $2.5 million of the Interwest Capital Trust I capitalsecurities in an effort to reduce funding costs.

 

**CAPITAL**

 

Pacific Northwest Bancorp iscommitted to managing capital for maximum shareholder benefit and maintainingstrong protection for depositors and creditors.  PNWB manages various capital levels at both the holding companyand subsidiary bank level to maintain adequate capital ratios and levels inaccordance with external regulations and capital guidelines established by theBoard of Directors of each institution. See Note 19 of the Consolidated Financial Statements for detail ofregulatory capital ratios for Pacific Northwest Bancorp and Pacific NorthwestBank.

 

On January 22, 2002, the Boardof Directors authorized the purchase of up to five percent or approximately780,000 shares of Pacific Northwest Bancorp’s outstanding shares of commonstock in the open market for the following twelve-month period.  The Board of Directors previously approved astock repurchase plan of ten percent in 1999. During the year ended December31, 2000, 468,000 shares (three percent of the total common shares outstanding)at a total price of $7.9 million were repurchased.  No shares were repurchased during 2001 under the stock repurchaseplan approved in 1999.

 

PNWB’s total shareholders’equity was $200.5 million and book value per share was $12.86 as of December31, 2001.  PNWB’s total shareholders’equity was $178.7 million and book value per share was $11.54 as of December31, 2000.  The increase in shareholders’equity was due to net income of $22.1 million, other comprehensive income of$6.8 million, the issuance of $0.8 million of common stock through exercise ofstock options and the ESOP debt repayment of $1.1 million, and partially offsetby $8.7 million in dividends paid to shareholders.

 

During fiscal year 2001,Pacific Northwest Bancorp declared cash dividends totaling $0.56 per share,consistent with $0.56 per share for the year ended December 31, 2000.

 

**LIQUIDITYRESOURCES**

 

Liquidity management focuses onthe need to meet both short-term funding requirements and PNWB’s long-termstrategies and goals.  Specifically, theobjective of liquidity management is to ensure the continuous availability offunds to meet the demands of depositors, creditors and borrowers.  Management structures the balance sheet tomeet these needs.  PNWB desires toattract and retain business and retail customer relationships with a focus ontransaction 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.  Other sources of funds for liquidity includeloan repayments, loan sales, security sales, mortgage-backed and related securityrepayments as well as wholesale and brokered certificates of deposit.  Repayments on loans and mortgage-backed andrelated securities and deposit inflows and outflows are affected by changes ininterest rates.

 

PNWB has capacity to borrowadditional funds from the FHLB through pre-approved credit lines.  These credit lines have pledge requirementswhereby PNWB must maintain unencumbered collateral with a par value at leastequal to the outstanding balance.  As ofDecember 31, 2001, the additional amount available under credit lines from theFHLB was $107.9 million.  Additionally,PNWB uses the securities market as a vehicle for borrowing by utilizing itssecurities available for sale as collateral. These borrowings are collateralized by securities with an estimated fairvalue exceeding the face value of the borrowings.  If the estimated fair value of the securities were to decline asa result of an increase in interest rates or other factors, PNWB would berequired to pledge additional securities or cash as collateral.  As of December 31, 2001, PNWB had $250.5million of available credit from third parties to sell securities underagreements to repurchase.

 

The analysis of liquidity alsoincludes a review of PNWB’s consolidated statement of cash flows for 2001.  The consolidated statement of cash flowsdetails PNWB’s operating, investing and financing activities during theyear.  The most significant items underoperating activities include net income of $22.1 million.  Operating activities also include the addback of non-cash depreciation, amortization of intangible assets, provision forlosses on loans and gain on other real estate totaling $14.8 million.  Net cash provided by operating activities isalso adjusted for the net gain on sale of loans and securities available forsale of $4.0 million, net loan fees deferred of $2.1 million and FHLB stockdividends of $3.1 million .  Investingactivities included proceeds from the sale of securities available for sale of$151.4 million, proceeds from maturing and principal repayments on securitiesavailable for sale of $385.4 million and purchases of securities available forsale of $373.2 million. Investing activities also include a $212.8 millionincrease in loans receivable and $143.3 million of proceeds from the sale ofloans.  During 2001, financingactivities included $42.1 million in borrowing repayments, net of borrowingproceeds, a $50.6 million increase in checking, savings and money marketaccount deposits offset by $162.9 million decrease 

 

17

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in certificates of deposit, $2.5 million paid to purchase InterwestCapital Trust I capital securities and $8.7 million paid in cash dividends toshareholders.

 

**SUPERVISIONAND REGULATION**

 

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

 

Pacific Northwest Bank is amember of the Federal Deposit Insurance Corporation (FDIC), and as such, issubject to examination thereby.  PacificNorthwest Bank is a state-chartered commercial bank subject to regulation andsupervision by the Washington Department of Financial Institutions Division ofBanks.  In practice, the primaryregulator makes regular examinations of the subsidiary bank subject to itsregulatory review or participates in joint examinations with 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 against bankingorganizations and institution-affiliated parties, as defined.  In general, enforcement actions must beinitiated for violations of laws and regulations and unsafe or unsoundpractices.   Other actions, orinactions, may provide the basis for enforcement action, including misleadingor untimely reports filed with regulatory authorities.  Applicable law also requires publicdisclosure of final enforcement actions.

 

**MARKET RISK**

 

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

 

PNWB is sensitive to thepotential change in interest rates and the resulting impact on net interestincome.  It has been an objective ofmanagement to reduce this sensitivity through the use of adjustable rate loansand short-term commercial and consumer loans. This enables PNWB to better matchthe duration of its deposit base with these types of assets.

 

In addition to adjustable rateloans, PNWB uses a number of additional strategies to minimize the impact onnet income due to significant changes in interest rates. The strategiesutilized by PNWB include sales of long-term, fixed-rate mortgage loans,emphasis on growth in non-interest-bearing deposits, variable rateinterest-bearing checking, savings and money market account deposits as well asadjustable rate commercial lending.

 

Management uses simulationanalysis to measure PNWB’s interest sensitivity position.  This simulation analysis is used to evaluatethe effects of potential interest rate movements on net interest income.  The simulation analysis model is dynamic innature, and incorporates management’s current balance sheet strategy.   Management develops assumptions regardinginterest rate spreads, projected balances, expected maturities, cash flows andprepayment assumptions under different interest rate scenarios.

 

The table on the following pagesets forth the balances of PNWB’s financial instruments at the expectedmaturity dates, as well as the estimated fair value of those financialinstruments as of December 31, 2001. The expected maturities take intoconsideration historical and estimated principal prepayments for loans andmortgage-backed securities.  Principalprepayments are the amounts of principal reduction, over and above normalamortization.

 

The expected maturities forfinancial liabilities with no stated maturity reflect assumptions based onhistorical and estimated future roll-off rates. The roll-off rate fornon-interest-bearing deposits, interest-bearing checking accounts, money marketaccounts and savings accounts is 20 percent. The weighted average interestrates for financial instruments presented are actual as of December 31, 2001.

 

The estimated fair valueamounts have been determined by PNWB using available market information andappropriate valuation methodologies. However, considerable judgment is necessary to interpret market data inthe development of the estimated fair value amounts.  Accordingly, the estimated fair values presented herein are notnecessarily indicative of the amounts PNWB could realize in a current marketexchange.  The use of different marketassumptions and/or estimation methodologies may have a material effect on theestimated fair value amounts. The carrying value of cash and due from banks,federal funds sold, securities purchased under agreements to resell andinterest receivable is a reasonable estimate of the fair value for suchfinancial assets.  The estimated fairvalues of securities available for sale and loans held for sale are based onquoted market rates and dealer quotes. The estimated fair value of loans receivable is based on discounted cashflows, using interest rates currently offered for loans of similarcharacteristics.  The estimated fairvalue of deposits with no stated maturity, such as checking accounts, moneymarket accounts and savings accounts, is equal to the amount payable on demandas of December 31, 2001.  The estimatedfair value of certificates of deposit is based on the present value ofcontractual cash flows using a discount rate based on the current average ratefor deposits with similar characteristics. The estimated fair value of FHLB advances and securities sold underagreements to repurchase is based on the present value of future cash flowsusing a discount rate equal to the rate offered on similar borrowings withsimilar maturities as of December 31, 2001. The estimated fair value of guaranteed preferred beneficial interests insubordinated debt is based on quoted market rates for subordinated debt withsimilar interest rates and similar characteristics.  The estimated fair values presented are based on informationavailable as of December 31, 2001.

 

18

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|                                                           |   | **Expected  maturity date  year ended December 31,** |   |     |   |     |   |     |   |
|----------------------------------------------------------------|--------|------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
|                                                           |   | **2002**                                             |   | **2003** |   | **2004** |   | **2005** |   | **2006** |   | **Thereafter** |   | **Total** |   | **Estimated  Fair Value** |   |
|                                                           |   | **Dollars in thousands**                             |   |
| MARKET RISK                                                    |   |                                                 |   |     |   |     |   |     |   |   |   |   |   |   |   |   |   |
|                                                           |   |                                                 |   |     |   |     |   |     |   |   |   |   |   |   |   |   |   |
| *Financial Assets*                                             |   |                                                 |   |     |   |     |   |     |   |   |   |   |   |   |   |   |   |
| Cash and due from banks                                        |   |                                                 |   |     |   |     |   |     |   |   |   |   |   |   |   |   |   |
| Non-interest-bearing                                           |   | $                                                    | 58,134 |     | $      | —   |   | $        | — |   | $ | — |   | $ | — |   | $ | — |   | $ | 58,134 |   | $ | 58,134 |   |
| Interest-bearing                                               |   | 491                                                  |   | —   |   | —   |   | —   |   | — |   | — |   | 491 |   | 491 |   |
| Weighted average interest rate                                 |   | 1.69                                                 | %      | —   |   | —   |   | —   |   | — |   | — |   | 1.69 | % |   |   |
| Securities available for sale                                  |   | 91,617                                               |   | 43,109   |   | 55,515   |   | 48,314   |   | 62,833 |   | 455,630 |   | 757,018 |   | 757,018 |   |
| Weighted average interest rate                                 |   | 6.28                                                 | %      | 6.19     | %      | 5.54     | %      | 5.90     | %      | 5.81 | % | 5.42 | % | 5.64 | % |   |   |
| Loans receivable, net                                          |   |                                                 |   |     |   |     |   |     |   |   |   |   |   |   |   |   |   |
| Fixed rate                                                     |   | 143,677                                              |   | 73,185   |   | 52,967   |   | 34,727   |   | 32,314 |   | 101,627 |   | 438,497 |   | 461,603 |   |
| Weighted average interest rate                                 |   | 7.52                                                 | %      | 8.04     | %      | 8.03     | %      | 7.92     | %      | 7.68 | % | 8.10 | % | 7.85 | % |   |   |
| Variable rate                                                  |   | 616,510                                              |   | 255,504  |   | 147,726  |   | 84,719   |   | 57,555 |   | 208,044 |   | 1,370,058 |   | 1,382,896 |   |
| Weighted average interest rate                                 |   | 5.55                                                 | %      | 7.11     | %      | 6.97     | %      | 6.79     | %      | 6.53 | % | 6.08 | % | 6.19 | % |   |   |
| Loans held for sale                                            |   | 43,757                                               |   | —   |   | —   |   | —   |   | — |   | — |   | 43,757 |   | 43,872 |   |
| Weighted average interest rate                                 |   | 6.95                                                 | %      | —   |   | —   |   | —   |   | — |   | — |   | 6.95 | % |   |   |
| Interest receivable                                            |   | 14,808                                               |   | —   |   | —   |   | —   |   | — |   | — |   | 14,808 |   | 14,808 |   |
|                                                           |   |                                                 |   |     |   |     |   |     |   |   |   |   |   |   |   |   |   |
| *Financial Liabilities*                                        |   |                                                 |   |     |   |     |   |     |   |   |   |   |   |   |   |   |   |
| Non-interest-bearing deposits                                  |   | $                                                    | 48,411 |     | $      | 48,315   |   | $        | 48,315 |   | $ | 48,315 |   | $ | 48,318 |   | $ | — |   | $ | 241,674 |   | $ | 241,674 |   |
| Interest-bearing checking accounts                             |   | 42,820                                               |   | 42,820   |   | 42,820   |   | 42,820   |   | 42,819 |   | — |   | 214,099 |   | 214,099 |   |
| Weighted average interest rate                                 |   | 0.61                                                 | %      | 0.55     | %      | 0.55     | %      | 0.55     | %      | 0.55 | % | — |   | 0.56 | % |   |   |
| Money market accounts                                          |   | 64,511                                               |   | 64,511   |   | 64,511   |   | 64,511   |   | 64,510 |   | — |   | 322,554 |   | 322,554 |   |
| Weighted average interest rate                                 |   | 2.24                                                 | %      | 2.01     | %      | 2.01     | %      | 2.01     | %      | 2.01 | % | — |   | 2.05 | % |   |   |
| Savings accounts                                               |   | 19,107                                               |   | 19,073   |   | 19,070   |   | 19,070   |   | 19,070 |   | — |   | 95,390 |   | 95,390 |   |
| Weighted average interest rate                                 |   | 1.00                                                 | %      | 1.00     | %      | 1.00     | %      | 1.00     | %      | 1.00 | % | — |   | 1.00 | % |   |   |
| Certificates of deposit                                        |   | 610,307                                              |   | 85,387   |   | 17,211   |   | 12,266   |   | 4,414 |   | 1,554 |   | 731,139 |   | 738,857 |   |
| Weighted average interest rate                                 |   | 3.54                                                 | %      | 5.19     | %      | 5.07     | %      | 5.77     | %      | 4.94 | % | 6.27 | % | 3.82 | % |   |   |
| FHLB advances                                                  |   |                                                 |   |     |   |     |   |     |   |   |   |   |   |   |   |   |   |
| Fixed rate                                                     |   | 463,825                                              |   | 40,000   |   | 85,000   |   | 45,621   |   | 4,901 |   | 75,000 |   | 714,347 |   | 719,612 |   |
| Weighted average interest rate                                 |   | 2.47                                                 | %      | 4.39     | %      | 4.12     | %      | 4.81     | %      | 3.97 | % | 5.40 | % | 3.24 | % |   |   |
| Adjustable rate                                                |   | 800                                                  |   | —   |   | —   |   | —   |   | — |   | 12,000 |   | 12,800 |   | 12,800 |   |
| Weighted average interest rate                                 |   | 1.85                                                 | %      | —   |   | —   |   | —   |   | — |   | 6.04 | % | 5.78 | % |   |   |
| Securities sold under agreements to  repurchase                |   | 89,319                                               |   | 33,552   |   | 21,682   |   | 4,951    |   | — |   | — |   | 149,504 |   | 149,761 |   |
| Weighted average interest rate                                 |   | 3.43                                                 | %      | 3.52     | %      | 4.11     | %      | 4.82     | %      | — |   | — |   | 3.60 | % |   |   |
| Guaranteed preferred beneficial interest in  subordinated debt |   | —                                               |   | —   |   | —   |   | —   |   | — |   | 37,500 |   | 37,500 |   | 35,318 |   |
| Weighted average interest rate                                 |   | —                                               |   | —   |   | —   |   | —   |   | — |   | 9.88 | % | 9.88 | % |   |   |

 

While this table provides someinformation about PNWB’s interest sensitivity, it does not predict the trendsof future earnings.  For this reason,PNWB uses financial modeling to forecast earnings under different interest rateprojections.  While this modeling ishelpful in managing interest rate risk, it does require significant assumptionsfor the projection of loan prepayment rates, loan origination volumes andliability funding sources that may prove to be inaccurate.

 

19

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**ACCOUNTINGCHANGES**

 

In October 2001, the FASBissued SFAS No. 144 “Accounting for the Impairment or Disposal of Long-LivedAssets”. SFAS No. 144 supersedes SFAS No. 121, “Accounting for the Impairmentof Long-Lived Assets and for Long-Lived Assets to Be Disposed Of”.  This statement, which excludes goodwill,provides a single accounting model for recognition and impairment of long-livedassets to be held for sale or disposed of. SFAS No. 144 retains many of the fundamental recognition and measurementprovisions of SFAS No. 121; however, it significantly changes the criteria thatwould have to be met to classify an asset as either held-for-sale or to bedisposed of. SFAS No. 144 became effective on January 1, 2002.  The adoption of this statement had nomaterial impact on PNWB’s financial condition or results of operations.

 

In July 2001, the FASB issuedSFAS No. 142 “Accounting for Goodwill and Other Intangible Assets”.  Under SFAS No. 142, goodwill and indefinitelived intangible assets are no longer amortized but are reviewed annually forimpairment or more frequently if impairment indicators arise.  Separable intangible assets that are notdeemed to have an indefinite life will continue to be amortized over theiruseful lives.  This Statement becameeffective on January 1, 2002.  Theadoption of SFAS No. 142 is expected to reduce PNWB’s goodwill amortizationexpense by approximately $1.1 million on an annual basis.  PNWB is currently performing the first ofthe required impairment assessments of goodwill in accordance with SFAS No. 142and does not expect the results of such assessments to have a material impacton PNWB’s financial condition or results of operations.

 

In September 2000, the FASBissued SFAS No. 140 “Accounting for Transfers and Servicing of Financial Assetsand Extinguishments of Liabilities,” a replacement of SFAS No. 125.  This statement revises the standards foraccounting for securitizations and other transfers of financial assets andcollateral and requires certain disclosures; however, it carries over most ofSFAS No. 125’s provisions without reconsideration.  The standards addressed in this statement are based on consistentapplication of a financial components approach that focuses on control.  Under this approach, after a transfer offinancial assets, an entity recognizes the financial and servicing assets itcontrols and the liabilities it has incurred, derecognizes financial assetswhen control has been surrendered, and derecognizes liabilities whenextinguished.  This statement iseffective for transfers and servicing of financial assets and extinguishmentsof liabilities occurring after March 31, 2001. This statement is effective for recognition and reclassification ofcollateral and for disclosures relating to securitization transactions andcollateral for the year ended December 31, 2000.  The adoption of this statement affected the disclosures in PNWB’sconsolidated financial statements; however, it had no material impact on PNWB’sfinancial condition or results of operations.

 

In June 1998, the FinancialAccounting and Standards Board (FASB) issued SFAS No. 133 “Accounting forDerivative Instruments and Hedging Activities.”  In June 2000, the FASB issued SFAS No. 138, which amended certainprovisions of SFAS No. 133 to clarify specific areas presenting difficulties inimplementation.  SFAS No. 133, asamended by SFAS No. 138, establishes accounting and reporting standards forderivative instruments, including certain derivative instruments imbedded inother contracts, and for hedging activities. It requires the recognition of all derivatives as either assets orliabilities in the statement of financial condition and the measurement ofthose instruments at estimated fair value. In certain defined conditions, a derivative may be specificallydesignated as a hedge for a particular exposure. The accounting for derivativesdepends on the intended use of the derivatives and the resultingdesignation.  This statement was adoptedby PNWB on January 1, 2001. The adoption of this statement did not have amaterial impact on PNWB’s financial condition or results of operations.  As permitted by the provisions of thisstatement, PNWB transferred all securities held to maturity to securitiesavailable for sale on January 1, 2001. This transfer resulted in othercomprehensive loss of $597,000, net of income taxes of $321,000.

 

**FORWARD-LOOKINGSTATEMENTS**

 

In this Management Discussionand Analysis, PNWB has included certain “forward-looking statements” concerningits future operations. It is PNWB’s desire to take advantage of the “safeharbor” provisions of the Private Securities Litigation Reform Act of 1995.This statement is for the express purpose of availing PNWB of the protectionsof such safe harbor with respect to all forward-looking statements contained inthis Management Discussion and Analysis. Sentences containing words such as “may,” “will,” “expect,”“anticipate,” “believe,” “estimate,” “should,” “projected,” or similar wordsmay constitute forward-looking statements. Although PNWB believes that the expectations expressed in theseforward-looking statements are based on reasonable assumptions within thebounds of its knowledge of its business and operations, it is possible thatactual results may differ materially from these expectations.  PNWB has used these statements to describeexpectations and estimates in various areas, including, but not limited to:changes in the economy of the markets in which it operates; interest ratemovements; future acquisition and growth strategies; system conversions andintegration activities; the impact of competitive products, services andpricing; and legislative, regulatory and accounting changes affecting thebanking and financial services industry. Actual results could vary materially from the future results covered inforward-looking statements.  Factorssuch as interest rate trends and loan delinquency rates, as well as the generalstate of the economy in Washington state and the United States as a whole,could also cause actual results to vary materially from the future resultsanticipated in such forward-looking statements. These factors should beconsidered in evaluating the forward-looking statements and undue relianceshould not be placed on such statements.

 

20

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**REPORT OF MANAGEMENT TO SHAREHOLDERS**

 

Management of Pacific NorthwestBancorp is responsible for the preparation, integrity and fair presentation ofits published financial statements.  Theconsolidated financial statements have been prepared in accordance with accountingprinciples generally accepted in the United States and include judgments andestimates of management.  PacificNorthwest Bancorp’s management also prepared the other information included inthis report and is responsible for its accuracy and consistency with theconsolidated financial statements.

 

Management is responsible forestablishing and maintaining an effective internal control structure overfinancial reporting.  The internalcontrol system is supported by written policies and procedures and by auditsperformed by an internal audit staff that reports to the Audit Committee of theBoard of Directors.  Internal auditorsmonitor the operation of the internal control system and report findings tomanagement and the Audit Committee, and corrective actions are taken to addressidentified control deficiencies and other opportunities for improving thesystem.  The Audit Committee providesoversight to the financial reporting process. There are inherent limitations in the effectiveness of any system ofinternal control, including the possibility of human error and circumvention oroverriding of controls.  Accordingly,even an effective internal control system can provide only reasonable assurancewith respect to financial statement preparation.  The concept of reasonable assurance is based on the recognitionthat the costs of such a system should not exceed the benefits to bereceived.  Management believes thesystem provides an appropriate cost/benefit balance.

 

Management assesses PacificNorthwest Bancorp’s internal control structure over financial reporting.  Based on these assessments, managementbelieves that Pacific Northwest Bancorp maintains an effective internal controlsystem over financial reporting.

 
| Patrick M.  Fahey                      |   | Bette J.  Floray              |
|----------------------------------------|--------|-------------------------------|
| President  and Chief Executive Officer |   | Executive  Vice President and |   |
|                                   |   | Chief  Financial Officer      |

 

**REPORTOFERNST&YOUNGLLP,INDEPENDENTAUDITORS**

 

To the Board of Directors andShareholders

Pacific Northwest Bancorp

 

We have audited theaccompanying consolidated statements of financial condition of PacificNorthwest Bancorp and subsidiaries as of December 31, 2001 and 2000, and therelated consolidated statements of income, shareholders’ equity, and cash flowsfor the years then ended, the three-month period ended December 31, 1999 andthe year ended September 30, 1999. These consolidated financial statements are the responsibility ofPacific Northwest Bancorp’s management. Our responsibility is to express an opinion on these consolidatedfinancial statements based on our audits.

 

We conducted our audits inaccordance with auditing standards generally accepted in the UnitedStates.  Those standards require that weplan and perform the audit to obtain reasonable assurance about whether the financialstatements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting theamounts and disclosures in the financial statements.  An audit also includes assessing the accounting principles usedand significant estimates made by management, as well as evaluating the overallfinancial statement presentation.  Webelieve that our audits provide a reasonable basis for our opinion.

 

In our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the consolidated financial position of Pacific NorthwestBancorp and subsidiaries at December 31, 2001 and 2000, and the consolidatedresults of their operations and their cash flows for the years then ended, thethree-month period ended December 31, 1999, and the year ended September 30,1999, in conformity with accounting principles generally accepted in the UnitedStates.

 

As described in note 2 to theconsolidated financial statements, Pacific Northwest Bancorp adopted certainnew accounting standards in fiscal 2001 as required by the Financial AccountingStandards Board.

 
| Seattle,  Washington |   |                     |
|----------------------|--------|--------------------------|
| January 25,  2002    |   | *Ernst & Young  LLP* |

 

21

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**CONSOLIDATED STATEMENTS OF FINANCIALCONDITION**

 
|                                                                                 |   | **As of December 31,**   |       |
|--------------------------------------------------------------------------------------|--------|--------------------------|------------|
|                                                                                 |   | **2001**                 |       | **2000** |   |
|                                                                                 |   | **Dollars in thousands** |       |
| *Assets*                                                                             |   |                     | ** ** |   | ** ** |
| Cash and due from banks                                                              |   |                     |       |   |   |
| Non-interest-bearing                                                                 |   | $                        | 58,134     |   | $ | 71,599 |   |
| Interest-bearing                                                                     |   |                     | 491        |   |   | 8,295 |   |
| Federal funds sold and securities purchased  under agreements to resell              |   | —                   |       | 7,467 |   |
| Securities available for sale, at estimated  fair value                              |   | 757,018                  |       | 840,489 |   |
| Securities held to maturity, at cost  (estimated fair value: 2000-$63,823)           |   | —                   |       | 64,741 |   |
| Loans receivable                                                                     |   | 1,808,555                |       | 1,775,075 |   |
| Allowance for losses on loans                                                        |   | (20,123                  | )          | (17,561 | ) |
|                                                                                 |   |                     |       |   |   |
| Net loans receivable                                                                 |   | 1,788,432                |       | 1,757,514 |   |
|                                                                                 |   |                     |       |   |   |
| Loans held for sale (estimated fair value:  2001-$43,872 and 2000-$14,385)           |   | 43,757                   |       | 14,187 |   |
| Interest receivable                                                                  |   | 14,808                   |       | 19,762 |   |
| Other real estate                                                                    |   | 5,762                    |       | 9,909 |   |
| Premises and equipment                                                               |   | 50,837                   |       | 58,466 |   |
| Goodwill and other intangible assets                                                 |   | 18,122                   |       | 20,701 |   |
| Other assets                                                                         |   | 4,147                    |       | 9,740 |   |
|                                                                                 |   |                     |       |   |   |
| Total assets                                                                         |   | $                        | 2,741,508  |   | $ | 2,882,870 |   |
|                                                                                 |   |                     |       |   |   |
| *Liabilities*                                                                        |   |                     |       |   |   |
|                                                                                 |   |                     |       |   |   |
| Deposits                                                                             |   |                     |       |   |   |
| Non-interest-bearing                                                                 |   | $                        | 241,674    |   | $ | 244,100 |   |
| Interest-bearing                                                                     |   | 1,363,181                |       | 1,473,008 |   |
|                                                                                 |   |                     |       |   |   |
| Total deposits                                                                       |   | 1,604,855                |       | 1,717,108 |   |
|                                                                                 |   |                     |       |   |   |
| Federal Home Loan Bank (FHLB) advances                                               |   | 714,526                  |       | 643,200 |   |
| Securities sold under agreements to  repurchase                                      |   | 149,504                  |       | 274,920 |   |
| Guaranteed preferred beneficial interests  in subordinated debt                      |   | 37,500                   |       | 40,000 |   |
| Other borrowings                                                                     |   | 12,621                   |       | 1,753 |   |
| Other liabilities                                                                    |   | 22,016                   |       | 27,153 |   |
|                                                                                 |   |                     |       |   |   |
| Total liabilities                                                                    |   | 2,541,022                |       | 2,704,134 |   |
|                                                                                 |   |                     |       |   |   |
| *Shareholders’ Equity*                                                          |   |                     |       |   |   |
|                                                                                 |   |                     |       |   |   |
| Common stock, no par value                                                           |   |                     |       |   |   |
| Authorized shares 30,000,000                                                         |   |                     |       |   |   |
| Issued and outstanding: 2001—15,595,204  shares and 2000—15,494,357 shares |   | —                   |       | — |   |
| Paid-in capital                                                                      |   | 26,757                   |       | 26,291 |   |
| Retained earnings                                                                    |   | 172,967                  |       | 159,613 |   |
| Debt related to employee stock ownership  plan (ESOP)                                |   | (543                     | )          | (1,668 | ) |
| Accumulated other comprehensive gain  (loss):                                        |   |                     |       |   |   |
| Unrealized gain (loss) on securities  available for sale, net of tax                 |   | 1,305                    |       | (5,500 | ) |
| Total shareholders’ equity                                                      |   | 200,486                  |       | 178,736 |   |
|                                                                                 |   |                     |       |   |   |
| Total liabilities and shareholders’ equity                                      |   | $                        | 2,741,508  |   | $ | 2,882,870 |   |

* *

*See Notes to Consolidated FinancialStatements*

 

22

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**CONSOLIDATED STATEMENTS OF INCOME**

 
|                                                            |   | **Year ended  December 31,  2001**                  |    | **Year endedDecember 31,  2000** |   | **Three months  December 31,1999** |   | **Year endedSeptember 30,  1999** |   |
|-----------------------------------------------------------------|--------|-----------------------------------------------------|---------|----------------------------------|--------|------------------------------------|--------|-----------------------------------|--------|
|                                                            |   | **Dollars in thousands, except per  share amounts** |    |
| *Interest Income*                                               |   |                                                |    |                             |   |                               |   |                              |   |
| Loans receivable and loans held for sale                        |   | $                                                   | 153,936 |                             | $      | 159,870                            |   | $                                 | 36,297 |   | $ | 126,482 |   |
| Securities available for sale                                   |   | 51,116                                              |    | 52,402                           |   | 12,264                             |   | 45,403                            |   |
| Securities held to maturity                                     |   | —                                              |    | 4,345                            |   | 1,096                              |   | 4,995                             |   |
| Other                                                           |   | 601                                                 |    | 1,571                            |   | 724                                |   | 2,779                             |   |
|                                                            |   | 205,653                                             |    | 218,188                          |   | 50,381                             |   | 179,659                           |   |
| *Interest Expense*                                              |   |                                                |    |                             |   |                               |   |                              |   |
|                                                            |   |                                                |    |                             |   |                               |   |                              |   |
| Deposits                                                        |   | 58,475                                              |    | 63,805                           |   | 14,791                             |   | 55,416                            |   |
| FHLB advances and other borrowings                              |   | 30,972                                              |    | 43,113                           |   | 9,553                              |   | 32,467                            |   |
| Securities sold under agreements to  repurchase                 |   | 10,498                                              |    | 17,787                           |   | 2,445                              |   | 7,597                             |   |
| Guaranteed preferred beneficial interests  in subordinated debt |   | 3,896                                               |    | 3,950                            |   | 494                                |   | —                            |   |
|                                                            |   |                                                |    |                             |   |                               |   |                              |   |
|                                                            |   | 103,841                                             |    | 128,655                          |   | 27,283                             |   | 95,480                            |   |
|                                                            |   |                                                |    |                             |   |                               |   |                              |   |
| Net interest income                                             |   | 101,812                                             |    | 89,533                           |   | 23,098                             |   | 84,179                            |   |
| Provision for losses on loans                                   |   | 6,050                                               |    | 4,750                            |   | 550                                |   | 2,000                             |   |
|                                                            |   |                                                |    |                             |   |                               |   |                              |   |
| Net interest income after provision for  losses on loans        |   | 95,762                                              |    | 84,783                           |   | 22,548                             |   | 82,179                            |   |
|                                                            |   |                                                |    |                             |   |                               |   |                              |   |
| *Non-Interest Income*                                           |   |                                                |    |                             |   |                               |   |                              |   |
|                                                            |   |                                                |    |                             |   |                               |   |                              |   |
| Service fees                                                    |   | 11,669                                              |    | 11,871                           |   | 2,744                              |   | 11,575                            |   |
| Gain on sale of loans                                           |   | 2,312                                               |    | 905                              |   | 71                                 |   | 8,095                             |   |
| Investment product fees and insurance  commissions              |   | 2,294                                               |    | 2,869                            |   | 634                                |   | 3,125                             |   |
| Gain (loss) on sale of securities available  for sale           |   | 1,709                                               |    | (6,113                           | )      | —                             |   | 72                                |   |
| Gain on sale of loan servicing rights                           |   | —                                              |    | —                           |   | —                             |   | 2,798                             |   |
| Other                                                           |   | 2,701                                               |    | 2,581                            |   | 748                                |   | 2,382                             |   |
|                                                            |   | 20,685                                              |    | 12,113                           |   | 4,197                              |   | 28,047                            |   |
| *Non-Interest Expense*                                          |   |                                                |    |                             |   |                               |   |                              |   |
|                                                            |   |                                                |    |                             |   |                               |   |                              |   |
| Compensation and employee benefits                              |   | 39,018                                              |    | 39,398                           |   | 9,799                              |   | 37,486                            |   |
| General and administrative                                      |   | 20,716                                              |    | 15,679                           |   | 4,064                              |   | 14,882                            |   |
| Occupancy and equipment                                         |   | 12,217                                              |    | 10,626                           |   | 2,516                              |   | 9,595                             |   |
| Data processing                                                 |   | 6,208                                               |    | 5,510                            |   | 1,258                              |   | 4,599                             |   |
| Other real estate owned                                         |   | 207                                                 |    | 2,327                            |   | (30                                | )      | 526                               |   |
| Amortization of goodwill and core deposit  intangible           |   | 1,296                                               |    | 1,290                            |   | 323                                |   | 698                               |   |
| Conversion and integration                                      |   | 1,290                                               |    | 7,361                            |   | —                             |   | —                            |   |
| Severance and employment agreements                             |   | 200                                                 |    | 3,325                            |   | 420                                |   | —                            |   |
| Impairment of goodwill                                          |   | —                                              |    | 749                              |   | —                             |   | —                            |   |
|                                                            |   |                                                |    |                             |   |                               |   |                              |   |
|                                                            |   | 81,152                                              |    | 86,265                           |   | 18,350                             |   | 67,786                            |   |
|                                                            |   |                                                |    |                             |   |                               |   |                              |   |
| Income before income taxes                                      |   | 35,295                                              |    | 10,631                           |   | 8,395                              |   | 42,440                            |   |
| Income tax expense                                              |   | 13,203                                              |    | 4,362                            |   | 2,933                              |   | 14,585                            |   |
| Net income                                                      |   | $                                                   | 22,092  |                             | $      | 6,269                              |   | $                                 | 5,462  |   | $ | 27,855 |   |
| Basic net income per share                                      |   | $                                                   | 1.42    |                             | $      | 0.40                               |   | $                                 | 0.34   |   | $ | 1.78 |   |
| Diluted net income per share                                    |   | $                                                   | 1.40    |                             | $      | 0.40                               |   | $                                 | 0.34   |   | $ | 1.74 |   |

 

*See Notes to Consolidated FinancialStatements*

 

23

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**CONSOLIDATED STATEMENTS OF SHAREHOLDERS’EQUITY**
|                                                                                   |   | **Common  Stock,  No Par Value   Shares**                  |   | **Paid-In  Capital** |   | **Retained  Earnings** |   | **Debt   Related   to ESOP** |   | **Accumulated    Other   Comprehensive  Income (Loss)** |   | **Total** |   |
|----------------------------------------------------------------------------------------|--------|------------------------------------------------------------|--------|----------------------|--------|------------------------|--------|------------------------------|--------|---------------------------------------------------------|--------|-----------|--------|
|                                                                                   |   |                                                       |   |                 |   |                   |
|                                                                                   |   | **Dollarsinthousands,    exceptshare data** |   |
| **October 1, 1998**                                                                    |   | 15,651,345                                                 |   | 36,512               |   | 139,781                |   | (3,935                       | )      | (706                                                    | )      | 171,652   |   |
| Dividends declared, $0.56 per share                                                    |   |                                                       |   |                 |   | (8,808                 | )      |                         |   |                                                    |   | (8,808    | )      |
| Issuance of common stock:                                                              |   |                                                       |   |                 |   |                   |   |                         |   |                                                    |   |      |   |
| Stock option plans                                                                     |   | 285,900                                                    |   | 1,525                |   |                   |   |                         |   |                                                    |   | 1,525     |   |
| Purchase and retirement of common stock                                                |   | (521,500                                                   | )      | (11,910              | )      |                   |   |                         |   |                                                    |   | (11,910   | )      |
| ESOP debt repayment                                                                    |   | 18,945                                                     |   |                 |   |                   |   | 327                          |   |                                                    |   | 327       |   |
| Comprehensive income:                                                                  |   |                                                       |   |                 |   |                   |   |                         |   |                                                    |   |      |   |
| Net income                                                                             |   |                                                       |   |                 |   | 27,855                 |   |                         |   |                                                    |   | 27,855    |   |
| Other comprehensive loss -                                                             |   |                                                       |   |                 |   |                   |   |                         |   |                                                    |   |      |   |
| Unrealized loss on securities available for  sale, net of taxes of $8,232              |   |                                                       |   |                 |   |                   |   |                         |   | (15,288                                                 | )      | (15,288   | )      |
| Reclassification adjustment for gains  included in net income, net of taxes of $25     |   |                                                       |   |                 |   |                   |   |                         |   | (47                                                     | )      | (47       | )      |
| Total comprehensive income                                                             |   |                                                       |   |                 |   |                   |   |                         |   |                                                    |   | 12,520    |   |
|                                                                                   |   |                                                       |   |                 |   |                   |   |                         |   |                                                    |   |      |   |
| **September 30, 1999**                                                                 |   | 15,434,690                                                 |   | 26,127               |   | 158,828                |   | (3,608                       | )      | (16,041                                                 | )      | 165,306   |   |
| Dividends declared, $0.14 per share                                                    |   |                                                       |   |                 |   | (2,247                 | )      |                         |   |                                                    |   | (2,247    | )      |
| Issuance of common stock:                                                              |   |                                                       |   |                 |   |                   |   |                         |   |                                                    |   |      |   |
| Stock option plans                                                                     |   | 55,600                                                     |   | 328                  |   |                   |   |                         |   |                                                    |   | 328       |   |
| Acquisitions                                                                           |   | 677,109                                                    |   | 14,463               |   |                   |   |                         |   |                                                    |   | 14,463    |   |
| Purchase and retirement of common stock                                                |   | (392,500                                                   | )      | (7,621               | )      |                   |   |                         |   |                                                    |   | (7,621    | )      |
| ESOP debt repayment                                                                    |   | 25,478                                                     |   |                 |   |                   |   | 628                          |   |                                                    |   | 628       |   |
| Comprehensive income:                                                                  |   |                                                       |   |                 |   |                   |   |                         |   |                                                    |   |      |   |
| Net income                                                                             |   |                                                       |   |                 |   | 5,462                  |   |                         |   |                                                    |   | 5,462     |   |
| Other comprehensive loss -                                                             |   |                                                       |   |                 |   |                   |   |                         |   |                                                    |   |      |   |
| Unrealized loss on securities available for  sale, net of taxes of $2,476              |   |                                                       |   |                 |   |                   |   |                         |   | (4,599                                                  | )      | (4,599    | )      |
| Total comprehensive income                                                             |   |                                                       |   |                 |   |                   |   |                         |   |                                                    |   | 863       |   |
|                                                                                   |   |                                                       |   |                 |   |                   |   |                         |   |                                                    |   |      |   |
| **December 31, 1999**                                                                  |   | 15,800,377                                                 |   | $                    | 33,297 |                   | $      | 162,043                      |   | $                                                       | (2,980 | )         | $      | (20,640 | ) | $ | 171,720 |   |
| Dividends declared, $0.56 per share                                                    |   |                                                       |   |                 |   | (8,699                 | )      |                         |   |                                                    |   | (8,699    | )      |
| Issuance of common stock:                                                              |   |                                                       |   |                 |   |                   |   |                         |   |                                                    |   |      |   |
| Stock option plans                                                                     |   | 111,964                                                    |   | 779                  |   |                   |   |                         |   |                                                    |   | 779       |   |
| Stock grants                                                                           |   | 2,455                                                      |   | 75                   |   |                   |   |                         |   |                                                    |   | 75        |   |
| Purchase and retirement of common stock                                                |   | (468,000                                                   | )      | (7,860               | )      |                   |   |                         |   |                                                    |   | (7,860    | )      |
| ESOP debt repayment                                                                    |   | 47,561                                                     |   |                 |   |                   |   | 1,312                        |   |                                                    |   | 1,312     |   |
| Comprehensive income:                                                                  |   |                                                       |   |                 |   |                   |   |                         |   |                                                    |   |      |   |
| Net income                                                                             |   |                                                       |   |                 |   | 6,269                  |   |                         |   |                                                    |   | 6,269     |   |
| Other comprehensive income -                                                           |   |                                                       |   |                 |   |                   |   |                         |   |                                                    |   |      |   |
| Unrealized gain on securities available for  sale, net of taxes of $6,013              |   |                                                       |   |                 |   |                   |   |                         |   | 11,167                                                  |   | 11,167    |   |
| Reclassification adjustment for losses  included in net income, net of taxes of $2,140 |   |                                                       |   |                 |   |                   |   |                         |   | 3,973                                                   |   | 3,973     |   |
| Total comprehensive income                                                             |   |                                                       |   |                 |   |                   |   |                         |   |                                                    |   | 21,409    |   |
| **December 31, 2000**                                                                  |   | 15,494,357                                                 |   | $                    | 26,291 |                   | $      | 159,613                      |   | $                                                       | (1,668 | )         | $      | (5,500 | ) | $ | 178,736 |   |

 

24

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|                                                                                                                                              |   | **Common  Stock,  No Par Value   Shares**                  |       | **Paid-In  Capital** |       | **Retained  Earnings** |   | **Debt   Related   to ESOP** |       | **Accumulated    Other   Comprehensive  Income (Loss)** |     | **Total** |   |
|---------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------------------------------------------|------------|----------------------|------------|------------------------|--------|------------------------------|------------|---------------------------------------------------------|----------|-----------|--------|
|                                                                                                                                              |   |                                                       |       |                 |       |                   |
|                                                                                                                                              |   | **Dollarsinthousands,    exceptshare data** |       |
| **January 1, 2001**                                                                                                                               |   | 15,494,357                                                 |       | $                    | 26,291     |                   | $      | 159,613                      |       | $                                                       | (1,668   | )         | $      | (5,500 | ) | $ | 178,736 |   |
|                                                                                                                                              |   |                                                       |       |                 |       |                   |   |                         |       |                                                    |     |      |   |
| Dividends declared, 0.56 per  share                                                                                                               |   |                                                       |       |                 |       | (8,738                 | )      |                         |       |                                                    |     | (8,738    | )      |
| Issuance of common stock:                                                                                                                         |   |                                                       |       |                 |       |                   |   |                         |       |                                                    |     |      |   |
| Stock option plans                                                                                                                                |   | 77,597                                                     |       | 808                  |       |                   |   |                         |       |                                                    |     | 808       |   |
| Purchase and retirement of  common stock                                                                                                          |   | (15,921                                                    | )          | (342                 | )          |                   |   |                         |       |                                                    |     | (342      | )      |
| ESOP debt repayment                                                                                                                               |   | 39,171                                                     |       |                 |       |                   |   | 1,125                        |       |                                                    |     | 1,125     |   |
| Comprehensive income:                                                                                                                             |   |                                                       |       |                 |       |                   |   |                         |       |                                                    |     |      |   |
| Net income                                                                                                                                        |   |                                                       |       |                 |       | 22,092                 |   |                         |       |                                                    |     | 22,092    |   |
| Other comprehensive income  (loss) -                                                                                                              |   |                                                       |       |                 |       |                   |   |                         |       |                                                    |     |      |   |
| Cumulative effect of adoption  of SFAS No. 133, Transfer of securities held to maturity to securities  available for sale, net of taxes of $(321) |   |                                                       |       |                 |       |                   |   |                         |       | (597                                                    | )        | (597      | )      |
| Unrealized gain on securities  available for sale, net of taxes of $4,584                                                                         |   |                                                       |       |                 |       |                   |   |                         |       | 8,513                                                   |     | 8,513     |   |
| Reclassification adjustment for  losses included in net income, net of taxes of $(598)                                                            |   |                                                       |       |                 |       |                   |   |                         |       | (1,111                                                  | )        | (1,111    | )      |
| Total comprehensive income                                                                                                                        |   |                                                       |       |                 |       |                   |   |                         |       |                                                    |     | 28,895    |   |
| **December 31, 2001**                                                                                                                             |   | **15,595,204**                                             | ** ** | **$**                | **26,757** | ** **             | **$**  | **172,967**                  | ** ** | **$**                                                   | **(543** | **)**     | **$**  | **1,305** | ** ** | **$** | 200,486 | ** ** |

 

*See Notes to Consolidated FinancialStatements*

 

25

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**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

 
|   |   | **Year ended  December 31,  2001** |   | **Year ended  December 31,  2000** |   | **Three months  December 31,  1999** |   | **Year ended****September 30,  1999** |   |
|--------|--------|------------------------------------|--------|------------------------------------|--------|--------------------------------------|--------|---------------------------------------|--------|
|   |   | **Dollars in thousands**           |   |

 
| *Operating  Activities*                                                                            |   |     |    |     |   |     |   |     |     |
|----------------------------------------------------------------------------------------------------|--------|----------|---------|----------|--------|----------|--------|----------|----------|
|                                                                                               |   |     |    |     |   |     |   |     |     |
| Net income                                                                                         |   | $        | 22,092  |     | $      | 6,269    |   | $        | 5,462    |   | $ | 27,855 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities:                 |   |     |    |     |   |     |   |     |     |
| Depreciation                                                                                       |   | 6,157    |    | 5,544    |   | 1,149    |   | 4,832    |     |
| Amortization of intangible assets                                                                  |   | 2,580    |    | 2,042    |   | 495      |   | 1,539    |     |
| Impairment of goodwill                                                                             |   | —   |    | 749      |   | —   |   | —   |     |
| Provision for losses on loans                                                                      |   | 6,050    |    | 4,750    |   | 550      |   | 2,000    |     |
| (Gain) on sale of other real estate                                                                |   | (607     | )       | (177     | )      | (93      | )      | (361     | )        |
| Loss from real estate write-downs                                                                  |   | 592      |    | 2,168    |   | 10       |   | 663      |     |
| Amortization (accretion) of premiums and  discounts, net                                           |   | (180     | )       | (76      | )      | 270      |   | 908      |     |
| Gain on sale of loans                                                                              |   | (2,312   | )       | (905     | )      | (71      | )      | (8,095   | )        |
| Gain on sale of loan servicing rights                                                              |   | —   |    | —   |   | —   |   | (2,798   | )        |
| (Gain) loss on sale of securities available  for sale                                              |   | (1,709   | )       | 6,113    |   | —   |   | (72      | )        |
| Loss on disposal of premises and equipment                                                         |   | 239      |    | —   |   | —   |   | —   |     |
| Loan fees deferred, net of amortization                                                            |   | 2,121    |    | 630      |   | 730      |   | 3,742    |     |
| FHLB stock dividends                                                                               |   | (3,126   | )       | (2,846   | )      | (777     | )      | (3,177   | )        |
| Changes in operating assets and liabilities:                                                       |   |     |    |     |   |     |   |     |     |
| (Increase) decrease in interest receivable                                                         |   | 4,879    |    | (2,981   | )      | (565     | )      | (971     | )        |
| (Increase) decrease in other assets                                                                |   | 5,582    |    | (5,059   | )      | 383      |   | (106     | )        |
| Increase (decrease) in other liabilities                                                           |   | (8,719   | )       | 10,940   |   | (1,516   | )      | (7,923   | )        |
| Net cash provided by operating activities                                                          |   | $        | 33,638  |     | $      | 27,161   |   | $        | 6,027    |   | $ | 18,036 |   |
|                                                                                               |   |     |    |     |   |     |   |     |     |
| *Investing  Activities*                                                                            |   |     |    |     |   |     |   |     |     |
|                                                                                               |   |     |    |     |   |     |   |     |     |
| Proceeds from sale of securities available  for sale                                               |   | 151,402  |    | 156,540  |   | —   |   | 258,509  |     |
| Purchases of securities available for sale                                                         |   | (373,172 | )       | (156,891 | )      | (14,380  | )      | (923,893 | )        |
| Proceeds from maturing and principal  repayments on securities available for sale                  |   | 385,443  |    | 87,320   |   | 20,290   |   | 552,145  |     |
| Proceeds from maturing and principal  repayments on securities held to maturity                    |   | —   |    | 4,094    |   | 1,780    |   | 16,340   |     |
| Proceeds from sale of loans                                                                        |   | 143,289  |    | 160,524  |   | 2,316    |   | 419,079  |     |
| Net increase in loans receivable                                                                   |   | (212,839 | )       | (371,793 | )      | (134,868 | )      | (592,534 | )        |
| Proceeds from sale of other real estate                                                            |   | 9,653    |    | 7,654    |   | 1,190    |   | 8,954    |     |
| Purchases of premises and equipment                                                                |   | (4,889   | )       | (10,452  | )      | (748     | )      | (9,171   | )        |
| Proceeds from sale of premises and  equipment                                                      |   | 5,200    |    | —   |   | —   |   | —   |     |
| Purchases of FHLB stock                                                                            |   | —   |    | (770     | )      | —   |   | (1,863   | )        |
| Redemption of FHLB stock                                                                           |   | —   |    | 5,000    |   | —   |   | —   |     |
| Proceeds from sale of loan servicing rights                                                        |   | —   |    | —   |   | —   |   | 5,622    |     |
| Cash paid for acquisitions, net of cash  received                                                  |   | —   |    | —   |   | 9,735    |   | (589     | )        |
| Improvements capitalized to other real  estate                                                     |   | (1,367   | )       | (2,081   | )      | (168     | )      | (1,570   | )        |
| Net decrease (increase) in federal funds  sold and securities purchased under agreements to resell |   | 7,467    |    | (7,467   | )      | —   |   | 19,863   |     |
|                                                                                               |   |     |    |     |   |     |   |     |     |
| Net cash provided by (used in) investing  activities                                               |   | $        | 110,187 |     | $      | (128,322 | )      | $        | (114,853 | ) | $ | (249,108 | ) |

 

 

26

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|                                                                                               |   | **Year ended  December 31,  2001** |    | **Year ended  December 31,  2000** |   | **Three months  December 31,  1999** |   | **Year ended****September 30,  1999** |    |
|----------------------------------------------------------------------------------------------------|--------|------------------------------------|---------|------------------------------------|--------|--------------------------------------|--------|---------------------------------------|---------|
|                                                                                               |   | **Dollars in thousands**           |    |
| *Financing  Activities*                                                                            |   |                               |    |                               |   |                                 |   |                                  |    |
| Net increase in deposits                                                                           |   | $                                  | 50,626  |                               | $      | 29,825                               |   | $                                     | 1,494   |   | $ | 28,376 |   |
| Net increase (decrease) in certificates of  deposit                                                |   | (162,878                           | )       | 89,093                             |   | (30,205                              | )      | (14,252                               | )       |
| Proceeds from FHLB advances, securities  sold under agreements to repurchase, and other borrowings |   | 3,803,363                          |    | 1,753,541                          |   | 559,087                              |   | 960,231                               |    |
| Repayment of FHLB advances, securities sold  under agreements to repurchase, and other borrowings  |   | (3,857,459                         | )       | (1,789,615                         | )      | (419,111                             | )      | (824,383                              | )       |
| Proceeds from issuance of notes payable                                                            |   | 12,000                             |    | —                             |   | —                               |   | —                                |    |
| Proceeds from issuance of guaranteed  preferred beneficial interests in subordinated debt          |   | —                             |    | —                             |   | 40,000                               |   | —                                |    |
| Purchase of  InterWest Capital Trust I — capital securities                              |   | (2,500                             | )       | —                             |   | —                               |   | —                                |    |
| Dividends paid to shareholders                                                                     |   | (8,712                             | )       | (8,770                             | )      | (2,178                               | )      | (8,843                                | )       |
| Issuance of common stock from exercise of  stock options                                           |   | 808                                |    | 779                                |   | 328                                  |   | 1,525                                 |    |
| Purchase and retirement of common stock                                                            |   | (342                               | )       | (7,860                             | )      | (7,621                               | )      | (11,910                               | )       |
|                                                                                               |   |                               |    |                               |   |                                 |   |                                  |    |
| Net cash provided by (used in) financing  activities                                               |   | (165,094                           | )       | 66,993                             |   | 141,794                              |   | 130,744                               |    |
| Net increase (decrease) in cash and cash  equivalents                                              |   | (21,269                            | )       | (34,168                            | )      | (32,968                              | )      | (100,328                              | )       |
|                                                                                               |   |                               |    |                               |   |                                 |   |                                  |    |
| Cash and due from banks:                                                                           |   |                               |    |                               |   |                                 |   |                                  |    |
| Beginning of period                                                                                |   | 79,894                             |    | 114,062                            |   | 81,094                               |   | 181,422                               |    |
| End of period                                                                                      |   | $                                  | 58,625  |                               | $      | 79,894                               |   | $                                     | 114,062 |   | $ | 81,094 |   |
|                                                                                               |   |                               |    |                               |   |                                 |   |                                  |    |
| *Supplemental Disclosures  of Cash Flow Information*                                               |   |                               |    |                               |   |                                 |   |                                  |    |
| Cash paid during the period for:                                                                   |   |                               |    |                               |   |                                 |   |                                  |    |
| Interest                                                                                           |   | $                                  | 108,594 |                               | $      | 122,465                              |   | $                                     | 26,321  |   | $ | 96,977 |   |
| Income taxes                                                                                       |   | 10,800                             |    | 9,630                              |   | —                               |   | 16,493                                |    |
| Non-cash investing and financing  activities:                                                      |   |                               |    |                               |   |                                 |   |                                  |    |
| Loans receivable transferred to other real  estate                                                 |   | 3,202                              |    | 8,214                              |   | 1,355                                |   | 3,419                                 |    |
| Premises and equipment transferred to other  real estate                                           |   | 923                                |    | 279                                |   | —                               |   | 532                                   |    |
| Loans receivable securitized as securities  available for sale                                     |   | —                             |    | 120,169                            |   | 57,018                               |   | 37,100                                |    |
| Transfer of securities from held to  maturity to available for sale                                |   | 64,741                             |    | —                             |   | —                               |   | —                                |    |
| ESOP debt repayment                                                                                |   | 1,125                              |    | 1,312                              |   | 628                                  |   | 327                                   |    |

 

*See Notes to Consolidated FinancialStatements*

 

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

 

**NOTE 1**SUMMARY OFSIGNIFICANT ACCOUNTING POLICIES

 

*BASISOFPRESENTATION* | The consolidated financial statementsinclude the accounts of Pacific Northwest Bancorp (Bancorp) and its whollyowned subsidiaries (collectively, PNWB). As of December 31, 2001, Bancorp’s wholly owned subsidiaries werePacific Northwest Bank and InterWest Capital Trust I.   All material intercompany transactions and balances have beeneliminated.

 

On June 20, 2000 the Board ofDirectors approved a change of PNWB’s fiscal year end from September 30 toDecember 31, retroactively to January 1, 2000. Effective September 1, 2000, InterWest Bancorp, Inc. changed its name toPacific Northwest Bancorp.  Inconjunction with this change, the company’s commercial bank subsidiary,InterWest Bank, changed its name to Pacific Northwest Bank.

 

*NATUREOFBUSINESS*| PacificNorthwest Bancorpisa bank holding company incorporated in Washington state.  Through its commercial banksubsidiary, Pacific Northwest Bank, a widerangeoffinancialservices are offeredtoindividuals and businesses throughout western and central Washington state.Financial services of PNWB include the banking activities of accepting depositsfrom businesses and individuals and originating commercial and commercial realestate loans, residential loans, consumer loans, and agricultural loans.

 

Investment products areavailable through Pacific Northwest Financial Services, Inc. and insuranceproducts are available through Pacific Northwest Insurance Agency, Inc., bothsubsidiaries of Pacific Northwest Bank.

 

*USE OF ESTIMATES* |Thepreparationofthe consolidated financialstatementsinconformitywithaccountingprinciples generally accepted in theUnited Statesrequiresmanagementtomakeestimatesandassumptionsthataffect amountsreportedinthe consolidated financialstatements.  Changesintheseestimatesandassumptionsareconsideredreasonablypossibleandmayhaveamaterialimpactonthe consolidated financialstatementsandthusactualresultscoulddifferfromtheamountsreportedanddisclosedherein.

 

*SECURITIES AVAILABLE FOR SALE AND SECURITIESHELD TO MATURITY*| Securities held to maturity are carriedat amortized cost, and are adjusted to the lower of cost or estimated fairvalue only when an other than temporary impairment in value occurs.  Effective January 1, 2001, PNWB adopted SFASNo. 133 “Accounting for Derivative Instruments and Hedging Activities” and as aresult, PNWB transferred all securities held to maturity to securitiesavailable for sale.

 

Those securities not classified as held tomaturity are classified as available for sale, and are carried at estimatedfair value. The estimated fair value of securities available for sale is basedon quoted market rates and dealer quotes. Unrealized gains and losses on securities available for sale areexcluded from net income and are reported, net of tax, as accumulated othercomprehensive income or loss, a component of shareholders’ equity.  The cost of securities sold is determined bythe specific identification method.

 

The carrying value ofsecurities held to maturity and securities available for sale is adjusted forunaccreted discounts and unamortized premiums over the estimated average lifeof the security, or in the case of callable securities, through the first calldate using the effective yield method. Such accretion and amortization is included as interest income onsecurities.

 

*LOANSRECEIVABLE *| Loans receivable are stated at theprincipal amount outstanding, net of deferred loan fees and discounts.  Commercial loans are generally secured byliens on real estate, capital assets, accounts receivable and inventory,although certain loans are unsecured. Real estate mortgage loans are generally secured by first liens on single-familyresidences, land, developed lots or commercial property. Agricultural loans aregenerally secured by farmland, crops and/or equipment.  Consumer loans consist of automobile loans,home equity loans, credit card loans and loans for other consumerpurposes.  Consumer loans include bothsecured and unsecured personal lines of credit.

 

*LOANSHELDFORSALE*| Loans held for sale are carried at thelower of cost or estimated fair value in aggregate. Net unrealized losses arerecognized in a valuation allowance by charges to income.  Management determines the appropriateclassification of loans held for sale at the time of origination.

 

*LOANFEEINCOME,INTERESTINCOMEONLOANSRECEIVABLEANDUNEARNEDINTEREST*| Loanorigination fees and direct costs related to loan origination activities aredeferred and amortized into interest income over contractual or actual loanlives as an adjustment to the loan yield. Deferred fees and costs related to loans sold are recognized into incomeat the time the loans are sold. Interest is accrued on loans receivable until the loan is 90 daysdelinquent or 120 days delinquent if the loan is a single family mortgage loan,or management doubts the collectibility of the loan or the unpaid

 

28

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interest, at which time PNWB establishes a reserve for any accruedinterest. If management determines the ultimate collectibility of principal isin doubt, all cash receipts on non-accrual loans are applied to reduce theprincipal balance.

* *

*ALLOWANCEFORLOSSESONLOANS*| The allowance for losses on loans ismaintained at an amount to sufficiently provide for estimated losses based onevaluating known and inherent risks in the loan portfolio.   Management analyzes the factors underlyingthe quality of the loan portfolio. These factors include changes in the sizeand composition of the loan portfolio, delinquency levels, actual loan lossexperience, current economic conditions, and detailed analysis of individualloans for which full collectibility may not be assured. The appropriateness ofthe allowance for losses on loans is estimated based upon these factors andtrends identified by management at the time financial statements are preparedin accordance with accounting principles generally accepted in the UnitedStates.   However, these factors andtrends may change in the future, which may result in a material impact on theconsolidated financial statements.

 

When available informationconfirms that specific loans or portions thereof are uncollectible, identifiedamounts are charged off against the allowance for losses on loans. Theexistence of some or all of the following criteria will generally confirm thata loss has been incurred: the loan is significantly delinquent and the borrowerhas not evidenced the ability or intent to bring the loan current; PNWB has norecourse to the borrower, or if it does, the borrower has insufficient assetsto pay the debt; the estimated fair value of the loan collateral issignificantly below the current loan balance, and there is little or nonear-term prospect for improvement.

 

All loans are periodicallyevaluated for impairment, except large groups ofhomogenousloansthatarecollectivelyevaluatedforimpairment,andloansthataremeasuredat estimated fair value or at the lower of cost or estimated fair value.PNWB considers all single-family residential and consumer loans to behomogenous loans.  A loan is consideredimpaired when it is deemed probable that a creditor will be unable to collectall amounts due according to the contractual terms of the loan agreement. Thevaluation of impaired loans is based on the present value of expected futurecash flows discounted at the loans effective interest rate or, as a practicalexpedient, at the loan’s observable market price or the estimated fair value ofthe collateral if the loan is collateral dependent.  Generally, PNWB evaluates a loan for impairment when it is placedon non-accrual status or if a loan is internally risk rated as substandard ordoubtful.

 

A provision for losses onloans, which is a charge against income, is added to the allowance for losseson loans based on quarterly assessments of the loan portfolio. The allowancefor losses on loans is allocated to certain loan categories based on therelative risk characteristics, asset classifications and actual loss experienceof the loan portfolio.  While managementhas attributed the allowance for losses on loans to various loan portfoliosegments, the allowance is general in nature and is available for the loanportfolio in its entirety.

 

The ultimate recovery of allloans is susceptible to future market factors beyond PNWB’s control. Thesefactors may result in losses or recoveries differing significantly from thoseprovided in the consolidated financial statements.

 

*OTHER REALESTATE*| Other real estate includes propertiesacquired through foreclosure and propertyacquiredfordevelopment.  Otherreal estate is initially recorded at the lower of cost or estimated fairvalue by a charge against the allowance for losses on loans, if necessary, atthe date of foreclosure, and is subsequently evaluated to determine that thecarrying value does not exceed the estimated fair value of the real estate.Losses that result from ongoing periodic valuation of other real estate arecharged to operations in the period in which the losses are identified and areincluded in other real estate owned expense in the consolidated statements ofincome.

 

*PREMISESANDEQUIPMENT* | Premises and equipment are stated atcost less accumulated depreciation. Depreciation expense is computed using thestraight-line method over estimated useful lives of up to forty years forbuildings and three to twenty years for furniture, equipment and leaseholdimprovements.

 

*GOODWILL AND OTHER INTANGIBLEASSETS* | Goodwill arising from acquisitionsrepresent the excess of the purchase price over the estimated fair value of netassets acquired. PNWB periodically evaluates goodwill for impairment bycomparing the carrying value of the reporting unit to its estimated fairvalue.  The estimated fair value of thereporting unit is based on quoted market price when available or on the presentvalue of estimated future cash flows.

 

Other intangible assets consistof mortgage servicing rights and core deposit intangibles. Mortgage servicingrights are capitalized when acquired either through the purchase or originationof loans that are subsequently sold or securitized with the servicing rightsretained.  The value of mortgageservicing rights at the date of the sale of loans is determined based on thediscounted present value of expected future cash flows using key assumptionsfor servicing income and costs and prepayment rates on the underlying loans.The estimated fair value is periodically evaluated for impairment by comparingactual cash flows and estimated future cash flows from the servicing assets tothose estimated at the time servicing assets were originated.   Mortgage servicing rights are amortized asan offset to service fees in proportion to and over the period of estimated netservicing income.

 

29

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Prior to January 1, 2002,goodwill and other intangible assets were amortized using the straight-line andaccelerated methods over periods not exceeding twenty years.  The level of goodwill and other intangibleassets as of December 31, 2001 was supported by the value attributed to theoperations acquired and mortgage servicing rights retained.

 

LONG-LIVED ASSETS| Long-livedassets are reviewed for impairment whenever events or changes in circumstancesindicate that the carrying amount may not be recoverable.  Impairment is measured by comparing thecarrying value of the long-lived assets to the estimated undiscounted futurecash flows expected to result from use of the assets and their ultimatedisposition.  In circumstances whereimpairment is determined to exist, PNWB will write down the assets to its fairvalue based on either present value of estimated expected future cash flows oranticipated realizable market value.

 

*ADVERTISING COSTS*| PNWB expenses advertising costs asincurred.   Advertising expenses for theyears ended December 31, 2001, and 2000, the three month period ended December31, 1999 and the year ended September 30, 1999 amounted to $1,986,000,$2,209,000, $565,000 and $2,015,000, respectively.

 

*INCOMETAXES* | PNWB accounts for income taxes usingthe liability method.  Under theliability method, a deferred tax asset or liability is determined based on theenacted tax rates which will be in effect when the differences between thefinancial statement carrying amounts and tax basis of existing assets andliabilities are expected to be reported in PNWB’s consolidated income taxreturn.  The deferred tax expense forthe period is equal to the net change in the deferred tax asset and liabilityaccounts from the beginning to the end of the period.  The effect on deferred taxes of a change in tax rates isrecognized in income in the period that includes the enactment date.

 

*NETINCOMEPERSHARE*| Basic net income per share is calculatedby dividing net income by the weighted average number of common sharesoutstanding during the period.  Dilutednet income per share is calculated by dividing net income by diluted weightedaverage shares outstanding, which includes common stock equivalent sharesoutstanding using the treasury stock method, unless such shares areanti-dilutive.  Common stock equivalentsinclude shares issuable upon exercise of stock options.  Unallocated shares relating to the debt-leveragedmoney purchase employee stock ownership plan debt obligation are deducted inthe calculation of weighted average shares outstanding.

 

*STOCKBASEDCOMPENSATION* | PNWBhas adopted the disclosure only provisions of Statement of Financial AccountingStandards (SFAS) No 123, “Accounting for Stock-based Compensation.”** Accordingly, employee stock options areaccounted for under Accounting Principle Board Opinion (APB) No. 25,“Accounting for Stock Issued to Employees.” Stock options are granted at exercise prices not less than the fairvalue of common stock on the date of grant. Under APB No. 25, no compensation expense is recognized pursuant toPNWB’s stock option plans.

 

*COMPREHENSIVE INCOME*| Comprehensive income includes net income andother comprehensive income, which refers to unrealized gains and losses thatunder accounting principles generally accepted in the United States areexcluded from net income.

 

*RECLASSIFICATIONS* | Certain reclassifications have beenmade to the 2000 and 1999 consolidated financial statements to conform to 2001presentation.  The effects of thereclassifications are not considered material.

 

**NOTE 2**ACCOUNTINGCHANGES

 

In October 2001, the FASBissued SFAS No. 144 “Accounting for the Impairment or Disposal of Long-LivedAssets”. SFAS No. 144 supersedes SFAS No. 121, “Accounting for the Impairmentof Long-Lived Assets and for Long-Lived Assets to Be Disposed Of”.  This statement, which excludes goodwill,provides a single accounting model for recognition and impairment of long-livedassets to be held for sale or disposed of. SFAS No. 144 retains many of the fundamental recognition and measurementprovisions of SFAS No. 121; however, it significantly changes the criteria thatwould have to be met to classify an asset as either held-for-sale or to bedisposed of. SFAS No. 144 became effective on January 1, 2002.  The adoption of this statement had nomaterial impact on PNWB’s financial condition or results of operations.

 

In July 2001, the FASB issuedSFAS No. 142 “Accounting for Goodwill and Other Intangible Assets”.  Under SFAS No. 142, goodwill and indefinitelived intangible assets are no longer amortized but are reviewed annually forimpairment or more frequently if impairment indicators arise.  Separable intangible assets that are notdeemed to have an indefinite life will continue to be amortized over theiruseful lives.  This Statement becameeffective on January 1, 2002.  Theadoption of SFAS No. 142 is expected to reduce PNWB’s goodwill amortizationexpense by approximately $1.1 million on an annual basis.  PNWB is currently performing the first ofthe required impairment assessments of goodwill in accordance with SFAS No. 142and does not expect the results of such assessments to have a material impacton PNWB’s financial condition or results of operations.

 

30

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In September 2000, the FASBissued SFAS No. 140 “Accounting for Transfers and Servicing of Financial Assetsand Extinguishments of Liabilities,” a replacement of SFAS No. 125.  This statement revises the standards foraccounting for securitizations and other transfers of financial assets andcollateral and requires certain disclosures; however, it carries over most ofSFAS No. 125’s provisions without reconsideration.  The standards addressed in this statement are based on consistentapplication of a financial components approach that focuses on control.  Under this approach, after a transfer offinancial assets, an entity recognizes the financial and servicing assets itcontrols and the liabilities it has incurred, derecognizes financial assetswhen control has been surrendered, and derecognizes liabilities whenextinguished.  This statement iseffective for transfers and servicing of financial assets and extinguishmentsof liabilities occurring after March 31, 2001. This statement is effective for recognition and reclassification ofcollateral and for disclosures relating to securitization transactions andcollateral for the year ended December 31, 2001.  The adoption of this statement affected the disclosures in PNWB’sconsolidated financial statements; however, it had no material impact on PNWB’sfinancial condition or results of operations.

 

In June 1998, the FinancialAccounting and Standards Board (FASB) issued SFAS No. 133 “Accounting forDerivative Instruments and Hedging Activities.”  In June 2000, the FASB issued SFAS No. 138, which amended certainprovisions of SFAS No. 133 to clarify specific areas presenting difficulties inimplementation.  SFAS No. 133, asamended by SFAS No. 138, establishes accounting and reporting standards forderivative instruments, including certain derivative instruments imbedded inother contracts, and for hedging activities. It requires the recognition of all derivatives as either assets orliabilities in the statement of financial condition and the measurement ofthose instruments at estimated fair value. In certain defined conditions, a derivative may be specificallydesignated as a hedge for a particular exposure. The accounting for derivativesdepends on the intended use of the derivatives and the resultingdesignation.  This statement was adoptedby PNWB on January 1, 2001. The adoption of this statement did not have amaterial impact on PNWB’s financial condition or results of operations.  As permitted by the provisions of thisstatement, PNWB transferred all securities held to maturity to securitiesavailable for sale on January 1, 2001. This transfer resulted in a decrease ofother comprehensive income of $597,000, net of income taxes of $321,000.

 

**NOTE 3**SECURITIESAVAILABLE FOR SALE

 

Securities available for saleare carried at estimated fair value. The amortized cost and estimated fair values of securities available forsale are summarized as follows:

 
|                                              |   | **Amortized  Cost**      |    | **Gross  Unrealized   Gains** |   | **Gross   Unrealized  Losses** |   | **Estimated  Fair  Value** |   |
|---------------------------------------------------|--------|--------------------------|---------|-------------------------------|--------|--------------------------------|--------|----------------------------|--------|
|                                              |   | **Dollars in thousands** |    |
| December 31, 2001                                 |   |                     |    |                          |   |                           |   |                       |   |
| U.S. treasury and agency securities               |   | $                        | 79,436  |                          | $      | 780                            |   | $                          | 192    |   | $ | 80,024 |   |
| Obligations of states and political  subdivisions |   | 1,120                    |    | 41                            |   | —                         |   | 1,161                      |   |
| Mortgage-backed and related securities            |   | 582,275                  |    | 6,019                         |   | 1,887                          |   | 586,407                    |   |
| FHLB stock                                        |   | 46,084                   |    | —                        |   | —                         |   | 46,084                     |   |
| Other securities                                  |   | 46,164                   |    | 288                           |   | 3,110                          |   | 43,342                     |   |
|                                              |   |                     |    |                          |   |                           |   |                       |   |
| Total                                             |   | $                        | 755,079 |                          | $      | 7,128                          |   | $                          | 5,189  |   | $ | 757,018 |   |
|                                              |   |                     |    |                          |   |                           |   |                       |   |   |   |   |   |
| December 31, 2000                                 |   |                     |    |                          |   |                           |   |                       |   |
| U.S. treasury and agency securities               |   | $                        | 222,788 |                          | $      | 585                            |   | $                          | 597    |   | $ | 222,776 |   |
| Obligations of states and political  subdivisions |   | 1,175                    |    | 14                            |   | 2                              |   | 1,187                      |   |
| Mortgage-backed and related securities            |   | 535,547                  |    | 1,959                         |   | 7,304                          |   | 530,202                    |   |
| FHLB stock                                        |   | 42,962                   |    | —                        |   | —                         |   | 42,962                     |   |
| Other securities                                  |   | 46,479                   |    | —                        |   | 3,117                          |   | 43,362                     |   |
|                                              |   |                     |    |                          |   |                           |   |                       |   |
| Total                                             |   | $                        | 848,951 |                          | $      | 2,558                          |   | $                          | 11,020 |   | $ | 840,489 |   |

 

31

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The amortized cost andestimated fair value of securities available for sale as of December 31, 2001,by contractual maturity are summarized as follows:

 
|                                      |   | **Amortized  Cost**      |    | **Estimated   Fair  Value** |   |
|-------------------------------------------|--------|--------------------------|---------|-----------------------------|--------|
|                                      |   | **Dollars in thousands** |    |
| Due in one year or less                   |   | $                        | 25,454  |                        | $      | 25,792 |   |
| Due after one year but within five years  |   | 54,819                   |    | 55,116                      |   |
| Due after five years but within ten years |   | 100                      |    | 105                         |   |
| Due after ten years                       |   | 46,347                   |    | 43,514                      |   |
|                                      |   | 126,720                  |    | 124,527                     |   |
| FHLB Stock                                |   | 46,084                   |    | 46,084                      |   |
| Mortgage-backed and related securities    |   |                     | 582,275 |                        |   | 586,407 |   |
| Total                                     |   | $                        | 755,079 |                        | $      | 757,018 |   |

 

Proceeds from the sale ofsecurities available for sale during the years ended December 31, 2001, 2000and September 30, 1999 were $151,402,000, $156,540,000 and $258,509,000,respectively. PNWB realized gains of $1,709,000, $663,000, and $238,000 andlosses of $0, $6,776,000 and $166,000 on those sales during the years endedDecember 31, 2001, 2000, and September 30, 1999, respectively.  There were no sales of securities availablefor sale during the three-month period ended December 31, 1999.

 

Securities available for saleinclude mortgage-backed and related securities with estimated fair values of$79,619,000, $175,935,000 and $89,291,000 as of December 31, 2001, 2000 and1999, respectively that were securitized from PNWB’s single-family residentialloan portfolio.

 

**NOTE 4** SECURITIESHELD TO MATURITY

 

Securities held to maturity arecarried at amortized cost.  As permittedby the provisions of SFAS No. 133 “Accounting for Derivative Instruments andHedging Activities”, PNWB reclassified all securities held to maturity tosecurities available for sale on January 1, 2001. This reclassificationresulted in other comprehensive loss of $597,000, net of income taxes of$321,000.  The amortized cost andestimated fair value of securities held to maturity as of December 31, 2000 aresummarized as follows:

 
|                                              |   | **Amortized  Cost**      |       | **Gross  Unrealized  Gains** |   | **Gross  Unrealized  Losses** |   | **Estimated  Fair  Value** |   |
|---------------------------------------------------|--------|--------------------------|------------|------------------------------|--------|-------------------------------|--------|----------------------------|--------|
|                                              |   | **Dollars in thousands** | ** ** |
| December 31,2000                                  |   |                     |       |                         |   |                          |   |                       |   |
| Obligations of states and political  subdivisions |   | $                        | 998        |                         | $      | 1                             |   | $                          | — |   | $ | 999 |   |
| Mortgage-backed and related securities            |   | 63,743                   |       | —                       |   | 919                           |   | 62,824                     |   |
|                                              |   |                     |       |                         |   |                          |   |                       |   |
| Total                                             |   | $                        | 64,741     |                         | $      | 1                             |   | $                          | 919    |   | $ | 63,823 |   |

 

The amortized cost andestimated fair value of securities held to maturity as of December 31, 2000, bycontractual maturity are summarized as follows:

 
|                                     |   | **Amortized  Cost**      |   | **Estimated  Fair  Value** |   |
|------------------------------------------|--------|--------------------------|--------|----------------------------|--------|
|                                     |   | **Dollars in thousands** |   |
| Due in one year or less                  |   | $                        | 897    |                       | $      | 898 |   |
| Due after one year but within five years |   | 101                      |   | 101                        |   |
|                                     |   | 998                      |   | 999                        |   |
| Mortgage-backed and related securities   |   | 63,743                   |   | 62,824                     |   |
| Total                                    |   | $                        | 64,741 |                       | $      | 63,823 |   |

 

32

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**NOTE 5** LOANSRECEIVABLE AND LOANS HELD FOR SALE

 

Loansreceivableandloansheldforsaleconsistedofthefollowingas of December 31:

 
|                             |   | **2001**                 |      | **2000**  |   |
|----------------------------------|--------|--------------------------|-----------|-----------|--------|
|                             |   | **Dollars in thousands** |
| Commercial loans:                |   |                     |      |      |   |
| Commercial                       |   | $                        | 539,241   |      | $      | 477,224 |   |
| Commercial real estate           |   | 482,829                  |      | 375,699   |   |
| Total commercial loans           |   | 1,022,070                |      | 852,923   |   |
|                             |   |                     |      |      |   |
| Single-family residential        |   | 351,828                  |      | 429,257   |   |
| Real estate construction         |   | 319,982                  |      | 330,267   |   |
| Consumer loans                   |   | 115,440                  |      | 128,346   |   |
| Agricultural loans               |   | 52,422                   |      | 57,224    |   |
|                             |   | 1,861,742                |      | 1,798,017 |   |
| Less:                            |   |                     |      |      |   |
| Loans held for sale              |   | 43,757                   |      | 14,187    |   |
| Allowance for losses on loans    |   | 20,123                   |      | 17,561    |   |
| Deferred loan fees and discounts |   | 9,430                    |      | 8,755     |   |
|                             |   |                     |      |      |   |
| Net loans receivable             |   | $                        | 1,788,432 |      | $      | 1,757,514 |   |

 

PNWB serviced loans, owned inwhole or in part by others, of $254,002,000, 484,110,000, $291,755,000 and$260,821,000 as of December 31, 2001, 2000, and September 30, 1999,respectively.

 

As of December31,2001, PNWB had $268,972,000 inrealestateloancommitments to extend credit.  Otherloancommitmentsto extend credit, which include commercial and consumer lines of credit,totaled $341,258,000 as of December 31, 2001. Outstanding commitments to extend credit under standby letters of creditand commercial letters of credit totaled $51,485,000 and $16,915,000 as ofDecember 31, 2001.

 

Non-accrual loans totaled$16,088,000 and $13,883,000 as of December 31, 2001 and 2000,respectively.  Interest income notrecognized on these loans was $1,968,000 and $1,429,000 as of December 31, 2001and 2000, respectively.

 

PNWB originates loans primarilyin the state of Washington. Although PNWB has a diversified loan portfolio, asubstantial portion of its debtors’ ability to honor their contracts isaffected by the economy in Washington state.

 

 

**NOTE 6** ALLOWANCE FORLOSSES ON LOANS

 

The activity in the allowancefor losses on loans for the years ended December 31, 2001 and 2000, thethree-month period ended December 31, 1999 and the year ended September 30,1999 is summarized as follows:

 
|                             |   | **Year ended  December 31,  2001** |   | **Year ended  December 31,  2000** |   | **Three  months  December 31,  1999** |   | **Year ended  September 30, 1999** |   |
|----------------------------------|--------|------------------------------------|--------|------------------------------------|--------|---------------------------------------|--------|-----------------------------------------|--------|
|                             |   | **Dollars in thousands**           |   |
| Balance, beginning of period     |   | $                                  | 17,561 |                               | $      | 15,182                                |   | $                                       | 14,123 |   | $ | 13,224 |   |
| Provision for losses on loans    |   | 6,050                              |   | 4,750                              |   | 550                                   |   | 2,000                                   |   |
| Merger and acquisition activity: |   |                               |   |                               |   |                                  |   |                                    |   |
| Allowance acquired               |   | —                             |   | —                             |   | 778                                   |   | —                                  |   |
| Charge-offs                      |   | (4,747                             | )      | (2,956                             | )      | (374                                  | )      | (1,553                                  | )      |
| Recoveries                       |   | 1,259                              |   | 585                                |   | 105                                   |   | 452                                     |   |
| Balance, end of period           |   | $                                  | 20,123 |                               | $      | 17,561                                |   | $                                       | 15,182 |   | $ | 14,123 |   |

 

33

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The following is a summary ofloans considered impaired and the related interest income as of and for theyears ended December 31, 2001 and 2000, the three month period ended December31, 1999 and the year ended September 30, 1999:

 
|                                                    |   | **Year ended  December 31,  2001** |   | **Year ended  December 31,   2000** |   | **Three  months   December 31,   1999** |   | **Year ended    September 30,   1999** |   |
|---------------------------------------------------------|--------|------------------------------------|--------|-------------------------------------|--------|-----------------------------------------|--------|----------------------------------------|--------|
|                                                    |   | **Dollars in thousands**           |   |
| Recorded investment in impaired loans at  end of period |   | $                                  | 2,523  |                                | $      | 3,819                                   |   | $                                      | 5,205  |   | $ | 2,797 |   |
| Average recorded investment in impaired  loans          |   | 3,171                              |   | 4,339                               |   | 5,119                                   |   | 2,890                                  |   |
| Interest income recognized on impaired  loans           |   | 180                                |   | 282                                 |   | 46                                      |   | 151                                    |   |
|                                                         |        |                                    |        |                                     |        |                                         |        |                                        |        |  |  |  |  |

 

Total allocated reserves forimpaired loans were $583,000 and $649,000 as of December 31, 2000 and 1999,respectively. Interest income on impaired loans is normally recognized on theaccrual basis, unless the loan is more than 90 days past due, in which caseinterest income is recorded on a cash basis.

 

 

**NOTE 7** PREMISES ANDEQUIPMENT

 

Premises and equipmentconsisted of the following as of December 31:

 
|                                 |   | **2001**                 |   | **2000** |   |
|--------------------------------------|--------|--------------------------|--------|----------|--------|
|                                 |   | **Dollars in thousands** |   |
| Buildings and leasehold improvements |   | $                        | 41,225 |     | $      | 41,109 |   |
| Furniture and equipment              |   | 32,650                   |   | 42,193   |   |
|                                 |   | 73,875                   |   | 83,302   |   |
| Less accumulated depreciation        |   | (32,962                  | )      | (35,250  | )      |
|                                 |   | 40,913                   |   | 48,052   |   |
| Land                                 |   | 9,913                    |   | 10,414   |   |
|                                 |   |                     |   |     |   |
| Total                                |   | $                        | 50,826 |     | $      | 58,466 |   |

 

Depreciation expense for theyears ended December 31, 2001 and 2000, and the three month period endingDecember 31, 1999, and the year ended September 30, 1999 was $6,016,000,$5,544,000, $1,149,000, and  $4,832,000respectively.

 

PNWB leases certain premisesunder operating leases.  Rental expensefor leased premises was $1,882,000, $1,582,000, $409,000, and $1,453,000 forthe years ended December 31, 2001 and 2000, the three month period endedDecember 31, 1999 and the year ended September 30, 1999, respectively.  Minimum rental commitments undernon-cancelable operating leases having an original or remaining term of morethan one year were as follows as of December 31, 2001:

 
| **Year  ending December 31:** |   | **2002**                  |   | **2003** |   | **2004** |   | **2005** |   | **2006** |   | **Thereafter** |   | **Total** |   |
|-------------------------------|--------|---------------------------|--------|----------|--------|----------|--------|----------|--------|----------|--------|----------------|--------|-----------|--------|
|                          |   | **Dollars in  thousands** |
| Minimum rental commitments    |   | $                         | 2,934  |     | $      | 2,741    |   | $        | 2,014  |     | $      | 836            |   | $         | 516    |   | $ | 793 |   | $ | 9,835 |   |
|                               |        |                           |        |          |        |          |        |          |        |          |        |                |        |           |        |  |  |  |  |  |  |  |

 

 

**NOTE 8** GOODWILL ANDOTHER INTANGIBLE ASSETS

 

Goodwill and other intangibleassets consisted of the following as of December 31:

 
|                      |   | **2001**                 |   | **2000** |   |
|---------------------------|--------|--------------------------|--------|----------|--------|
|                      |   | **Dollars in thousands** |   |
| Goodwill                  |   | $16,137                  |   | $17,242  |   |
| Core deposit intangible   |   | 423                      |   | 598      |   |
| Mortgage servicing rights |   | 1,562                    |   | 2,861    |   |
|                      |   |                     |   |     |   |
| Total                     |   | $18,122                  |   | $20,701  |   |

 

Accumulated amortization ofgoodwill totaled $2,966,000 and $1,845,000 as of December 31, 2001 and 2000.  During theyear ended December 31, 2000, PNWB consolidated and restructured its mortgageloan origination functions and related processes, and as a result, recorded animpairment of $749,000 of goodwill related to the acquisition of a mortgagebrokerage subsidiary in 1996.

34

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The changes in mortgageservicing rights for the years ended December 31, 2001 and 2000, the threemonth period ended December 31, 1999 and the year ended September 30, 1999 aresummarized as follows:

 
|                         |   | **Year ended    December 31,   2001** |   | **Year ended    December 31,   2000** |   | **Three  months   December 31,   1999** |   | **Year ended    September 30,   1999** |   |
|------------------------------|--------|---------------------------------------|--------|---------------------------------------|--------|-----------------------------------------|--------|----------------------------------------|--------|
|                         |   | **Dollars in thousands**              |   |
| Balance, beginning of period |   | $                                     | 2,861  |                                  | $      | 1,987                                   |   | $                                      | 1,714  |   | $ | 3,690 |   |
| Additions                    |   | —                                |   | 1,659                                 |   | 424                                     |   | 2,637                                  |   |
| Less: Basis sold             |   | —                                |   | —                                |   | —                                  |   | (3,203                                 | )      |
| Amortization and write-downs |   | (1,299                                | )      | (785                                  | )      | (151                                    | )      | (1,410                                 | )      |
|                         |   |                                  |   |                                  |   |                                    |   |                                   |   |
| Balance, end of period       |   | $                                     | 1,562  |                                  | $      | 2,861                                   |   | $                                      | 1,987  |   | $ | 1,714 |   |

 

The estimated fair value ofmortgage servicing rights exceeded the net book value as of December 31, 2001and 2000.  The estimated fair value wasdetermined by comparing actual cash flows and estimated future cash flows fromthe servicing assets to those estimated at the time servicing assets wereoriginated.

 

During theyear ended December 31, 2000, PNWB sold $66,543,000 of commercial real estatemortgage loans, securitized $120,169,000 of single-family residential loans andsold $62,360,000 of single-family residential loans and retained the right toservice the respective loans.   PNWBdoes not have any retained interests in the loans sold.  Information and weighted average assumptionsat the time of these sales and securitizations are as follows:

 
|                                      |   | **Single   Family   Residential** |   | **Commercial Real Estate** |   |
|-------------------------------------------|--------|-----------------------------------|--------|---------------------------------|--------|
|                                      |   | **Dollars in thousands**          |   |
| Servicing asset recognized                |   | $                                 | 1,393  |                            | $      | 266 |   |
| Estimated annual servicing income         |   | 0.25                              | %      | 0.11                            | %      |
| Weighted average life of loans (in years) |   | 3.9                               |   | 5.1                             |   |
| Prepayment rate                           |   | 14.8                              | %      | 7.3                             | %      |
| Cash flow discount rate                   |   | 8.7                               | %      | 8.9                             | %      |
|                                           |        |                                   |        |                                 |        |  |  |

 

**NOTE 9**INTEREST-BEARING DEPOSITS

 

Interest-bearing depositsconsisted of the following as of December 31:
|                                    |   | **Weighted  Average  Interest Rate as of   December 31, 2001** |       | **2001** |      | **2000** |   |
|-----------------------------------------|--------|----------------------------------------------------------------|------------|----------|-----------|----------|--------|
|                                    |   | **Dollars in thousands**                                       | ** ** |
| Interest-bearing checking accounts      |   | 0.65                                                           | %          | $        | 214,098   |     | $      | 201,894 |   |
| Money market accounts                   |   | 2.05                                                           | %          | 322,554  |      | 266,933  |   |
| Savings accounts                        |   | 0.99                                                           | %          | 95,390   |      | 100,831  |   |
|                                    |   | 1.42                                                           | %          | 632,042  |      | 569,658  |   |
| Certificates of deposit:                |   |                                                           |       |     |      |     |   |
| Due within one year                     |   |                                                           |       | 606,659  |      | 785,962  |   |
| After one year but within two years     |   |                                                           |       | 86,135   |      | 65,575   |   |
| After two years but within three years  |   |                                                           |       | 16,856   |      | 38,720   |   |
| After three years but within four years |   |                                                           |       | 15,082   |      | 4,705    |   |
| After four years but within five years  |   |                                                           |       | 4,240    |      | 6,558    |   |
| After five years                        |   |                                                           |       | 2,167    |      | 1,830    |   |
| Total certificates of deposit           |   | 3.86                                                           | %          | 731,139  |      | 903,350  |   |
| Total                                   |   | 2.73                                                           | %          | $        | 1,363,181 |     | $      | 1,473,008 |   |

 

Deposits as of December 31,2001 and 2000 included $159,051,000 and $144,455,000, respectively, in publicfund deposits.  Securities with bookvalues of $33,566,000 and $24,992,000 were pledged as collateral on thesedeposits as of December 31, 2001 and 2000, respectively, which exceedstheminimumcollateralrequirementsestablishedbytheWashingtonPublicDepositProtectionCommission.

35

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Certificates of deposit greaterthan or equal to $100,000 totaled $393,830,000 and $467,769,000 as of December31, 2001 and 2000, respectively.

 

Deposit interest expense byaccount type for the years ended December 31, 2001 and 2000, the three monthperiod ended December 31, 1999 and the year ended September 30, 1999 were asfollows:

 
|                                                       |   | **Year ended  December 31,   2001** |   | **Year ended    December 31,   2000** |   | **Three  months  December 31,  1999** |   | **Year ended    September 30,   1999** |   |
|------------------------------------------------------------|--------|-------------------------------------|--------|---------------------------------------|--------|---------------------------------------|--------|----------------------------------------|--------|
|                                                       |   | **Dollars in thousands**            |   |
| Certificates of deposit greater than or  equal to $100,000 |   | $                                   | 24,762 |                                  | $      | 24,897                                |   | $                                      | 5,700  |   | $ | 19,126 |   |
| Other certificates of deposit                              |   | 21,011                              |   | 23,606                                |   | 5,413                                 |   | 22,959                                 |   |
| Money market accounts                                      |   | 9,786                               |   | 11,563                                |   | 2,707                                 |   | 9,392                                  |   |
| Interest-bearing checking accounts                         |   | 1,723                               |   | 2,017                                 |   | 539                                   |   | 2,102                                  |   |
| Savings accounts                                           |   | 1,193                               |   | 1,722                                 |   | 432                                   |   | 1,837                                  |   |
|                                                       |   |                                |   |                                  |   |                                  |   |                                   |   |
| Total                                                      |   | $                                   | 58,475 |                                  | $      | 63,805                                |   | $                                      | 14,791 |   | $ | 55,416 |   |

 

**NOTE 10**FEDERAL HOMELOAN BANK ADVANCES

 

As of December 31, FHLBadvances were scheduled to mature as follows:

 
|                                    |   | **2001**                 |    | **2000**            |         |
|-----------------------------------------|--------|--------------------------|---------|---------------------|--------------|
|                                    |   | **Amount**               |    | **Interest  Rates** |         | **Amount** |   | **Interest  Rates** |   |
|                                    |   | **Dollars in thousands** |    |
| Due within one year                     |   | $                        | 464,625 |                | 1.80% - 7.70 | % | $ | 517,000 |   | 6.20% - 7.23 | % |
| After one year but within two years     |   | 40,000                   |    | 3.04% - 4.92        | %            | 1,200 |   | 6.54% - 7.70 | % |
| After two years but within three years  |   | 85,000                   |    | 3.65% - 4.51        | %            | 25,000 |   | 4.92% - 7.70 | % |
| After three years but within four years |   | 45,000                   |    | 4.50% - 5.05        | %            | — |   | — | % |
| After four years but within five years  |   | 4,901                    |    | 3.97                | %            | 25,000 |   | 5.05 | % |
| After six years but within seven years  |   | 75,000                   |    | 5.08% - 5.56        | %            | 75,000 |   | 5.08 - 5.56 | % |
|                                    |   |                     |    |                |         |   |   |   |   |
| Total                                   |   | $                        | 714,526 |                | —       |   | $ | 643,200 |   | — |   |

 

FHLB advances arecollateralized by FHLB stock owned by PNWB, deposits with the FHLB and certainmortgages or deeds of trust securingsuchproperties.  As of December 31,2001, the minimum book value of eligible collateral pledged for theseborrowings was $857,431,000.  As ofDecember 31, 2001, the additional amount available under credit lines from theFHLB was $107,927,000.   Certain FHLBadvances contractually due beyond one year have an option whereby the FHLB cancall the advance due prior to the contractual maturity.  The amount of such advances with call dateswithin one year was $50,000,000 as of December 31, 2001.

 

The maximum and average amountoutstanding and weighted average interest rates on FHLB advances were asfollows during the years ended December 31, 2001 and 2000, the three monthperiod ended December 31, 1999 and the year ended September 30, 1999:

 
|                                 |   | **Year ended    December 31,   2001** |    | **Year ended    December 31,   2000** |   | **Three  months   December 31,   1999** |   | **Year ended    September 30,   1999** |    |
|--------------------------------------|--------|---------------------------------------|---------|---------------------------------------|--------|-----------------------------------------|--------|----------------------------------------|---------|
|                                 |   | **Dollars in thousands**              |    |
| Maximum outstanding at any month end |   | $                                     | 721,200 |                                  | $      | 787,526                                 |   | $                                      | 696,587 |   | $ | 718,709 |   |
| Average outstanding                  |   | 651,824                               |    | 707,814                               |   | 680,928                                 |   | 601,931                                |    |
| Weighted average interest rates:     |   |                                  |    |                                  |   |                                    |   |                                   |    |
| For the period                       |   | 4.63                                  | %       | 6.07                                  | %      | 5.55                                    | %      | 5.38                                   | %       |
| End of period                        |   | 3.23                                  | %       | 6.36                                  | %      | 5.59                                    | %      | 5.41                                   | %       |
|                                      |        |                                       |         |                                       |        |                                         |        |                                        |         |  |  |  |  |

 

36

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**NOTE 11** SECURITIESSOLD UNDER AGREEMENTS TO REPURCHASE

 

PNWB has sold certainsecurities of the U.S. government and its agencies and other approvedinvestments under agreements to repurchase. The securities sold were classified as securities available for salewith a carrying value of $145,708,000 and an estimated fair value of$147,929,000 as of December 31, 2001. PNWB had $250,497,000 of available creditfrom third parties to sell securities under agreements to repurchase as ofDecember 31, 2001.

 

As of December31, securities sold under agreements to repurchase were scheduled to mature asfollows:

 
|                             |   | **2001**                 |    | **2000**            |         |
|----------------------------------|--------|--------------------------|---------|---------------------|--------------|
|                             |   | **Amount**               |    | **Interest  Rates** |         | **Amount** |   | **Interest  Rates** |   |
|                             |   | **Dollars in thousands** |    |
| Within 30 days                   |   | $                        | 67,119  |                | 1.75% - 6.00 | % | $ | 27,193 |   | 5.57% - 6.63 | % |
| After 30 days but within 90 days |   | 22,200                   |    | 7.40                | %            | 114,800 |   | 6.64% - 7.24 | % |
| After 90 days                    |   | 60,185                   |    | 3.42% - 4.82        | %            | 132,927 |   | 6.47% - 7.40 | % |
|                             |   |                     |    |                |         |   |   |   |   |
| Total                            |   | $                        | 149,504 |                | —       |   | $ | 274,920 |   | — |   |

 

The maximum and average amountoutstanding and weighted average interest rates on securities sold underagreements to repurchase were as follows during the years ended December 31,2001 and 2000, the three month period ended December 31, 1999 and the yearended September 30, 1999:

 
|                                 |   | **Year ended    December 31,   2001** |    | **Year ended    December 31,   2000** |   | **Three  months   December 31,   1999** |   | **Year ended    September 30,   1999** |    |
|--------------------------------------|--------|---------------------------------------|---------|---------------------------------------|--------|-----------------------------------------|--------|----------------------------------------|---------|
|                                 |   | **Dollars in thousands**              |    |
| Maximum outstanding at any month end |   | $                                     | 279,176 |                                  | $      | 286,807                                 |   | $                                      | 282,655 |   | $ | 133,992 |   |
| Average outstanding                  |   | 193,607                               |    | 267,570                               |   | 165,612                                 |   | 131,723                                |    |
| Weighted average interest rates      |   |                                  |    |                                  |   |                                    |   |                                   |    |
| For the period                       |   | 5.49                                  | %       | 6.66                                  | %      | 5.86                                    | %      | 5.77                                   | %       |
| End of period                        |   | 3.63                                  | %       | 6.88                                  | %      | 5.96                                    | %      | 5.70                                   | %       |
|                                      |        |                                       |         |                                       |        |                                         |        |                                        |         |  |  |  |  |

 

**NOTE 12**GUARANTEEDPREFERRED BENEFICIAL INTEREST IN SUBORDINATED DEBT

 

On November 15, 1999,$40,000,000 of 9.875 percent Capital Securities were issued by InterWestCapital Trust I (the Trust).  The Trustis a business trust organized in November 1999, and Bancorp owns 100 percent ofthe common equity of the Trust.

 

The proceeds of the offeringwere invested by the Trust in junior subordinated debentures of Bancorp.  The debentures held by the Trust are thesole assets of the Trust.  Distributionson the capital securities issued by the Trust are payable semiannually at 9.875percent per annum, which is equal to the interest rate being earned by theTrust on the debentures held by the Trust. The capital securities are subject to mandatory redemption, in whole orin part, upon repayment of the debentures. Bancorp has entered into agreementswhich, taken collectively, fully and unconditionally guarantee the capitalsecurities subject to the terms of each of the guarantees. The capitalsecurities qualify as Tier I capital under the capital guidelines of theFederal Reserve Board.  During the yearended December 31, 2001, Bancorp purchased $2,500,000 of the InterWest CapitalTrust I capital securities.

 

37

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At Bancorp’s option, thedebentures will not mature earlier than November 15, 2009, and not later thanNovember 15, 2029.  After November 15,2019, the debentures can be redeemed at par value. If Bancorp elects to redeemthe debentures prior to November 15, 2019, an adjusted prepayment price will bepaid as follows during each of the respective years ending November 15:

 

| **Year** |   | **Price** |   |
|----------|--------|-----------|--------|
| 2009     |   | 104.938   | %      |
| 2010     |   | 104.444   | %      |
| 2011     |   | 103.950   | %      |
| 2012     |   | 103.457   | %      |
| 2013     |   | 102.963   | %      |
| 2014     |   | 102.469   | %      |
| 2015     |   | 101.975   | %      |
| 2016     |   | 101.481   | %      |
| 2017     |   | 100.988   | %      |
| 2018     |   | 100.494   | %      |

 

**NOTE 13**OTHERBORROWINGS

 

On March 14, 2001, Bancorpentered into an agreement with an unaffiliated lender for a $10,000,000promissory note.  The note accruesinterest at the lender’s base lending rate, which is set at the lender’s solediscretion, plus a margin of 0.75 percent. The interest rate on the note was 6.25% as of December 31, 2001.  The principle of the promissory note is dueon April 1, 2008.

 

On September 26, 2001, Bancorpentered into an agreement with an unaffiliated lender for a $2,000,000 promissorynote.  The note accrues interest at thelender’s base lending rate, which is set at the lender’s sole discretion, plusa margin of one percent.  The interestrate on the note was 6.50% as of December 31, 2001.  The principle of the promissory note is due on September 1, 2008.

 

**NOTE 14**SHAREHOLDERS’EQUITY

 

On January 20, 1999, the Boardof Directors approved a stock repurchase plan of 5 percent of Bancorp’soutstanding shares of common stock.  OnNovember 16, 1999, the Board of Directors authorized the purchase of anadditional 5 percent of Bancorp’s outstanding shares of common stock for thefollowing twelve-month period.  Duringthe year ended December 31, 2000, 468,000 shares (3 percent of the total commonshares outstanding) at a total price of $7,860,000 were repurchased.   This represents an average price of $16.79per common share repurchased.  Duringthe three months ended December 31, 1999, 392,500 shares (2.5 percent of thetotal common shares outstanding) at a total price of $7,621,000 were repurchased.  This represents an average price of $19.42per common share repurchased. During the year ended September 30, 1999, Bancorprepurchased 521,500 shares (3.3 percent of the total common shares outstanding)at a total price of $11,910,000.  This representsan average price of $22.84 per common share repurchased.  At December 31, 2001, no stock repurchasesassociated with these Board approved activities remained outstanding.

 

On January 22, 2002, the Boardof Directors approved a stock repurchase plan of up to 5% of Bancorp’soutstanding shares of common stock over the next twelve months.

 

**NOTE 15**CONVERSIONAND INTEGRATION

 

During theyear ended December 31, 2000, PNWB initiated the process of converting itssubsidiary bank to a single enhanced operating system.  The conversion was completed on April 9,2001.  Conversion and integration costswere expensed as incurred.  Totalexpenses associated with conversion and integration efforts were $1,290,000 and$7,361,000 during the years ended December 31, 2001 and 2000,respectively.  These expenses includedthe buyout of previous data processing contracts, outside professional fees,accelerated depreciation for equipment and other costs incurred in conjunctionwith conversion and integration initiatives.  Other costs include the preparation and mailing of customernotifications for the conversion of customer accounts and trainingexpenses.  All conversion andintegration expenses were paid out as of December 31, 2001.

 

38

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**NOTE 16**SEVERANCEAND EMPLOYMENT AGREEMENTS

 

Inconjunction with executive management changes and elimination of duplicateadministrative functions, PNWB incurred $200,000 and $3,325,000 in expensesassociated with severance and employment agreements during the year endedDecember 31, 2001 and 2000, respectively.  There were approximately 40 employees affected by these severance andemployment agreements.  During the yearsended December 31, 2001 and 2000, $515,000 and $1,154,000 of such expenses werepaid out, respectively.  As of December31, 2001, PNWB had an accrued liability of $1,356,000 related to certainagreements that will be paid out in future periods.

 

**NOTE 17**INCOME TAXES

 

A reconciliation of income taxexpense based on the statutory corporate tax rate on pre-tax income and theamount of expenseshownintheaccompanyingconsolidatedstatementsofincomefortheyearsended December31, 2001 and 2000, the three-month period ended December 31, 1999 andthe year ended September 30, 1999 isasfollows:

 
|                                    |   | **Year ended    December 31,   2001** |   | **Year ended    December 31,   2000** |       | **Three  months   December 31, 1999** |   | **Year ended    September 30,  1999** |   |
|-----------------------------------------|--------|---------------------------------------|--------|---------------------------------------|------------|--------------------------------------------|--------|---------------------------------------|--------|
|                                    |   |                                  |   | **As a percentage**              |       |                                       |   | **As a percentage**              |   |   |   | **As a   percentage** |   |   |   | **As a   percentage** |   |
|                                    |   |                                  |   |                                  |       |                                       |   |                                  |   |   |   |   |   |
|                                    |   |                                  |   | **of pretax income**             |       |                                       |   | **of pretax income**             |   |   |   | **of pretax income** |   |   |   | **of pretax income** |   |
|                                    |   | **Amount**                            |   |                                  | **Amount** |                                       |   | **Amount**                            |   |   | **Amount** |   |   |
|                                    |   | **Dollars in thousands**              |   |
| Federal income taxes at statutory rates |   | $                                     | 12,353 |                                  | 35.0       | %                                          | $      | 3,721                                 |   | 35.0 | % | $ | 2,938 |   | 35.0 | % | $ | 14,854 |   | 35.0 | % |
| Tax effect of:                          |   |                                  |   |                                  |       |                                       |   |                                  |   |   |   |   |   |   |   |   |   |
| Goodwill amortization                   |   | 455                                   |   | 1.3                                   |       | 714                                        |   | 6.7                                   |   | 180 |   | 2.1 |   | 146 |   | 0.3 |   |
| Tax-exempt interest                     |   | (36                                   | )      | (0.1                                  | )          | (52                                        | )      | (0.5                                  | )      | (10 | ) | (0.1 | ) | (105 | ) | (0.3 | ) |
| Other, net                              |   | 431                                   |   | 1.2                                   |       | (21                                        | )      | (0.2                                  | )      | (175 | ) | (2.1 | ) | (310 | ) | (0.6 | ) |
|                                    |   |                                  |   |                                  |       |                                       |   |                                  |   |   |   |   |   |   |   |   |   |
| Total                                   |   | $                                     | 13,203 |                                  | 37.4       | %                                          | $      | 4,362                                 |   | 41.0 | % | $ | 2,933 |   | 34.9 | % | $ | 14,585 |   | 34.4 | % |
|                                    |   |                                  |   |                                  |       |                                       |   |                                  |   |   |   |   |   |   |   |   |   |
| Current income tax expense              |   | $                                     | 13,881 |                                  | 39.3       |                                       | $      | 7,346                                 |   | 69.1 |   | $ | 3,032 |   | 36.1 |   | $ | 14,775 |   | 34.8 |   |
| Deferred income tax benefit             |   | (678                                  | )      | (1.9                                  | )          | (2,984                                     | )      | (28.1                                 | )      | (99 | ) | (1.2 | ) | (190 | ) | (0.4 | ) |
|                                    |   |                                  |   |                                  |       |                                       |   |                                  |   |   |   |   |   |   |   |   |   |
| Total                                   |   | $                                     | 13,203 |                                  | 37.4       | %                                          | $      | 4,362                                 |   | 41.0 | % | $ | 2,933 |   | 34.9 | % | $ | 14,585 |   | 34.4 | % |

 

Tax effects of temporarydifferences that give rise to elements of deferred tax assets (liabilities)consisted of the following as of December 31:

 
|                                              |   | **2001**                 |   | **2000** |   |
|---------------------------------------------------|--------|--------------------------|--------|----------|--------|
|                                              |   | **Dollars in thousands** |   |
| Deferred tax assets:                              |   |                     |   |     |   |
| Allowance for losses on loans                     |   | $                        | 6,650  |     | $      | 6,041 |   |
| Deferred compensation                             |   | 566                      |   | 592      |   |
| Other real estate                                 |   | 1,242                    |   | 1,167    |   |
| Accrued expenses                                  |   | 1,064                    |   | 2,101    |   |
| Unrealized loss on securities available for  sale |   | 0                        |   | 2,962    |   |
| Other                                             |   | 985                      |   | 566      |   |
| Total deferred tax assets                         |   | 10,507                   |   | 13,429   |   |
| Deferred tax liabilities:                         |   |                     |   |     |   |
| Loan fees                                         |   | (2,581                   | )      | (2,584   | )      |
| FHLB stock dividends                              |   | (5,939                   | )      | (5,375   | )      |
| Depreciation                                      |   | (1,660                   | )      | (1,676   | )      |
| Unrealized gain on securities available for  sale |   | (678                     | )      | 0        |   |
| Other                                             |   | (59                      | )      | (1,242   | )      |
| Total deferred tax liabilities                    |   | (10,917                  | )      | (10,877  | )      |
|                                              |   |                     |   |     |   |
| Net deferred tax (liability)/asset                |   | $                        | (410   | )        | $      | 2,552 |   |

 

 

39

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The realization of deferred taxassets is dependent upon the ability to generate taxable income in futureperiods.  PNWB has evaluated availableevidence supporting the realization of its deferred tax assets and determinedit is more likely than not that deferred tax assets will be realized.

 

**NOTE 18**EMPLOYEEBENEFITS

 

*RETIREMENT AND SAVINGS PLANS* | PNWB has a debt-leveraged moneypurchase employee stock ownership plan (ESOP) for employees.  The ESOP is a non-contributory stockownership plan.  PNWB contributes 5percent of qualified participants’ compensation to the ESOP on a monthly basis.

 

During 1998, the ESOP enteredinto a line of credit agreement with an unrelated third party to borrow up to atotal of $4,000,000 for the purpose of acquiring Bancorp common stock.  Interest on the line of credit is computedat one-month LIBOR plus 1.75 percent. Interest paid was $82,000, $205,000, $66,000, and $284,000 for the yearsended December 31, 2001 and 2000, the three month period ended December 31,1999 and the year ended September 30, 1999, respectively.  The obligation is reduced, and shareholders’equity increased, by the amount of any principal reduction of the line ofcredit by the ESOP. During the years ended December 31, 2001 and 2000, thethree-month period ended December 31, 1999 and the year ended September 30,1999 the ESOP made principal repayments of $1,125,000, $1,312,000, $628,000 and$327,000 on the ESOP line of credit. Dividends paid on unallocated shares of stock may be used to makepayments on the loan.  Accordingly,$24,000, $76,000, $21,000, and $85,000 of dividends were applied toward loanpayments during the years ended December 31, 2001 and 2000, the three monthperiod ended December 31, 1999 and the years ended September 30,1999,respectively. The compensation of the leveraged shares is calculated by takingthe difference between the average fair value of the shares released and thecost of the shares.  Shares are releasedas the loan payments are made on the ESOP line of credit.  Leveraged ESOP shares during the years endedDecember 31, 2001 and 2000, the three-month period ended December 31, 1999 andthe year ended September 30, 1999 were as follows:

 
|                                  |   | **Year ended    December 31,   2000** |   | **Year ended    December 31,   2000** |   | **Three  months   December 31,   1999** |   | **Year ended    September 30,   1999** |   |
|---------------------------------------|--------|---------------------------------------|--------|---------------------------------------|--------|-----------------------------------------|--------|----------------------------------------|--------|
| Leveraged shares, beginning of period |   | 55,071                                |   | 102,632                               |   | 128,110                                 |   | 147,055                                |   |
| Shares leveraged                      |   | —                                |   | —                                |   | —                                  |   | —                                 |   |
| Shares released for allocation        |   | (39,171                               | )      | (47,561                               | )      | (25,478                                 | )      | (18,945                                | )      |
|                                  |   |                                  |   |                                  |   |                                    |   |                                   |   |
| Unallocated shares, end of period     |   | 15,900                                |   | 55,071                                |   | 102,632                                 |   | 128,110                                |   |

 

The fair value of unallocatedshares was $325,000, $761,000, $1,976,000, and $2,658,000 as of December 31,2001, 2000, December 31, 1999, and September 30, 1999, respectively.

 

PNWB has a salary deferral401(k) plan that is a defined contribution plan.  Employees can make contributions to their respective accounts inthe 401(k) plan on a pre-tax basis up to the maximum amount permitted bylaw.  PNWB matches a portion of thesalary deferred by each participant according to the schedule in the plan.  Employees direct both employee’s and PNWB’scontributions to any of the eight investment options offered in the 401(K)plan.  Effective January 1, 2002,employees may also direct the contributions to purchase Bancorp commonstock.  PNWB’s expenses, includingcontributions, for the ESOP and 401(k) plan were $2,063,000, $2,008,000,$573,000, and $1,575,000 for the years ended December 31, 2001 and 2000, thethree month period ended December 31, 1999 and the year ended September 30,1999, respectively.

 

PNWB also maintains severalnon-qualified deferred compensation programs for certain executive officers.

 

*STOCK OPTION PLANS* | During January 1993, the shareholdersof Bancorp approved the addition of a qualified employee stock option plan(1993 incentive plan). The awarding of stock options to certain employees ofPNWB is at the discretion of the Board of Directors.  The term of the options granted is generally five or tenyears.  Substantially all of the optionsgranted under the 1993 incentive plan vest over three to five-year periods.

 

In January 1997, theshareholders of Bancorp approved the non-qualified 1996 Outside Directors StockOptions-For-Fees Plan (1996 Director Plan). Under the 1996 Director Plan,non-employee directors may elect to receive stock options in lieu of feesotherwise due for board services and may exercise those options after oneyear.  Each option granted under the1996 Director Plan has a term of five years.

40

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PNWB had a qualified stockoption plan prior to 1993 that provided for the awarding of stock options tocertain officers and employees of PNWB at the discretion of the Board ofDirectors.  The term of the stockoptions granted ranged from four to ten years from the date of grant.  This plan expired during 1993; however,there are exercisable options outstanding under the plan during the period.

 

Companies acquired by PNWB hadstock option plans that have been assumed by PNWB. The number of stock optionshares and exercise prices were appropriately adjusted to reflect the commonstock exchange ratios for each acquisition. All outstanding Central, Puget, Pacific Northwest Bank, Pioneer,Kittitas and NBT stock options became 100 percent vested and exercisable uponthe consummation of the respective acquisitions.  No further awards will be granted under any of these plans.

 

Theexercisepriceofoptionsgrantedunder most of theseplanswas equaltothefairvalueofthecommonstockonthedateofthegrant.Averageexercisepricepershare,numberofsharesauthorized,availableforgrant,granted,exercised,outstandingandcurrentlyexercisablereflect adjustments for common stock splits.  Information with respect to options grantedunder all stock option plans is as follows:

 
|                       |   | **Average Exercise Price** |   | **Options  Outstanding** |      | **Options   Exercisable** |    |
|----------------------------|--------|---------------------------------|--------|--------------------------|-----------|---------------------------|---------|
| Balance September 30, 1998 |   | 11.17                           |   | 902,027                  |      | 670,896                   |    |
| Options granted            |   | 20.80                           |   | 202,610                  |      | 3,250                     |    |
| Options exercised          |   | 5.65                            |   | (285,881                 | )         | (285,881                  | )       |
| Options rescinded/expired  |   | 25.72                           |   | (22,880                  | )         | —                    |    |
| Options vested             |   | —                          |   | —                   |      | 69,895                    |    |
| Balance September 30, 1999 |   | 15.30                           |   | 795,876                  |      | 458,160                   |    |
| Options granted            |   | 17.50                           |   | 269,350                  |      | 4,500                     |    |
| Options exercised          |   | 5.91                            |   | (55,600                  | )         | (55,600                   | )       |
| Options rescinded/expired  |   | 16.85                           |   | (4,002                   | )         | —                    |    |
| Options vested             |   | —                          |   | —                   |      | 83,626                    |    |
| Balance December 31, 1999  |   | 16.40                           |   | 1,005,624                |      | 490,686                   |    |
| Options granted            |   | 13.45                           |   | 152,875                  |      | —                    |    |
| Options exercised          |   | 6.97                            |   | (111,969                 | )         | (111,969                  | )       |
| Options rescinded/expired  |   | 19.02                           |   | (114,566                 | )         | —                    |    |
| Options vested             |   | —                          |   | —                   |      | 109,538                   |    |
| Balance December 31, 2000  |   | $                               | 16.73  |                     | 931,964   |                      | 488,255 |   |
| Options granted            |   | 19.11                           |   | 614,613                  |      | —                    |    |
| Options exercised          |   | 10.24                           |   | (65,343                  | )         | (65,343                   | )       |
| Options rescinded/expired  |   | 19.40                           |   | (80,693                  | )         | —                    |    |
| Options vested             |   | —                          |   | —                   |      | 154,627                   |    |
| Balance December 31, 2001  |   | $                               | 17.97  |                     | 1,400,541 |                      | 577,539 |   |

 

AdditionalfinancialdatapertainingtooutstandingstockoptionsasofDecember31, 2001 is asfollows:

 
| **Range of   Exercise Prices** |              | **Number of   Option Shares** |    | **Weighted  Average   Remaining  Contractual Life   (in years)** |   | **Weighted  Average   Exercise Price  of Option Shares** |   | **Number of  Exercisable   Option Shares** |    | **Weighted  Average   Exercise Price   of Exercisable   Option Shares** |   |
|--------------------------------|-------------------|-------------------------------|---------|------------------------------------------------------------------|--------|----------------------------------------------------------|--------|--------------------------------------------|---------|-------------------------------------------------------------------------|--------|
| $                              | 5.49—$6.92   |                          | 55,029  |                                                             | 1.18   |                                                     | $      | 6.88                                       |    | 55,029                                                                  |   | $ | 6.88 |   |
| $                              | 7.56—$9.79   |                          | 58,388  |                                                             | 2.65   |                                                     | 8.34   |                                       | 57,848  |                                                                    | 8.34   |   |
| $                              | 10.46—$14.74 |                          | 163,212 |                                                             | 5.84   |                                                     | 12.81  |                                       | 80,647  |                                                                    | 12.72  |   |
| $                              | 15.57—$17.50 |                          | 537,751 |                                                             | 7.35   |                                                     | 17.37  |                                       | 139,154 |                                                                    | 17.08  |   |
| $                              | 18.86—$27.73 |                          | 586,161 |                                                             | 6.57   |                                                     | 21.96  |                                       | 244,861 |                                                                    | 22.81  |   |
|                           |              |                          |    |                                                             |   |                                                     |   |                                       |    |                                                                    |   |
| Total                          |              | 1,400,541                     |    | 6.41                                                             |   | $                                                        | 17.97  |                                       | 577,539 |                                                                    | $      | 17.04 |   |

 

As of December 31, 2001, therewere a total of 2,911,833 shares authorized under all stock option plans and atotal of 528,549 shares available for future stock option grants.

 

SFAS No. 123, “Accounting forStock-based Compensation,”**requires the disclosure of pro forma netincome and net income per share had PNWB adopted the fair value method ofaccounting for stock options.  Underthis statement, the fair 

41

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value of stock-based awards iscalculated through the use of option pricing models.  These models require the use of subjective assumptions, includingstock price volatility, dividend yield, risk-free interest rate and expectedtime to exercise. The fair value of options granted under stock option plans isestimated on the date of grant using the Black-Scholes option-pricingmodel.  Using the assumptions below, theweighted average estimated fair value of options granted was $5.89, $4.12,$6.72, and $7.06 during the years ended December 31, 2001 and December 31,2000, the three-month period ended December 31, 1999 and the year endedSeptember 30, 1999, respectively.  Thefollowing weighted average assumptions were used in the computation of theweighted average estimated fair value of stock options for the years endedDecember 31, 2001 and 2000, the three month period ended December 31, 1999 andthe year ended September 30, 1999:

 
|                     |   | **Year ended  December 31,  2001** |   | **Year ended  December 31,   2000** |   | **Three  months   December 31,   1999** |    | **Year ended    September 30   1999** |   |
|--------------------------|--------|------------------------------------|--------|-------------------------------------|--------|-----------------------------------------|---------|---------------------------------------|--------|
| Expected volatility      |   | 40.3                               | %      | 40.9                                | %      | 42.4                                    | %       | 37.4                                  | %      |
| Expected dividend yield  |   | 2.7                                | %      | 4.1                                 | %      | 2.9                                     | %  | 2.4                                   | %      |
| Risk-free interest rate  |   | 5.1                                | %      | 5.5                                 | %      | 6.3                                     | %  | 4.5                                   | %      |
| Expected life (in years) |   | 4.7                                |   | 5.8                                 |   | 6.6                                     |    | 6.1                                   |   |

 

If compensation expense forPNWB’s stock option plans had been determined consistent with SFAS No. 123, netincome and net income per share would have been the following pro forma amountsfor the years ended December 31, 2001 and 2000, the three month period endedDecember 31, 1999 and the year ended September 30, 1999:

 
|                          |   | **Year ended  December 31, 2001**                   |   | **Year ended  December 31, 2000** |   | **Three  months December 31, 1999** |   | **Year ended  September 30, 1999** |   |
|-------------------------------|--------|-----------------------------------------------------|--------|-----------------------------------|--------|-------------------------------------|--------|------------------------------------|--------|
|                          |   | **Dollars in thousands, except per  share amounts** |   |
| Net income:                   |   |                                                |   |                              |   |                                |   |                               |   |
| As reported                   |   | $                                                   | 22,092 |                              | $      | 6,269                               |   | $                                  | 5,462  |   | $ | 27,855 |   |
| Pro forma                     |   | 21,725                                              |   | 5,963                             |   | 5,302                               |   | 27,451                             |   |
| Basic net income per share:   |   |                                                |   |                              |   |                                |   |                               |   |
| As reported                   |   | $                                                   | 1.42   |                              | $      | 0.40                                |   | $                                  | 0.34   |   | 1.78 |   |
| Pro forma                     |   | 1.40                                                |   | 0.38                              |   | 0.33                                |   | 1.76                               |   |
| Diluted net income per share: |   |                                                |   |                              |   |                                |   |                               |   |
| As reported                   |   | $                                                   | 1.40   |                              | $      | 0.40                                |   | $                                  | 0.34   |   | 1.74 |   |
| Pro forma                     |   | 1.38                                                |   | 0.38                              |   | 0.33                                |   | 1.73                               |   |
|                               |        |                                                     |        |                                   |        |                                     |        |                                    |        |  |  |  |  |

 

The compensation expenseincluded in the pro forma net income and net income per share is not likely tobe representative of the effect on reported net income for future years becausestock options vest over several years and additional option grants generallyare made each year.

 

**NOTE 19**REGULATORYCAPITAL

 

Bancorp and Pacific NorthwestBank are subject to risk-based capital guidelines requiring minimum capitallevels based on the credit risk of assets. Failure to meet minimum capital requirements can initiate certainmandatory and possibly additional discretionary, actions by regulators that, ifundertaken, could have a material effect on PNWB’s consolidated financialstatements.  Under capital adequacyguidelines and the regulatory framework for prompt corrective action, 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 therelevant capital levels for the five categories. In general terms, the capitaldefinitions are as follows:

 
|                           |   | **Total  Capital   (to Risk   Weighted Assets)** |   | **Tier  1Capital   (to Risk   Weighted Assets)** |   | **Tier 1  Capital   (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                                   | %      |

 

42

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Bancorpissubjecttorisk-basedcapitalguidelinesissuedbytheFederalReserveBoard(FRB), which establish a risk-adjustedratio relating capital to different categories of assets.  Tier I capital is comprised of shareholders’equity and guaranteed preferred beneficial interests in subordinated debt lesscertain intangibles, and excludes the equity impact of adjusting securitiesavailable for sale to estimated fair value. Total capital is Tier I capital andthe allowance for losses on loans.  TheFRB’s risk-based capital rules are supplemented by a leverage capital ratio,defined as Tier I capital to adjusted quarterly average total assets. As ofDecember 31, 2001 and 2000, under the FRB’s capital guidelines, Bancorp’sconsolidated regulatory capital exceeded the FRB’s minimum requirements.

 

The capital amounts and ratiosfor Pacific Northwest Bancorp and Pacific Northwest Bank as of December 31,2001 and 2000 are presented in the following table:

 

 
|                                     |   |                     |    |
|------------------------------------------|--------|--------------------------|---------|
|                                     |   | **Actual**               |    | **For  Capital   Adequacy   Purposes** |   | **To Be Well  Capitalized Under Prompt Corrective   Action Provisions** |
|                                     |   | **Amount**               |    | **Ratio** |   | **Amount** |   | **Ratio** |   | **Amount** |   | **Ratio** |   |
|                                     |   | **Dollars in thousands** |    |
| **December 31, 2001**                    |   |                     |    |   |   |   |   |   |   |   |   |   |   |
| *Pacific Northwest Bancorp:*             |   |                     |    |   |   |   |   |   |   |   |   |   |   |
| Total capital (to risk-weighted assets)  |   | $                        | 252,089 |   | 12.09 | % | $ | 166,802 |   | 8.0 | % | $ | 208,502 |   | 10.0 | % |
| Tier I capital (to risk-weighted assets) |   | 219,966                  |    | 10.55 | % | 83,401 |   | 4.0 | % | 125,101 |   | 6.0 | % |
| Tier I capital (to average assets)       |   | 219,966                  |    | 8.02 | % | 109,692 |   | 4.0 | % | 137,115 |   | 5.0 | % |
|                                     |   |                     |    |   |   |   |   |   |   |   |   |   |   |
| *Pacific Northwest Bank:*                |   |                     |    |   |   |   |   |   |   |   |   |   |   |
| Total capital (to risk-weighted assets)  |   | $                        | 248,486 |   | 11.96 | % | $ | 166,274 |   | 8.0 | % | $ | 207,842 |   | 10.0 | % |
| Tier I capital (to risk-weighted assets) |   | 228,363                  |    | 10.99 | % | 83,137 |   | 4.0 | % | 124,705 |   | 6.0 | % |
| Tier I capital (to average assets)       |   | 228,363                  |    | 8.35 | % | 109,427 |   | 4.0 | % | 136,783 |   | 5.0 | % |
|                                     |   |                     |    |   |   |   |   |   |   |   |   |   |   |
| **December 31, 2000**                    |   |                     |    |   |   |   |   |   |   |   |   |   |   |
| *Pacific Northwest Bancorp:*             |   |                     |    |   |   |   |   |   |   |   |   |   |   |
| Total capital (to risk-weighted assets)  |   | $                        | 223,657 |   | 11.05 | % | $ | 161,912 |   | 8.0 | % | $ | 202,391 |   | 10.0 | % |
| Tier I capital (to risk-weighted assets) |   | 206,096                  |    | 10.18 | % | 80,956 |   | 4.0 | % | 121,434 |   | 6.0 | % |
| Tier I capital (to average assets)       |   | 206,096                  |    | 7.23 | % | 114,066 |   | 4.0 | % | 142,583 |   | 5.0 | % |
|                                     |   |                     |    |   |   |   |   |   |   |   |   |   |   |
| *Pacific Northwest Bank:*                |   |                     |    |   |   |   |   |   |   |   |   |   |   |
| Total capital (to risk-weighted assets)  |   | $                        | 221,312 |   | 10.96 | % | $ | 161,548 |   | 8.0 | % | $ | 201,935 |   | 10.0 | % |
| Tier I capital (to risk-weighted assets) |   | 203,751                  |    | 10.09 | % | 80,774 |   | 4.0 | % | 121,161 |   | 6.0 | % |
| Tier I capital (to average assets)       |   | 203,751                  |    | 7.30 | % | 111,703 |   | 4.0 | % | 139,629 |   | 5.0 | % |

 

As of December 31, 2001 and2000, Pacific Northwest Bank was in compliance with well-capitalized capitalrequirements. Management believes that under the current regulations PacificNorthwest Bank will continue to meet minimum well-capitalized capitalrequirements in the foreseeable future. However, events beyond the control of Pacific Northwest Bank, such as adownturn in the economy in areas where Pacific Northwest Bank has most of itsloans, could adversely affect future earnings and, consequently, the ability ofPacific Northwest Bank to meet future well-capitalized requirements.

 

Currently, Bancorp paysquarterlydividends, whichitintendstocontinueto do. The funding source for dividends paid toshareholders is dividends received from Pacific Northwest Bank. The payment ofdividends to Bancorp from Pacific Northwest Bank willbebasedon earningsand financial condition and is subject to ongoing review by regulatory agenciesand various statutory limitations. Generally, PNWB is precluded from paying dividends on its common stockif capital would be reduced to below regulatory requirements at either theholding company or subsidiary bank level. As of December 31, 2001, $82,212,000 of retained earnings was availablefor dividend distribution based on the capital levels and restrictions ofBancorp and Pacific Northwest Bank.

 

In addition to regulatoryrestrictions on the payment of dividends, Pacific Northwest Bank is subject tocertain restrictions imposed by federal law on any extensions of credit toPacific Northwest Bancorp.  As ofDecember 31, 2001, $24,000,000 of credit was available to Pacific NorthwestBancorp from Pacific Northwest Bank under these limitations.

 

43

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**NOTE 20** DISCLOSUREABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS

 

The estimated fair valueamounts are determined by PNWB using available market information andappropriate valuation methodologies. However, considerable judgment isnecessary to interpret market data in the development of the estimates of fairvalue. Accordingly, the estimates presented herein are not necessarilyindicative of the amounts PNWB could realize in a current market exchange. Theuse of different market assumptions and/or estimation methodologies may have amaterial impact on the estimated fair value amounts. The following methods andassumptions were used to estimate the fair value of each class of PNWB’sfinancial instruments as of December 31, 2001 and 2000:

 

*CASHANDDUE FROM BANKS, FEDERAL FUNDS SOLD ANDSECURITIES PURCHASED UNDER AGREEMENTS TO RESELL* | The carrying value is a reasonableestimate of the fair value.

 

*SECURITIESAVAILABLEFORSALE,SECURITIESHELDTOMATURITYANDLOANSHELDFORSALE* | The estimated fair value of securitiesavailable for sale, securities held to maturity and loans held for sale arebased on quoted market rates and dealer quotes.

 

*LOANSRECEIVABLE* | The estimated fair value of loansreceivable is based on discounted cash flows, using estimated interest ratescurrently offered for loans of similar characteristics.

 

No adjustment was made to theestimated interest rates for changes in credit of performing loans for whichthere are no known credit concerns. Management believes that the risk factor embedded in the estimatedinterest rates, along with the allowance for losses on loans applicable to theloan portfolio, results in a fair valuation of such loans.

 

*DEPOSITS*| The estimated fair value of depositswith no stated maturity, such as checking accounts, money market and savingsaccounts, is equal to the amount payable on demand as of December 31, 2001 and2000, respectively.  The estimated fairvalue of certificates of deposit is based on the discounted value ofcontractual cash flows. The discount rate is estimated using the current ratefor certificates of deposit with similar characteristics.

 

*FHLBADVANCES,SECURITIESSOLDUNDERAGREEMENTSTOREPURCHASE ANDOTHER BORROWINGS*| The fair value of FHLB advances,securities sold under agreements to repurchase and other borrowings areestimated based on the present values using a discount rate equal to the ratecurrently offered on similar borrowings with similar maturities.

 

*GUARANTEED PREFERRED BENEFICIAL INTERESTS INSUBORDINATED DEBT*|The estimated fair value is determined based on quoted market rates forsubordinated debt with similar interest rates and similar characteristics.

 

*OTHER*| The carrying value of other financialinstruments has been determined to be a reasonable estimate of their fairvalue.

 

44

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|                                                                    |   | **December  31, 2001**    |    | **December  31, 2000**    |   |
|-------------------------------------------------------------------------|--------|---------------------------|---------|---------------------------|--------|
|                                                                    |   | **Carrying  Value**       |    | **Estimated  Fair Value** |   | **Carrying  Value** |   | **Estimated  Fair Value** |   |
|                                                                    |   | **Dollars in  thousands** |    |
| *Financial assets*                                                      |   |                      |    |                      |   |   |   |   |   |
|                                                                    |   |                      |    |                      |   |   |   |   |   |
| Cash and due from banks                                                 |   | $                         | 58,625  |                      | $      | 58,625 |   | $ | 78,861 |   | $ | 78,861 |   |
| Federal funds sold and securities purchased  under agreements to resell |   | —                    |    | —                    |   | 7,467 |   | 7,467 |   |
| Securities available for sale                                           |   | 757,018                   |    | 757,018                   |   | 840,489 |   | 840,489 |   |
| Securities held to maturity                                             |   | —                    |    | —                    |   | 64,741 |   | 63,823 |   |
| Loans receivable                                                        |   | 1,808,555                 |    | 1,844,499                 |   | 1,775,075 |   | 1,786,382 |   |
| Loans held for sale                                                     |   | 43,757                    |    | 43,872                    |   | 14,187 |   | 14,385 |   |
|                                                                    |   |                      |    |                      |   |   |   |   |   |
| *Financial liabilities*                                                 |   |                      |    |                      |   |   |   |   |   |
|                                                                    |   |                      |    |                      |   |   |   |   |   |
| Non-interest-bearing deposits                                           |   | $                         | 241,674 |                      | $      | 241,674 |   | $ | 244,100 |   | $ | 244,100 |   |
| Interest-bearing checking accounts                                      |   | 214,099                   |    | 214,099                   |   | 201,894 |   | 201,894 |   |
| Money market accounts                                                   |   | 322,554                   |    | 322,554                   |   | 266,933 |   | 266,933 |   |
| Savings accounts                                                        |   | 95,390                    |    | 95,390                    |   | 100,831 |   | 100,831 |   |
| Certificates of deposit                                                 |   | 731,139                   |    | 73,8857                   |   | 903,350 | ` | 905,672 |   |
| Total deposits                                                          |   | 1,604,855                 |    | 1,612,574                 |   | 1,717,108 |   | 1,719,430 |   |
|                                                                    |   |                      |    |                      |   |   |   |   |   |
| FHLB advances and other borrowings                                      |   | 727,147                   |    | 732,412                   |   | 644,953 |   | 643,901 |   |
| Securities sold under agreements to  repurchase                         |   | 149,504                   |    | 149,761                   |   | 274,920 |   | 275,776 |   |
| Guaranteed preferred beneficial interests  in subordinated debt         |   | 37,500                    |    | 35,318                    |   | 40,000 |   | 37,393 |   |
|                                                                    |   |                      |    |                      |   |   |   |   |   |
| *Off balance sheet loan commitments:*                                   |   |                      |    |                      |   |   |   |   |   |
| Real estate                                                             |   | $                         | 268,972 |                      | $      | 268,972 |   | $ | 266,211 |   | $ | 266,211 |   |
| Non Real Estate Commercial                                              |   | 341,258                   |    | 341,258                   |   | 250,294 |   | 250,294 |   |
| Standby letters of credit                                               |   | 51,485                    |    | 51,485                    |   | 47,512 |   | 47,512 |   |
| Commercial letters of credit                                            |   | 16,915                    |    | 16,915                    |   | 16,614 |   | 16,614 |   |

* *

*LIMITATIONS* | The estimated fair values presented arebased on information available to management as of December 31, 2001 and2000.  Since December 31, 2001 and 2000,amounts have not been comprehensively revalued for purposes of these consolidatedfinancial statements and, therefore, current estimates of fair value may differfrom the amounts disclosed above.

 

**NOTE 21**CONTINGENCIES

 

At periodic intervals, theFDIC, the Washington Department of Financial Institutions, Division of Banks,the Federal Reserve Bank (FRB) and other regulatory agencies (collectively theregulators), examine Bancorp and Pacific Northwest Bank as part of theregulatory oversight of the banking industry. Based on their examinations, the regulators may direct Bancorp orPacific Northwest Bank to adjust financial statements in accordance with theirfindings.  A future examinationbytheregulatorscouldincludeareviewofcertaintransactionsorotheramountsreportedin PNWB’s2001 consolidated financial statements. The regulators have not proposed significant adjustments to PNWB’sconsolidated financial statements in prior years and management is not aware ofany basis for any such adjustments for 2001. In view of the uncertain regulatory environment in which PNWB operates,the extent, if any, to which a forthcomingexaminationmayultimatelyresultinregulatoryadjustmentstothe 2001 consolidated financialstatementscannotpresently bedetermined.

 

In the normal course ofbusiness, PNWB has various legal claims and other contingent mattersoutstanding.  Management believes thatany ultimate liability arising from these actions will not have a materialadverse impact on PNWB’s financial condition or results of operations.

 

During the year ended September30, 1998, PNWB sold $26,709,000 of single-family residential mortgage loanswith recourse.  As of December 31, 2001,$11,170,000 of single-family mortgage loans sold with recourse wereoutstanding.

 

45

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**NOTE 22** CONDENSEDPARENT COMPANY FINANCIAL INFORMATION PACIFIC NORTHWEST BANCORP

 

Condensed financial informationfor Pacific Northwest Bancorp (parent company only) as of December 31, 2001 and2000 and for the years ended December 31, 2001 and 2000, the three month periodended December 31, 1999 and the year ended September 30, 1999, is as follows:

 

CONDENSED STATEMENTS OFFINANCIAL CONDITION

 

** **
| **As of  December 31,**                                 |   | **2001**                  |    | **2000** |   |
|---------------------------------------------------------|--------|---------------------------|---------|----------|--------|
|                                                    |   | **Dollars in  thousands** |    |
| *Assets*                                                |   |                      |    |     |   |
|                                                    |   |                      |    |     |   |
| Cash and due from banks                                 |   | $                         | 2,735   |     | $      | 2,057 |   |
| Securities available for sale, at estimated  fair value |   | 984                       |    | 300      |   |
| Goodwill                                                |   | 15,487                    |    | 16,533   |   |
| Other assets                                            |   | 3,326                     |    | 8,219    |   |
| Investment in subsidiaries                              |   | 234,757                   |    | 201,094  |   |
|                                                    |   |                      |    |     |   |
| Total                                                   |   | $                         | 257,289 |     | $      | 228,203 |   |
|                                                    |   |                      |    |     |   |
| *Liabilities and Shareholders’ Equity*             |   |                      |    |     |   |
|                                                    |   |                      |    |     |   |
| Other liabilities                                       |   | $                         | 3,022   |     | $      | 6,561 |   |
| Borrowings from subsidiaries                            |   | 41,238                    |    | 41,238   |   |
| Other borrowings                                        |   | 12,543                    |    | 1,668    |   |
| Shareholders’ equity                               |   | 200,486                   |    | 178,736  |   |
|                                                    |   |                      |    |     |   |
| Total                                                   |   | $                         | 257,289 |     | $      | 228,203 |   |

 

CONDENSEDSTATEMENTS OF INCOME

 
|                                                                                       |   | **Year ended**            |   | **Year ended**    |   | **Three  months** |   | **Year ended**     |   |
|--------------------------------------------------------------------------------------------|--------|---------------------------|--------|-------------------|--------|-------------------|--------|--------------------|--------|
|                                                                                       |   | **December  31,**         |   | **December  31,** |   | **December  31,** |   | **September  30,** |   |
|                                                                                       |   | **2001**                  |   | **2000**          |   | **1999**          |   | **1999**           |   |
|                                                                                       |   | **Dollars in  thousands** |   |
| Dividend  income received from subsidiaries                                                |   | $                         | 9,900  |              | $      | 17,000            |   | $                  | 8,000  |   | $ | 25,000 |   |
| Interest  income                                                                           |   | 194                       |   | 122               |   | 15                |   | —             |   |
| Non-interest  income                                                                       |   | 25                        |   | 88                |   | 23                |   | —             |   |
| Total  income                                                                              |   | 10,119                    |   | 17,210            |   | 8,038             |   | 25,000             |   |
| Interest  expense                                                                          |   | 4,698                     |   | 4,072             |   | 509               |   | —             |   |
| Non-interest expense                                                                       |   | 2,366                     |   | 11,779            |   | 1,164             |   | 1,966              |   |
| Total expenses                                                                             |   | 7,064                     |   | 15,851            |   | 1,673             |   | 1,966              |   |
| Income before income tax benefit and equity  in undistributed net income from subsidiaries |   | 3,055                     |   | 1,359             |   | 6,365             |   | 23,034             |   |
| Income tax benefit                                                                         |   | (1,678                    | )      | (5,039            | )      | (493              | )      | (691               | )      |
| Net income before equity (deficit) in undistributed  net income from subsidiaries          |   | 4,733                     |   | 6,398             |   | 6,858             |   | 23,725             |   |
| Equity (deficit) in undistributed net  income from subsidiaries                            |   | 17,359                    |   | (129              | )      | (1,396            | )      | 4,130              |   |
| Net income                                                                                 |   | $                         | 22,092 |              | $      | 6,269             |   | $                  | 5,462  |   | $ | 27,855 |   |

 

 

46

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CONDENSEDSTATEMENTS OF CASH FLOWS

 
|                                                                               |   | **Year ended  December 31,  2001** |   | **Year ended  December 31,  2000** |   | **Three  months  December 31,  1999** |   | **Year ended  September 30,  1999** |   |
|------------------------------------------------------------------------------------|--------|------------------------------------|--------|------------------------------------|--------|---------------------------------------|--------|-------------------------------------|--------|
|                                                                               |   | **Dollars in  thousands**          |   |
| Cash flows from operating activities:                                              |   |                               |   |                               |   |                                  |   |                                |   |
| Net income                                                                         |   | $                                  | 22,092 |                               | $      | 6,269                                 |   | $                                   | 5,462  |   | $ | 27,855 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |   |                               |   |                               |   |                                  |   |                                |   |
| Equity in net income from subsidiaries                                             |   | (27,260                            | )      | (16,871                            | )      | (6,604                                | )      | (29,130                             | )      |
| Cash dividends received from subsidiaries                                          |   | 9,900                              |   | 17,000                             |   | 8,000                                 |   | 25,000                              |   |
| Change in other assets and liabilities, net                                        |   | 352                                |   | (1,634                             | )      | (1,273                                | )      | (2,135                              | )      |
| Amortization of goodwill                                                           |   | 1,046                              |   | 1,028                              |   | 255                                   |   | 417                                 |   |
| Net cash provided by operating activities                                          |   | 6,130                              |   | 5,792                              |   | 5,840                                 |   | 22,007                              |   |
|                                                                               |   |                               |   |                               |   |                                  |   |                                |   |
| Cash flows from investing activities:                                              |   |                               |   |                               |   |                                  |   |                                |   |
| Investments in subsidiaries                                                        |   | (6,000                             | )      | —                             |   | (26,238                               | )      | (2,000                              | )      |
| Purchase of securities available for sale                                          |   | (706                               | )      | —                             |   | —                                |   | (300                                | )      |
| Net cash used in investing activities                                              |   | (6,706                             | )      | —                             |   | (26,238                               | )      | (2,300                              | )      |
|                                                                               |   |                               |   |                               |   |                                  |   |                                |   |
| Cash flows from financing activities:                                              |   |                               |   |                               |   |                                  |   |                                |   |
| Proceeds from issuance of notes payable                                            |   | 12,000                             |   | —                             |   | —                                |   | —                              |   |
| Payment of dividends                                                               |   | (8,712                             | )      | (8,770                             | )      | (2,178                                | )      | (8,843                              | )      |
| Purchase and retirement of treasury stock                                          |   | (342                               | )      | (7,860                             | )      | (7,621                                | )      | (11,910                             | )      |
| Proceeds from subsidiary borrowings                                                |   | —                             |   | —                             |   | 41,238                                |   | —                              |   |
| Proceeds from stock option exercises                                               |   | 808                                |   | 779                                |   | 328                                   |   | 1,525                               |   |
| Purchase of InterWest Capital Trust I —  Capital securities                   |   | (2,500                             | )      | —                             |   | —                                |   | —                              |   |
| Net cash provided by (used in) financing  activities                               |   | 1,254                              |   | (15,851                            | )      | 31,767                                |   | (19,228                             | )      |
|                                                                               |   |                               |   |                               |   |                                  |   |                                |   |
| Net increase (decrease) in cash and cash  equivalents                              |   | 678                                |   | (10,059                            | )      | 11,369                                |   | 479                                 |   |
|                                                                               |   |                               |   |                               |   |                                  |   |                                |   |
| Cash and due from banks at beginning of  period                                    |   | 2,057                              |   | 12,116                             |   | 747                                   |   | 268                                 |   |
|                                                                               |   |                               |   |                               |   |                                  |   |                                |   |
| Cash and due from banks at end of period                                           |   | $                                  | 2,735  |                               | $      | 2,057                                 |   | $                                   | 12,116 |   | $ | 747 |   |

 

**NOTE 23**NET INCOMEPER SHARE

 

The following table presentsthe computation of basic and diluted net income per share for the years ended December31, 2001 and 2000, the three month period ended December 31, 1999 and the yearended September 30, 1999:

 
|                                                                                                                    |   | **Year ended  December 31,  2001**                         |   | **Year ended  December 31,  2000** |   | **Three  months  December 31,  1999** |   | **Year ended  September 30,  1999** |   |
|-------------------------------------------------------------------------------------------------------------------------|--------|------------------------------------------------------------|--------|------------------------------------|--------|---------------------------------------|--------|-------------------------------------|--------|
|                                                                                                                    |   | **Dollars in  thousands, except share and per share data** |   |
| Numerator                                                                                                               |   |                                                       |   |                               |   |                                  |   |                                |   |
| Net income                                                                                                              |   | $                                                          | 22,092 |                               | $      | 6,269                                 |   | $                                   | 5,462  |   | $ | 27,855 |   |
|                                                                                                                    |   |                                                       |   |                               |   |                                  |   |                                |   |
| Denominator                                                                                                             |   |                                                       |   |                               |   |                                  |   |                                |   |
| Denominator for basic net income per  share-Weighted average shares                                                     |   | 15,557,237                                                 |   | 15,504,759                         |   | 16,001,909                            |   | 15,628,141                          |   |
| Effect of dilutive securities: Stock  options                                                                           |   | 175,586                                                    |   | 106,323                            |   | 208,300                               |   | 355,002                             |   |
| Denominator for diluted net income per  share-Weighted average shares and assumed conversion of dilutive stock  options |   | 15,732,823                                                 |   | 15,611,082                         |   | 16,210,209                            |   | 15,983,143                          |   |
|                                                                                                                    |   |                                                       |   |                               |   |                                  |   |                                |   |
| Basic net income per share                                                                                              |   | $                                                          | 1.42   |                               | $      | 0.40                                  |   | $                                   | 0.34   |   | $ | 1.78 |   |
|                                                                                                                    |   |                                                       |   |                               |   |                                  |   |                                |   |
| Diluted net income per share                                                                                            |   | $                                                          | 1.40   |                               | $      | 0.40                                  |   | $                                   | 0.34   |   | $ | 1.74 |   |

 

47

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**NOTE 24** BUSINESSSEGMENTS

 

Between the period August 31,1996 and October 1999, PNWB acquired six commercial banking institutions.  Subsequent to these acquisitions, PNWB wasmanaged at the individual subsidiary bank level.  Each subsidiary bank had a board of directors and an executivemanagement team that was responsible for the operation and performance of therespective subsidiary bank.

 

During the year ended December31, 2000, PNWB merged the subsidiary banks into one single bank.  In addition, PNWB consolidated its executivemanagement functions and implemented a new organizational structure, whileconverting separate banking systems into a single operating system.  As a result of these organizational andsystem changes, the financial information that is used by the chief operatingdecision maker in allocating resources and assessing performance is onlyprovided for one reportable segment as of December 31, 2001 and 2000.  Prior periods have been restated to reflectthe change in segment reporting.

 

**NOTE 25** SELECTEDQUARTERLY FINANCIAL DATA (UNAUDITED)

 
|                                                     |       | **Fourth  Quarter** |   | **Third  Quarter** |   | **Second  Quarter** |   | **First  Quarter** |   |
|----------------------------------------------------------|------------|---------------------|--------|--------------------|--------|---------------------|--------|--------------------|--------|
| **Dollars in thousands except per share data**           | ** ** |
| Year ended December 31, 2001                             |       |                |   |               |   |                |   |               |   |
| Interest income                                          |       | $                   | 48,163 |               | $      | 50,663              |   | $                  | 52,780 |   | $ | 54,047 |   |
| Interest expense                                         |       | 19,095              |   | 24,038             |   | 28,265              |   | 32,443             |   |
| Net interest income                                      |       | 29,068              |   | 26,625             |   | 24,515              |   | 21,604             |   |
| Provision for losses on loans                            |       | 1,700               |   | 1,550              |   | 1,400               |   | 1,400              |   |
| Net interest income after provision for  losses on loans |       | 27,368              |   | 25,075             |   | 23,115              |   | 20,204             |   |
| Gain on sale of securities available for  sale           |       | 51                  |   | 514                |   | 446                 |   | 698                |   |
| Other non-interest income                                |       | 4,772               |   | 4,596              |   | 4,664               |   | 4,944              |   |
| Non-interest expense                                     |       | 21,025              |   | 20,427             |   | 20,434              |   | 19,266             |   |
| Income before income taxes                               |       | 11,166              |   | 9,758              |   | 7,791               |   | 6,580              |   |
| Income tax expense                                       |       | 4,179               |   | 3,651              |   | 2,916               |   | 2,457              |   |
| Net income                                               |       | $                   | 6,987  |               | $      | 6,107               |   | $                  | 4,875  |   | $ | 4,123 |   |
| Basic net income per share                               |       | $                   | 0.45   |               | $      | 0.39                |   | $                  | 0.31   |   | $ | 0.27 |   |
| Diluted net income per share                             |       | $                   | 0.44   |               | $      | 0.39                |   | $                  | 0.31   |   | $ | 0.26 |   |
|                                                     |       |                |   |               |   |                |   |               |   |
| Year ended December 31, 2000                             |       |                |   |               |   |                |   |               |   |
| Interest income                                          |       | $                   | 55,684 |               | $      | 55,023              |   | $                  | 54,337 |   | $ | 53,144 |   |
| Interest expense                                         |       | 34,338              |   | 33,075             |   | 31,646              |   | 29,596             |   |
| Net interest income                                      |       | 21,346              |   | 21,948             |   | 22,691              |   | 23,548             |   |
| Provision for losses on loans                            |       | 1,400               |   | 1,400              |   | 1,400               |   | 550                |   |
| Net interest income after provision for  losses on loans |       | 19,946              |   | 20,548             |   | 21,291              |   | 22,998             |   |
| Gain (loss) on sale of securities available  for sale    |       | 658                 |   | 5                  |   | (6,781              | )      | 5                  |   |
| Other non-interest income                                |       | 4,649               |   | 4,887              |   | 4,324               |   | 4,366              |   |
| Non-interest expense                                     |       | 20,028              |   | 20,371             |   | 27,635              |   | 18,231             |   |
| Income (loss) before income taxes                        |       | 5,225               |   | 5,069              |   | (8,801              | )      | 9,138              |   |
| Income tax expense (benefit)                             |       | 1,912               |   | 1,861              |   | (2,668              | )      | 3,257              |   |
| Net income (loss)                                        |       | $                   | 3,313  |               | $      | 3,208               |   | $                  | (6,133 | ) | $ | 5,881 |   |
| Basic net income (loss) per share                        |       | $                   | 0.21   |               | $      | 0.21                |   | $                  | (0.40  | ) | $ | 0.38 |   |
| Diluted net income (loss) per share                      |       | $                   | 0.21   |               | $      | 0.21                |   | $                  | (0.40  | ) | $ | 0.37 |   |

 

Non-interest expense for thequarter ended March 31, 2001 includes conversion and integration expenses of$856,000.  Non-interest expense for thequarter ended June 30, 2001 includes conversion and integration expenses of$434,000, and expenses associated with severance and employment agreements of$200,000.

 

Non-interest expense for thequarter ended June 30, 2000 includes conversion and integration expenses of$3,210,000, expenses associated with severance and employment agreements of$3,205,000 and impairment of goodwill of $749,000.  Non-interest expense for the quarter ended September 30, 2000 includesconversion and integration expenses of $1,827,000 and expenses associated withseverance and employment agreements of $120,000.  Non-interest expense for the quarter ended December 31, 2000includes conversion and integration expenses of $2,007,000.

48

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