**UNITED
      STATES**


SECURITIES
      AND EXCHANGE COMMISSION


**Washington,
      D.C. 20549**




**FORM
      10-Q**






(Mark
                One)x
            
            **Quarterly Report Pursuant to
              Section
              13 or 15(d) of****The
              Securities Exchange Act of 1934**For the quarterly period
              ended................................................March 31,
              2006**OR**o
            
            **Transition Report Pursuant
              to Section
              13 or 15(d) of****The
              Securities Exchange Act of 1934**For the transition period from
              ________________ to ________________






Commission
      File Number 005-57091








**FIRST
      MUTUAL BANCSHARES, INC.**


(Exact
      name of registrant as specified in its charter)






WASHINGTON
            
            91-2005970(State
                or other jurisdiction of
            
            (I.R.S.
                Employer Identification Number)incorporationor
                organization)







400
      108th Avenue N.E., Bellevue, WA 98004


(Address
      of principal executive offices) (Zip code)






Registrant's
      telephone number, including area code:   (425)
      455-7300






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




Yes
x     No
o




Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated  filer,
      or
      a non-accelerated filer. See definition of "accelerated filer and large
      accelerated filer"
      in
      Rule 12b-2 of the Exchange Act).




Large accelerated filer o
            Accelerated filer x
            Non-accelerated filer o




Indicate
      by check mark whether the registrant is a shell company (as defined in Rule 12b-2
      of
      the Exchange Act).




Yes
oNo
x




Indicate
      the number of shares outstanding of each of the issuer's classes of common
      stock, as
      of the
      latest practicable
      date. April 28,
      2006  5,315,107








FIRST
          MUTUAL BANCSHARES, INC.
 
 QUARTERLY
          REPORT ON FORM 10-Q
 March
          31,
          2006
 
 TABLE
          OF
          CONTENTS
  PagePART
                    I:  FINANCIAL INFORMATION
                1Forward-Looking
                    Statements Disclaimer
                1ITEM
                    1. Financial Statements
                2ITEM
                    2. Management’s Discussion and Analysis of Financial Condition
                    andResults
                    of Operations
                15General
                15Overview
                15Results
                    of Operations
                17Net
                    Income
                17Net
                    Interest Income
                17Noninterest
                    Income
                21Noninterest
                    Expense
                23Financial
                    Condition
                27Asset
                    Quality
                30Portfolio
                    Information
                32Deposit
                    Information
                35Business
                    Segments
                35Consumer
                    Lending
                36Residential
                    Lending
                37Business
                    Banking Lending
                38Income
                    Property Lending
                39Liquidity
                40Capital
                42Subsequent
                    Events
                43ITEM
                    3. Quantitative and Qualitative Disclosures About Market
                    Risk
                43ITEM
                    4. Controls and Procedures
                49PART
                    II:  OTHER INFORMATION
                49ITEM
                    1. Legal Proceedings
                49ITEM
                    1A. Risk Factors
                49ITEM
                    2. Unregistered Sales of Equity Securities and Use of
                    Proceeds
                49ITEM
                    3. Defaults Upon Senior Securities
                49ITEM
                    4. Submission of Matters to a Vote of Security Holders
                49ITEM
                    5. Other Information
                49ITEM
                    6. Exhibits
                50SIGNATURES
                51CERTIFICATIONS
  
 **PART
            I :** **FINANCIAL
            INFORMATION**
  **FORWARD-LOOKING
            STATEMENTS DISCLAIMER**
 
 Our
            Form
            10-Q contains statements concerning future operations, trends, expectations,
            plans, capabilities, and prospects of First Mutual Bancshares, Inc. and
            First
            Mutual Bank (together, the “Bank”) that are forward-looking statements for the
            purposes of the safe harbor provisions under the Private Securities Litigation
            Reform Act of 1995. Such forward-looking statements include statements
            regarding
            our goals and expectations regarding our target net income and return
            on equity;
            as well as references to potential changes in interest rate margins,
            anticipated
            growth in loan production and growth in sales of loans, expectations
            regarding
            our Business Banking segment, expectation regarding an increased percentage
            of
            checking accounts in our deposit mix, observations regarding our provision
            for
            loan losses and information based on our Market Risk models and analysis.
            Although we believe that the expectations expressed in these forward-looking
            statements are based on reasonable assumptions within the bounds of our
            knowledge of our business, operations, and prospects, these forward-looking
            statements are subject to numerous uncertainties and risks, and actual
            events,
            results, and developments will ultimately differ from the expectations
            and may
            differ materially from those expressed or implied in such forward-looking
            statements. Factors which could affect actual results include economic
            conditions in our market area and the nation as a whole, interest rate
            fluctuations, the impact of competitive products, services, and pricing,
            our
            credit risk management, our ability to control our costs and expenses
            including
            our business banking expenses, loan delinquency rates, and the legislative
            and
            regulatory changes affecting the banking industry. There are other risks
            and
            uncertainties that could affect us which are discussed from time to time
            in our
            filings with the Securities and Exchange Commission. These risks and
            uncertainties should be considered in evaluating the forward-looking
            statements,
            and undue reliance should not be placed on such statements. We are not
            responsible for updating any such forward-looking statements.
 
 ITEM
                    1.
                  Financial
                      Statements
 
 In
            the
            opinion of management, the accompanying consolidated statements of financial
            condition and related interim consolidated statements of income, comprehensive
            income, stockholders’ equity and cash flows reflect all adjustments (which
            include reclassifications and normal recurring adjustments) that are
            necessary
            for a fair presentation in conformity with accounting principles generally
            accepted in the United States of America (“GAAP”). The preparation of financial
            statements in conformity with GAAP requires management to make estimates
            and
            assumptions that affect amounts reported in the financial statements.
            Changes in
            these estimates and assumptions are considered reasonably possible and
            may have
            a material impact on the financial statements.
 
 Certain
            reclassifications have been made to the 2005 financial statements to
            conform to
            the 2006 presentation. There is no effect on net income, earnings per
            share, or
            equity. All significant intercompany transactions and balances have been
            eliminated.
 
 The
            information included in this Form 10-Q should be read in conjunction
            with the
            First Mutual Bancshares, Inc. Year 2005 Annual Report on Form 10-K to
            the
            Securities and Exchange Commission. Interim results are not necessarily
            indicative of results for a full year.
 
 Consolidated
            Financial Statements of the Company begin on page 2.
  -1-
  **Item
                  1.**
                **Financial
                    Statements**




**FIRST
        MUTUAL BANCSHARES, INC.**
 **CONSOLIDATED
          STATEMENTS OF FINANCIAL CONDITION**


March
                  31,
              
              
              
              December
                  31,2006
              
              
              
              2005**ASSETS:**
              
              *(Unaudited)***CASH
                  AND CASH EQUIVALENTS:**Interest-earning
                  deposits
              
              $
              3,235,303
              
              
              
              
              $
              1,229,176Noninterest-earning
                    demand depositsand cash on hand
              
              
              23,036,318
              
              
              
              
              
              24,551,43626,271,621
              
              
              
              
              
              25,780,612**MORTGAGE-BACKED
                    AND OTHER SECURITIES**AVAILABLE-FOR-SALE
              
              
              110,063,643
              
              
              
              
              
              114,450,342**LOANS
                  RECEIVABLE, HELD-FOR-SALE**
              
              
              13,919,711
              
              
              
              
              
              14,683,507**MORTGAGE-BACKED
                  AND OTHER SECURITIES HELD-TO-****MATURITY,
                  fair value of $6,284,331 and $6,970,890**
              
              
              6,341,961
              
              
              
              
              
              6,966,295**LOANS
                  RECEIVABLE**
              
              
              881,461,733
              
              
              
              
              
              878,066,241**RESERVE
                  FOR LOAN LOSSES**
              
              
              (10,086,880
              )
              
              
              
              
              (10,069,020
              )**LOANS
                  RECEIVABLE, net**
              
              
              871,374,853
              
              
              
              
              
              867,997,221**ACCRUED
                  INTEREST RECEIVABLE**
              
              
              5,362,094
              
              
              
              
              
              5,350,493**LAND,
                  BUILDINGS AND EQUIPMENT, net**
              
              
              34,268,724
              
              
              
              
              
              33,483,998**REAL
                  ESTATE HELD-FOR-SALE**
              
              
              27,600
              
              
              
              
              
              —**FEDERAL
                  HOME LOAN BANK (FHLB) STOCK,**
              
              
              13,122,300
              
              
              
              
              
              13,122,300**at
                  cost****SERVICING
                  ASSETS**
              
              
              2,474,519
              
              
              
              
              
              1,865,698**OTHER
                  ASSETS**
              
              
              2,040,257
              
              
              
              
              
              2,464,369**TOTAL
                  ASSETS**
              
              $
              1,085,267,283
              
              
              
              
              $
              1,086,164,835






See
      Notes
      to Financial Statements.


-2-


**FIRST
          MUTUAL BANCSHARES, INC.**
 **CONSOLIDATED
          STATEMENTS OF FINANCIAL CONDITION**
 **(Continued)**
  March
                  31,
              
              
              
              December
                  31,2006
              
              
              
              2005(Unaudited)**LIABILITIES:**Deposits:Money
                  market deposit andchecking
                  accounts
              
              $
              290,733,991
              
              
              
              
              $
              263,444,641Savings
              
              
              8,165,678
              
              
              
              
              
              8,053,510Time
                  deposits
              
              
              484,714,760
              
              
              
              
              
              489,222,486Total
                  deposits
              
              
              783,614,429
              
              
              
              
              
              760,720,637Drafts
                  payable
              
              
              1,171,727
              
              
              
              
              
              733,773Accounts
                  payable and other liabilities
              
              
              6,979,987
              
              
              
              
              
              15,706,624Advance
                    payments by borrowers fortaxes
                    and insurance
              
              
              2,877,787
              
              
              
              
              
              1,671,496FHLB
                  advances
              
              
              206,969,630
              
              
              
              
              
              225,705,005Other
                  advances
              
              
              4,600,000
              
              
              
              
              
              4,600,000Junior
                  subordinated long-term debentures
              
              
              17,000,000
              
              
              
              
              
              17,000,000Total
                  liabilities
              
              
              1,023,213,560
              
              
              
              
              
              1,026,137,535**STOCKHOLDERS’
                  EQUITY:**Common
                        stock, $1 par value-Authorized, 30,000,000 shares Issued and
                        outstanding, 5,315,107 and 5,296,810 shares, respectively
              
              $
              5,315,107
              
              
              
              
              $
              5,296,810Additional
                  paid-in capital
              
              
              45,631,334
              
              
              
              
              
              45,288,791Retained
                  earnings
              
              
              13,061,390
              
              
              
              
              
              10,877,529Accumulated
                  other comprehensive income(loss):Unrealized
                    (loss) on securities available-for-saleand interest rate swap, net
                    of federal income tax
              
              
              (1,954,108
              )
              
              
              
              
              (1,435,830
              )Total
                  stockholders’
                  equity
              
              
              62,053,723
              
              
              
              
              
              60,027,300**TOTAL
                  LIABILITIES AND STOCKHOLDER’S
                  EQUITY**
              
              $
              1,085,267,283
              
              
              
              
              $
              1,086,164,835






See
      Notes to Financial Statements.


-3-




**FIRST
          MUTUAL BANCSHARES, INC.**
 **CONSOLIDATED
          STATEMENTS OF INCOME**
    Quarter
                  ended March 31,2006
              
              
              
              2005*(Unaudited)***INTEREST
                  INCOME:**Loans
                  Receivable
              
              $
              17,547,059
              
              
              
              
              $
              13,932,200Interest
                  on Available For Sale Securities
              
              
              1,193,181
              
              
              
              
              
              1,271,081Interest
                  on Held To Maturity Securities
              
              
              90,230
              
              
              
              
              
              94,146Interest
                  Other
              
              
              118,287
              
              
              
              
              
              101,76918,948,757
              
              
              
              
              
              15,399,196**INTEREST
                  EXPENSE:**Deposits
              
              
              5,916,325
              
              
              
              
              
              3,571,414FHLB
                  and other advances
              
              
              2,800,992
              
              
              
              
              
              2,027,5368,717,317
              
              
              
              
              
              5,598,950Net
                  interest income
              
              
              10,231,440
              
              
              
              
              
              9,800,246**PROVISION
                  FOR LOAN LOSSES**
              
              
              71,000
              
              
              
              
              
              400,000Net
                    interest income, after provisionfor loan
                    losses
              
              
              10,160,440
              
              
              
              
              
              9,400,246**NONINTEREST
                  INCOME:**Gain
                  on sales of loans
              
              
              756,083
              
              
              
              
              
              524,537Servicing
                  fees, net of amortization
              
              
              334,747
              
              
              
              
              
              326,294Fees
                  on deposits
              
              
              181,869
              
              
              
              
              
              135,328Other
              
              
              442,150
              
              
              
              
              
              383,604Total
                  noninterest income
              
              
              1,714,849
              
              
              
              
              
              1,369,763




See
        Notes to Financial Statements.


-4-




**FIRST
          MUTUAL BANCSHARES, INC.**
 **CONSOLIDATED
          STATEMENTS OF INCOME**
 (Continued)
  Quarter
                  ended March 31,2006
              
              
              
              2005(Unaudited)**NONINTEREST
                  EXPENSE:**Salaries
                  and employee benefits
              
              $
              4,446,460
              
              
              
              
              $
              3,946,432Occupancy
              
              
              1,009,575
              
              
              
              
              
              783,459Other
              
              
              2,232,277
              
              
              
              
              
              2,133,017Total
                  noninterest expense
              
              
              7,688,312
              
              
              
              
              
              6,862,908Income
                  before provision for federal income tax
              
              
              4,186,977
              
              
              
              
              
              3,907,101**PROVISION
                  FOR FEDERAL INCOME TAX**
              
              
              1,472,905
              
              
              
              
              
              1,322,841**NET
                  INCOME**
              
              $
              2,714,072
              
              
              
              
              $
              2,584,260**PER
                  SHARE DATA:**Basic
                  earnings per common share
              
              $
              0.51
              
              
              
              
              $
              0.49Earnings
                  per common share, assuming dilution
              
              $
              0.50
              
              
              
              
              $
              0.47**WEIGHTED
                  AVERAGE SHARES OUTSTANDING**
              
              
              5,301,838
              
              
              
              
              
              5,301,235**WEIGHTED
                    AVERAGE SHARES OUTSTANDINGINCLUDING DILUTIVE STOCK
                    OPTIONS**
              
              
              5,407,028
              
              
              
              
              
              5,552,302




See
        Notes to Financial Statements.


-5-




**FIRST
          MUTUAL BANCSHARES, INC. AND SUBSIDIARIES**
 **CONSOLIDATED
          STATEMENTS OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE
          INCOME**


Common
                  Stock
              
              Additional
                Paid-in
              
              Retained
              
              Accumulated
                Comprehensive
                IncomeShares
              
              Amount
              
              Capital
              
              Earnings
              
              (Loss)
              
              TotalBALANCE,
                  December 31, 2003
              
              
              4,729,693
              
              $
              4,729,693
              
              $
              33,678,181
              
              $
              12,832,652
              
              $
              (413,770
              )
              $
              50,826,756Comprehensive
                  income:Net
                  income
              
              
              
              
              
              
              
              
              
              
              
              9,287,813
              
              
              
              
              
              9,287,813Other
                  comprehensive income (loss), net of tax:Unrealized
                  (loss) on securities available-for-sale
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (414,879
              )
              
              (414,879
              )Unrealized
                  gain on interest rate swap
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              171,664
              
              
              171,664Total
                  comprehensive income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              9,044,598Options
                  exercised, including tax benefit of $337,052
              
              
              80,697
              
              
              80,697
              
              
              1,138,303
              
              
              
              
              
              
              
              
              1,219,000Issuance
                  of stock through employees' stock plans
              
              
              2,019
              
              
              2,019
              
              
              47,992
              
              
              
              
              
              
              
              
              50,01110%
                  stock dividend
              
              
              476,080
              
              
              476,080
              
              
              10,730,843
              
              
              (11,206,923
              )
              
              
              
              
              —Cash
                  dividend declared ($0.32 per share)
              
              
              
              
              
              
              
              
              
              
              
              (1,693,092
              )
              
              
              
              
              (1,693,092
              )BALANCE,
                  December 31, 2004
              
              
              5,288,489
              
              $
              5,288,489
              
              $
              45,595,319
              
              $
              9,220,450
              
              $
              (656,985
              )
              $
              59,447,273Comprehensive
                  income:Net
                  income
              
              
              
              
              
              
              
              
              
              
              
              10,318,649
              
              
              
              
              
              10,318,649Other
                  comprehensive income (loss), net of tax:Unrealized
                  (loss) on securities available-for-sale
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (945,014
              )
              
              (945,014
              )Unrealized
                  gain on interest rate swap
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              166,169
              
              
              166,169Total
                  comprehensive income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              9,539,804Options
                  exercised, including tax benefit of $478,492
              
              
              148,511
              
              
              148,511
              
              
              1,763,597
              
              
              
              
              
              
              
              
              1,912,108Retirement
                  of shares repurchased
              
              
              (144,036
              )
              
              (144,036
              )
              
              (2,166,275
              )
              
              (1,343,882
              )
              
              
              
              
              (3,654,193
              )Issuance
                  of stock through employees' stock plans
              
              
              3,846
              
              
              3,846
              
              
              96,150
              
              
              
              
              
              
              
              
              99,996Cash
                  dividend declared ($1.38 per share)
              
              
              
              
              
              
              
              
              
              
              
              (7,317,688
              )
              
              
              
              
              (7,317,688
              )BALANCE,
                  December 31, 2005
              
              
              5,296,810
              
              $
              5,296,810
              
              $
              45,288,791
              
              $
              10,877,529
              
              $
              (1,435,830
              )
              $
              60,027,300Comprehensive
                  income:Net
                  income
              
              
              
              
              
              
              
              
              
              
              
              2,714,072
              
              
              
              
              
              2,714,072Other
                  comprehensive income (loss), net of tax:Unrealized
                  (loss) on securities available-for-sale
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (546,349
              )
              
              (546,349
              )Unrealized
                  gain on interest rate swap
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              28,071
              
              
              28,071Total
                  comprehensive income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              2,195,794Compensation
                  related to stock options
              
              
              
              
              
              
              
              
              135,230
              
              
              
              
              
              
              
              
              135,230Options
                  exercised, including tax benefit of $4,824
              
              
              14,441
              
              
              14,441
              
              
              111,183
              
              
              
              
              
              
              
              
              125,624Issuance
                  of stock through employees' stock plans
              
              
              3,856
              
              
              3,856
              
              
              96,130
              
              
              
              
              
              
              
              
              99,986Cash
                  dividend declared ($0.10 per share)
              
              
              
              
              
              
              
              
              
              
              
              (530,211
              )
              
              
              
              
              (530,211
              )BALANCE,
                  March 31, 2006
              
              
              5,315,107
              
              $
              5,315,107
              
              $
              45,631,334
              
              $
              13,061,390
              
              $
              (1,954,108
              )
              $
              62,053,723






See
        Notes to Financial Statements.


-6-




**FIRST
          MUTUAL BANCSHARES, INC.**
 **CONSOLIDATED
          STATEMENTS OF CASH FLOWS**
   Three
                  months ended March 31,2006
              
              
              
              2005(Unaudited)**OPERATING
                  ACTIVITIES:**Net
                  income
              
              $
              2,714,072
              
              
              
              
              $
              2,584,260Adjustments
                    to reconcile net income to net cashfrom operating
                    activities:Provision
                  for loan losses
              
              
              71,000
              
              
              
              
              
              400,000Depreciation
                  and amortization
              
              
              448,394
              
              
              
              
              
              319,309Deferred
                  loan origination fees, net of accretion
              
              
              247,053
              
              
              
              
              
              (21,591
              )Amortization
                  of servicing assets
              
              
              250,877
              
              
              
              
              
              210,019Gain
                  on sales of loans
              
              
              (756,083
              )
              
              
              
              
              (524,536
              )Loss
                  on sale of repossessed real estate and other assets
              
              
              —
              
              
              
              
              
              2,205FHLB
                  stock dividends
              
              
              —
              
              
              
              
              
              (52,900
              )Stock
                  based compensation
              
              
              135,230
              
              
              
              
              
              —Changes
                  in operating assets & liabilities:Loans
                  receivable held-for-sale
              
              
              763,796
              
              
              
              
              
              (790,000
              )Accrued
                  interest receivable
              
              
              (11,601
              )
              
              
              
              
              (375,621
              )Other
                  assets
              
              
              (107,607
              )
              
              
              
              
              7,650Drafts
                  payable
              
              
              437,954
              
              
              
              
              
              67,449Federal
                    income tax refund applied tocurrent year estimated
                    taxes
              
              
              472,811
              
              
              
              
              
              512,372Accounts
                  payable and other liabilities
              
              
              (3,378,638
              )
              
              
              
              
              (2,366,971
              )Advance
                  payments by borrowers for taxes and insurance
              
              
              1,206,291
              
              
              
              
              
              1,337,488Net
                  cash provided by operating activities
              
              
              2,493,549
              
              
              
              
              
              1,309,133**INVESTING
                  ACTIVITIES:**Loan
                  originations
              
              
              (98,760,470
              )
              
              
              
              
              (99,348,104
              )Loan
                  principal repayments
              
              
              99,693,649
              
              
              
              
              
              79,181,675Increase
                  (decrease) in undisbursed loan proceeds
              
              
              (4,734,060
              )
              
              
              
              
              7,720,855Principal
                    repayments & redemptions onmortgage-backed and other
                    securities
              
              
              11,397,803
              
              
              
              
              
              3,891,994Purchase
                  of securities held-to-maturity
              
              
              —
              
              
              
              
              
              (1,015,435
              )Purchase
                  of securities available-for-sale
              
              
              (7,170,095
              )
              
              
              
              
              (4,991,406
              )Purchases
                  of premises and equipment
              
              
              (1,329,269
              )
              
              
              
              
              (1,931,816
              )Purchase
                  of FHLB stock
              
              
              —
              
              
              
              
              
              (26,400
              )Proceeds
                  from sale of impaired loan
              
              
              340,000
              
              
              
              
              
              —Net
                  cash (used) by investing activities
              
              
              (562,442
              )
              
              
              
              
              (16,518,637
              )




See
        Notes to Financial Statements.


-7-


**FIRST
        MUTUAL BANCSHARES, INC.**
 **CONSOLIDATED
          STATEMENTS OF CASH FLOWS**
 (Continued)


Three
                  months ended March 31,2006
              
              
              
              2005(Unaudited)**FINANCING
                  ACTIVITIES:**Net
                  increase in deposit accounts
              
              $
              17,496,792
              
              
              
              
              $
              12,953,521Interest
                  credited to deposit accounts
              
              
              5,397,000
              
              
              
              
              
              3,349,919Issuance
                  of stock through employees' stock plans
              
              
              99,986
              
              
              
              
              
              99,996Proceeds
                  from advances
              
              
              143,556,000
              
              
              
              
              
              292,286,000Repayment
                  of advances
              
              
              (162,291,375
              )
              
              
              
              
              (291,540,021
              )Dividends
                  paid
              
              
              (5,824,125
              )
              
              
              
              
              (475,964
              )Proceeds
                    from exercise of stock options and excess taxbenefit from stock
                    option exercises
              
              
              125,624
              
              
              
              
              
              158,498Net
                  cash (used) provided by financing activities
              
              
              (1,440,098
              )
              
              
              
              
              16,831,949**NET
                  INCREASE IN CASH AND CASH EQUIVALENTS**
              
              $
              491,009
              
              
              
              
              $
              1,622,445**CASH
                  & CASH EQUIVALENTS:**Beginning
                  of year
              
              
              25,780,612
              
              
              
              
              
              13,845,441End
                  of quarter
              
              $
              26,271,621
              
              
              
              
              $
              15,467,886**SUPPLEMENTAL
                    DISCLOSURES OF CASH FLOWINFORMATION:**Loans
                  originated for sale in the secondary market
              
              $
              22,657,046
              
              
              
              
              $
              18,579,744Loans
                  originated for investment activities
              
              $
              98,760,470
              
              
              
              
              $
              99,348,104Proceeds
                  from sale of loans held-for-sale
              
              $
              23,420,842
              
              
              
              
              $
              17,789,744Cash
                  paid during the year for:Interest
              
              $
              8,272,047
              
              
              
              
              $
              5,409,644**SUPPLEMENTAL
                    DISCLOSURES OF NONCASHINVESTING
                    ACTIVITIES:**Loans
                    transferred to real estateheld-for-sale, net
              
              $
              27,600
              
              
              
              
              $
              —




See
        Notes to Financial Statements.


-8-


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**(Unaudited)**
  **Note
                1.**
              **SUMMARY
                  OF SIGNIFICANT ACCOUNTING
                  POLICIES**
 
 The
        results of operations for the interim periods shown in this report are not
        necessarily indicative of results to be expected for the fiscal year. In
        the
        opinion of management, the information contained herein reflects all adjustments
        necessary to make the results of operations for the interim periods a fair
        statement of such operations.
 **Note
                  2.**
                **STOCK-BASED
                    COMPENSATION**
  We
          adopted Statement of Financial Accounting Standards (SFAS) Number 123(R), *Share-Based
          Payment* (SFAS
          No. 123(R)), on January 1, 2006 using the modified prospective method.
          Under
          this method, awards that are granted, modified, or settled after December
          31,
          2005, are measured and accounted for in accordance with SFAS No.123(R).
          Also
          under this method, expense is recognized for unvested awards that were
          granted
          prior to January 1, 2006, based upon the fair value determined at the grant
          date
          under SFAS No. 123, *Accounting
          for Stock-Based Compensation* (SFAS
          No. 123). Prior to adoption of SFAS No. 123(R), we accounted for stock
          compensation under the intrinsic value method permitted by Accounting Principles
          Board Opinion No. 25, *Accounting
          for Stock Issued to Employees* (APB
          No.
          25) and related interpretations. Accordingly, we previously recognized
          no
          compensation cost for employee stock options that were granted with an
          exercise
          price equal to the market value of the underlying common stock on the date
          of
          grant.
 
 The
          following table illustrates the effect on net income and earnings per share
          if
          we had applied the fair value recognition provisions of SFAS No. 123(R)
          in
          2005.
 
 Three
                    Months Ended March 31, 2005Net
                    Income, as reported
                
                $
                2,584,260Deduct:
                    Total stock-based employee
                  compensation
                    determined under fair value based
                  method
                    for all awards, net of related tax effects (1)
                
                
                (105,887
                )Pro
                    Forma Net Income
                
                $
                2,478,373Earnings
                    per share:Basic,
                    as reported
                
                $
                0.49Basic,
                    pro forma
                
                $
                0.47Diluted,
                    as reported
                
                $
                0.47Diluted,
                    pro forma
                
                $
                0.45
 
 (1)
              A
                  Black-Scholes option pricing model was used to determine the fair
                  value of
                  the options granted. 
 As
          a
          result of adopting SFAS 123(R) on January 1, 2006, income before taxes
          and net
          income for the quarter ended March 31, 2006 are $135,000 and $88,000 lower,
          respectively, than if we had continued to account for share-based compensation
          under APB No. 25. Basic and diluted earnings per share for the quarter
          ended
          March 31, 2006 would have been $0.53 and $0.51, respectively, if we had
          not
          adopted SFAS 123(R), compared to reported basic and diluted earnings per
          share
          of $0.51 and $0.50, respectively. Prior to adopting SFAS 123(R), we presented
          all tax benefits of deductions resulting from the exercise of stock options
          as
          operating cash flows in the Consolidated Statements of Cash Flows. SFAS
          123(R)
          requires the cash flows resulting from the tax benefits resulting from
          tax
          deductions in excess of the compensation cost recognized for those options
          (excess tax benefits) to be classified as financing cash flows. The $4,824
          excess tax benefit classified as a financing cash flow would have been
          classified as an operating cash inflow if we had not adopted SFAS
          123(R).
  -9-
 
 Share-based
          compensation expense recognized for stock options was $135,000 for the
          three
          months ended March 31, 2006. The total related income tax benefit recognized
          was
          $17,500 for the three months ended March 31, 2006.
 
 *Stock
          Option Plans*
 
 We
          have
          stock option plans for directors and employees. Options have a term of
          six,
          seven or ten years and are granted at fair market value on the grant date. The
          Compensation and Stock Options Committees determine vesting of the options.
          Options generally become exercisable in one or more installments during
          their
          term, and the right to exercise may be cumulative. At March 31, 2006, 596,435
          shares of common stock, adjusted for stock dividends, were available for
          grant
          under the plan. A total of 250,343 shares are currently exercisable at
          March 31,
          2006.
 
 The
          following table presents the activity related to options under all plans
          for the
          three months ended March 31, 2006.
 
 Options
                
                Weighted-
                  Average
                  Exercise
                  Price
                
                Weighted-
                  Average
                  Remaining
                  Term
                    (in
                  years)
                
                Aggregate
                  Intrinsic
                  ValueOptions
                    Outstanding at January 1, 2006
                
                
                558,577
                
                $
                17.22Granted
                
                
                —
                
                
                —Exercised
                
                
                (14,441
                )
                
                8.37Forfeited
                    or Expired
                
                
                —
                
                
                —Outstanding
                    at March 31, 2006
                
                
                544,136
                
                $
                17.46
                
                
                5.7
                
                $
                4,469,000Exercisable
                    at March 31, 2006
                
                
                250,343
                
                $
                11.96
                
                
                4.2
                
                $
                3,432,332
 
 No
          options were granted during the three months ended March 31, 2006 and 2005.
          The
          total intrinsic value (amount by which the fair value of the underlying
          stock
          exceeds the exercise price of an option on exercise date) of options exercised
          during the three months ended March 31, 2006 and 2005 was $250,566 and
          $252,744,
          respectively.
 
 Cash
          received from option exercises for the three months ended March 31, 2006
          and
          2005 was $120,800 and $158,500, respectively.
 
 We
          issue
          new shares to satisfy option exercises.
 
 A
          summary
          of the status of nonvested shares and changes during the three months ended
          March 31, 2006 is presented below:
 
 Nonvested
                    Shares
                
                Shares
                
                Weighted-Average
                    Grant-Date
                  Fair
                    ValueNonvested
                    at January 1, 2006
                
                
                298,926
                
                
                $
                    7.67Granted
                
                
                —
                
                
                —Vested
                
                
                5,133
                
                
                $
                    8.70Forfeited
                
                
                —
                
                
                —Nonvested
                    at March 31, 2006
                
                
                293,793
                
                
                $
                    7.81
 
 At
          March
          31, 2006, there was $1.2 million of total unrecognized compensation cost
          related
          to nonvested share-based compensation arrangements granted under the Plan.
          That
          cost is expected to be recognized over a weighted-average period of 1.7
          years.
          The total fair value of shares vested during the three months ended March
          31,
          2006 and 2005, was $44,700, and $35,600, respectively.


-10-


**Note
                  3.**
                **MORTGAGE-BACKED
                      AND OTHER SECURITIES
                      AVAILABLE-FOR-SALE**
 The
        amortized cost and estimated fair value of securities available-for-sale
        at
        March 31, 2006 and December 31, 2005 are summarized as
        follows:




Gross
              
              GrossGross
              
              Unrealized
              
              Unrealized
              
              EstimatedAmortized
              
              Unrealized
              
              Losses
              
              Losses
              
              FairCost
              
              Gains
              
              <1
                  Year
              
              >1
                  Year
              
              Value**March
                  31, 2006**Freddie
                  Mac securities
              
              
              $
              16,196,463
              
              $
              12,659
              
              $
              71,645
              
              $
              610,358
              
              $
              15,527,119Fannie
                  Mae securities
              
              
              
              37,309,200
              
              
              21,218
              
              
              270,075
              
              
              1,197,716
              
              
              35,862,627Ginnie
                  Mae securities
              
              
              
              41,432,184
              
              
              —
              
              
              153,912
              
              
              496,334
              
              
              40,781,938US
                  agency securities
              
              
              
              18,208,093
              
              
              —
              
              
              198,934
              
              
              117,200
              
              
              17,891,959$
              113,145,940
              
              $
              33,877
              
              $
              694,566
              
              $
              2,421,608
              
              $
              110,063,643**December
                  31, 2005**Freddie
                  Mac securities
              
              
              $
              16,639,949
              
              $
              15,285
              
              $
              60,164
              
              $
              485,345
              
              $
              16,109,725Fannie
                  Mae securities
              
              
              
              38,209,406
              
              
              28,119
              
              
              334,933
              
              
              672,624
              
              
              37,229,968Ginnie
                  Mae securities
              
              
              
              43,632,279
              
              
              2,673
              
              
              340,680
              
              
              172,152
              
              
              43,122,120US
                  agency securities
              
              
              
              18,207,150
              
              
              —
              
              
              123,328
              
              
              95,293
              
              
              17,988,529$
              116,688,784
              
              $
              46,077
              
              $
              859,105
              
              $
              1,425,414
              
              $
              114,450,342




Certain
        investment securities shown above currently have fair values less than amortized
        cost and therefore contain unrealized losses. The Bank has evaluated these
        securities and has determined that the decline in value is temporary and
        is
        related to the change in market interest rates since purchase. The decline
        in
        value is not related to any company or industry specific event. At March
        31,
        2006 and December 31, 2005 there were four investment securities with unrealized
        losses for both years. The Bank anticipates full recovery of amortized cost
        with
        respect to these securities at maturity or sooner in the event of a more
        favorable market interest rate environment.
  **Note
                    4.**
                  **MORTGAGE-BACKED
                          AND OTHER SECURITIES
                          HELD-TO-MATURITY**
 The
        amortized cost and estimated fair value of securities held-to-maturity at
        March
        31, 2006 and December 31, 2005 are summarized as follows:
  Gross
              
              GrossGross
              
              Unrealized
              
              Unrealized
              
              EstimatedAmortized
              
              Unrealized
              
              Losses
              
              Losses
              
              FairCost
              
              Gains
              
              <1
                  Year
              
              >1
                  Year
              
              Value**March
                  31, 2006**Fannie
                  Mae securities
              
              
              $
              4,827,746
              
              $
              49,563
              
              $
              28,895
              
              $
              78,686
              
              $
              4,769,728Freddie
                  Mac securities
              
              
              
              344,620
              
              
              4,896
              
              
              —
              
              
              —
              
              
              349,516Municipal
                  bonds
              
              
              
              1,169,595
              
              
              561
              
              
              5,069
              
              
              —
              
              
              1,165,087$
              6,341,961
              
              $
              55,020
              
              $
              33,964
              
              $
              78,686
              
              $
              6,284,331**December
                  31, 2005**Fannie
                  Mae securities
              
              
              $
              5,345,378
              
              $
              68,712
              
              $
              56,460
              
              $
              17,175
              
              $
              5,340,455Freddie
                  Mac securities
              
              
              
              432,808
              
              
              9,659
              
              
              —
              
              
              —
              
              
              442,467Municipal
                  bonds
              
              
              
              1,188,109
              
              
              649
              
              
              —
              
              
              790
              
              
              1,187,968$
              6,966,295
              
              $
              79,020
              
              $
              56,460
              
              $
              17,965
              
              $
              6,970,890




Certain
        investment securities shown above currently have fair values less than amortized
        cost and therefore contain unrealized losses. The Bank has evaluated these
        securities and has determined that the decline in value is temporary and
        is
        related to the change in market interest rates since purchase. The decline
        in
        value is not related to any company or industry specific event.  At March
        31, 2006 and December 31, 2005 there
        were four investment securities with unrealized losses for both years. The
        Bank
        anticipates full recovery of amortized cost with respect to these securities
        at
        maturity or sooner in the event of a more favorable market interest rate
        environment.




-11-
  **Note
                  5.**
                **NONPERFORMING
                          ASSETS**


Non-performing
        loans are summarized as follows:




March
                  31, 2006
              
              December
                  31, 2005Impaired
                  loans with a valuation allowance
              
              $
              12,226
              
              $
              308,645Valuation
                  allowance related to impaired loans
              
              
              (1,025
              )
              
              (172,475
              )Net
                  impaired loans
              
              
              11,201
              
              
              136,170Non-accrual
                  loans
              
              
              456,473
              
              
              761,020Total
                  non-performing or non-accrual loans
              
              
              467,674
              
              
              897,190Real
                estate owned
              
              
              27,600
              
              
              —Nonperforming
                Assets
              
              $
              495,274
              
              
              897,190Total
                  loans past due 90-days or more and still accruing interest
              
              
              84,827
              
              
              —Average
                  balance of impaired loans
              
              
              73,686
              
              
              138,002Interest
                  income recognized on impaired loans
              
              
              105
              
              
              793




The
        impaired loan balance was lower at the end of March 31, 2006, due to the
        payoff
        of one loan with a balance of $296,304 at December 31, 2005. That loan was
        paid
        off in February 2006, bringing the number of impaired loans to one at the
        end of
        March.
  **Note
                  6.**
                **EARNINGS
                            PER
                            SHARE**
 
 Basic
        Earnings Per Share is computed by dividing net income by the weighted-average
        number of shares outstanding during the period. Diluted EPS reflects the
        potential dilutive effect of stock options and is computed by dividing net
        income by the weighted-average number of shares outstanding during the period,
        plus the dilutive common shares that would have been outstanding had the
        stock
        options been exercised.
 
 The
        following is a reconciliation of the numerators and denominators of the basic
        and diluted earnings per share computations for quarters ending March 31,
        2006
        and March 31, 2005:
  Income
                
                Shares
                
                Per
                    share(numerator)
                
                (denominator)
                
                amountQuarter
                    ended March 31, 2006Basic
                    EPS:Income
                    available to common shareholders
                
                $
                2,714,072
                
                
                5,301,838
                
                $
                0.51Effect
                    of dilutive stock options
                
                
                —
                
                
                105,190Diluted
                    EPS:Income
                      available to common shareholdersplus assumed stock options
                      exercised
                
                $
                2,714,072
                
                
                5,407,028
                
                $
                0.50Quarter
                    ended March 31, 2005Basic
                    EPS:Income
                    available to common shareholders
                
                $
                2,584,260
                
                
                5,301,235
                
                $
                0.49Effect
                    of dilutive stock options
                
                
                —
                
                
                251,067Diluted
                    EPS:Income
                      available to common shareholdersplus assumed stock options
                      exercised
                
                $
                2,584,260
                
                
                5,552,302
                
                $
                0.47










-12-




**Note
                  7.**
                **RATE
                              VOLUME
                              ANALYSIS**
 (Dollars
                                in
                                thousands)


FIRST
                  QUARTER 2006VSFIRST
                  QUARTER 2005INCREASE
                  (DECREASE) DUE TOTOTALVOLUME
              
              RATE
              
              CHANGEINTEREST
                  INCOMEInvestments:Available-for-sale
                  securities
              
              $
              (123
              )
              $
              45
              
              $
              (78
              )Held-to-maturity
                  securities
              
              
              (16
              )
              
              12
              
              
              (4
              )Other
                  equity investments
              
              
              63
              
              
              (47
              )
              
              16Total
                  investments
              
              
              (76
              )
              
              10
              
              
              (66
              )Loans:Residential
              
              $
              643
              
              $
              470
              
              $
              1,113Residential
                  construction
              
              
              561
              
              
              561
              
              
              1,122Multifamily
              
              
              (399
              )
              
              283
              
              
              (116
              )Multifamily
                  construction
              
              
              201
              
              
              61
              
              
              262Commercial
                  real estate and business
              
              
              (63
              )
              
              616
              
              
              553Commercial
                  real estate construction
              
              
              27
              
              
              137
              
              
              164Consumer
                  and other
              
              
              396
              
              
              121
              
              
              517Total
                  loans
              
              
              1,366
              
              
              2,249
              
              
              3,615Total
                  interest income
              
              $
              1,290
              
              $
              2,259
              
              $
              3,549INTEREST
                  EXPENSEDeposits:Money
                  market deposit and checking
              
              $
              70
              
              $
              542
              
              $
              612Savings
              
              
              (1
              )
              
              4
              
              
              3Time
                  deposits
              
              
              406
              
              
              1,324
              
              
              1,730Total
                  deposits
              
              
              475
              
              
              1,870
              
              
              2,345FHLB
                  advances and other
              
              
              (198
              )
              
              971
              
              
              773Total
                  interest expense
              
              
              277
              
              
              2,841
              
              
              3,118Net
                  interest income
              
              $
              1,013
              
              $
              (582
              )
              $
              431






-13-




**Note
                  8.**
                **BUSINESS
                            SEGMENTS**
 
 The
        management reporting process measures the performance of the operating segments
        based on the management structure of the Bank and is not necessarily comparable
        with similar information for any other financial institution.
 
 The
        reportable segments include the following:
 
 Consumer
        Lending - Consumer lending includes home equity lending, direct consumer
        loans,
        and indirect home improvement loans (sales finance). These loans include
        lines
        of credit and loans for primarily consumer purposes.
 
 Residential
        Lending - Residential lending offers loans to borrowers to purchase, refinance,
        or build homes secured by one-to-four-unit family dwellings. They also finance
        the purchase or refinance of buildable residential lots.
 
 Business
        Banking Lending- Business Banking lending offers a full range of banking
        services to small and medium size businesses including deposit and cash
        management products, loans for financing receivables, inventory, equipment
        as
        well as permanent and interim construction loans for commercial real estate.
        The
        underlying real estate collateral or business asset being financed typically
        secures these loans.
 
 Income
        Property Lending - Income Property lending offers permanent and interim
        construction loans for multi-family housing (over four units), manufactured
        housing communities, commercial real estate properties, and spec single-family
        construction. The underlying real estate collateral being financed typically
        secures these loans.
 
 Each
        of
        these business segments also sells loans into the secondary market. We may
        choose to retain or sell the right to service the loans sold (i.e., collection
        of principal and interest payments) depending upon market
        conditions.
 
 These
        segments are managed separately because each business unit requires different
        processes and different marketing strategies to reach the customer base that
        purchases the products and services. The segments derive a majority of their
        revenue from interest income, and we rely primarily on net interest revenue
        in
        managing these segments. No single customer provides more than 10% of the
        Bank's
        revenues.
 
 Financial
        information for the Bank's segments is shown below for March 31, 2006, 2005,
        and
        2004:


**Consumer**
              
              **Residential**
              
              **Business
                  Banking**
              
              **Income
                  Property****Quarter
                  ended March 31:**
              
              
              
              **Lending**
              
              **Lending**
              
              **Lending**
              
              **Lending**
              
              **Totals**Interest
                  income
              
              
              2004
              
              $
              2,026,129
              
              $
              3,582,827
              
              $
              1,311,138
              
              $
              5,983,546
              
              $
              12,903,6402005
              
              
              2,245,488
              
              
              4,544,937
              
              
              1,953,146
              
              
              6,655,625
              
              
              15,399,1962006
              
              
              2,729,031
              
              
              6,444,935
              
              
              2,775,189
              
              
              6,999,602
              
              
              18,948,757Interest
                  Expense
              
              
              2004
              
              
              550,609
              
              
              1,380,386
              
              
              328,770
              
              
              2,153,810
              
              
              4,413,5752005
              
              
              738,248
              
              
              1,882,561
              
              
              490,713
              
              
              2,487,428
              
              
              5,598,9502006
              
              
              1,106,222
              
              
              3,174,013
              
              
              1,110,159
              
              
              3,326,923
              
              
              8,717,317Net
                  Interest Income
              
              
              2004
              
              
              1,475,520
              
              
              2,202,441
              
              
              982,368
              
              
              3,829,736
              
              
              8,490,0652005
              
              
              1,507,240
              
              
              2,662,376
              
              
              1,462,433
              
              
              4,168,197
              
              
              9,800,2462006
              
              
              1,622,809
              
              
              3,270,922
              
              
              1,665,030
              
              
              3,672,679
              
              
              10,231,440Provision
                  for loan losses
              
              
              2004
              
              
              93,099
              
              
              22,279
              
              
              25,459
              
              
              109,163
              
              
              250,0002005
              
              
              135,715
              
              
              48,705
              
              
              59,125
              
              
              156,455
              
              
              400,0002006
              
              
              20,020
              
              
              (132,050
              )
              
              68,750
              
              
              114,280
              
              
              71,000Net
                  interest income, after
              
              
              2004
              
              
              1,382,421
              
              
              2,180,162
              
              
              956,909
              
              
              3,720,573
              
              
              8,240,065provision
                  for loan losses
              
              
              2005
              
              
              1,371,525
              
              
              2,613,671
              
              
              1,403,308
              
              
              4,011,742
              
              
              9,400,2462006
              
              
              1,602,789
              
              
              3,402,972
              
              
              1,596,280
              
              
              3,558,399
              
              
              10,160,440Noninterest
                  income
              
              
              2004
              
              
              369,907
              
              
              172,085
              
              
              88,964
              
              
              266,732
              
              
              897,6882005
              
              
              862,255
              
              
              213,155
              
              
              102,833
              
              
              191,520
              
              
              1,369,7632006
              
              
              1,156,721
              
              
              188,296
              
              
              148,654
              
              
              221,178
              
              
              1,714,849Noninterest
                  expense
              
              
              2004
              
              
              1,196,233
              
              
              1,393,090
              
              
              1,102,515
              
              
              1,948,189
              
              
              5,640,0272005
              
              
              1,649,215
              
              
              1,697,541
              
              
              1,590,520
              
              
              1,925,632
              
              
              6,862,9082006
              
              
              1,983,636
              
              
              1,945,842
              
              
              1,917,270
              
              
              1,841,564
              
              
              7,688,312Income
                  before provision
                forfederal
                  income taxes
              
              
              2004
              
              
              556,095
              
              
              959,157
              
              
              (56,642
              )
              
              2,039,116
              
              
              3,497,7262005
              
              
              584,565
              
              
              1,129,285
              
              
              (84,379
              )
              
              2,277,630
              
              
              3,907,1012006
              
              
              775,874
              
              
              1,645,426
              
              
              (172,336
              )
              
              1,938,013
              
              
              4,186,977Provision
                  for federal
                income
                  taxes
              
              
              2004
              
              
              188,393
              
              
              324,540
              
              
              (19,887
              )
              
              690,540
              
              
              1,183,5862005
              
              
              198,125
              
              
              382,218
              
              
              (29,393
              )
              
              771,891
              
              
              1,322,8412006
              
              
              273,309
              
              
              579,049
              
              
              (61,693
              )
              
              682,240
              
              
              1,472,905Net
                  income
              
              
              2004
              
              
              367,702
              
              
              634,617
              
              
              (36,755
              )
              
              1,348,576
              
              
              2,314,1402005
              
              
              386,440
              
              
              747,067
              
              
              (54,986
              )
              
              1,505,739
              
              
              2,584,2602006
              
              
              502,565
              
              
              1,066,377
              
              
              (110,643
              )
              
              1,255,773
              
              
              2,714,072Total
                  Interest Earning assets
              
              
              2004
              
              
              98,304,930
              
              
              245,542,118
              
              
              96,215,039
              
              
              432,300,709
              
              
              872,362,796(ending
                  period balances)
              
              
              2005
              
              
              110,144,818
              
              
              305,275,674
              
              
              123,543,351
              
              
              439,124,200
              
              
              978,088,0432006
              
              
              122,048,884
              
              
              363,489,229
              
              
              154,177,226
              
              
              386,591,348
              
              
              1,026,306,687






-14-


ITEM
                2.
              Management’s
                  Discussion and Analysis of Financial Condition and Results of
                  Operations
  **GENERAL**
 
 First
        Mutual Bancshares, Inc. (the "Company"), a Washington corporation, is a bank
        holding company owning all of the equity of its wholly owned subsidiary,
        First
        Mutual Bank. The Company is subject to regulation by the Federal Reserve
        Bank of
        San Francisco. This discussion refers to the consolidated statements of the
        Company and the Bank, and therefore the references to “Bank” in this discussion
        refer to both entities.
 
 First
        Mutual Bank is a Washington-chartered savings bank subject to regulation
        by the
        State of Washington Department of Financial Institutions and the Federal
        Deposit
        Insurance Corporation ("FDIC"). The Bank conducts business from its headquarters
        in Bellevue, Washington, and has 12 full-service retail banking centers located
        in Bellevue (3), Issaquah, Kirkland (2), Monroe, Redmond, Sammamish, Seattle
        (2), and Woodinville. We also have a consumer loan office located in
        Jacksonville, Florida. The Bank's business consists mainly of attracting
        deposits from the general public as well as wholesale funding sources, and
        investing those funds primarily in real estate loans, small and mid-sized
        business loans, and consumer loans.
  **OVERVIEW**
 
 The
        first
        quarter of 2006 marked our fifty-fourth consecutive quarter of year-over-year
        earnings growth, as net income increased 5% over the first quarter of 2005,
        to
        $2.7 million, or $0.50 per diluted share, compared to $2.6 million, or $0.47
        per
        diluted share in the first quarter of last year. Our return on average equity
        (ROE) totaled 17.8% for the quarter, compared to 17.2% in the first quarter
        of
        last year. As a result, we were able to exceed one of our general corporate
        goals, obtaining an ROE of at least 15%, but were unsuccessful in the other,
        achieving year-over-year net income growth in the range of 10% to 12%. Note
        that
        we consider these targets to be our corporate goals, and not indicative of
        current forecasts or expected future operating results.
 
 The
        primary source of revenue for each of our business lines is net interest
        income,
        which is generally measured with the net interest margin ratio. As had been
        expected, our net interest margin for the first quarter of 2006 declined
        relative to the fourth quarter of 2005. At 4.02% the level achieved for the
        quarter remained comparable to our typical margin over the last several
        quarters, but fell short of the range we had forecast in our fourth quarter
        2005
        press release. The greater-than-expected decline in the margin was primarily
        attributable to a combination of increases in non-maturity deposit rates
        and
        large balances of maturing certificates and FHLB advances that were renewed
        at
        significantly higher rates than the maturing instruments.
 
 In
        the
        first quarter of 2006, core deposits grew by 10%, or $27 million relative
        to
        their 2005 year-end level. We consider controlling the interest expense paid
        on
        our liabilities to be a critical element to maintaining a consistent net
        interest margin in the current economic environment, and continue to focus
        our
        efforts on improving the percentage of lower-cost non-maturity deposit products
        in our funding mix, reducing as significantly as is prudent the occurrence
        of
        promotional deposit rates, and utilizing wholesale funding sources when
        estimates of marginal funding costs indicate it may be advantageous to do
        so.
  -15-
 
 The
        other
        key driver of net interest income is the growth of the business lines’ earning
        assets, which averaged slightly more than $1.0 billion for the first quarter
        of
        2006, an increase of nearly $56 million, or 6% over the same quarter last
        year.
        The growth occurred in our loan portfolio, with our Residential Lending and
        Business Banking segments showing the most substantial asset growth over
        the
        last twelve months. The rate of growth has slowed, however, in each of the
        last
        four quarters and totaled less than 1% (quarterly, not annualized) in the
        first
        quarter of this year. More specifically, while we continued to see portfolio
        growth in our Business Banking and Residential Lending segments in the first
        quarter of 2006, a substantial part of this growth was offset by reductions
        in
        our Consumer Lending and Income Property portfolios. Please see the “Net
        Interest Income,” “Business Segments,” and “Asset and Liability Management”
sections for further discussions of net interest income, earning assets,
        and the
        processes by which we manage that source of revenue.
 
 A
        secondary source of revenue is our noninterest income, which increased 25%
        compared to the first quarter of 2005, based on a significant increase in
        loan
        sales and resulting gains thereon. During the first quarter, we sold
        approximately 87% of our sales finance loan production, which resulted in
        a
        significant increase in gains on sales of loans in the current period, and
        should contribute incrementally to servicing fee income in future quarters.
        The
        previously mentioned deposit growth also contributed to the increase in
        noninterest income. Please see the “Noninterest Income” section for additional
        discussion.
 
 Noninterest
        expense increased $825,000, or 12% in the first quarter of 2006 compared
        to the
        first quarter of 2005, but declined $10,000 on a sequential quarter basis.
        Depreciation expense contributed significantly to the increase over the first
        quarter of last year based on improvements made to our First Mutual Center
        headquarters building and the remodeling and/or reconstruction of four of
        our
        banking centers over the last twelve months. Also contributing to the first
        quarter 2006 increase was the implementation of FAS 123 (revised 2004) *Share-Based
        Payment* ,
        which
        requires the expensing of stock options. The expensing of options impacted
        earnings by $88,000, net of tax, and $0.01 per diluted share.
 
 Another
        critical factor in achieving our goal of consistent earnings is the credit
        quality of our loan portfolio, which has exceeded the national average for
        many
        years. For the quarter ended March 31, 2006, our credit quality remained
        strong,
        with total non-performing assets (NPAs) declining to $495,000, or 0.05% of
        total
        assets, compared to $957,000, or 0.09% for the first quarter last year, and
        $897,000, or 0.08% at the 2005 year-end. For the quarter, we reserved $71,000
        in
        provisions for loan losses, based on a $340,000 recovery on a residential
        loan,
        combined with the previously mentioned slowdown in loan portfolio growth.
        Included in the recovery was a $171,000 impairment charge, which had been
        charged-off against the reserve for loan losses. Based on the unique and
        nonrecurring nature of this recovery, we expect our provision for loan losses
        to
        return to a more normal level in the second quarter. Our reserve for loan
        losses
        totaled approximately $10.1 million, up from $9.5 million at March 31, 2005
        and
        little changed from the year-end level. The allowance for loan losses
        represented 1.13% of gross loans at both the 2006 quarter- and 2005 year-end,
        and 1.14% as of March 31, 2005. For additional information regarding our
        credit
        quality, please refer to the “Asset Quality” section.
 
 -16-
 
 **RESULTS
        OF OPERATIONS**
 
 **Net
        Income**
 
 Net
        income increased 5%, from $2.6 million in the first quarter of 2005 to $2.7
        million in the same period of 2006. Net interest income, after provision
        for
        loan losses, rose $760,000, and noninterest income increased $345,000 on
        a first
        quarter comparison. Partially offsetting the growth in revenue was a rise
        of
        $825,000 in noninterest expense.
 
 **Net
        Interest Income**
  For
        the
        quarter ended March 31, 2006, our net interest income increased $431,000,
        or 4%,
        relative to the first quarter of last year. This improvement resulted from
        growth in our earning assets, as the net effects of asset and liability
        repricing negatively impacted the quarter’s net interest income. The following
        table illustrates the impacts to our net interest income from balance sheet
        growth and rate changes on our assets and liabilities, with the results
        attributable to the level of earning assets classified as “volume” and the
        effect of asset and liability repricing labeled “rate.”
  **Rate/Volume
        Analysis**
 **Quarter
                  Ended****March
                  31, 2006 vs. March 31, 2005****Increase/(Decrease)
                  due to**(Dollars
                  in thousands)**Volume**
              
              **Rate**
              
              **Total**Interest
                  IncomeTotal
                  Investments
              
              $
              (76
              )
              $
              10
              
              $
              (66
              )Total
                  Loans
              
              
              1,366
              
              
              2,249
              
              
              3,615Total
                  Interest Income
              
              $
              1,290
              
              $
              2,259
              
              $
              3,549Interest
                  ExpenseTotal
                  Deposits
              
              $
              475
              
              $
              1,870
              
              $
              2,345FHLB
                  and Other
              
              
              (198
              )
              
              971
              
              
              773Total
                  Interest Expense
              
              $
              277
              
              $
              2,841
              
              $
              3,118Net
                  Interest Income
              
              **$**
              **1,013**
              
              **$**
              **(582**
              **)**
              **$**
              **431**
  **Earning
        Asset Growth (Volume)**
  For
        the
        first quarter of 2006, the growth in our earning assets contributed an
        additional $1.3 million in interest income relative to the like quarter last
        year. Partially offsetting this improvement was an additional $277,000 in
        interest expense incurred from the funding sources used to accommodate the
        asset
        growth. Consequently, the net impact of asset growth was an improvement in
        net
        interest income of slightly more than $1.0 million compared to the quarter
        ended
        March 31, 2005.
  -17-
  **Quarter
                  Ended**
              
              **Average
                  Earning**
                **Assets**
              
              **Average
                  Net**
                **Loans**
              
              **Average**
                **Deposits**(Dollars
                  in thousands)March
                  31, 2005
              
              $
              962,613
              
              $
              816,127
              
              $
              683,521June
                  30, 2005
              
              $
              979,981
              
              $
              834,064
              
              $
              705,680September
                  30, 2005
              
              $
              995,159
              
              $
              854,343
              
              $
              723,595December
                  31, 2005
              
              $
              1,009,727
              
              $
              873,042
              
              $
              744,112March
                  31, 2006
              
              $
              1,018,253
              
              $
              883,988
              
              $
              772,168
  Our
        earning assets averaged slightly more than $1.0 billion for the first quarter
        of
        2006, an increase of nearly $56 million, or 6% over the same quarter last
        year.
        The growth over the prior year was attributable to additional balances in
        our
        loan portfolio, as our securities portfolio contracted in size relative to
        its
        level as of March 31, 2005. Over the past year, we have typically found the
        yields available on investment securities to be significantly less attractive
        than those on loans, particularly when the funding costs to support the
        additional assets were taken into account. Consequently, as the securities
        in
        our portfolio amortized or matured over the last four quarters, we generally
        did
        not replace the paid off securities balances, and instead redirected those
        cash
        flows to support loan growth. In the event that market conditions should
        become
        more conducive to holding investment securities, we would consider increasing
        the size of our securities portfolio at that time.
  While
        we
        have succeeded in growing our earning assets over the last year, the rate
        of
        growth has slowed in each of the last four quarters and actually declined
        by
        less than 1% (quarterly, not annualized) in the first quarter of this year.
        More
        specifically, while we continued to see portfolio growth in our Business
        Banking
        and Residential Lending segments in the first quarter of 2006, a substantial
        part of this growth was offset by reductions in our Consumer Lending and
        Income
        Property portfolios. In the case of the Consumer Lending segment, the portfolio
        contraction was largely attributable to a significant increase in loan sales,
        which totaled slightly more than $13 million for the first
        quarter.
  In
        contrast, the decline in our Income Property portfolio, which continued a
        trend
        observed in recent quarters, is primarily a product of declining originations
        of
        permanent multifamily and commercial real estate loans, along with a high
        level
        of prepayments on the loan portfolio, which we attribute to a combination
        of a
        flat yield curve and increased competition from other lenders. The flat yield
        curve, which has resulted from a number of increases in short-term interest
        rates, has reduced the rate differential between short- and long-term financing
        costs and provided a financial incentive for borrowers to select longer-term,
        fixed-rate loans as opposed to adjustable-rate financing. As we have
        historically been an originator of short-term and adjustable-rate loans,
        this
        impacted us in two ways. First, as prospective borrowers sought loans with
        terms
        that fell outside of our typical underwriting structures, our originations
        of
        permanent multifamily and commercial real estate loans declined. Second,
        with
        the yield curve providing borrowers a financial incentive to refinance
        adjustable-rate loans, which make up the majority of our loan portfolio,
        with
        longer-term, fixed-rate debt, the prepayment rates on our Income Property
        portfolio remained at relatively high levels. Increased competition among
        lenders in our local market accelerated both the decline in new volumes as
        well
        as portfolio payoffs, as the competition frequently resulted in lenders offering
        prospective borrowers new loan commitments, or existing borrowers the
        opportunity to refinance, at unusually low margins.
  -18-
  When
        taking into account our expected production volumes, payoffs, and loan sales
        for
        all business segments, including an estimated $14 million to $18 million
        in
        consumer loan sales, we anticipate loan growth in the range of $4 million
        to $6
        million for the second quarter of 2006.
  We
        generally rely on growth in our deposit balances, including certificates
        issued
        in institutional markets through deposit brokerage services, to support our
        asset growth. During times when our deposit growth is not sufficient to fully
        support our asset growth, we also utilize advances from the FHLB as an
        alternative funding source. For the first quarter of 2006, our deposits averaged
        $772 million, representing growth of nearly $89 million over the average
        level
        of the same quarter in the prior year. As of the quarter-end, total deposits
        were up $92 million from the March 31, 2005 level, with checking and money
        market balances accounting for nearly $48 million, or approximately 52% of
        the
        growth. As deposit growth exceeded that of our loan portfolio for the twelve
        months, it allowed us to reduce our outstanding borrowings from the FHLB
        - in
        this case by approximately $28 million at March 31, 2006 compared to one
        year
        earlier.
  Between
        the 2005 year-end and March 31, 2006, our deposits grew nearly $23 million,
        with
        over $27 million in growth observed in our checking and money market accounts.
        While certificate balances declined by nearly $5 million, the decline in
        retail
        certificates was, in fact, significantly larger, as these declines were
        partially offset by a net increase of $13 million in certificates issued
        through
        deposit brokerage services and other institutional deposits. The decision
        to
        increase our institutional deposits in recent quarters has been attributable
        to
        rate differentials between these deposits and FHLB advances. Historically,
        rates
        on the two funding sources have been very comparable. On several occasions
        in
        recent quarters, however, the rates on brokered certificates have run as
        much as
        20 basis points below the rates on comparable term FHLB advances. At such
        times
        we have routinely issued brokered deposits to replace FHLB
        advances.
  We
        view
        our year-to-date deposit activity as very favorable to our longer-term
        objectives. First, in most interest rate environments, checking and money
        market
        accounts will typically represent a lower cost source of funds than
        certificates. Consequently, we view growth in these product types as being
        a
        priority for us and an important part of our future funding strategy. Second,
        with regard to the decline in retail certificates, we have attempted to move
        away from offering rates competitive with the higher rates in the local market.
        While this has resulted, and will continue to result in the months ahead,
        in a
        minority of depositors exiting the Bank for higher rates elsewhere, the majority
        of balances are remaining on our books at significantly lower costs to the
        Bank.
        In the past, we have not had the opportunity to put such a strategy in place,
        as
        our loan portfolio growth required not only the retention of every possible
        depositor, but significant inflows of new deposit dollars.
  -19-
  **Asset
                Yields and
                Funding Costs (Rate)****Quarter
                  Ended**
              **Net
                  Interest**
                **Margin**March
                  31, 2005
              4.08%June
                  30, 2005
              4.01%September
                  30, 2005
              4.03%December
                  31, 2005
              4.18%March
                  31, 2006
              4.02%
  As
        had
        been expected and indicated in our fourth-quarter 2005 press release, our
        net
        interest margin declined in the first quarter of 2006. At 4.02% the level
        achieved for the quarter remained comparable to our typical margin over the
        last
        several quarters, but fell short of the range we had forecasted in the
        aforementioned press release. The greater-than-expected decline in the margin
        was primarily attributable to a combination of increases in non-maturity
        deposit
        costs and large balances of maturing certificates and FHLB advances that
        were
        renewed at significantly higher rates than the maturing instruments. In
        contrast, the absence of rate increases in non-maturity deposit costs and
        smaller balances of maturing certificates and FHLB advances were major
        contributors to the unusually high margin in the fourth quarter of last
        year.
  The
        effects of interest rate movements and repricing on our loan portfolio accounted
        for $2.2 million in additional interest income relative to the first quarter
        of
        last year. Adjustable-rate loans, which reprice according to terms specified
        in
        our loan agreements with the borrowers, accounted for approximately 84% of
        our
        loan portfolio as of the end of the first quarter this year. While most of
        the
        repricing of these loans occurs on an annual basis, a notable exception is
        those
        loans tied to the prime rate, which typically reprice within one or two days
        of
        any increase in the Federal Funds target rate by the Federal Reserve. With
        adjustable-rate loans accounting for the vast majority of our loan portfolio,
        and new loan production being originated at higher interest rates, all major
        loan categories benefited from rising interest rate indexes.
  On
        the
        liability side of the balance sheet, the effects of interest rate movements
        and
        repricing increased our interest expense on deposits and wholesale funding
        by
        more than $2.8 million for the quarter. By comparison, the combined increase
        in
        the fourth quarter of 2005 totaled $2.4 million.
  In
        the
        fourth quarter of 2005, our margin increased substantially as we completed
        the
        quarter without any significant increases in the rates paid to our depositors,
        and particularly on our non-maturity deposit products, while the yield earned
        on
        our loan portfolio continued to increase in response to rising market interest
        rates. This contributed significantly to the greater than expected net interest
        margin for that quarter. Additionally, promotional time deposit rates offered
        in
        the fourth quarter were offered only for new deposit balances, and not on
        renewals of maturing certificates. This allowed us to further contain increases
        in interest expense and improve our net interest margin.
  In
        the
        first quarter of 2006, however, we realized that we could not avoid raising
        our
        deposit rates indefinitely and still expect to retain deposit balances. In
        response to aggressive deposit rates and product offerings by some of our
        competitors, we reached a point where we had no choice but to raise rates
        in
        order to retain balances. In doing so, the same factors that contributed
        to the
        expansion of the margin in the fourth quarter of 2005 led to the contraction
        of
        the margin in the first quarter of 2006.
  -20-
  Further
        impacting the margin this quarter were maturities of significant FHLB advance
        balances originated in the lower-rate environments of 2002 to 2004 and renewed
        between December 2005 and February 2006. Based on increases in market rates
        since that time, these advances were renewed at rates much higher than their
        original rates, resulting in increased interest expense and further compression
        of the margin.
  As
        a
        result, for the first quarter of 2006, the net effects of rate movements
        and
        repricing negatively impacted our net interest income by $582,000 relative
        to
        the first quarter of 2005, as these deposit rate increases and large volumes
        of
        maturing/repricing liabilities resulted in a greater increase in liability
        costs
        than was observed for asset yields. In contrast, the net effects of asset
        and
        liability repricing had increased our net interest income by $290,000 for
        the
        fourth quarter of 2005 relative to the same period in 2004.
 
 Looking
        forward, we expect to see continued compression in our net interest margin
        over
        the next two quarters as the impact of repricing large certificate balances
        in
        the second quarter takes effect and we increase sales of our home improvement
        (Sales Finance) loans, which are generally among our highest yielding assets.
        Between these two factors, we expect our net interest margin to decline to
        3.95%-4.00% in the second quarter, followed by a further drop to 3.90%-3.95%
        in
        the third quarter, after which we expect the margin to slowly trend upwards
        as
        assets subject to repricing exceed that of liabilities, core deposits continue
        to grow, and more rate-sensitive certificate holders are replaced with less
        price-sensitive depositors.
 
 **Noninterest
        Income**
  For
        the
        first quarter of 2006, our noninterest income rose $345,000 over the same
        period
        in the prior year, representing growth of 25%, based primarily on significant
        increases in loan sales and gains thereon.
  
 **Gains/(Losses)
                  on Loan Sales:**
              
              **Q1
                  2006**
              
              **Q1
                  2005**Consumer
              
              $
              749,000
              
              $
              501,000Residential
              
              
              (20,000
              )
              
              24,000Commercial
              
              
              27,000
              
              
              0Total
                  Gains on Loan Sales
              
              $
              756,000
              
              $
              525,000**Loans
                  Sold:**Consumer
              
              $
              13,016,000
              
              $
              10,638,000Residential
              
              
              9,395,000
              
              
              7,152,000Commercial
              
              
              1,010,000
              
              
              0Total
                  Loans Sold
              
              $
              23,421,000
              
              $
              17,790,000
  Gains
        on
        loan sales exceeded those of the prior year because of a substantial increase
        in
        the sales of our consumer loans. For the quarter, gains totaled $756,000,
        representing an increase of nearly 44% over the first quarter of last year.
        Improved execution also contributed to the improvement in gains relative
        to last
        year while the total volume of loans sold only increased 32%. Moreover, gains
        on
        consumer loan sales rose 49% while the total volume of loans sold increased
        by
        22%.
  -21-
  In
        our
        fourth-quarter 2005 press release, we noted that we were experiencing a growing
        level of interest in, and favorable opportunities to market our consumer
        loans
        to other institutional investors. As can be seen above, consumer loan sales
        exceeded both those of the first quarter of 2005 as well as our own expectation
        of $8 million to $10 million for the quarter. Based on our current levels
        of
        loan production and market demand, our expectation is for quarterly consumer
        loan sales to total in the $14 million to $18 million range, significantly
        exceeding the prior year’s sales levels. Note that these expectations may be
        subject to change based on changes in loan production, market conditions,
        and
        other factors.
  A
        sale of
        approximately $5.4 million in “interest only” residential mortgages contributed
        to a gain of $229,000 in the fourth quarter of 2005, which compares to a
        modest
        loss in the first quarter this year. This result was well below our expectation
        for the quarter, as a sale of low-documentation residential loans that had
        been
        expected to close in the first quarter of 2006 did not occur as previously
        anticipated. While we still regard a sale of these loans as possible in the
        future, it is our expectation that gains on residential loan sales will not
        represent a material source of income in future quarters.
  Since
        our
        second-quarter 2005 press release, in which we noted that we had experienced
        increased interest in sales of participations in our commercial real-estate
        loans, the volume of commercial real-estate loans sold has remained relatively
        modest. While we would note that these volumes do not reflect a decision
        against
        expanding our commercial real-estate loan sales, we would reiterate our comment
        that commercial real-estate loan transactions, particularly those that are
        candidates for sales of participations to other institutions, tend to be
        larger-dollar credits and unpredictable in their timing and frequency of
        occurrence. As a result, the volumes of commercial real-estate loans sold,
        and
        gains thereon, can be expected to vary considerably from one quarter to the
        next
        depending on the timing of the loan and sales transactions.
  **Service
        Fee Income**
 **Q1
                  2006**
              
              **Q1
                  2005**Consumer
                  Loans
              
              $
              332,000
              
              $
              300,000Commercial
                  Loans
              
              
              9,000
              
              
              24,000Residential
                  Loans
              
              
              (6,000
              )
              
              2,000Total
                  Service Fee Income
              
              $
              335,000
              
              $
              326,000
  For
        the
        first quarter of 2006, our total servicing fee income rose approximately
        3% over
        the level earned in the same period last year, as an increase in fees earned
        on
        consumer loans sold to and serviced for other institutions offset reductions
        in
        service fees earned on other loan types. The growth in consumer loan service
        fees was largely attributable to additional loan sales in the first quarter
        and
        corresponding growth in our portfolio of consumer loans serviced for others.
        As
        was previously noted, we expect to significantly increase our sales of consumer
        loans in 2006. Based on this anticipated increase in sales volumes and resulting
        growth in the servicing portfolio, we expect to see continued growth in consumer
        loan service fee income in the remainder of 2006.
  -22-
  Because
        of a modest level of sales in recent quarters, fee income earned on our
        commercial loans serviced for others declined from its prior year level and
        was
        not a major contributor to our total service fee income this quarter.
        Residential loans are typically sold servicing released, which means we no
        longer service those loans once they are sold. Consequently, we do not view
        these loans as a significant source of servicing fee income.
  **Fees
        on Deposits**
  Fee
        income earned on deposit accounts rose by $47,000, or 34%, compared to the
        first
        quarter of 2005. The improvement was attributable to increased fees from
        checking accounts, which have grown as we have continued our efforts to expand
        our base of business and consumer accounts.
  **Other
        Noninterest Income**
 **Q1
                  2006**
              
              **Q1
                  2005**ATM/Wire/Safe
                  Deposit Fees
              
              $
              74,000
              
              $
              56,000Late
                  Charges
              
              
              51,000
              
              
              48,000Loan
                  Fee Income
              
              
              96,000
              
              
              70,000Rental
                  Income
              
              
              157,000
              
              
              166,000Miscellaneous
                  Fee Income
              
              
              64,000
              
              
              44,000Total
                  Other Noninterest Income
              
              $
              442,000
              
              $
              384,000
  For
        the
        quarter, our noninterest income from sources other than those described earlier
        rose by nearly $58,000, or 15% over the same quarter last year. Loan fees,
        and
        more specifically brokerage fees on income property loans, which totaled
        $28,000
        for the quarter, were the largest single contributor to this growth.
  Significant
        growth was also observed in our Visa/ATM fee income, included in ATM/Wire/Safe
        Deposit Fees above, which totaled over $55,000 for the quarter, an increase
        of
        $13,000, or 30% over the first quarter of 2005. We expect this source of
        income
        to continue rising as checking accounts become a greater piece of our overall
        deposit mix.
 
 **Noninterest
        Expense**
  Noninterest
        expenses increased $825,000, or 12% in the first quarter of 2006 compared
        to the
        first quarter of 2005. On a sequential quarter basis, noninterest expenses
        decreased $10,000 from the fourth quarter of last year, representing a change
        of
        less than 1%.
  -23-
  **Salaries
        and Employee Benefits Expense**
  Salary
        and employee benefits expenses increased 13% in the first quarter of 2006
        compared to the same quarter of last year. The notable increase in this expense
        category was related to compensation, in particular the expensing of stock
        option grants. On a sequential quarter basis, salary and employee benefits
        costs
        grew 6% or $263,000.
 
 **Q1
                  2006**
              
              **Q1
                  2005**Salaries
              
              $
              2,973,000
              
              $
              2,621,000Commissions
                  and Incentive Bonuses
              
              
              540,000
              
              
              511,000Employment
                  Taxes and Insurance
              
              
              300,000
              
              
              289,000Temporary
                  Office Help
              
              
              95,000
              
              
              42,000Benefits
              
              
              538,000
              
              
              483,000Total
              
              $
              4,446,000
              
              $
              3,946,000
  The
        expense related to stock options in the first quarter of 2006 was $135,000.
        We
        anticipate that stock option expenses will show slight increases over the
        remaining quarters of 2006. As stock option expense is accounted for each
        quarter, the offset to the expense is recorded as additional paid-in capital,
        increasing total shareholders’ equity. The offset in additional paid-in capital
        will continue as stock option expenses are recognized each quarter. Had stock
        option expenses been excluded, salary expense would have only increased by
        8%.
  A
        portion
        of the escalation in compensation expense in the first quarter was attributable
        to a rise in the number of full-time equivalent (FTE) employees. At the end
        of
        the first quarter of 2005, we employed 219 FTE employees, as compared to
        234 FTE
        employees at quarter end. This change represents staff growth of 7%. Also
        affecting compensation costs were the annual increases in staff salaries
        in
        second quarter of last year which typically amounted to between 2% to
        4%.
  Salary
        expense increased on a sequential quarter basis, from $2,734,000 in the fourth
        quarter of 2005 to $2,973,000 in the first quarter of 2006. In addition to
        stock
        option expense, a significant reduction in deferred loan costs in our
        Residential Lending area contributed to the sequential quarter
        increase.
  In
        accordance with current accounting standards, certain loan origination costs,
        including some salary expenses tied to loan origination, are deferred and
        amortized over the life of each loan originated, rather than expensed in
        the
        current period. Expenses are then reported in the financial statements net
        of
        these deferrals. The amount of expense subject to deferral and amortization
        can
        vary from one period to the next based upon the number of loans originated,
        the
        mix of loan types, and year-to-year changes in “standard loan costs”. In this
        instance, both the number of loans originated by our Residential lending
        area in
        the first quarter of 2006 as well as the deferred costs associated with each
        origination declined relative to the fourth quarter of last year. Consequently,
        the amount of salary expense to be deferred and amortized declined between
        the
        fourth quarter of 2005 and first quarter of 2006, increasing our first quarter
        salary expense by $130,000.
  -24-
  Expenditures
        for temporary office help increased by 126% from the first quarter of 2005
        to
        the same period in the current year, and 36% from the fourth quarter of 2005
        to
        the first quarter of 2006. The business areas with the heaviest use of temporary
        office help in the first quarter of 2006 were the sales finance and consumer
        loan administration units. The increased use of temporary office help was
        attributable to the use of temporary help in positions affected by turnover
        and
        the use of “temp-to-perm” employment; that is, hiring an employee on a temporary
        basis before extending an offer of permanent employment.
  Expenses
        related to pension plan administration and matching 401k contributions continued
        along an increasing trend. The escalation of costs related to employee pension
        plans is a function of increasing numbers of employees enrolled in the
        company-sponsored plan. At the end of the first quarter, 176 employees were
        enrolled in the plan as compared to 162 employees one year prior, an increase
        of
        9%.
  **Occupancy
        Expense**
  Our
        total
        occupancy expense increased by 29% in the first quarter of 2006 compared
        to the
        first quarter of 2005. When comparing this year’s first quarter to the last
        quarter of 2005, occupancy expense decreased by 2%.
 
 **Q1
                  2006**
              
              **Q1
                  2005**Rent
                  Expense
              
              $
              79,000
              
              $
              78,000Utilities
                  and Maintenance
              
              
              204,000
              
              
              189,000Depreciation
                  Expense
              
              
              509,000
              
              
              339,000Other
                  Occupancy Costs
              
              
              218,000
              
              
              178,000Total
                  Occupancy Expense
              
              $
              1,010,000
              
              $
              784,000
  The
        most
        significant increase was in depreciation expense, which rose 50% from the
        first
        quarter of 2005 to the like quarter this year. Within the depreciation expense
        category, the largest increase was attributable to depreciation of office
        building improvements. In the latter half of 2005, we concluded remodeling
        projects at our corporate headquarters, First Mutual Center, as well as several
        banking centers. In addition to the depreciation for building improvements,
        depreciation expense related to furniture, fixtures, and personal computers
        also
        increased, as the newly remodeled spaces were furnished and filled with new
        equipment. Depreciation expense was essentially unchanged between the fourth
        quarter of 2005 and the first quarter of 2006, rising from $508,000 to
        $509,000.
  We
        expect
        to see continued increases in depreciation expenses in 2006, as a new banking
        center in West Seattle is scheduled for completion in the second quarter
        of
        2006. At that time, the new banking center is expected to result in additional
        depreciation expense of $15,000 to $20,000 per quarter.
  Within
        the other occupancy costs category, the cost of maintenance for computers,
        furniture, and equipment increased $32,000 from the first quarter of last
        year,
        largely due to a strategic change in the management of and contract on office
        equipment such as fax machines and copy machines. A comparison of the last
        quarter of 2005 to the first quarter of 2006 indicates that these maintenance
        costs remained relatively stable, showing an increase of only $2,000. Upgrades
        to security systems in several banking centers also contributed to additional
        occupancy expense in the first quarter of 2006.
  -25-
  **Other
        Noninterest Expense**
  Other
        noninterest expense increased only 5% from the first quarter of 2005 to the
        same
        period in 2006, as growth in credit insurance and other costs were partially
        offset by declines in expenses for marketing and public relations, outside
        services, and information systems. On a sequential quarter basis, other
        noninterest expense declined 11% or $254,000 from the fourth quarter 2005
        level.
 
 **Q1
                  2006**
              
              **Q1
                  2005**Marketing
                  and Public Relations
              
              $
              252,000
              
              $
              354,000Credit
                  Insurance
              
              
              462,000
              
              
              333,000Outside
                  Services
              
              
              168,000
              
              
              198,000Taxes
              
              
              145,000
              
              
              141,000Information
                  Systems
              
              
              204,000
              
              
              247,000Legal
                  Fees
              
              
              187,000
              
              
              135,000Other
              
              
              814,000
              
              
              725,000Total
                  Other Noninterest Expense
              
              $
              2,232,000
              
              $
              2,133,000
  Marketing
        and public relations expenses declined from the first quarter of 2005 compared
        to both the same period of 2006 and the fourth quarter of 2005 as we reduced
        marketing expenditures for our Residential, Income Property, Business Banking
        and Community Business Banking departments. We anticipate that marketing
        expenses for the second quarter of 2006 will again be lower than the prior
        year
        level and fall within a range of $150,000 to $200,000. For the second half
        of
        2006, however, we expect marketing spending to return to levels comparable
        to
        the prior year.
  Credit
        insurance premiums increased by $129,000, or 39%, in the first quarter of
        2006
        compared to the first quarter of 2005, but remained essentially unchanged
        on a
        sequential quarter basis, with the majority of credit insurance premiums
        attributable to sales finance loans. For the first quarter of 2006,
        approximately 40% of the sales finance loan portfolio and 31% (by balance)
        of
        the loans originated in the quarter were insured. A small portion of consumer,
        residential, and income property loans are also insured. The fourth quarter
        of
        2005 marked the inception of a new insurance policy on a pool of loans
        previously insured by an existing policy. This “double insurance” raised credit
        insurance costs by approximately $70,000 a quarter.
  Our
        expenditures for credit insurance represent a significant component of our
        total
        noninterest expenses. As reported, our efficiency ratio for the first quarter
        of
        2006 totaled 64.4%. If credit insurance costs were taken out of the noninterest
        expense calculations, our efficiency ratio would have been 60.5%.
  -26-
  Costs
        related to outside services decreased from the first quarter of 2005 to the
        first quarter of this year, declining by $30,000 or 15%. In the first quarter
        of
        last year, banking center renovations and relocating departments at First
        Mutual
        Center during stages of the building’s remodeling resulted in an unusually high
        level of expense. The lack of these expenses in the first quarter of 2006
        accounted for most of the decline in expenditures on a year-over-year basis.
        On
        a sequential quarter basis, outside services expenses declined by $81,000
        or
        33%. The higher costs in the fourth quarter of 2005 were partially the result
        of
        consulting fees paid for testing internal data processing controls related
        to
        compliance with the Sarbanes/Oxley Act, as well as expenses related to internal
        moves associated with the remodel of several banking centers and First Mutual
        Center late in 2005.
  Tax
        expenses increased slightly from the first quarter of 2005 to the first quarter
        of 2006 when we increased the effective tax rate from 34% to 35.07%. The
        higher
        effective tax rate is a direct result of the expensing of stock options.
        As
        previously noted, the offset to stock option expense is recorded as additional
        paid-in capital in shareholders’ equity. As such, some of these expenses are not
        deemed to be tax deductible, which results in a higher effective tax
        rate.
  Compared
        to the first quarter of 2005, legal fees increased from $135,000 to $187,000,
        or
        38%, with several “work-out” loans contributing significantly to the increase.
        Subsequent to the quarter-end, we successfully recovered a portion of the
        legal
        expenses related to some of these loans. Taking the recovery of these expenses
        into account, we anticipate legal fees of $70,000 to $80,000 in the second
        quarter. Additionally, legal expenses for our sales finance area were higher
        than the prior year mainly due to an annual compliance review process that
        evaluates the Bank’s practices in the states in which we do business. Sales
        Finance related legal expenses totaled $35,000 last year and increased to
        $56,000 this year. Legal fees in the fourth quarter of 2005 were higher than
        the
        first quarter of 2006, partially as a result of expenses associated with
        several
        non-performing assets. We have subsequently recovered some of those
        expenses.
  **FINANCIAL
        CONDITION**
 
 **Assets**
 
 As
        of
        March 31, 2006 our assets totaled $1.085 billion, virtually unchanged from
        their
        level at December 31, 2005, as the first quarter saw modest loan growth offset
        by a decline in our securities portfolio.
 
 **Securities**
 
 Security
        investments (available-for-sale and held-to-maturity) declined by $5 million
        in
        the first quarter from year-end 2005, to $116.4 million as of March 31, 2006.
        Our expectation for 2006 is that we will periodically purchase securities
        throughout the year to replace part of the run-off in securities. Beyond
        these
        replacement purchases, we do not anticipate increasing the size of our
        securities portfolio at this time. Over the past year, we have typically
        found
        the yields available on investment securities to be significantly less favorable
        than alternative earning assets, particularly when the funding costs to support
        the additional assets were taken into account. Consequently, as the securities
        in our portfolio amortized or matured over the quarter, we generally did
        not
        replace the paid off securities balances, and instead typically elected to
        redirect those cash flows to support loan growth. In the event that market
        conditions shift to be more conducive to holding investment securities, we
        would
        consider increasing the size of our securities portfolio at that
        time.
  -27-
 
 Based
        on
        current accounting literature, any investment security purchased is classified
        in one of the following categories: 1) trading, 2) available-for-sale, or
        3)
        held-to-maturity. The majority of the securities in our present portfolio
        are of
        the second type, available-for-sale. None of the securities in our portfolio
        are
        classified in the trading category. Available-for-sale securities are reviewed
        regularly, and any unrealized gains or losses are recorded in comprehensive
        income in the shareholders’ equity account. As of March 31, 2006, the balance of
        the unrealized loss in comprehensive income, net of federal income taxes,
        totaled $2.0 million, representing an increase over the balance of the
        unrealized loss at the end of 2005, which was $1.4 million. Generally, falling
        interest rates will enhance the amount recorded as unrealized gain, and rising
        rates will erode unrealized gains, as the market value of securities inversely
        adjusts to the change in interest rates. The passage of time partially
        counteracts these interest rate effects, as the unrealized gain or loss on
        a
        given security will gradually decline to zero as the security approaches
        its
        pay-off date. As we do not anticipate liquidating any of our securities
        currently in an unrealized loss position, we do not expect that any of the
        current unrealized loss will directly impact the gain or loss from security
        sales in future periods.
 
 **Servicing
        Assets**
 
 Servicing
        assets represent the deferred servicing rights generated from sales of loans
        that are sold servicing retained, reduced by the amortization and prepayments
        of
        loans serviced, as well as any impairment charges that may occur. Although
        the
        increases in servicing assets have not been a major factor in our overall
        asset
        growth, this area is expected to continue increasing with anticipated future
        loan sales.
 
 Servicing
        assets grew by $608,000, or 33%, in the three months since December 31, 2005.
        Comparatively, servicing assets grew by $368,000, or 24%, in the first quarter
        of 2005. In both instances, the significant growth in servicing assets was
        attributable to high volumes of consumer loan sales during the
        quarter.
 
 **Servicing
                  Assets**
              
              **Q1
                  2006**
              
              **Q1
                  2005**
              
              **Year-end
                  2005**Commercial
              
              $
              275,000
              
              
              151,000
              
              $
              292,000Residential
              
              
              92,000
              
              
              12,000
              
              
              114,000Consumer
              
              
              2,107,000
              
              
              1,730,000
              
              
              1,460,000Total
              
              
              2,474,000
              
              
              1,893,000
              
              
              1,866,000Loan
                  Balances Serviced for Others
              
              
              107,479,000
              
              
              120,898,000
              
              
              105,850,000
  After
        sizeable sales in the first quarter of 2005, we had substantially reduced
        our
        consumer loan sales in the remainder of the year, resulting in a decline
        in our
        consumer loan servicing asset by the 2005 year-end. The first quarter of
        2006,
        however, presented favorable opportunities to sell additional consumer loans.
        The larger volume of sales in turn increased our servicing asset balances.
        Based
        on our current levels of loan production and market demand, our expectation
        is
        for continued growth of our consumer loan servicing asset based on quarterly
        loan sales expected to total in the $14 million to $18 million range. Note
        that
        these expectations may be subject to change based on changes in loan production,
        market conditions, and other factors.
 
 Our
        servicing assets related to commercial loans decreased slightly from the
        2005
        year-end, but showed notable increase since March 31, 2005, based on the
        second-quarter 2005 sale of a commercial real estate credit that included
        both
        construction financing as well as a permanent mortgage to refinance that
        loan
        following the completion of construction. While we continue to explore and
        consider opportunities for selling participations in our commercial real
        estate
        loans, the unique nature of such transactions can result in significant
        variances in the volumes of commercial real estate loan sales, and gains
        thereon, from one quarter to the next.
 
 In
        contrast to the above loan types, residential loans are typically sold servicing
        released, and consequently are not expected to contribute to the future growth
        of our servicing assets or servicing fee income.
  -28-
 
 **Loans**
 
 Loans
        receivable, excluding loans held-for-sale, increased $3 million from $878
        million at the close of 2005 to $881 million at March 31, 2006. Loan
        originations for the first three months of 2006 totaled $121 million, an
        increase of 3% over the first quarter of 2005.
 
 **Portfolio
                  Distribution**
              
              **Q1
                  2006**
              
              **Q1
                  2005**
              
              **Year-end
                  2005**Single
                  Family Residential (includes held for sale)
              
              26%
              
              23%
              
              25%Income
                  Property
              
              
              31%
              
              
              40%
              
              
              34%Business
                  Banking
              
              
              14%
              
              
              12%
              
              
              13%Commercial
                  Construction
              
              
              4%
              
              
              3%
              
              
              3%Single
                  Family Construction:Spec
                  Construction
              
              
              3%
              
              
              2%
              
              
              2%Custom
                  Construction
              
              
              10%
              
              
              9%
              
              
              10%Consumer
              
              
              12%
              
              
              11%
              
              
              13%Total
              
              
              100%
              
              
              100%
              
              
              100%
 
 The
        most
        significant growth in our loan portfolio continues to be in the area of one-
        to
        four-family residential loans. While these are typically non-conforming
        residential loans that do not meet the requirements for sale into the secondary
        market, they generally offer higher yields than conforming residential mortgages
        and are still considered eligible collateral for borrowing from the
        FHLB.
 
 In
        addition to the increase observed in our Residential Lending business segment,
        portfolio growth continued in our Business Banking lending area. Expansion
        in
        these areas was partially offset by reductions in our Consumer Lending and
        Income Property portfolios. In the case of Consumer Lending, the portfolio
        contraction was largely attributable to a significant increase in loan sales,
        which totaled slightly more than $13 million for the first quarter.
 
 Our
        income property loans, which consist of investor-owned commercial real estate
        and multifamily mortgages, have fallen, as a percentage of the portfolio,
        by 9%
        since the first quarter of last year and 3% since the end of 2005. This steady
        decline has been largely the result of lower originations of permanent
        multifamily and commercial real estate loans, along with a high level of
        prepayments on the loan portfolio, which we attribute to a combination of
        a
        flattening of the yield curve and increased competition from other lenders.
        The
        flattening of the yield curve, which resulted from rising short-term interest
        rates and relatively static longer-term interest rates, reduced the rate
        differential between short- and long-term financing costs and provided a
        financial incentive for borrowers to select longer-term, fixed-rate loans
        as
        opposed to short-term or adjustable-rate financing. As we have historically
        been
        an originator of short-term and adjustable-rate loans, this has impacted
        us in
        two ways. First, as prospective borrowers sought loans with terms that fell
        outside of our typical underwriting structures, our originations of permanent
        multifamily and commercial real estate loans declined. Second, with the yield
        curve providing borrowers with a financial incentive to refinance
        adjustable-rate loans, which make up the majority of our loan portfolio,
        with
        longer-term, fixed-rate debt, the prepayment rates on our income property
        portfolio remain at relatively high levels. Increased competition among lenders
        in our local market accelerated both the decline in new volumes as well as
        portfolio payoffs, as the competition frequently resulted in lenders offering
        prospective borrowers new loan commitments or existing borrowers the opportunity
        to refinance, at unusually low margins.
  -29-
 
 **Deposits
        and Borrowings**
 
 Our
        total
        deposit balances rose 3% over their 2005 year-end levels, totaling $784 million
        as of March 31, 2006. Money market deposit and checking account balances
        increased $27 million, or 10%, over the first quarter of 2005, while time
        deposit balances declined $5 million, or 1%, during the same time
        period.
 
 The
        increase in checking and money market deposit accounts was a reversal from
        the
        overall trend observed in 2005, when deposit growth was typically centered
        in
        time deposit balances. Increases in short-term market interest rates over
        the
        prior year had started to affect the yields on retail deposits, with the
        rates
        paid on time deposits increasing more significantly than those paid on money
        market accounts. Consequently, we observed a migration of deposit balances
        from
        money market accounts to time deposits at those times in 2005 when time deposit
        rates increased and money market rates remained relatively stable. This climate
        made it more difficult to retain or grow checking and money market
        balances.
 
 The
        growth of checking and money market accounts typically helps us reduce our
        overall cost of funds. Consequently, we consider the growth of these types
        of
        account to be an important part of our funding strategy for the future. To
        encourage this growth, we actively monitor the products and rates offered
        by our
        competition in the local market and develop new products and/or offer aggressive
        rates to attract new balances in the most cost-effective manner
        possible.
 
 While
        our
        balances in money market deposit and checking accounts have increased, balances
        in retail certificates declined in the first quarter of 2006. This decrease
        has
        materialized as we have attempted to move away from offering rates competitive
        with the higher rates in the local market. While this has resulted, and will
        continue to result in the months ahead, in a minority of depositors exiting
        the
        Bank for higher rates elsewhere, the majority of balances are remaining on
        our
        books at significantly lower costs to the Bank.
 
 Utilization
        of FHLB advances, our preferred supplemental funding mechanism, declined
        slightly from year-end 2005. FHLB advances decreased $19 million or 8% over
        the
        first three months of 2006, as the additional deposits described above more
        than
        supported our asset growth. As of March 31, 2006, we had the authority to
        borrow
        up to a total of approximately $434 million in FHLB advances, subject to
        sufficient collateral to support those advances.
 
 **ASSET
        QUALITY**
 
 **Provision
        and Reserve for Loan Losses**
  The
        provision for loan losses reflects the amount deemed appropriate to produce
        an
        adequate reserve for probable loan losses inherent in the risk characteristics
        of the loan portfolio. In determining the appropriate reserve balance, we
        consider the current and historical performance of the loan portfolio, the
        amount and type of new loans added to the portfolio, our level of non-performing
        loans, the amount of loans charged off, and the economic conditions in which
        we
        currently operate.
 
 The
        determination of the level of reserves, and thus any additional provision,
        is
        arrived at through a process that begins with the Asset Management Department,
        which analyzes the loan portfolio from a historical credit perspective and
        a
        composition and geographic concentration viewpoint. The Asset Management
        Department then prepares an economic analysis of the Puget Sound region that
        includes, when appropriate, employment forecasts, housing sales, vacancy
        rates,
        and commercial real estate analysis. That information is then reviewed by
        our
        Loan Policy Committee, which further evaluates national and international
        trends
        and makes a recommendation as to the loan loss provision to the Audit Committee
        of the Board of Directors. The Audit Committee considers the input of the
        Asset
        Management Department and the recommendation of the Loan Policy Committee
        and
        determines the appropriate level of reserves. The Board of Directors reviews
        the
        actions of the Audit Committee.
  -30-
 
 For
        the
        quarter, we reserved $71,000 for loan losses, down significantly from the
        $400,000 provision reserved in the first quarter of 2005. The reduction in
        this
        year’s first quarter provision was based in large part on a recovery on an
        impaired loan. Included in the recovery was a $171,000 impairment charge,
        which
        had been charged-off against the reserve for loan losses in a prior period.
        Based on the unique and nonrecurring nature of this recovery, we expect our
        provision for loan losses to return to a more normal level in the second
        quarter. Our net charged-off loan balances totaled only $53,000 for the first
        quarter of 2006, net of recoveries, including the $171,000. In contrast,
        net
        charge-offs totaled $211,000 in the first quarter of 2005. Our reserve for
        loan
        losses totaled approximately $10.1 million, up from $9.5 million at March
        31,
        2005 and little changed from the year-end level. The allowance for loan losses
        represented 1.13% of gross loans at both the first quarter 2006 and 2005
        year-end, and 1.14% as of March 31, 2005.
 
 Also
        contributing to the significant reduction in the provision for loan losses
        was
        the rate of growth observed in our loan portfolio during the first quarter.
        The
        loan portfolio’s rate of growth slowed in each of the last four quarters, and
        totaled less than 1% (quarterly, not annualized) in the first quarter of
        this
        year. Additionally, our loan growth has been largely attributable to our
        residential lending segment, which is generally considered lower risk than
        commercial real estate, business banking, or unsecured consumer lending,
        although the local economy can have a significant effect on the performance
        of
        all loan types.
 
 The
        national economy, as well as conditions in the Puget Sound metropolitan area
        remained favorable, with solid, though not dramatic growth. The local housing
        market remained strong, with prices continuing to increase despite signs
        of the
        market beginning to slow, and commercial office vacancy rates declining from
        levels observed in recent years.
 
 Another
        factor that has influenced the size of the loan loss provision for the last
        three years has been the level of non-performing assets as a percentage of
        total
        assets. For the quarter ended March 31, 2006, our total non-performing assets
        (NPAs) declined to $495,000, or 0.05% of total assets, compared to $957,000,
        or
        0.09% for the first quarter of last year, and $897,000, or 0.08% at the 2005
        year-end. The comparative ratio for all FDIC-insured institutions was 0.50%
        at
        the 2005 year-end (*). For a number of years we have experienced better than
        average ratios for non-performing assets and we are hopeful that our credit
        culture will allow us to continue that trend in the future.
 
 *(*)
        Fourth Quarter 2005 FDIC Quarterly Banking Profile*
  **Non-Performing
        Assets**
  Our
        exposure to non-performing loans and repossessed assets as of March 31, 2006
        was:
  -31-
 
 Forty-six
                  consumer loans. Full recovery anticipated from insurance
                claims.
              
              $
              247,000Five
                  consumer loans. Possible loss of the total loan balances.
              
              
              31,000Four
                  consumer loans. No anticipated loss.
              
              
              28,000One
                  land loan in Seattle, Washington. Possible loss of
                  $69,000.
              
              
              162,000Total
                  Non-Performing Loans
              
              $
              468,000Total
                  Real Estate Owned
              
              
              27,000Total
                  Non-Performing Assets
              
              $
              495,000
  In
        the
        first quarter of 2006, following extensive negotiation with the borrower
        and
        other involved parties, we received $340,000 on a residential loan that had
        been
        partially charged-off in the third quarter of 2004. Included in this recovery
        was a $171,000 impairment charge that had been charged-off against the reserve
        for loan losses, $125,000 recovery of the outstanding principal, and $44,000
        reimbursement of legal fees. This recovery, combined with the previously
        mentioned slowdown in loan portfolio growth led to a significant reduction
        in
        our provision for loan losses for the first quarter of 2006.
 
 **PORTFOLIO
        INFORMATION**
 
 **Commercial
        Real Estate Loans**
  The
        average loan size (excluding construction loans) in the Commercial Real Estate
        portfolio was $713,000 as of March 31, 2006, with an average loan-to-value
        ratio
        of 62%. At quarter-end, two of these commercial loans totaling $456,800 were
        delinquent for 30 days or more. Small individual investors or their limited
        liability companies and business owners typically own the properties securing
        these loans. At quarter-end, the portfolio was 43% residential (multifamily
        or
        mobile home parks) and 57% commercial.
  The
        loans
        in our commercial real estate portfolio are well diversified, secured by
        small
        retail shopping centers, office buildings, warehouses, mini-storage facilities,
        restaurants and gas stations, as well as other properties classified as general
        commercial use. To diversify our risk and to continue serving our customers,
        we
        sell participation interests in some loans to other financial institutions.
        About 9% of commercial real estate loan balances originated by the Bank have
        been sold in this manner. We continue to service the customer’s loan and are
        paid a servicing fee by the participant. Likewise, we occasionally buy an
        interest in loans originated by other lenders. About $15 million of the
        portfolio, or 5%, has been purchased in this manner.
  **Sales
        Finance (Home Improvement) Loans**
  The
        Sales
        Finance loan portfolio balance declined $7 million to $79 million, based
        on $15
        million in new loan production, $13 million in loan sales, and loan prepayments
        that ranged from 30%-40% (annualized). This reduction was primarily due to
        a
        higher level of loan sales this quarter than has occurred in the
        past.
  We
        manage
        the portfolio by segregating it into its uninsured and insured balances.
        The
        uninsured balance totaled $47 million at the end of the first quarter 2006,
        while the insured balance amounted to $32 million. A decision to insure a
        loan
        is principally determined by the borrower’s credit score. Uninsured loans have
        an average credit score of 734 while the insured loans have an average score
        of
        668. We are responsible for loan losses with uninsured loans, and as illustrated
        in the following table the charge-offs for that portion of the portfolio
        have
        ranged from a low of $93,000 to a high of $223,000 in the most recent quarter.
        The charge-offs in the first quarter were largely attributable to bankruptcy
        filings that occurred as a consequence of the change in bankruptcy laws in
        October 2005.
  -32-
  **UNINSURED
                  PORTFOLIO - BANK BALANCES****Bank**
                **Balance**
              **Net
                  Charge-**
                **Offs**
              **Charge-offs**
                **(%
                  of Bank**
                **Portfolio)**
              **Delinquent**
                **Loans**
                **(%
                  of Bank**
                **Portfolio)**March
                  31, 2005
              $40
                  million
              $141,000
              0.35%
              0.62%June
                  30, 2005
              $44
                  million
              $
                  147,000
              0.33%
              0.77%September
                  30, 2005
              $48
                  million
              $
                  98,000
              0.21%
              1.20%December
                  31, 2005
              $52
                  million
              $
                  93,000
              0.18%
              1.18%March
                  31, 2006
              $47
                  million
              $
                  223,000
              0.47%
              0.92%
  Losses
        that we sustain in the insured portfolio are reimbursed by an insurance carrier.
        As shown in the following table, the claims to the insurance carrier have
        varied
        in the last five quarters from a low of $359,000 to as much as $1,023,000
        in the
        fourth quarter of 2005. The substantial increase in claims paid during the
        fourth quarter 2005 and first quarter 2006 was largely attributable to
        bankruptcy filings that occurred just prior to the change in bankruptcy laws
        on
        October 17, 2005. The standard limitation on loss coverage for this portion
        of
        the portfolio is 10% of the original pool of loans for any given pool year.
 
 **INSURED
                  PORTFOLIO - BANK AND INVESTOR LOANS****Claims
                  Paid**
              **Claims
                  (% of Insured Balance)**
              **Delinquent
                  Loans**
                **(%
                  of Bank Portfolio)**March
                  31, 2005
              $516,000
              1.05%
              2.75%June
                  30, 2005
              $359,000
              0.70%
              3.23%September
                  30, 2005
              $483,000
              0.89%
              3.64%December
                  31, 2005
              $1,023,000
              1.87%
              3.60%March
                  31, 2006
              $937,000
              1.72%
              3.60%
  Through
        the third quarter of 2005, we maintained a relationship with a single credit
        insurance company (Insurer #1) that provided credit insurance on Sales Finance
        loans as well as on a small number of home equity products. In August 2005,
        we
        entered into an agreement with another credit insurance company (Insurer
        #2) to
        provide similar insurance products with very similar underwriting and pricing
        terms.
  In
        October of 2005, we were unable to reach an agreement on the pricing of
        insurance for Sales Finance loans with Insurer #1, and have since placed
        newly
        insured loans with Insurer #2. This decision does not affect the pricing
        or
        coverage in place on loans currently insured with Insurer #1, and we continue
        to
        have a relationship with Insurer #1 for home equity loan
        products.
  In
        March
        2006, the pool for the policy year 2002/2003 reached the 10% cap from Insurer
        #1. Earlier, in October 2005, we acquired back-up insurance through Insurer
        #2
        to address this circumstance. The policy through Insurer #2 added $1.07 million
        in additional coverage to that pool year, an amount equal to 10% of the
        outstanding balances at the policy date. The cost of this policy is competitive
        with the premiums that we were paying to Insurer #1. In addition to the
        insurance coverage, we have periodically adjusted our underwriting approval
        criteria to reflect ongoing risk.
  -33-
  **Insurer
        #1**
 **Remaining****Current**
              **Original**
              
              **Remaining**
              **Limit
                  as %**
              **Current****Policy**
              **Loans**
              **Loan**
              **Loss**
              **Claims**
              **Loss**
              **of
                  Current**
              **Delinquency****Year***
              **Insured**
              **Balance**
              **Limit**
              **Paid**
              **Limit**
              **Balance**
              **Rate**2002/2003
              $21,442,000
              $8,693,000
              $2,144,000
              $2,143,000
              $1,000
              0%
              4.53%2003/2004
              $35,242,000
              $18,394,000
              $3,524,000
              $2,231,000
              $1,293,000
              7.03%
              5.11%2004/2005
              $23,964,000
              $17,125,000
              $2,396,000
              $580,000
              $1,816,000
              10.60%
              3.08%
  Policy
        years close on 9/30 of each year
  **Insurer
        #2**
 **Remaining****Current**
              **Original**
              
              **Remaining**
              **Limit
                  as %**
              **Current****Policy**
              **Loans**
              **Loan**
              **Loss**
              **Claims**
              **Loss**
              **of
                  Current**
              **Delinquency****Year**
              **Insured**
              **Balance**
              **Limit**
              **Paid**
              **Limit**
              **Balance**
              **Rate**2002/2003*
              $10,768,000
              $8,693,000
              $1,077,000
              $39,000
              $1,038,000
              11.94%
              4.53%2005/2006**
              $11,602,000
              $10,232,000
              Not
                  Applicable**
              $0
              Not
                  Applicable**
              Not
                  Applicable
              0.84%
  *Loans
        in
        this policy year are the same loans insured with Insurer #1 during the same
        time
        period.
  **Policy
        year closes on 7/31 of each year
  The
        prepayment speeds for the entire portfolio continue to remain in a range
        of
        between 30% and 40%. During the first quarter of 2006, the average new loan
        amount was $10,400. The average loan balance in the entire portfolio is $9,100,
        and the yield on this portfolio is 10.38%. Loans with credit insurance in
        place
        represent 40% of our portfolio balance, and 31% (by balance) of the loans
        originated in the first quarter were insured.
  **Residential
        Lending**
  The
        residential lending portfolio (including loans held for sale) totaled $328
        million on March 31, 2006. This represents an increase of $21 million from
        the
        end of the fourth quarter 2005. The breakdown of that portfolio at March
        31,
        2006 was:
  
 **Bank
                  Balance**
              
              **%
                  of Portfolio**Adjustable
                  rate permanent loans
              
              $
              181
                  million
              
              
              55%Fixed
                  rate permanent loans
              
              $
              13
                  million
              
              
              4%Residential
                  building lots
              
              $
              39
                  million
              
              
              12%Disbursed
                  balances on custom construction loans
              
              $
              89
                  million
              
              
              27%Loans
                  held-for-sale
              
              $
              6
                  million
              
              
              2%Total
              
              $
              328
                  million
              
              
              100%
  The
        portfolio has performed in an exceptional manner, and currently only two
        loans,
        or 0.10% of loan balances, are delinquent more than one payment.
  -34-
  The
        average loan balance in the permanent-loan portfolio is $208,000, and the
        average balance in the building-lot portfolio is $120,000. Owner-occupied
        properties, excluding building lots, constitute 76% of the loan balances.
        Our
        portfolio program underwriting is typically described as non-conforming and
        largely consists of loans that, for a variety of reasons, are not readily
        salable in the secondary market at the time of origination. The yield earned
        on
        the portfolio is generally much higher than the yield earned on a more typical
        “conforming underwriting” portfolio. We underwrite the permanent loans by
        focusing primarily on the borrower’s good or excellent credit and our overall
        exposure on the loan. We manually underwrite all loans and review the loans
        for
        compensating factors to offset the non-conforming elements of those loans.
        We do
        not currently originate loans with interest-only payment plans nor do we
        originate an “Option ARM” product, where borrowers are given a variety of
        monthly payment options that allow for the possibility of negative
        amortization.
 
 **DEPOSIT
        INFORMATION**
  The
        number of business checking accounts increased by 17%, from 2,021 at March
        31,
        2005, to 2,354 as of March 31, 2006, a gain of 333 accounts. The deposit
        balances for those accounts grew 27%. Consumer checking accounts also increased,
        from 7,059 in the first quarter of 2005 to 7,521 this year, an increase of
        462
        accounts, or 7%. Our total balances for consumer checking accounts rose 4%.
  The
        following table shows the distribution of our deposits.
  **Time**
                **Deposits**
              **Checking**
              **Money
                  Market**
                **Accounts**
              **Savings**March
                  31, 2005
              64%
              13%
              22%
              1%June
                  30, 2005
              64%
              14%
              21%
              1%September
                  30, 2005
              65%
              14%
              20%
              1%December
                  31, 2005
              64%
              14%
              21%
              1%March
                  31, 2006
              62%
              13%
              24%
              1%
  **BUSINESS
        SEGMENTS**
 
 The
        management reporting process measures the performance of the operating segments
        based on the management structure of the Bank and is not necessarily comparable
        with similar information for any other financial institution.
 
 The
        reportable segments include the following:
 
 ·
            *Consumer
                Lending -*Consumer
                lending includes home equity lending, direct consumer loans, and
                indirect
                home improvement loans (sales finance). These loans include lines
                of
                credit and loans for primarily consumer purposes. 
 ·
            *Residential
                Lending -*Residential
                lending offers loans to borrowers to purchase, refinance, or build
                homes
                secured by one-to-four-unit family dwellings. They also finance the
                purchase or refinance of buildable residential lots. 
 ·
            *Business
                Banking Lending -*Business
                Banking lending offers a full range of banking services to small
                and
                medium size businesses including deposit and cash management products,
                loans for financing receivables, inventory, equipment as well as
                permanent
                and interim construction loans for commercial real estate. The underlying
                real estate collateral or business asset being financed typically
                secures
                these loans. 
 ·
            *Income
                Property Lending -*Income
                Property lending offers permanent and interim construction loans
                for
                multifamily housing (over four units), manufactured housing communities,
                commercial real estate properties, and spec single-family construction.
                The underlying real estate collateral being financed typically secures
                these loans. 
 -35-
  Each
        of
        these business segments also sells loans into the secondary market. We may
        choose to retain or sell the right to service the loans sold (i.e., collection
        of principal and interest payments) depending upon market
        conditions.
 
 These
        segments are managed separately because each business unit requires different
        processes and different marketing strategies to reach the customer base that
        purchases the products and services. The segments derive a majority of their
        revenue from interest income, and we rely primarily on net interest revenue
        in
        managing these segments. No single customer provides more than 10% of the
        Bank’s
        revenues.
 
 **Consumer
        Lending**
 
 **Quarter
                  Ended**
              **Net
                  Income**
              **Return
                  on**
                **Equity**
              **Total
                  Earning**
                **Assets
                  (Ending)**March
                  31, 2004
              $368,000
              18.4%
              $98,305,000March
                  31, 2005
              $386,000
              18.2%
              $110,145,000March
                  31, 2006
              $503,000
              22.0%
              $122,049,000
 
 The
        Consumer Lending segment’s net income rose significantly relative to the first
        quarter of last year, totaling $503,000, based on a combination of earning
        asset
        growth and related net interest income, a reduction in the provision for
        loan
        losses, and additional noninterest income, particularly gains on loan sales.
        These improvements were, however, partially offset by a substantial increase
        in
        noninterest expense.
 
 The
        Consumer segment’s earning assets totaled $122 million at the end of the first
        quarter, an increase of nearly 11% over the prior year’s level, despite sales of
        over $13 million in consumer loans in the first quarter of this year. With
        the
        additional earning assets the Consumer Lending segment’s interest income
        increased nearly 22% relative to the same period last year. By comparison,
        interest expense rose nearly 50% relative to the first quarter of last year,
        based on a combination of increases in non-maturity deposit costs and large
        balances of maturing certificates and FHLB advances that were renewed at
        significantly higher rates than the maturing instruments, as well as the
        cost of
        the additional funds required to support the growth in earning
        assets.
 
 Overall,
        the Consumer segment’s net interest income rose $117,000, or nearly 8%, from its
        first-quarter 2005 level. Following a $116,000 reduction in the provision
        for
        loan loss, the segment’s net interest income after provision increased $231,000
        as compared to the first quarter of 2005.
 
 The
        segment’s noninterest income exceeded the prior year level by $294,000, an
        increase of 34%, based on a significantly higher volume of loan sales and
        gains
        thereon. For the quarter, gains on consumer loan sales totaled $749,000 on
        sales
        of $13 million, up from $501,000 on sales of under $11 million in the first
        quarter of last year. Improved execution also contributed to the improvement
        in
        gains relative to last year, as gains on consumer loan sales rose 49% from
        the
        prior year level while the total volume of loans sold increased by
        22%.
  -36-
  In
        our
        fourth-quarter 2005 press release, we noted that we were experiencing a growing
        level of interest in, and favorable opportunities to market our consumer
        loans
        to other institutional investors. Consequently, consumer loan sales in the
        first
        quarter of 2006 exceeded both those of the first quarter of 2005 as well
        as our
        own expectation of $9 million to $10 million for the quarter. Based on our
        current levels of loan production and market demand, our expectation is for
        quarterly consumer loan sales to total in the $14 million to $18 million
        range,
        significantly exceeding the prior year’s sales levels. Note that these
        expectations may be subject to change based on changes in loan production,
        market conditions, and other factors.
 
 Partially
        offsetting the additional net interest and noninterest income, however, was
        growth in the Consumer segment’s noninterest expenses, which increased $334,000,
        or 20% compared to the prior year, with the largest single contributor being
        our
        credit insurance expense. This additional insurance cost was attributable
        to
        growth in insured sales finance loan balances, including both the loans in
        our
        portfolio and those serviced for other institutions, as well as a supplemental
        insurance policy taken out in late 2005 on a seasoned pool of previously
        insured
        loans. Also contributing to the additional expense were higher compensation
        costs, which increased as a result of annual salary increases in the second
        quarter of last year as well as the arrival of new personnel, including a
        new
        manager, for our Sales Finance lending area, and higher tax and legal expenses.
        The increase in legal expenses was attributable to the annual compliance
        review
        process that evaluates our practices in the states in which we do
        business.
 
 In
        addition to the above, administrative and support costs allocated to this
        segment, particularly expenses related to our Asset Management department,
        contributed to the additional expense. The Asset Management expenses allocated
        to this segment have risen based on the increased efforts required to manage
        the
        growing sales finance portfolio, including those loans serviced for
        others.
 
 **Residential
        Lending**
 
 **Quarter
                  Ended**
              **Net
                  Income**
              **Return
                  on**
                **Equity**
              **Total
                  Earning**
                **Assets
                  (Ending)**March
                  31, 2004
              $635,000
              25.8%
              $245,542,000March
                  31, 2005
              $747,000
              24.0%
              $305,276,000March
                  31, 2006
              $1,066,000
              29.8%
              $363,489,000
 
 The
        Residential Lending segment’s net income for the first quarter of 2006 totaled
        nearly $1.1 million, representing a 43% increase over the same period last
        year,
        with the improvement resulting from growth in net interest income and a
        reduction in the provision for loan loss. These improvements were, however,
        partly offset by a reduction in noninterest income and rising operating
        expenses.
 
 The
        Residential segment has been the largest contributor to our earning asset
        growth
        in recent years. Earning asset growth increased over $58 million relative
        to the
        level as of March 31, 2005. With the additional assets and the repricing
        effects
        resulting from increases in interest rate indexes from which the loan rates
        are
        set, interest income earned on the portfolio increased nearly 42% as compared
        to
        the first quarter of last year.
 
 As
        with
        the Consumer Lending segment, the increase in the Residential segment’s interest
        expense exceeded the rate of interest income growth, totaling nearly 69%
        on a
        quarter-to-quarter comparison, due to the rising retail deposit and wholesale
        funding rates mentioned earlier, as well as the cost of the additional funds
        required to support the earning asset growth. The increase in funding costs,
        combined with a $181,000 reduction in the segment’s provision for loan loss,
        resulted in an overall increase in the segment’s net interest income after
        provision of 30% over the prior year level. Note that the first-quarter
        provision for the Residential segment reflects a recovery on a residential
        loan
        that had been charged-off in a prior period, and that given the unique and
        nonrecurring nature of this recovery, we expect our provision for loan losses
        to
        return to a more normal level in the second quarter.
  -37-
  The
        Residential Lending segment’s noninterest income declined $25,000, or nearly
        12%, based largely on a reduction in gains on loan sales, which were well
        below
        our expectation for the quarter. A sale of low-documentation residential
        loans
        that had been expected to close in the first quarter of 2006 did not occur
        as
        previously anticipated. It is our expectation that gains on residential loan
        sales will not represent a material source of income in future
        quarters.
 
 The
        Residential segment’s noninterest expense increased $248,000, or nearly 15%,
        partially offsetting the quarter’s income growth over the same period last year.
        A reduction in the amount of loan origination expenses eligible for deferral
        and
        amortization contributed significantly to the increase relative to the first
        quarter of last year.
 
 In
        accordance with current accounting standards, certain loan origination costs,
        including some salary expenses tied to loan origination, are deferred and
        amortized over the life of each loan, rather than expensed in the current
        period. Expenses are then reported in the financial statements net of these
        deferrals. The amount of expense subject to deferral and amortization can
        vary
        from one period to the next based upon the number of loans originated, the
        mix
        of loan types, and year-to-year changes in “standard loan costs”. In this
        instance, both the number of loans originated by our Residential lending
        area in
        the first quarter of 2006 as well as the deferred costs associated with each
        origination declined relative to the prior year. This resulted in a higher
        level
        of expense being recognized in the current period.
 
 Also
        contributing to the additional expense in 2006 were rising allocations of
        administrative and other costs, including expenses incurred at the banking
        centers. These allocations have increased with the growth of the Residential
        segment.
 
 **Business
        Banking Lending**
 
 **Quarter
                  Ended**
              **Net
                  Loss**
              **Return
                  on**
                **Equity**
              **Total
                  Earning**
                **Assets
                  (Ending)**March
                  31, 2004
              ($37,000)
              (1.9%)
              $96,215,000March
                  31, 2005
              ($55,000)
              (2.3%)
              $123,543,000March
                  31, 2006
              ($111,000)
              (3.8%)
              $154,177,000
  Our
        Business Banking segment is one of the newer business lines in which we have
        invested, and will continue to invest our resources with the eventual goal
        of
        achieving our targeted 15% return on equity and consistent year-over-year
        earnings growth. At this time, these results have not yet been achieved,
        nor do
        we anticipate reaching these goals in 2006. We continue to invest in this
        segment, however, based upon its ability to attract low-cost core deposits,
        which helps to reduce our overall cost of funds, the diversification it brings
        to our portfolio of earning assets, and the potential it offers for generating
        longer-term relationship-banking opportunities and additional sources of
        noninterest income.
 
 For
        the
        first quarter, the Business Banking segment’s net interest income after
        provision for loan losses rose $193,000, or 14%, over the first quarter of
        last
        year. Like the Consumer and Residential segments, the Business Banking segment
        succeeded in building incremental assets over the prior year, with earning
        assets totaling $154 million as of March 31, 2006, an increase of nearly
        25%
        over the prior year level and the highest rate of increase for any of the
        four
        business segments.
  -38-
 
 In
        addition to the earning asset growth, the prevalence of prime-based loans
        in the
        Business Banking portfolio also contributed to the improvement in interest
        income. The majority of the adjustable-rate loans in our portfolio reprice
        according to contractually defined schedules, most commonly on an annual
        basis.
        The rates on prime-based loans, on the other hand, typically adjust in response
        to any change in the prime rate. Consequently, these loans typically reprice
        within days of any change to the index, rather than at a specified reset
        date
        potentially months into the future, and may reprice on several occasions
        over
        the course of the year.
 
 The
        Business Banking segment’s noninterest income rose $46,000, or 45% over the
        first quarter 2005 level. Contributing to the segment’s noninterest income
        growth has been the expansion of the Business Banking segment’s deposit base,
        measured by both total deposit balances as well as the number of open accounts.
        Fee income earned on these additional deposits has contributed to the
        improvement in noninterest income, and is expected to generate additional
        noninterest income for the segment in the future.
 
 Offsetting
        the growth in net interest and noninterest income was an additional $327,000
        in
        noninterest expense relative the first quarter of last year. The primary
        drivers
        of the additional noninterest expense were increases in expenses from our
        retail
        banking centers and other administrative departments allocated to the Business
        Banking segment. The expenses from our retail banking centers allocated to
        the
        Business Banking segment have increased largely as a result of the strong
        growth
        of our business checking and other commercial deposit accounts. Additionally,
        the segment’s compensation expense increased as a result of higher loan officer
        commissions this year in response to the quarter’s production of earning asset
        and deposit balances.
 
 **Income
        Property Lending**
 
 **Quarter
                  Ended**
              **Net
                  Income**
              **Return
                  on**
                **Equity**
              **Total
                  Earning**
                **Assets
                  (Ending)**March
                  31, 2004
              $1,349,000
              18.9%
              $432,301,000March
                  31, 2005
              $1,506,000
              19.9%
              $439,124,000March
                  31, 2006
              $1,256,000
              18.8%
              $386,591,000
  The
        Income Property segment’s first-quarter net income declined relative to the same
        period last year and continued a gradual downward trend, as a reduction in
        earning assets negatively impacted net interest income. While improvements
        were
        observed in the provision for loan loss, noninterest income, and noninterest
        expense relative to the prior year, these were insufficient to offset the
        quarter’s decline in net interest income.
 
 The
        segment’s net interest income after provision for loan loss declined $453,000,
        or 11%, based on interest income growth of 5% and a more-than-offsetting
        34%
        increase in interest expense. Unlike our other business segments, the Income
        Property segment’s portfolio of earning assets declined in the first quarter of
        2006, continuing a trend observed in recent quarters. The contraction of
        the
        segment’s earning assets is primarily a product of declining originations of
        permanent multifamily and commercial real estate loans, combined with a high
        level of prepayments on the loan portfolio, which we attribute to a combination
        of a flat yield curve and increased competition from other lenders. The flat
        yield curve, which has resulted from a number of increases in short-term
        interest rates, has reduced the rate differential between short- and long-term
        financing costs and provided a financial incentive for borrowers to select
        longer-term, fixed-rate loans as opposed to adjustable-rate financing. As
        we
        have historically been an originator of short-term and adjustable-rate loans,
        this impacted us in two ways. First, as prospective borrowers sought loans
        with
        terms that fell outside of our typical underwriting structures, our originations
        of permanent multifamily and commercial real estate loans declined. Second,
        with
        the yield curve providing borrowers with a financial incentive to refinance
        adjustable-rate loans, which make up the majority of our loan portfolio,
        with
        longer-term, fixed-rate debt, the prepayment rates on our Income Property
        portfolio remained at relatively high levels. Increased competition among
        lenders in our local market accelerated both the decline in new volumes as
        well
        as portfolio payoffs, as the competition frequently resulted in lenders offering
        prospective borrowers new loan commitments, or existing borrowers the
        opportunity to refinance, at unusually low margins.
  -39-
 
 Noninterest
        income for the Income Property segment rose $30,000, or 16% relative to the
        first quarter of 2005, based on higher gains on loan sales, loan prepayment,
        and
        brokered loan fees, which more than offset a reduction in service fee income.
        Since our second-quarter 2005 press release, in which we noted that we had
        experienced increased interest in sales of participations in our commercial
        real-estate loans, the volume of commercial real-estate loans sold has remained
        relatively modest. While we would note that these volumes do not reflect
        a
        decision against expanding our commercial real-estate loan sales, we would
        reiterate our comment that commercial real-estate loan transactions,
        particularly those that are candidates for sales of participations to other
        institutions, tend to be larger-dollar credits and unpredictable in their
        timing
        and frequency of occurrence. As a result, the volumes of commercial real-estate
        loans sold, and gains thereon, can be expected to vary considerably from
        one
        quarter to the next depending on the timing of the loan and sales transactions.
        The increase in brokered loan fees was the result of returning to a normal
        level
        of loan brokerage activity following an absence of such in the first quarter
        of
        2005.
 
 In
        contrast to the other business segments, noninterest expense for the Income
        Property segment declined by 4% compared to the first quarter of 2005. As
        noted
        above, the asset growth exhibited by the other business lines was not observed
        with the Income Property segment, which instead saw its balances decline
        as the
        other business lines grew their operations and became larger components of
        our
        overall asset mix. Consequently, for a number of different expenses that
        we
        allocate out to the business segments, such as banking center and administrative
        costs, the percentages allocated to other business lines increased over the
        prior year with their growing activity and asset balances, thus reducing
        the
        percentage allocated to the Income Property segment.
 
 **LIQUIDITY**
 
 Our
        primary sources of liquidity are loan and security sales and repayments,
        deposits, and wholesale funds. A secondary source of liquidity is cash from
        operations, which, though not a significant source of liquidity, is a consistent
        source based upon the quality of our earnings. Our principle uses of liquidity
        are the origination and acquisition of loans and securities, and to a lesser
        extent, to purchase facilities and equipment.
 
 **Q1
                  2006**
              
              **Q1
                  2005**(Dollars
                  in thousands)Loan
                  Originations (disbursed)
              
              $
              121,000
              
              $
              118,000Increase/(Decrease)
                  in Undisbursed Loan
                Proceeds
              
              
              5,000
              
              
              (8,000
              )Security
                  Purchases
              
              
              7,000
              
              
              6,000Total
                  Originations and Purchases
              
              $
              133,000
              
              $
              116,000Loan
                  and Security Repayments
              
              $
              111,000
              
              $
              83,000Sales
                  of Loans
              
              
              23,000
              
              
              18,000Total
                  Repayments and Sales
              
              $
              134,000
              
              $
              101,000Net
                  Difference
              
              $
              (1,000
              )
              $
              15,000
 Loan
        and
        security sales and repayments, our primary sources of funding, are heavily
        influenced by trends in mortgage rates. When rates trend downward, our
        prepayment speeds typically increase as borrowers refinance their loans at
        lower
        interest rates. Conversely, as rates move upwards, prepayments will generally
        tend to slow, as fewer borrowers will have a financial incentive to refinance
        their loans. The loan portfolio, excluding loans sold into the secondary
        market
        and spec construction loans, experienced an annualized prepayment rate of
        40% in
        the first quarter of 2006, compared to 29% and 35% for the first quarter
        of 2005
        and the fiscal year 2005, respectively.
 
 We
        believe the flat to inverted shape of the yield curve in the first quarter
        likely contributed to the continued high level of prepayments, as the rate
        differential between short- and long-term financing diminished and reduced
        the
        financial incentive for borrowers to use shorter-term, adjustable-rate financing
        rather than longer-term fixed-rate loans. This, in turn, provides borrowers
        holding short-term or adjustable-rate loans with an incentive to refinance
        with
        long-term fixed-rate loans.
  -40-
 
 Our
        preferred method of funding the net difference between originations/purchases
        and repayments/sales is with deposits. To the extent that deposit growth
        is
        insufficient to fully fund the difference, we may rely on wholesale funding
        sources including, but not limited to FHLB advances, brokered certificates
        of
        deposit, and reverse repurchase agreements. During the first quarters of
        2005
        and 2006, changes in funds from deposits and borrowings were as
        follows:
 
 **Q1
                  2006**
              
              **Q1
                  2005**(Dollars
                  in thousands)Deposits
              
              $
              23,000
              
              $
              16,000Borrowings
              
              
              (19,000
              )
              
              1,000Total
              
              $
              4,000
              
              $
              17,000
 
 Between
        the 2005 year-end and March 31, 2006, our deposits grew nearly $23 million,
        with
        over $27 million in growth observed in our checking and money market accounts.
        While certificate balances declined by nearly $5 million, the decline in
        retail
        certificates was, in fact, significantly larger, as the decline was partially
        offset by a net increase of $13 million in certificates issued through deposit
        brokerage services and other institutional deposits. Given the absence of
        asset
        growth during the quarter, this deposit growth was largely utilized to reduce
        outstanding balances of FHLB advances.
 
 The
        inflow of deposits varies from period to period, and our ability to raise
        liquidity from this source is dependent on our effectiveness in competing
        with
        other financial institutions in our local market. That competition tends
        to
        focus on rate and service. Although we control the quality of service that
        we
        provide, we have no control over the rates offered by our competitors.
 
 Our
        other
        major source of liquidity is wholesale funds, which includes borrowings from
        the
        FHLB, brokered deposits, reverse repurchase agreements, and a revolving line
        of
        credit at the Holding Company level. The most utilized wholesale funding
        source
        is FHLB advances, which totaled $207 million at March 31, 2006. Our credit
        line
        with the FHLB is reviewed annually, and our maximum allowable borrowing level
        is
        currently set at 40% of assets or $434 million. As a percentage of quarter-end
        assets, our FHLB borrowings totaled 19%, compared to 23% at March 31, 2005
        and
        21% at the 2005 year-end. Potential risks associated with this funding source
        include the reduction or non-renewal of the line and insufficient collateral
        to
        utilize the line. We try to mitigate the risk of non-renewal by maintaining
        the
        credit quality of our loans and securities and attending to the quality and
        consistency of our earnings.
 
 The
        potential risk of not holding enough collateral to fully utilize our available
        FHLB advances is monitored to ensure that ample collateral is available to
        meet
        our funding needs. Collateral to secure our FHLB line totaled $320 million
        as of
        our most recent assessment, representing 29% of total quarter-end assets.
        Our
        two principal sources of preferred collateral are single-family residential
        and
        multifamily loans. Over the last three years, we have seen an increase in
        single-family loans, while the level of multifamily loans has declined. As
        of
        March 31, 2006, single-family loans represented 26% of our total loan portfolio,
        showing an increase over the 25% level at year-end 2005 and 23% at March
        31,
        2005. The percentage of multifamily loans in the portfolio, on the other
        hand,
        has fallen from 22% at March 31, 2005, to 18% at year-end 2005, to 17% at
        the
        end of the first quarter of 2006. The decrease in multifamily loans has largely
        been offset by the increase in single-family loans. As of the end of the
        first
        quarter of 2005, the combined total of single- and multifamily loans comprised
        45% of the loan portfolio. This percentage declined to 43% at the end of
        the
        first quarter of 2006. Because single-family lending is our most profitable
        business segment and has exhibited the most growth in the last few years,
        we are
        encouraged that the business line will be able to provide sufficient collateral
        to meet our FHLB borrowing requirements.
  -41-
 
 Brokered
        deposits, which are included in the deposit totals, amounted to $51 million
        as
        of March 31, 2006, compared to $36 million at March 31, 2005. The decision
        to
        increase our institutional deposits in recent quarters has been attributable
        to
        rate differentials between these deposits and FHLB advances. Historically,
        rates
        on the two funding sources have been very comparable. At various points during
        the fourth quarter of 2005 and first quarter of 2006, interest rates on brokered
        deposits fell below those of similar term FHLB advances. Consequently, we
        increased our use of this funding source and routinely issued brokered deposits
        to replace maturing FHLB advances. As of March 31, 2006, brokered deposits
        represented 6.5% of total deposits. We may continue to increase our use in
        the
        future, depending on the costs of various wholesale funding sources and subject
        to internal policy limits.
 
 Reverse
        repurchase lines are lines of credit collateralized by securities. We have
        lines
        totaling $60 million, of which the full amount is currently available. There
        has
        been no usage of these lines in the past three years. The risks associated with
        these lines are the withdrawal of the line based on credit standing of the
        Bank
        and the potential lack of sufficient collateral to support the lines.
 
 An
        additional source of liquidity has been our cash from operations, which,
        though
        not a significant source of liquidity, is a consistent source based upon
        the
        quality of our earnings. On a very limited basis it can be viewed as cash
        from
        operations, adjusted for items such as provision for loan losses and
        depreciation. See the “Consolidated Statements of Cash Flows” in the financial
        statements section of this filing for a calculation of net cash provided
        by
        operating activities.
 
 In
        addition to using liquidity to fund loans and securities, we routinely invest
        in
        facilities and equipment. In the first quarter of 2006 we invested $1.3 million
        in these assets, down from $1.9 million in the first quarter of 2005. Over
        the
        year 2006 we intend to invest $4.0 million in facilities and equipment. Planned
        projects include: the completion of the remodeling projects in First Mutual
        Center, the installation of a drive-through facility at our corporate
        headquarters, the completion of the West Seattle banking center, and the
        construction of our Canyon Park banking center, which is anticipated to open
        in
        the first quarter of 2007.
 
 **CAPITAL**
 
 The
        FDIC’s statutory framework for capital requirements establishes five categories
        of capital strength, ranging from a high of well capitalized to a low of
        critically under-capitalized. An institution’s category depends upon its capital
        level in relation to relevant capital measures, including a risk-based capital
        measure, a leverage capital measure, and certain other factors. At March
        31,
        2006, we exceeded the capital levels required to meet the definition of a
        well-capitalized institution:
  -42-
  Actual
                
                Minimum
                    for
                  Capital
                  Adequacy
                    Purposes
                
                Minimum
                    to be
                  Categorized
                    as “Well Capitalized” Under
                  Prompt
                    Corrective
                  Action
                    ProvisionsTotal
                    capital (to risk-weighted assets):First
                    Mutual Bancshares, Inc
                
                11.39%
                
                8.00%
                
                N/AFirst
                    Mutual Bank
                
                
                11.32
                
                
                8.00
                
                
                10.00%Tier
                    I capital (to risk-weighted assets):First
                    Mutual Bancshares, Inc.
                
                
                10.14
                
                
                4.00
                
                
                N/AFirst
                    Mutual Bank
                
                
                10.07
                
                
                4.00
                
                
                6.00Tier
                    I capital (to average assets):First
                    Mutual Bancshares, Inc.
                
                
                7.28
                
                
                4.00
                
                
                N/AFirst
                    Mutual Bank
                
                
                7.36
                
                
                4.00
                
                
                5.00
  **SUBSEQUENT
        EVENTS**
 
 The
        Bank
        is the beneficiary of a key-man life insurance policy and we expect to receive
        tax free proceeds in the second quarter of $400,000. We anticipate investing
        these funds in the on-going operations of the Bank. That may take the form
        of
        reduced Sales Finance loan sales, and/or other activities that will be explored
        in the coming weeks. It is not our current intent to use these proceeds as
        a
        windfall profit that would augment earnings for second quarter.
 
 The
        receipt of these proceeds is the result of the unexpected passing of our
        Sales
        Finance Manager for the Eastern Region, a key employee who was instrumental
        in
        the success of First Mutual Bank. The First Mutual Bank family is relatively
        small and thus the loss of a popular and highly successful member of the
        family
        is keenly felt. The remaining members of the business line team have had
        the
        opportunity over the years to experience success and we are comfortable that
        they will be able to continue the programs developed under the leadership
        of our
        departed senior manager.
  ITEM
                3.
              Quantitative
                  and Qualitative Disclosures About Market
                  Risk
 
 Market
        risk is defined as the sensitivity of income and capital to changes in interest
        rates, and other relevant market rates or prices. Our profitability is largely
        dependent on our net interest income. Consequently, our primary exposure
        to
        market risk arises from the interest rate risk inherent in our lending, mortgage
        banking, deposit, and borrowing activities. Interest rate risk is the risk
        to
        earnings and capital resulting from adverse movements in interest rates.
        To that
        end, we actively monitor and manage our exposure to interest rate
        risk.
 
 A
        number
        of measures are utilized to monitor and manage interest rate risk, including
        net
        interest income and economic value of equity simulation models, as well as
        traditional “gap” models. We prepare these models on a monthly basis for review
        by our Asset Liability Committee (ALCO), senior management, and Board of
        Directors. The use of these models requires us to formulate and apply
        assumptions to various balance sheet items. Assumptions regarding interest
        rate
        risk are inherent in all financial institutions, and may include, but are
        not
        limited to, prepayment speeds on loans and mortgage-backed securities, cash
        flows and maturities of financial instruments held for purposes other than
        trading, changes in market conditions, loan volumes and pricing, deposit
        sensitivities, consumer preferences, and management’s capital leverage plans. We
        believe that the data and assumptions used for our models are reasonable
        representations of our portfolio and possible outcomes under the various
        interest rate scenarios. Nonetheless, these assumptions are inherently
        uncertain; therefore, the models cannot precisely estimate net interest income
        or predict the impact of higher or lower interest rates on net interest income.
        Actual results may differ significantly from simulated results due to timing,
        magnitude, and frequency of interest rate changes, and changes in market
        conditions and specific strategies, among other factors.
  -43-
 
 **Asset
        and Liability Management**
 
 Our
        primary objective in managing interest rate risk is to minimize the adverse
        impact of changes in interest rates on our net interest income and capital,
        while structuring the asset and liability components to maximize net interest
        margin, utilize capital effectively, and provide adequate liquidity. We rely
        primarily on our asset and liability structure to control interest rate
        risk.
 
 Asset
        /liability management is the responsibility of the Asset Liability Committee,
        which acts within policy directives established by the Board of Directors.
        This
        committee meets regularly to monitor the composition of the balance sheet,
        to
        assess projected earnings trends, and to formulate strategies consistent
        with
        the objectives for liquidity, interest rate risk, and capital adequacy. The
        objective of asset/liability management is to maximize long-term shareholder
        returns by optimizing net interest income within the constraints of credit
        quality, interest rate risk policies, levels of capital leverage, and adequate
        liquidity. Assets and liabilities are managed by matching maturities and
        repricing characteristics in a systematic manner.
 
 **Hedging
        Techniques**
 
 We
        review
        interest rate trends on a monthly basis and employ hedging techniques where
        appropriate. These techniques may include financial futures, options on
        financial futures, interest rate caps and floors, interest rate swaps, and
        extended commitments on future lending activities.
 
 Typically,
        the extent of our off-balance-sheet derivative agreements has been the use
        of
        forward loan commitments, which are used to hedge our loans held-for-sale.
        Additionally, in 2002 we entered into an interest rate swap with the FHLB.
        The
        purpose of the swap was to protect against potential adverse interest rate
        volatility that could be realized from the Trust Preferred Securities (TPS)
        issued in June 2002. The swap accomplished this by fixing the interest rate
        payable for the first five years of the TPS’ life.
 
 We
        expect
        to utilize interest rate swaps in connection with the underwriting of
        longer-term, fixed-rate commercial real estate loans. The decision is the
        result
        of prospective borrowers’ demand for longer-term, fixed-rate loans, and the
        preference of depositors for instruments of significantly shorter terms.
        Our
        intention is to originate commercial mortgage loans with amortization schedules
        of up to thirty years, with a fixed-rate for the ten years until the loan’s
        contractual maturity. To hedge the interest rate risk exposure presented
        by
        ten-year, fixed-rate instruments, our intention is to utilize interest rate
        swaps on a loan-by-loan basis to convert the loan’s fixed-rate to an adjustable
        rate subject to regular repricing relative to a market index rate, typically
        the
        one-month LIBOR rate. As this is a new program, we do not yet have an
        expectation of the number of loans that will likely be originated and hedged
        in
        such a manner. These interest rate swaps will be used solely for the purpose
        of
        managing the interest rate risk associated with longer-term, fixed-rate assets
        and not for any speculative purposes. There were no such arrangements at
        March
        31, 2006, December 31, 2005, or March 31, 2004.
 
 **Net
        Interest Income (NII) and Economic Value of Equity (EVE) Simulation Model
        Results**
 
 **March
                  31, 2006**
              
              **December
                  31, 2005****Percentage
                  Change**
              
              **Percentage
                  Change****Change
                  in**
                **Interest
                  Rates**
              
              **Net
                  Interest**
              **Economic**
                **Value**
              
              **Net
                  Interest**
              **Economic**
                **Value****(in
                  basis points)**
              
              **Income**
              **of
                  Equity**
              
              **Income**
              **of
                  Equity**+200
              
              1.19%
              (3.39%)
              
              0.06%
              (2.72%)+100
              
              n/a
              (0.94%)
              
              n/a
              (0.55%)-100
              
              n/a
              (0.37%)
              
              n/a
              (1.94%)-200
              
              0.01%
              (3.10%)
              
              (1.32%)
              (6.54%)
  -44-
  **Net
        Interest Income Simulation**
 
 Our
        income simulation model, constructed using data as of March 31, 2006, indicated
        that our net interest income over the following twelve months was projected
        to
        increase from its “base case” level in scenarios in which interest rates are
        assumed to gradually increase or decline by 200 bps over a twelve-month period.
        The magnitudes of the changes, however, suggest that there is little sensitivity
        in net interest income from the “base case” level over a twelve-month horizon in
        either scenario, as an increase in net interest income of only 1.19% was
        observed in the rising rate environment, and a change of only 0.01% was
        indicated in the falling rate scenario.
 
 The
        changes indicated by the simulation model represent variances from a “base case”
scenario, which is a projection of net interest income assuming interest
        rates
        remain unchanged from their current levels over the life of the forecast,
        and
        that the size of the balance sheet remains stable over the forecast timeframe.
        The base model will, however, illustrate the future effects of rate changes
        that
        have already occurred but have not yet flowed through to all the assets and
        liabilities on our balance sheet. These changes can either increase or decrease
        net interest income, depending on the timing and magnitudes of those changes.
        Additionally, the tendencies for loan and investment prepayments to accelerate
        in falling interest rate scenarios and slow when interest rates rise have
        been
        incorporated into the model assumptions. Implicit in these assumptions are
        additional assumptions for increased securities purchases and loan originations
        at lower interest rate levels to offset accelerated prepayments, and conversely,
        reduced securities purchases and loan production when rates increase and
        prepayments slow.
 
 The
        rising and falling rate ramp scenarios indicate that if the slope of the
        yield
        curve remains the same, and customer loan and deposit preferences do not
        change
        in response to further movements of the yield curve, then a parallel 200
        basis
        point increase or decrease in rates will not significantly change net interest
        income from what is presently expected in the “base case.” In the event the
        simulation model indicated that the increase or decrease in interest rates
        over
        the following twelve months would adversely affect our net interest income
        over
        the same period by more than 10% relative to the “base case” scenario, we would
        consider the indicated risk to have exceeded our internal policy
        limit.
 
 **Economic
        Value of Equity (EVE) Simulation**
 
 The
        EVE
        analysis goes beyond simulating net interest income for a specified period
        to
        estimating the present value of all financial instruments in our portfolio
        and
        then analyzing how the economic value of the portfolio would be affected
        by
        various alternative interest rate scenarios. The portfolio’s economic value is
        calculated by generating principal and interest cash flows for the entire
        life
        of all assets and liabilities, then discounting these cash flows back to
        their
        present values. The assumed discount rate used for each projected cash flow
        is
        based on a current market rate, such as a LIBOR, FHLB, or swap curve rate,
        and
        from alternative instruments of comparable risk and duration. In the event
        the
        simulation model demonstrates that a 200 basis point increase or decrease
        in
        rates would adversely affect our EVE by more than 25%, we consider the indicated
        risk to have exceeded our internal policy limit. Again, as illustrated in
        the
        above results, we are operating within the 25% internal policy limit in all
        scenarios.
 
 In
        the
        simulated 200 bps upward shift of the yield curve, the discount rates used
        to
        calculate the present values of assets and liabilities will increase, causing
        the present values of both assets and liabilities to fall, with more prominent
        effects on longer-term, fixed-rate instruments. Additionally, when interest
        rates rise, the cash flows on our assets are typically expected to decelerate
        as
        borrowers are assumed to become less likely to prepay their loans. As the
        cash
        flows on these assets are shifted further into the future, their present
        values
        are further reduced. Our EVE simulation model results as of March 31, 2006
        indicated that our assets and liabilities would be expected to exhibit similar
        levels of sensitivity to rising rates, with the economic value of assets
        declining by 2.42%, compared to a decline of 2.31% for our liabilities. Given
        the higher asset sensitivity and greater asset balance than liabilities,
        the
        reduction in the economic value of assets exceeded the impact on liabilities.
        Consequently, the economic value of our equity was negatively impacted in
        this
        scenario, declining 3.39%.
  -45-
 
 The
        opposite occurs when rates decline, as the discount rates used to calculate
        the
        present values of assets and liabilities will decrease, causing the present
        values of both assets and liabilities to rise. Counteracting this effect
        for
        assets, however, is the tendency for cash flows from assets to accelerate
        in a
        falling rate scenario, as borrowers refinance their existing loans at lower
        interest rates. These loan prepayments prevent the economic values of these
        assets from increasing in a declining rate scenario, illustrating an effect
        referred to as negative convexity. Taking this negative convexity into account,
        the simulation results indicated a negative impact to EVE in the falling
        rate
        scenario. In this case, the economic values of both assets and liabilities
        were
        positively impacted when rates were assumed to fall by 200 bps, assets by
        1.80%
        and liabilities by 2.37%. As a result, with the value of liabilities rising
        more
        than asset values, our economic value of equity was negatively impacted in
        this
        scenario, declining 3.10%.
 
 The
        Net
        Interest Income and Economic Value of Equity sensitivity analyses do not
        necessarily represent forecasts. As previously noted, there are numerous
        assumptions inherent in the simulation models as well as in the gap report,
        including the nature and timing of interest levels, the shape of the yield
        curve, loan and deposit growth, prepayments on loans and securities, deposit
        decay rates, pricing decisions on loans and deposits, reinvestment/replacement
        of asset and liability cash flows, customer preferences, and competitor and
        economic influences.
 
 **Gap
        Model**
 
 In
        addition to the above simulation models, an interest “gap” analysis is used to
        measure the matching of our assets and liabilities and exposure to changes
        in
        interest rates. This model, which represents a traditional view of interest
        rate
        sensitivity, quantifies the mismatch between assets maturing, repricing,
        or
        prepaying within a period, and liabilities maturing or repricing within the
        same
        period. A gap is considered positive when the amount of interest-rate-sensitive
        assets exceeds the amount of interest-rate-sensitive liabilities within a
        given
        period. A gap is considered negative in the reverse situation.
 
 Certain
        shortcomings are inherent in gap analysis, including the failure to recognize
        differences in the frequencies and magnitudes of repricing for different
        balance
        sheet instruments. Additionally, some assets and liabilities may have similar
        maturities or repricing characteristics, but they may react differently to
        changes in interest rates. This illustrates a facet of interest rate exposure
        referred to as “basis risk.” Assets, such as adjustable-rate mortgage loans, may
        also have features that limit the effect that changes in interest rates have
        on
        the asset in the short-term and/or over the life of the loan, for example
        a
        limit on the amount by which the interest rate on the loan is allowed to
        adjust
        each year. This illustrates another area of interest rate exposure referred
        to
        as “option risk.” Due to the limitations of the gap analysis, these features are
        not taken into consideration. Additionally, in the event of a change in interest
        rates, prepayment and early withdrawal penalties could deviate significantly
        from those assumed in the gap calculation. As a result, we utilize the gap
        report as a complement to our income simulation and economic value of equity
        models.
 
 **One-Year
        Interest Rate Sensitivity Gap**
 
 **March
                  31, 2006**
              
              **December
                  31, 2005**(Dollars
                  in thousands)One-Year
                  Repricing/Maturing Assets
              
              $
              691,111
              
              $
              715,543One-Year
                  Repricing/Maturing Liabilities
              
              
              743,656
              
              
              773,093One-Year
                  Gap
              
              $
              (52,545
              )
              $
              (57,550
              )Total
                  Assets
              
              $
              1,085,267
              
              $
              1,086,165One-Year
                  Interest Rate Gap as a Percentage of Assets
              
              
              (4.8%)
              
              
              (5.3%)
 
 -46-
 
 At
        a
        negative, or liability sensitive, 4.8% of assets, our twelve-month interest
        rate
        sensitivity gap was relatively little changed from the liability sensitive
        5.3%
        observed at the 2005 year-end. These results indicated that more liabilities
        than assets were expected to mature, reprice, or prepay within the twelve
        months.
 
 **Securities**


**ITEM
        3**
 
 The
        following table sets forth certain information regarding carrying values
        and
        percentage of total carrying values of the Bank's consolidated portfolio
        of
        securities classified as available-for-sale and held-to-maturity (dollars
        in
        thousands).
  March
                    31,2006
                
                2005**Available-for-Sale:**
                
                Carrying
                    Value
                
                Percent
                    of Total
                
                Carrying
                    Value
                
                Percent
                    of TotalUS
                    Government treasury and agency obligations
                
                $
                17,892
                
                
                16
                %
                $
                17,723
                
                
                14
                %Mortgage
                    backed securities:Freddie
                    Mac
                
                
                15,527
                
                
                14
                %
                
                18,184
                
                
                15
                %Ginnie
                    Mae
                
                
                40,782
                
                
                37
                %
                
                51,891
                
                
                42
                %Fannie
                    Mae
                
                
                35,863
                
                
                33
                %
                
                36,551
                
                
                29
                %Total
                    mortgage-backed securities
                
                
                92,172
                
                
                84
                %
                
                106,626
                
                
                86
                %**Total
                    securities available-for-sale**
                
                **$**
                **110,064**
                
                
                **100**
                **%**
                **$**
                **124,349**
                
                
                **100**
                **%**March
                    31,2006
                
                2005**Held-to-Maturity:**
                
                
                Carrying
                    Value
                
                
                Percent
                    of Total
                
                
                Carrying
                    Value
                
                
                Percent
                    of TotalMunicipal
                    bonds
                
                $
                1,170
                
                
                18
                %
                $
                1,203
                
                
                14
                %Mortgage
                    backed securities:Freddie
                    Mac
                
                
                345
                
                
                6
                %
                
                487
                
                
                6
                %Fannie
                    Mae
                
                
                4,827
                
                
                76
                %
                
                6,597
                
                
                80
                %Total
                    mortgage-backed securities
                
                
                5,172
                
                
                82
                %
                
                7,084
                
                
                86
                %**Total
                    securities held-to-maturity**
                
                **$**
                **6,342**
                
                
                **100**
                **%**
                **$**
                **8,287**
                
                
                **100**
                **%****Estimated
                    market value**
                
                **$**
                **6,284**
                
                
                
                
                **$**
                **8,339**






-47-


**ITEM
          3A**
  The
          following table shows the maturity or period to repricing of the Bank's
          consolidated portfolio of securities available-for-sale and held-to-maturity
          (dollars in thousands):
  Available-for-sale
                  at March 31, 2006One
                  Year or Less
              
              Over
                  One to Three Years
              
              Over
                  Three to Five Years
              
              Over
                  Five to Ten Years
              
              Over
                  Ten to Twenty Years
              
              Over
                  Twenty Years
              
              TotalCarrying
                  Value
              
              Weighted
                  Average Yield
              
              Carrying
                  Value
              
              Weighted
                  Average Yield
              
              Carrying
                  Value
              
              Weighted
                  Average Yield
              
              Carrying
                  Value
              
              Weighted
                  Average Yield
              
              Carrying
                  Value
              
              Weighted
                  Average Yield
              
              Carrying
                  Value
              
              Weighted
                  Average Yield
              
              Carrying
                  Value
              
              Weighted
                  Average Yield**Available-for-Sale:**US
                  Government treasury and agency obligations
              
              $
              7,218
              
              
              0.00
              %
              $
              —
              
              
              0.00
              %
              $
              5,791
              
              
              4.08
              %
              $
              —
              
              
              0.00
              %
              $
              4,883
              
              
              4.00
              %
              $
              —
              
              
              0.00
              %
              $
              17,892
              
              
              2.41
              %Mortgage
                  backed securities:Ginnie
                  Mae
              
              
              —
              
              
              0.00
              %
              
              40,782
              
              
              4.06
              %
              
              —
              
              
              0.00
              %
              
              —
              
              
              0.00
              %
              
              —
              
              
              0.00
              %
              
              —
              
              
              —
              
              
              40,782
              
              
              4.06
              %Freddie
                  Mac
              
              
              283
              
              
              5.46
              %
              
              370
              
              
              5.50
              %
              
              4,587
              
              
              3.58
              %
              
              3,302
              
              
              4.61
              %
              
              6,985
              
              
              4.50
              %
              
              —
              
              
              0.00
              %
              
              15,527
              
              
              4.29
              %Fannie
                  Mae
              
              
              366
              
              
              5.62
              %
              
              5,403
              
              
              4.79
              %
              
              3,549
              
              
              4.11
              %
              
              —
              
              
              0.00
              %
              
              26,545
              
              
              4.30
              %
              
              —
              
              
              0.00
              %
              
              35,863
              
              
              4.36
              %Total
                  mortgage-backed securities
              
              
              649
              
              
              5.55
              %
              
              46,555
              
              
              4.16
              %
              
              8,136
              
              
              3.81
              %
              
              3,302
              
              
              4.61
              %
              
              33,530
              
              
              4.34
              %
              
              —
              
              
              0.00
              %
              
              92,172
              
              
              4.22
              %Total
                  securities available-for-sale -- Carrying Value
              
              $
              7,867
              
              
              0.46
              %
              $
              46,555
              
              
              4.16
              %
              $
              13,927
              
              
              3.92
              %
              $
              3,302
              
              
              4.61
              %
              $
              38,413
              
              
              4.29
              %
              $
              —
              
              
              0.00
              %
              $
              110,064
              
              
              3.92
              %Total
                  securities available-for-sale -- Amortized Cost
              
              $
              7,855
              
              
              0.45
              %
              $
              47,230
              
              
              4.16
              %
              $
              14,468
              
              
              3.92
              %
              $
              3,373
              
              
              4.61
              %
              $
              40,220
              
              
              4.29
              %
              
              —
              
              
              —
              
              $
              113,146
              
              
              3.93
              %Held-to-maturity
                  at March 31, 2006One
                  Year or Less
              
              
              Over
                  One to Three Years
              
              
              Over
                  Three to Five Years
              
              
              Over
                  Five to Ten Years
              
              
              Over
                  Ten to Twenty Years
              
              
              Over
                  Twenty Years
              
              TotalCarrying
                  Value
              
              
              Weighted
                  Average Yield
              
              
              Carrying
                  Value
              
              
              Weighted
                  Average Yield
              
              
              Carrying
                  Value
              
              
              Weighted
                  Average Yield
              
              
              Carrying
                  Value
              
              
              Weighted
                  Average Yield
              
              
              Carrying
                  Value
              
              
              Weighted
                  Average Yield
              
              
              Carrying
                  Value
              
              
              Weighted
                  Average Yield
              
              
              Carrying
                  Value
              
              
              Weighted
                  Average Yield**Held-to-Maturity:**Municipal
                  bonds
              
              $
              —
              
              
              0.00
              %
              $
              —
              
              
              0.00
              %
              $
              —
              
              
              0.00
              %
              $
              —
              
              
              0.00
              %
              $
              220
              
              
              5.38
              %
              $
              950
              
              
              6.30
              %
              $
              1,170
              
              
              6.12
              %Mortgage
                  backed securities:Freddie
                  Mac
              
              
              345
              
              
              5.32
              %
              
              —
              
              
              0.00
              %
              
              —
              
              
              0.00
              %
              
              —
              
              
              0.00
              %
              
              —
              
              
              0.00
              %
              
              —
              
              
              0.00
              %
              
              345
              
              
              5.32
              %Fannie
                  Mae
              
              
              1,463
              
              
              6.26
              %
              
              1,710
              
              
              4.70
              %
              
              —
              
              
              0.00
              %
              
              —
              
              
              0.00
              %
              
              1,655
              
              
              4.78
              %
              
              —
              
              
              0.00
              %
              
              4,828
              
              
              5.20
              %Total
                  mortgage-backed securities
              
              
              1,808
              
              
              6.08
              %
              
              1,710
              
              
              4.70
              %
              
              —
              
              
              0.00
              %
              
              —
              
              
              0.00
              %
              
              1,655
              
              
              4.78
              %
              
              —
              
              
              0.00
              %
              
              5,173
              
              
              5.21
              %Total
                  securities held-to-maturity -- Carrying Value
              
              $
              1,808
              
              
              6.08
              %
              $
              1,710
              
              
              4.70
              %
              $
              —
              
              
              0.00
              %
              $
              —
              
              
              0.00
              %
              $
              1,875
              
              
              4.85
              %
              $
              950
              
              
              6.30
              %
              $
              6,343
              
              
              5.38
              %Total
                  securities held-to-maturity -- Fair Market Value
              
              $
              1,850
              
              
              6.08
              %
              $
              1,675
              
              
              4.73
              %
              $
              —
              
              
              0.00
              %
              $
              —
              
              
              0.00
              %
              $
              1,815
              
              
              4.85
              %
              $
              945
              
              
              6.30
              %
              $
              6,284
              
              
              5.40
              %
  -48-




ITEM
                4.
              Controls
                  and Procedures
 
 An
        evaluation of the Company’s disclosure controls and procedures (as defined in
        Rules 13a-15(e) of the Securities Exchange Act of 1934 (the “Act”)) was carried
        out under the supervision and with the participation of the Company’s Chief
        Executive Officer, Chief Financial Officer, and other members of the Company’s
        senior management, as of the end of the period covered by this report (the
        "Evaluation Date"). Based upon this evaluation, the Company’s Chief Executive
        Officer and Chief Financial Officer concluded that, as of the Evaluation
        Date,
        the Company’s disclosure controls and procedures are effective in providing
        reasonable assurance that the material information required to be disclosed
        by
        the Company in the reports it files or submits under the Act is (i) accumulated
        and communicated to the Company’s management (including the Company’s Chief
        Executive Officer and Chief Financial Officer) in a timely manner, and (ii)
        recorded, processed, summarized, and reported within the time periods specified
        in the SEC’s rules and forms.
 
 **PART
                II:**
              **OTHER
                  INFORMATION**
 
 ITEM
                1.
              Legal
                  Proceedings
 
 At
        March
        31, 2006, the Company was not engaged in any litigation, which in the opinion
        of
        management, after consultation with its legal counsel, would be material
        to the
        Company.
 
 ITEM
                1A.
              Risk
                  Factors
 
 For
        information regarding certain Risk Factors, please refer to Part I, Item
        1A, in
        the Company’s Annual Report on Form 10-K for the year ended December 31,
        2005.
 
 ITEM
                2.
              Unregistered
                  Sales of Equity Securities and Use of
                  Proceeds
 
 None.
 
 ITEM
                3.
              Defaults
                  Upon Senior Securities
 
 None.
 
 ITEM
                4.
              Submission
                  of Matters to a Vote of Security
                  Holders
 
 None.
 
 ITEM
                5.
              Other
                  Information
 
 None.
  -49-
 
 ITEM
                6.
              Exhibits
 
 (3.1)
              Amended
                  and Restated Articles of Incorporation, incorporated by reference
                  onForm
                  10-Q filed with the SEC on August 8,
                  2005.
 
 (3.3)
              Bylaws
                  (as amended and restated), incorporated by reference on Form 10-Q
                  filed
                  withthe
                  SEC on August 13, 2004.
 
 (11)
              Statement
                  regarding computation of per share earnings. Reference is made
                  to theCompany’s
                  Consolidated Statements of Income attached hereto as part of Item
                  IFinancial
                  Statements, which are incorporated herein
                  by reference.
 
 (31.1)
              Certification
                  by President and Chief Executive Officer pursuant to Section 302
                  of the
                  Sarbanes-Oxley Act of 2002.
  
 (31.2)
              Certification
                  by Executive Vice President and Chief Financial Officer pursuant
                  to
                  Section302
                  of the Sarbanes-Oxley Act of 2002.
 
 (32)
              Certification
                  by Chief Executive Officer and Chief Financial Officer pursuant
                  toSection
                  906 of the Sarbanes-Oxley Act of
                  2002.
 
  -50-
 
 **SIGNATURES**
 
 Pursuant
        to the requirements of the Securities Exchange Act of 1934, the registrant
        has
        duly caused this report to be signed on its behalf by the undersigned thereunto
        duly authorized.
 
 
 
 
 Date:
                May 5, 2006
              FIRST
                MUTUAL BANCSHARES, INC.By:
              /s/ John
                R. ValaasJohn
                R. ValaasPresident
                and Chief Executive Officer By:
              /s/ Roger
                A. ManderyRoger
                  A. ManderyExecutive
                  Vice President
                (Principal
                  Financial Officer)
 
  -51-