**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................................................June 30,
              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. August 2,
      2006  6,649,598








FIRST
            MUTUAL BANCSHARES, INC.
 
 QUARTERLY
            REPORT ON FORM 10-Q
 June
            30,
            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
                  16General
                  16Overview
                  16Results
                      of Operations
                  18Net
                      Income
                  18Net
                      Interest Income
                  18Noninterest
                      Income
                  21Noninterest
                      Expense
                  25Financial
                      Condition
                  28Asset
                      Quality
                  33Portfolio
                      Information
                  34Deposit
                      Information
                  37Business
                      Segments
                  37Consumer
                      Lending
                  38Residential
                      Lending
                  40Business
                      Banking Lending
                  41Income
                      Property Lending
                  42Liquidity
                  43Capital
                  47Subsequent
                      Events
                  47ITEM
                      3. Quantitative and Qualitative Disclosures About Market
                      Risk
                  48ITEM
                      4. Controls and Procedures
                  54PART
                      II:  OTHER INFORMATION
                  54ITEM
                      1. Legal Proceedings
                  54ITEM
                      1A. Risk Factors
                  54ITEM
                      2. Unregistered Sales of Equity Securities and Use of
                      Proceeds
                  54ITEM
                      3. Defaults Upon Senior Securities
                  54ITEM
                      4. Submission of Matters to a Vote of Security Holders
                  54ITEM
                      5. Other Information
                  55ITEM
                      6. Exhibits
                  55SIGNATURES
                  56CERTIFICATIONS
  -i-
  **PART
                    :I**
                  **FINANCIAL
                      INFORMATION**
  **FORWARD-LOOKING
            STATEMENTS DISCLAIMER**
 
 Our
            Form
            10-Q for the quarter ended June 30, 2006, contains statements concerning
            forecasts of our financial results and condition, expectations of our
            operations
            and business and our assumptions for those forecasts and expectations
            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 forecasts and expectations
            with
            respect to 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 or reductions in sales of loans, expectations regarding
            our Business Banking segment and other segments, 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**
  June
                        30,
                    
                    December
                        31,2006
                    
                    2005**Assets**
                    
                    *(Unaudited)*Cash
                        and Cash Equivalents:Interest-earning
                        deposits
                    
                    $
                    918,382
                    
                    $
                    1,229,176Noninterest-earning
                        demand deposits and cash on hand
                    
                    
                    20,083,795
                    
                    
                    24,551,436Total
                        cash and cash equivalents
                    
                    
                    21,002,177
                    
                    
                    25,780,612Mortgage-backed
                        and other securities available-for-sale
                    
                    
                    97,139,370
                    
                    
                    114,450,342Mortgage-backed
                        and other securities held-to-maturityfair
                        value of $6,032,475 and $6,970,890
                    
                    
                    6,152,587
                    
                    
                    6,966,295Loans
                        held for sale
                    
                    
                    20,500,997
                    
                    
                    14,683,507Loans
                        receivable
                    
                    
                    908,737,928
                    
                    
                    878,066,241Reserve
                        for loan losses
                    
                    
                    (9,821,144
                    )
                    
                    (10,069,020
                    )Loans
                        receivable, net
                    
                    
                    898,916,784
                    
                    
                    867,997,221Accrued
                        interest receivable
                    
                    
                    5,364,959
                    
                    
                    5,350,493Land,
                        buildings and equipment, net
                    
                    
                    35,079,557
                    
                    
                    33,483,998Federal
                        Home Loan Bank (FHLB) stock, at cost
                    
                    
                    13,122,300
                    
                    
                    13,122,300Servicing
                        assets
                    
                    
                    2,702,330
                    
                    
                    1,865,698Other
                        assets
                    
                    
                    3,191,942
                    
                    
                    2,464,369**Total
                        Assets**
                    
                    $
                    1,103,173,003
                    
                    $
                    1,086,164,835
    See
              Notes
              to the Financial Statements


-2-




**FIRST
        MUTUAL BANCSHARES, INC.**
 **CONSOLIDATED
        STATEMENTS OF FINANCIAL CONDITION**
 **(Continued)**
 June
                    30,
                
                December
                    31,2006
                
                2005*(Unaudited)***Liabilities**Deposits:Money
                    market deposit and checking accounts
                
                $
                285,882,128
                
                $
                263,444,641Savings
                
                
                7,050,588
                
                
                8,053,510Time
                    deposits
                
                
                467,411,435
                
                
                489,222,486Total
                    deposits
                
                
                760,344,151
                
                
                760,720,637Drafts
                    payable
                
                
                467,778
                
                
                733,773Accounts
                    payable and other liabilities
                
                
                6,858,202
                
                
                15,706,624Advance
                    payments by borrowers for taxes and insurance
                
                
                1,869,969
                
                
                1,671,496FHLB
                    advances
                
                
                248,332,119
                
                
                225,705,005Other
                    advances
                
                
                4,600,000
                
                
                4,600,000Junior
                    subordinated long-term debentures
                
                
                17,000,000
                
                
                17,000,000Total
                    liabilities
                
                
                1,039,472,219
                
                
                1,026,137,535**Stockholders’
                    Equity**Common
                    stock, $1 par value-Authorized,
                    30,000,000 sharesIssued
                    and outstanding, 5,318,732and
                    5,296,810 shares, respectively
                
                $
                5,318,732
                
                $
                5,296,810Additional
                    paid-in capital
                
                
                45,772,391
                
                
                45,288,791Retained
                    earnings
                
                
                15,241,279
                
                
                10,877,529Accumulated
                    other comprehensive income(loss):Unrealized
                    (loss) on securities available-for-saleand
                    interest rate swap, net of federal income tax
                
                
                (2,631,618
                )
                
                (1,435,830
                )Total
                    stockholders’
                    equity
                
                
                63,700,784
                
                
                60,027,300**Total
                    Liabilities and Stockholders' Equity**
                
                $
                1,103,173,003
                
                $
                1,086,164,835




See
        Notes
        to the Financial Statements


-3-




**FIRST
        MUTUAL BANCSHARES, INC.**
 **CONSOLIDATED
        STATEMENTS OF INCOME**
  Quarter
                    ended June 30,
                
                Six
                    months ended June 30,2006
                
                2005
                
                2006
                
                2005*(Unaudited)***Interest
                    Income**Loans
                    receivable
                
                $
                18,517,882
                
                $
                14,823,403
                
                $
                36,064,941
                
                $
                28,755,603Interest
                    on available-for-sale securities
                
                
                1,088,358
                
                
                1,266,563
                
                
                2,281,539
                
                
                2,537,644Interest
                    on held-to-maturity securities
                
                
                86,877
                
                
                102,513
                
                
                177,107
                
                
                196,659Interest
                    other
                
                
                131,474
                
                
                93,968
                
                
                249,761
                
                
                195,737Total
                    interest income
                
                
                19,824,591
                
                
                16,286,447
                
                
                38,773,348
                
                
                31,685,643**Interest
                    Expense**Deposits
                
                
                6,447,053
                
                
                4,253,965
                
                
                12,363,378
                
                
                7,825,379FHLB
                    and other advances
                
                
                3,353,014
                
                
                2,205,743
                
                
                6,154,006
                
                
                4,233,279Total
                    interest expense
                
                
                9,800,067
                
                
                6,459,708
                
                
                18,517,384
                
                
                12,058,658Net
                    interest income
                
                
                10,024,524
                
                
                9,826,739
                
                
                20,255,964
                
                
                19,626,985Provision
                    for loan and lease losses
                
                
                134,837
                
                
                450,000
                
                
                205,837
                
                
                850,000Net
                    interest income, after provisionfor
                    loan and lease losses
                
                
                9,889,687
                
                
                9,376,739
                
                
                20,050,127
                
                
                18,776,985**Noninterest
                    Income**Gain
                    on sales of loans
                
                
                554,567
                
                
                419,956
                
                
                1,310,650
                
                
                944,493Servicing
                    fees, net of amortization
                
                
                300,021
                
                
                369,259
                
                
                634,768
                
                
                695,553Fees
                    on deposits
                
                
                193,737
                
                
                170,561
                
                
                375,606
                
                
                305,889Other
                
                
                1,009,289
                
                
                612,127
                
                
                1,451,439
                
                
                995,731Total
                    noninterest income
                
                
                2,057,614
                
                
                1,571,903
                
                
                3,772,463
                
                
                2,941,666




See
        Notes
        to the Financial Statements


-4-




**FIRST
        MUTUAL BANCSHARES, INC.**
 **CONSOLIDATED
        STATEMENTS OF INCOME**
 (Continued)
 Quarter
                    ended June 30,
                
                Six
                    months ended June 30,2006
                
                2005
                
                2006
                
                2005*(Unaudited)***Noninterest
                    Expense**Salaries
                    and employee benefits
                
                $
                4,476,781
                
                $
                4,331,748
                
                $
                8,923,241
                
                $
                8,278,180Occupancy
                
                
                1,043,255
                
                
                848,828
                
                
                2,052,830
                
                
                1,632,287Other
                
                
                2,314,867
                
                
                1,962,323
                
                
                4,547,144
                
                
                4,095,340Total
                    noninterest expense
                
                
                7,834,903
                
                
                7,142,899
                
                
                15,523,215
                
                
                14,005,807Income
                    before provision for federal income tax
                
                
                4,112,398
                
                
                3,805,743
                
                
                8,299,375
                
                
                7,712,844Provision
                    for federal income tax
                
                
                1,400,661
                
                
                1,288,398
                
                
                2,873,566
                
                
                2,611,239**Net
                    Income**
                
                $
                2,711,737
                
                $
                2,517,345
                
                $
                5,425,809
                
                $
                5,101,605**Per
                    Share Data:**Basic
                    earnings per common share
                
                $
                0.51
                
                $
                0.47
                
                $
                1.02
                
                $
                0.96Diluted
                    earnings per common share
                
                $
                0.50
                
                $
                0.45
                
                $
                1.00
                
                $
                0.92**Weighted
                    Average Number of Shares Outstanding**
                
                
                5,315,843
                
                
                5,319,017
                
                
                5,308,879
                
                
                5,310,175**Weighted
                    Average Number of Shares Outstanding****Including
                    Dilutive Stock Options**
                
                
                5,432,078
                
                
                5,554,215
                
                
                5,450,956
                
                
                5,553,308


See
        Notes
        to the Financial Statements




-5-




First
        Mutual Bancshares, Inc. and Subsidiaries
 Consolidated
        Statements of Stockholders’ Equity and Comprehensive Income
   AccumulatedAdditional
              
              
              
              ComprehensiveCommon
                  Stock
              
              Paid-in
              
              Retained
              
              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
              
              
              
              
              
              
              
              
              
              
              
              5,425,809
              
              
              
              
              
              5,425,809Other
                  comprehensive income (loss), net of tax:Unrealized
                  (loss) on securities available-for-sale
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (1,237,478
              )
              
              (1,237,478
              )Unrealized
                  gain on interest rate swap
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              41,690
              
              
              41,690Total
                  comprehensive income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              4,230,021Compensation
                  related to stock options
              
              
              
              
              
              
              
              
              260,404
              
              
              
              
              
              
              
              
              260,404Options
                  exercised, including tax benefit of $4,824
              
              
              18,066
              
              
              18,066
              
              
              127,066
              
              
              
              
              
              
              
              
              145,132Issuance
                  of stock through employees’ stock plans
              
              
              3,856
              
              
              3,856
              
              
              96,130
              
              
              
              
              
              
              
              
              99,986Cash
                  dividend declared ($0.20 per share)
              
              
              
              
              
              
              
              
              
              
              
              (1,062,059
              )
              
              
              
              
              (1,062,059
              )BALANCE,
                  June 30, 2006
              
              
              5,318,732
              
              $
              5,318,732
              
              $
              45,772,391
              
              $
              15,241,279
              
              $
              (2,631,618
              )
              $
              63,700,784




See
      Notes
      to the Financial Statements


-6-




**FIRST
        MUTUAL BANCSHARES, INC.**
 **CONSOLIDATED
        STATEMENTS OF CASH FLOWS**
 Six
                    months ended June 30,2006
                
                2005*(Unaudited)***Cash
                    Flows from Operating Activities**Net
                    income
                
                $
                5,425,809
                
                $
                5,101,605Adjustments
                    to reconcile net income to net cashfrom
                    operating activities:Provision
                    for loan and lease losses
                
                
                205,837
                
                
                850,000Depreciation
                    and amortization
                
                
                958,646
                
                
                773,219Deferred
                    loan origination fees, net of accretion
                
                
                644,729
                
                
                (125,792
                )Amortization
                    of servicing assets
                
                
                599,388
                
                
                454,005Gain
                    on sales of loans
                
                
                (1,310,650
                )
                
                (944,493
                )(Gain)
                    loss on sale of repossessed real estate and other assets
                
                
                329
                
                
                (2,205
                )FHLB
                    stock dividends
                
                
                —
                
                
                (52,900
                )Stock
                    based compensation
                
                
                260,404
                
                
                —Excess
                    tax benefit from stock-based compensation
                
                
                (4,824
                )
                
                —Changes
                    in operating assets and liabilities:Loans
                    held-for-sale
                
                
                (5,817,490
                )
                
                (3,343,896
                )Accrued
                    interest receivable
                
                
                (14,466
                )
                
                (511,087
                )Other
                    assets
                
                
                (1,259,292
                )
                
                (381,446
                )Drafts
                    payable
                
                
                (265,995
                )
                
                163,301Federal
                    and state income tax refunds
                
                
                497,372
                
                
                —Accounts
                    payable and other liabilities
                
                
                (3,521,796
                )
                
                (2,095,505
                )Advance
                    payments by borrowers for taxes and insurance
                
                
                198,473
                
                
                223,763Net
                    cash (used) provided by operating activities
                
                
                (3,403,526
                )
                
                108,569**Cash
                    Flows from Investing Activities**Loan
                    originations
                
                
                (222,704,968
                )
                
                (221,601,789
                )Loan
                    principal repayments
                
                
                192,965,552
                
                
                177,067,006Increase
                    (decrease) in undisbursed loan proceeds
                
                
                (1,817,490
                )
                
                11,330,860Principal
                    repayments and redemptions onmortgage-backed
                    and other securities
                
                
                23,534,914
                
                
                9,154,203Purchase
                    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
                
                
                (2,664,232
                )
                
                (3,902,997
                )Purchase
                    of FHLB stock
                
                
                —
                
                
                (150,700
                )Proceeds
                    from sale of impaired loan
                
                
                340,000
                
                
                —Net
                    cash (used) by investing activities
                
                
                (17,516,319
                )
                
                (34,110,258
                )


See
        Notes
        to the Financial Statements


-7-




**FIRST
        MUTUAL BANCSHARES, INC.**
 **CONSOLIDATED
        STATEMENTS OF CASH FLOWS**
 (Continued)
 Six
                    months ended June 30,2006
                
                2005*(Unaudited)***Cash
                    Flows from Financing Activities**Net
                    increase (decrease) in deposit accounts
                
                $
                (11,601,275
                )
                $
                36,950,365Interest
                    credited to deposit accounts
                
                
                11,224,789
                
                
                7,367,649Issuance
                    of stock through employees' stock plans
                
                
                99,986
                
                
                99,996Proceeds
                    from advances
                
                
                452,901,000
                
                
                576,770,500Repayment
                    of advances
                
                
                (430,273,886
                )
                
                (582,858,603
                )Dividends
                    paid
                
                
                (6,354,336
                )
                
                (953,710
                )Proceeds
                    from exercise of stock options and excess taxbenefit
                    of $4,824 from stock-based compensation
                
                
                145,132
                
                
                502,529Net
                    cash provided by financing activities
                
                
                16,141,410
                
                
                37,878,726**Increase/(decrease)
                    in cash and cash equivalents**
                
                $
                (4,778,435
                )
                $
                3,877,037Cash
                    and cash equivalents, beginning of the year
                
                
                25,780,612
                
                
                13,845,441Cash
                    and cash equivalents, June 30, 2006
                
                $
                21,002,177
                
                $
                17,722,478**Supplemental
                    Disclosures of Cash Flow Information**Loans
                    originated for sale in the secondary market
                
                $
                57,165,022
                
                $
                33,679,880Loans
                    originated for investment activities
                
                
                222,704,968
                
                
                221,601,789Proceeds
                    from sale of loans held-for-sale
                
                
                51,347,532
                
                
                30,335,984Cash
                    paid during the year for:Interest
                
                
                17,923,231
                
                
                12,180,884Income
                    taxes
                
                
                2,333,000
                
                
                1,667,000


See
        Notes
        to the 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 to 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
                        June
                      30,
                        2005
                    
                    Six
                      Months
                      Ended
                        June
                      30,
                        2005Net
                        Income, as reported
                    
                    $
                    2,517,345
                    
                    $
                    5,101,605Deduct:
                        Total stock-based employee compensationdetermination
                        under fair value based method for all
                      awards,
                        net of related tax effects (1)
                    
                    
                    (109,626
                    )
                    
                    (215,513
                    )Pro
                        forma net income
                    
                    $
                    2,407,719
                    
                    $
                    4,886,092Earnings
                        per share:Basic
                        - as reported
                    
                    $
                    0.47
                    
                    $
                    0.96Basic
                        - pro forma
                    
                    $
                    0.45
                    
                    $
                    0.92Diluted
                        - as reported
                    
                    $
                    0.45
                    
                    $
                    0.92Diluted
                        - pro forma
                    
                    $
                    0.44
                    
                    $
                    0.89




(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 June 30, 2006 are $125,000 and $83,000 lower,
          respectively, than if we had continued to account for share-based compensation
          under APB No. 25. The impact on income before tax and net income for the
          first
          six months of 2006 were $260,000 and $171,000 lower, respectively. Basic
          and
          diluted earnings per share for the quarter ended June 30, 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.
          Year-to-date basic and diluted earnings per share for the first six months
          of
          2006 would have been $1.05 and $1.02, respectively had we not adopted SFAS
          123(R). 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).
  Compensation
          cost is recorded as if each vesting portion of the award is a separate
          award.
          Share-based compensation expense recognized for stock options was $125,000
          for
          the three months ended June 30, 2006 and $260,000 for the first half of
          2006.
          The total related income tax benefit recognized was $20,000 for the second
          quarter of 2006 and $37,000 for the six months ended June 30, 2006.
  -9-




*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 Option Committee determine vesting and the right to
        exercise may be cumulative. At June 30, 2006, 612,925 shares of common stock,
        adjusted for stock dividends, were available for grant under the plan. A
        total
        of 338,092 shares are currently exercisable at June 30, 2006.
 
 The
        following table presents the activity related to options under all plans
        for the
        six months ended June 30, 2006:
 Options
                
                Weighted-
                  Average
                  Exercise
                  Price
                
                Weighted-
                  Average
                  Remaining
                  Term
                    (in years)
                
                Aggregate
                  Intrinsic
                  ValueOptions
                    Outstanding at January 1, 2006
                
                
                558,577
                
                $
                17.22Granted
                
                
                18,000
                
                
                26.50Exercised
                
                
                (18,066
                )
                
                7.77Forfeited
                
                
                (16,490
                )
                
                23.55Outstanding
                    at June 30, 2006
                
                
                542,021
                
                $
                17.65
                
                
                5.5
                
                $
                5,115,248Exercisable
                    at June 30, 2006
                
                
                338,092
                
                $
                13.93
                
                
                4.8
                
                $
                4,449,741




Eighteen
        thousand options were granted during the three and six months ended June
        30,
        2006. Options granted during the second quarter and first six months of 2005
        totaled 117,450. The total intrinsic value (amount by which fair value of
        the
        underlying stock exceeds the exercise price of an option on exercise date)
        of
        options exercised during the three and six months ended June 30, 2006 was
        $10,620 and the like amount for both periods in 2005 was $72,743.
 
 We
        have
        estimated the fair value of all stock option awards as of the date of the
        grant
        by applying a Black-Scholes pricing valuation model. The weighted-average
        assumptions for options issued during the three months ended June 30, 2006
        are
        as follows:
  Expected
                    Price Volatility
                19.4%Risk-Free
                    Interest Rate
                5.1%Dividend
                    Yield
                1.5%Expected
                    Life in Years
                4.8




The
        expected price volatility was based on the historical volatility of the stock
        price, the risk-free interest rate was based on US Treasury Constant Maturity
        yields for periods similar to the expected life of the options, the dividend
        yield was based on current cash dividend yields and the expected life was
        based
        on historical data.
 
 Cash
        received from options exercised for the three and six months ended June 30,
        2006
        totaled $20,000 and $140,000, respectively. Cash received from options exercised
        for the three and six months ended June 30, 2005 totaled $344,000 and $503,000,
        respectively. We issue new shares to satisfy option exercises.
 
 A
        summary
        of the status of unvested shares and changes during the six months ended
        June
        30, 2006 is presented below:




Shares
              
              Weighted-Average
                  Grant-
                Date
                  Fair ValueUnvested
                  Shares at January 1, 2006
              298,926
              
              $7.67Granted
              18,000
              
              $6.02Vested
              (96,507)
              
              $8.14Forfeited
              (16,490)
              
              $7.89Unvested
                  Shares at June 30, 2006
              203,929
              
              $7.44




At
        June
        30, 2006, there was $1.1 million of total unrecognized compensation cost
        related
        to unvested share-based compensation arrangements granted under the Plan.
        That
        cost is expected to be recognized over a weighted-average period of 1.6 years.
        The total fair value of shares vested during the three and six months ended
        June
        30, 2006 was $741,000 and $786,000, respectively. The total fair value of
        shares
        vested during the three and six months ended June 30, 2005 was $472,000 and
        $507,000, 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 June
            30, 2006 and December 31, 2005 are summarized as follows:
 Gross
                    
                    GrossGross
                    
                    Unrealized
                    
                    Unrealized
                    
                    EstimatedAmortized
                    
                    Unrealized
                    
                    Losses
                    
                    Losses
                    
                    FairCost
                    
                    Gains
                    
                    <1
                        Year
                    
                    >1
                        Year
                    
                    Value**June
                        30, 2006**Freddie
                        Mac securities
                    
                    $
                    15,776,225
                    
                    $
                    10,394
                    
                    $
                    —
                    
                    $
                    939,451
                    
                    $
                    14,847,168Fannie
                        Mae securities
                    
                    
                    35,726,705
                    
                    
                    17,627
                    
                    
                    75,095
                    
                    
                    1,858,833
                    
                    
                    33,810,404Ginnie
                        Mae securities
                    
                    
                    38,714,609
                    
                    
                    —
                    
                    
                    283,322
                    
                    
                    560,088
                    
                    
                    37,871,199US
                        agency securities
                    
                    
                    10,988,999
                    
                    
                    —
                    
                    
                    —
                    
                    
                    378,400
                    
                    
                    10,610,599$
                    101,206,538
                    
                    $
                    28,021
                    
                    $
                    358,417
                    
                    $
                    3,736,772
                    
                    $
                    97,139,370**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 June 30,
        2006
        and December 31, 2005 there were 33 and 34 investment securities with unrealized
        losses, respectively.  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 June
            30, 2006 and December 31, 2005 are summarized as follows:
 Gross
                    
                    GrossGross
                    
                    Unrealized
                    
                    Unrealized
                    
                    EstimatedAmortized
                    
                    Unrealized
                    
                    Losses
                    
                    Losses
                    
                    FairCost
                    
                    Gains
                    
                    <1
                        Year
                    
                    >1
                        Year
                    
                    Value**June
                        30, 2006**Fannie
                        Mae securities
                    
                    $
                    4,662,139
                    
                    $
                    35,775
                    
                    $
                    —
                    
                    $
                    148,371
                    
                    $
                    4,549,543Freddie
                        Mac securities
                    
                    
                    324,425
                    
                    
                    4,092
                    
                    
                    —
                    
                    
                    —
                    
                    
                    328,517Municipal
                        bonds
                    
                    
                    1,166,023
                    
                    
                    —
                    
                    
                    11,608
                    
                    
                    —
                    
                    
                    1,154,415$
                    6,152,587
                    
                    $
                    39,867
                    
                    $
                    11,608
                    
                    $
                    148,371
                    
                    $
                    6,032,475**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 June 30,
        2006
        and December 31, 2005 there were 5 and 4 investment securities with unrealized
        losses, respectively. 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**




Nonperforming
        loans are summarized as follows:




June
                  30, 2006
              
              December
                  31, 2005Impaired
                  loans with a valuation allowance
              
              $
              174,537
              
              $
              308,645Valuation
                  allowance related to impaired loans
              
              
              (111,025
              )
              
              (172,475
              )Net
                  impaired loans
              
              
              63,512
              
              
              136,170Non
                  accrual loans
              
              
              322,416
              
              
              761,020Total
                  nonperforming or non-accrual loans
              
              
              385,928
              
              
              897,190Real
                  estate owned
              
              
              —
              
              
              —Nonperforming
                  Assets
              
              $
              385,928
              
              $
              897,190Total
                  loans past due 90-days or more and still accruing interest
              
              $
              —
              
              $
              —Average
                  balance of impaired loans
              
              $
              99,841
              
              $
              138,002Interest
                  income recognized on impaired loans
              
              $
              265
              
              $
              793




The
        impaired loan balance was lower at June 30, 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. In May 2006 an additional loan was added with a balance of
        $162,353 on June 30, 2006. This brought the number of impaired loans to two
        at
        the end of June.
  **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 year. 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 year, 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 and six months
          ending
          June 30, 2006 and June 30, 2005:
 Income
                  
                  Shares
                  
                  Per
                      share(numerator)
                  
                  (denominator)
                  
                  amountQuarter
                      ended June 30, 2006Basic
                      EPS:Income
                      available to common shareholders
                  
                  $
                  2,711,737
                  
                  
                  5,315,843
                  
                  $
                  0.51Effect
                      of dilutive stock options
                  
                  
                  —
                  
                  
                  116,235Diluted
                      EPS:Income
                      available to common shareholdersplus
                      assumed stock options exercised
                  
                  $
                  2,711,737
                  
                  
                  5,432,078
                  
                  $
                  0.50Six
                      months ended June 30, 2006Basic
                      EPS:Income
                      available to common shareholders
                  
                  $
                  5,425,809
                  
                  
                  5,308,879
                  
                  $
                  1.02Effect
                      of dilutive stock options
                  
                  
                  —
                  
                  
                  142,077Diluted
                      EPS:Income
                      available to common shareholdersplus
                      assumed stock options exercised
                  
                  $
                  5,425,809
                  
                  
                  5,450,956
                  
                  $
                  1.00Quarter
                      ended June 30, 2005Basic
                      EPS:Income
                      available to common shareholders
                  
                  $
                  2,517,345
                  
                  
                  5,319,017
                  
                  $
                  0.47Effect
                      of dilutive stock options
                  
                  
                  —
                  
                  
                  235,198Diluted
                      EPS:Income
                      available to common shareholdersplus
                      assumed stock options exercised
                  
                  $
                  2,517,345
                  
                  
                  5,554,215
                  
                  $
                  0.45Six
                      months ended June 30, 2005Basic
                      EPS:Income
                      available to common shareholders
                  
                  $
                  5,101,605
                  
                  
                  5,310,175
                  
                  $
                  0.96Effect
                      of dilutive stock options
                  
                  
                  —
                  
                  
                  243,133Diluted
                      EPS:Income
                      available to common shareholdersplus
                      assumed stock options exercised
                  
                  $
                  5,101,605
                  
                  
                  5,553,308
                  
                  $
                  0.92




-12-




**Note
        7.**




**Rate
        Volume Analysis**
 (Dollars
        in thousands)
  SECOND
                  QUARTER 2006
              
              SIX
                  MONTHS ENDED 2006VS
              
              VSSECOND
                  QUARTER 2005
              
              SIX
                  MONTHS ENDED 2005INCREASE
                  (DECREASE) DUE TO
              
              INCREASE
                  (DECREASE) DUE TOTOTAL
              
              
              
              
              
              TOTALVOLUME
              
              RATE
              
              CHANGE
              
              VOLUME
              
              RATE
              
              CHANGEINTEREST
                  INCOMEInvestments:Available-for-sale
                  securities
              
              $
              (199
              )
              $
              20
              
              $
              (179
              )
              $
              (322
              )
              $
              65
              
              
              (257
              )Held-to-maturity
                  securities
              
              
              (22
              )
              
              6
              
              
              (16
              )
              
              (38
              )
              
              18
              
              
              (20
              )Other
                  equity investments
              
              
              26
              
              
              12
              
              
              38
              
              
              89
              
              
              (35
              )
              
              54Total
                  investments
              
              
              (195
              )
              
              38
              
              
              (157
              )
              
              (271
              )
              
              48
              
              
              (223
              )Loans:Residential
              
              $
              569
              
              $
              508
              
              $
              1,077
              
              $
              1,212
              
              $
              978
              
              
              2,190Residential
                  construction
              
              
              678
              
              
              359
              
              
              1,037
              
              
              1,239
              
              
              920
              
              
              2,159Multifamily
              
              
              (586
              )
              
              374
              
              
              (212
              )
              
              (985
              )
              
              657
              
              
              (328
              )Multifamily
                  construction
              
              
              262
              
              
              161
              
              
              423
              
              
              463
              
              
              222
              
              
              685Commercial
                  real estate and business
              
              
              112
              
              
              466
              
              
              578
              
              
              49
              
              
              1,082
              
              
              1,131Commercial
                  real estate construction
              
              
              143
              
              
              203
              
              
              346
              
              
              170
              
              
              340
              
              
              510Consumer and
                  other
              
              
              279
              
              
              167
              
              
              446
              
              
              675
              
              
              288
              
              
              963Total
                  loans
              
              
              1,457
              
              
              2,238
              
              
              3,695
              
              
              2,823
              
              
              4,487
              
              
              7,310Total
                  interest income
              
              $
              1,262
              
              $
              2,276
              
              $
              3,538
              
              $
              2,552
              
              $
              4,535
              
              $
              7,087INTEREST
                  EXPENSEDeposits:Money
                  market deposit and checking
              
              $
              130
              
              $
              567
              
              $
              697
              
              $
              200
              
              $
              1,109
              
              $
              1,309Savings
              
              
              (2
              )
              
              4
              
              
              2
              
              
              (3
              )
              
              8
              
              
              5Time
                  deposits
              
              
              192
              
              
              1,302
              
              
              1,494
              
              
              598
              
              
              2,626
              
              
              3,224Total
                  deposits
              
              
              320
              
              
              1,873
              
              
              2,193
              
              
              795
              
              
              3,743
              
              
              4,538FHLB
                  advances and other
              
              
              (87
              )
              
              1,234
              
              
              1,147
              
              
              (285
              )
              
              2,205
              
              
              1,920Total
                  interest expense
              
              
              233
              
              
              3,107
              
              
              3,340
              
              
              510
              
              
              5,948
              
              
              6,458Net
                  interest income
              
              $
              1,029
              
              $
              (831
              )
              $
              198
              
              $
              2,042
              
              $
              (1,413
              )
              $
              629






-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 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.
 
 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 June 30, 2006, 2005, and
        2004:
  **Consumer**
                
                **Residential**
                
                **Business
                    Banking**
                
                **Income
                    Property****Quarter
                    ended June 30:**
                
                
                
                **Lending**
                
                **Lending**
                
                **Lending**
                
                **Lending**
                
                **Totals**Interest
                    Income
                
                
                2004
                
                $
                2,059,604
                
                $
                3,951,681
                
                $
                1,295,871
                
                $
                6,154,868
                
                $
                13,462,0242005
                
                
                2,324,663
                
                
                5,137,589
                
                
                2,122,272
                
                
                6,701,923
                
                
                16,286,4472006
                
                
                2,720,567
                
                
                6,623,600
                
                
                3,155,024
                
                
                7,325,400
                
                
                19,824,591Interest
                    Expense
                
                
                2004
                
                
                546,897
                
                
                1,532,006
                
                
                303,382
                
                
                2,222,952
                
                
                4,605,2372005
                
                
                861,286
                
                
                2,201,985
                
                
                650,473
                
                
                2,745,964
                
                
                6,459,7082006
                
                
                1,189,051
                
                
                3,595,707
                
                
                1,366,892
                
                
                3,648,417
                
                
                9,800,067Net
                    Interest Income
                
                
                2004
                
                
                1,512,707
                
                
                2,419,675
                
                
                992,489
                
                
                3,931,916
                
                
                8,856,7872005
                
                
                1,463,377
                
                
                2,935,604
                
                
                1,471,799
                
                
                3,955,959
                
                
                9,826,7392006
                
                
                1,531,516
                
                
                3,027,893
                
                
                1,788,132
                
                
                3,676,983
                
                
                10,024,524Provision
                    for Loan and Lease Losses
                
                
                2004
                
                
                156,535
                
                
                47,125
                
                
                55,935
                
                
                180,405
                
                
                440,0002005
                
                
                154,500
                
                
                57,070
                
                
                73,115
                
                
                165,315
                
                
                450,0002006
                
                
                (50,327
                )
                
                119,164
                
                
                29,347
                
                
                36,653
                
                
                134,837Net
                    Interest Income, after
                
                
                2004
                
                
                1,356,172
                
                
                2,372,550
                
                
                936,554
                
                
                3,751,511
                
                
                8,416,787Provision
                    for Loan and Lease Losses
                
                
                2005
                
                
                1,308,877
                
                
                2,878,534
                
                
                1,398,684
                
                
                3,790,644
                
                
                9,376,7392006
                
                
                1,581,843
                
                
                2,908,729
                
                
                1,758,785
                
                
                3,640,330
                
                
                9,889,687Noninterest
                    Income
                
                
                2004
                
                
                377,095
                
                
                190,428
                
                
                84,624
                
                
                276,204
                
                
                928,3512005
                
                
                610,822
                
                
                311,280
                
                
                277,945
                
                
                371,856
                
                
                1,571,9032006
                
                
                852,925
                
                
                446,214
                
                
                279,457
                
                
                479,018
                
                
                2,057,614Noninterest
                    Expense
                
                
                2004
                
                
                1,429,173
                
                
                1,429,456
                
                
                1,283,620
                
                
                1,898,024
                
                
                6,040,2732005
                
                
                1,727,721
                
                
                1,874,550
                
                
                1,589,714
                
                
                1,950,914
                
                
                7,142,8992006
                
                
                1,901,690
                
                
                2,048,303
                
                
                1,964,874
                
                
                1,920,036
                
                
                7,834,903Income
                    Before Provision for Federal Income Taxes
                
                
                2004
                
                
                304,094
                
                
                1,133,522
                
                
                (262,442
                )
                
                2,129,691
                
                
                3,304,8652005
                
                
                191,978
                
                
                1,315,264
                
                
                86,915
                
                
                2,211,586
                
                
                3,805,7432006
                
                
                533,078
                
                
                1,306,640
                
                
                73,368
                
                
                2,199,312
                
                
                4,112,398Provision
                    for Federal Income Taxes
                
                
                2004
                
                
                102,766
                
                
                383,672
                
                
                (89,781
                )
                
                721,357
                
                
                1,118,0142005
                
                
                64,596
                
                
                445,268
                
                
                28,782
                
                
                749,752
                
                
                1,288,3982006
                
                
                180,352
                
                
                443,160
                
                
                25,365
                
                
                751,784
                
                
                1,400,661Net
                    Income
                
                
                2004
                
                
                201,328
                
                
                749,850
                
                
                (172,661
                )
                
                1,408,334
                
                
                2,186,8512005
                
                
                127,382
                
                
                869,996
                
                
                58,133
                
                
                1,461,834
                
                
                2,517,3452006
                
                
                352,726
                
                
                863,480
                
                
                48,003
                
                
                1,447,528
                
                
                2,711,737Total
                    Interest Earning Assets
                
                
                2004
                
                
                106,368,450
                
                
                273,980,679
                
                
                99,436,965
                
                
                447,499,013
                
                
                927,285,107(ending
                    period balances)
                
                
                2005
                
                
                116,559,900
                
                
                327,186,650
                
                
                131,570,274
                
                
                419,257,639
                
                
                994,574,4632006
                
                
                122,969,195
                
                
                363,973,925
                
                
                179,362,547
                
                
                380,259,476
                
                
                1,046,565,143






-14-




**Note
        8.**


**Segments
        (continued)**
  **Consumer**
                
                **Residential**
                
                **Business
                    Banking**
                
                **Income
                    Property****Year-to-date
                    ended June 30:**
                
                
                
                **Lending**
                
                **Lending**
                
                **Lending**
                
                **Lending**
                
                **Totals**Interest
                    Income
                
                
                2004
                
                $
                4,085,733
                
                $
                7,534,509
                
                $
                2,607,009
                
                $
                12,138,413
                
                $
                26,365,6642005
                
                
                4,570,151
                
                
                9,682,525
                
                
                4,075,418
                
                
                13,357,549
                
                
                31,685,6432006
                
                
                5,449,598
                
                
                13,068,534
                
                
                5,930,213
                
                
                14,325,003
                
                
                38,773,348Interest
                    Expense
                
                
                2004
                
                
                1,097,506
                
                
                2,912,392
                
                
                632,151
                
                
                4,376,763
                
                
                9,018,8122005
                
                
                1,599,534
                
                
                4,084,545
                
                
                1,141,186
                
                
                5,233,393
                
                
                12,058,6582006
                
                
                2,295,273
                
                
                6,769,719
                
                
                2,477,051
                
                
                6,975,341
                
                
                18,517,384Net
                    Interest Income
                
                
                2004
                
                
                2,988,227
                
                
                4,622,117
                
                
                1,974,858
                
                
                7,761,650
                
                
                17,346,8522005
                
                
                2,970,617
                
                
                5,597,980
                
                
                2,934,232
                
                
                8,124,156
                
                
                19,626,9852006
                
                
                3,154,325
                
                
                6,298,815
                
                
                3,453,162
                
                
                7,349,662
                
                
                20,255,964Provision
                    for Loan and Lease Losses
                
                
                2004
                
                
                249,634
                
                
                69,404
                
                
                81,394
                
                
                289,568
                
                
                690,0002005
                
                
                290,215
                
                
                105,775
                
                
                132,240
                
                
                321,770
                
                
                850,0002006
                
                
                (30,307
                )
                
                (12,886
                )
                
                98,097
                
                
                150,933
                
                
                205,837Net
                    Interest Income, after
                
                
                2004
                
                
                2,738,593
                
                
                4,552,713
                
                
                1,893,464
                
                
                7,472,082
                
                
                16,656,852Provision
                    for Loan and Lease Losses
                
                
                2005
                
                
                2,680,402
                
                
                5,492,205
                
                
                2,801,992
                
                
                7,802,386
                
                
                18,776,9852006
                
                
                3,184,632
                
                
                6,311,701
                
                
                3,355,065
                
                
                7,198,729
                
                
                20,050,127Noninterest
                    Income
                
                
                2004
                
                
                747,002
                
                
                362,513
                
                
                173,588
                
                
                542,936
                
                
                1,826,0392005
                
                
                1,473,077
                
                
                524,434
                
                
                380,777
                
                
                563,378
                
                
                2,941,6662006
                
                
                2,009,646
                
                
                634,510
                
                
                428,111
                
                
                700,196
                
                
                3,772,463Noninterest
                    Expense
                
                
                2004
                
                
                2,625,406
                
                
                2,822,546
                
                
                2,386,135
                
                
                3,846,213
                
                
                11,680,3002005
                
                
                3,376,936
                
                
                3,572,091
                
                
                3,180,234
                
                
                3,876,546
                
                
                14,005,8072006
                
                
                3,885,326
                
                
                3,994,145
                
                
                3,882,144
                
                
                3,761,600
                
                
                15,523,215Income
                    Before Provision for Federal Income Taxes
                
                
                2004
                
                
                860,189
                
                
                2,092,680
                
                
                (319,083
                )
                
                4,168,805
                
                
                6,802,5912005
                
                
                776,543
                
                
                2,444,548
                
                
                2,535
                
                
                4,489,218
                
                
                7,712,8442006
                
                
                1,308,952
                
                
                2,952,066
                
                
                (98,968
                )
                
                4,137,325
                
                
                8,299,375Provision
                    for Federal Income Taxes
                
                
                2004
                
                
                291,159
                
                
                708,211
                
                
                (109,668
                )
                
                1,411,897
                
                
                2,301,5992005
                
                
                262,720
                
                
                827,486
                
                
                (610
                )
                
                1,521,643
                
                
                2,611,2392006
                
                
                453,662
                
                
                1,022,208
                
                
                (36,328
                )
                
                1,434,024
                
                
                2,873,566Net
                    Income
                
                
                2004
                
                
                569,030
                
                
                1,384,469
                
                
                (209,415
                )
                
                2,756,908
                
                
                4,500,9922005
                
                
                513,823
                
                
                1,617,062
                
                
                3,145
                
                
                2,967,575
                
                
                5,101,6052006
                
                
                855,290
                
                
                1,929,858
                
                
                (62,640
                )
                
                2,703,301
                
                
                5,425,809Total
                    Interest Earning Assets
                
                
                2004
                
                
                102,336,690
                
                
                259,761,399
                
                
                97,826,002
                
                
                439,899,861
                
                
                899,823,952(average
                    balances)
                
                
                2005
                
                
                113,352,359
                
                
                316,231,162
                
                
                127,556,812
                
                
                429,190,920
                
                
                986,331,2532006
                
                
                122,509,040
                
                
                363,731,577
                
                
                166,769,887
                
                
                383,425,411
                
                
                1,036,435,915
   -15-




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 consumer loan offices located in
        Jacksonville, Florida and Mt. Clemens, Michigan. 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
        second quarter of 2006 marked our fifty-fifth consecutive quarter of
        year-over-year earnings growth, as net income increased 8% over the second
        quarter of 2005, to $2.7 million, or $0.50 per diluted share, compared to
        $2.5
        million, or $0.45 per diluted share in the second quarter of last year. For
        the
        first six months of 2006, net income totaled $5.4 million, up from $5.1 million
        in the first half of 2005, with diluted earnings per share growing 9% to
        $1.00,
        compared to $0.92 in the same period last year. Our return on average equity
        (ROE) totaled 17.3% for the quarter and 17.5% for the six months ended June
        30,
        2006, compared to 16.0% and 16.5% in the same periods last year. As a result,
        we
        were able to exceed one of our general corporate goals, obtaining an ROE
        of at
        least 15%, for both the quarter and year-to-date periods. We did not, however,
        manage to achieve our other general corporate goal, year-over-year net income
        growth in the range of 10% to 12%, for either the second quarter or first
        half
        of this year. That said, we were successful in achieving 11% year-over-year
        growth in our diluted earnings per share in the second quarter. 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 commonly measured with the net interest margin ratio. As had been
        expected, our margin declined in the second quarter of 2006, though at 3.91%
        the
        second quarter margin fell short of the 3.95% to 4.00% range we had
        anticipated.
  -16-
 
 After
        the
        first quarter, we had indicated that we expected to see continued compression
        in
        our net interest margin as we increased sales of our home improvement loans,
        which are generally among our highest yielding assets. Also expected to impact
        the margin were large FHLB advance balances that matured over the first quarter
        of 2006 and large time deposit balances maturing in the second quarter. Based
        on
        increases in rates since the times these advances and certificates were
        originated, these liabilities were subject to renewal at rates much higher
        than
        their original rates, resulting in increased interest expense and additional
        compression of the margin. Taking these factors into account, we expected
        to see
        some compression in our net interest margin over the next two
        quarters.
 
 In
        addition to the increased level of home improvement loan sales and large
        liability balances repricing throughout the first and second quarters, the
        greater than expected decline in the margin was largely attributable to the
        use
        of wholesale funds to accommodate asset growth and offset the runoff of deposit
        balances in the second quarter. Further impacting our margin were rate
        modifications on a number of multifamily and commercial mortgage loans. In
        an
        effort to prevent prepayments of certain multifamily and commercial mortgage
        loans, rate modifications were offered to some of our borrowers. While these
        modifications effectively reduced asset yields and negatively impacted the
        net
        interest margin, we believe the impact of these modifications on net interest
        income, and ultimately earnings, to be less than the reduction in net interest
        income would have been had these loans been refinanced elsewhere and paid
        off,
        resulting in an erosion of the multifamily and commercial mortgage
        portfolio.
 
 The
        other
        key driver of net interest income is the growth of the business lines’ earning
        assets, which totaled nearly $1.04 billion as of the June 2006 quarter-end,
        up
        from $1.02 billion at both December 31, 2005, and March 31, 2006. This growth
        was achieved despite sales of over $10 million in consumer loans during the
        quarter and a $13 million reduction in the size of our securities portfolio
        relative to March 31, 2006. The increase in earning assets during the second
        quarter was attributable to growth in our loan portfolio, with our Business
        Banking and Residential Lending segments once again making the most significant
        contributions. Additionally, our consumer lending segment would likely have
        shown significant growth for the quarter, were it not for the previously
        mentioned loan sales. 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 rose $486,000
        relative to the second quarter of last year, representing growth of nearly
        31%,
        based primarily on the accrual of $400,000 in insurance proceeds from a key-man
        life insurance policy. The accrual of these proceeds was the result of the
        passing of our Eastern Region Sales Finance Manager. We are not the beneficiary
        of any other life insurance policies on employees and we have no bank-owned
        life
        insurance. Significant increases in loan sales and resulting gains thereon
        also
        contributed to the growth in fee income as compared to last year. For the
        six
        months ended June 30, 2006, noninterest income increased $831,000 relative
        to
        the prior year level, with the above mentioned insurance proceeds and higher
        gains on loan sales again being the most significant contributors to the
        additional income. Please see the “Noninterest Income” section for additional
        discussion.
 
 Noninterest
        expense increased $692,000, or 10% in the second quarter of 2006 over the
        like
        period of 2005, but rose only 2% on a sequential quarter basis against the
        first
        quarter of this year. On a year-to-date basis, noninterest expense grew by
        $1.5
        million, or 11% relative to the
  -17-
  same
        period last year. Depreciation expense contributed significantly to the increase
        over the second quarter of last year based on improvements made to our First
        Mutual Center headquarters building and the remodeling and/or reconstruction
        of
        several banking centers. Also contributing to the 2006 increase were increased
        expenditures for credit insurance on our loan portfolio, legal and consulting
        services, and the implementation of Statement of Financial Accounting Standards
        No. 123 (R), *Share
        Based Payment,* which
        requires the expensing of stock options. Through the first half of 2006,
        the
        expensing of options decreased earnings by $171,000, net of tax, which
        translated to $0.02 per diluted share. Please see the “Noninterest Expense”
section for additional information.
 
 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. At June 30, 2006, our credit quality remained strong, with total
        non-performing assets (NPAs) declining to $386,000, or 0.03% of total assets,
        compared to $797,000, or 0.08% at June 30, 2005, and $897,000, also 0.08%,
        at
        the 2005 year-end. For the quarter, we reserved $135,000 in provisions for
        loan
        losses, as net charge-offs totaled only $60,000. With this provision, our
        reserve for loan losses totaled approximately $10.2 million, up from $9.7
        million at June 30, 2005 and $10.1 million at the 2005 year-end. Note that
        the
        $10.2 million figure for the second quarter of 2006 includes a $341,000
        liability representing a reserve for losses for unfunded commitments. The
        allowance for loan losses represented 1.09% of gross loans at the end of
        the
        second quarter, far in excess of non-performing loans, though down from 1.13%
        at
        the 2005 year-end and 1.14% as of June 30, 2005. For additional information
        regarding our credit quality please refer to the “Asset Quality”
section.
 
 **RESULTS
        OF OPERATIONS**
 
 **Net
        Income**
 
 Net
        income increased 8%, from $2.5 million in the second quarter of 2005 to $2.7
        million in the same period of 2006. Net interest income, after provision
        for
        loan losses, rose $513,000, and noninterest income increased $486,000 on
        a
        second quarter comparison. Partially offsetting the growth in revenue was
        a rise
        of $692,000 in noninterest expense.
 
 **Net
        Interest Income**
 
 For
        the
        quarter and six months ended June 30, 2006, our net interest income increased
        $198,000 and $629,000 relative to the same periods in 2005. This improvement
        resulted from growth in our earning assets, as the net effects of asset and
        liability repricing negatively impacted net interest income for both periods.
        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
              
              Six
                  Months EndedJune
                  30, 2006 vs. June 30, 2005
              
              June
                  30, 2006 vs. June 30, 2005Increase/(Decrease)
                  due to
              
              Increase/(Decrease)
                  due toVolume
              
              Rate
              
              Total
              
              Volume
              
              Rate
              
              TotalInterest
                  Income
              
              (Dollars
                  in thousands)Total
                  Investments
              
              $
              (195
              )
              $
              38
              
              $
              (157
              )
              $
              (271
              )
              $
              48
              
              $
              (223
              )Total
                  Loans
              
              
              1,457
              
              
              2,238
              
              
              3,695
              
              
              2,823
              
              
              4,487
              
              
              7,310
  -18-
  Total
                  Interest Income
              
              $
              1,262
              
              $
              2,276
              
              $
              3,538
              
              $
              2,552
              
              $
              4,535
              
              $
              7,087Interest
                  ExpenseTotal
                  Deposits
              
              $
              320
              
              $
              1,873
              
              $
              2,193
              
              $
              795
              
              $
              3,743
              
              $
              4,538FHLB
                  and Other
              
              
              (87
              )
              
              1,234
              
              
              1,147
              
              
              (285
              )
              
              2,205
              
              
              1,920Total
                  Interest Expense
              
              $
              233
              
              $
              3,107
              
              $
              3,340
              
              $
              510
              
              $
              5,948
              
              $
              6,458Net
                  Interest Income
              
              $
              1,029
              
              $
              (831
              )
              $
              198
              
              $
              2,042
              
              $
              (1,413
              )
              $
              629
  **Earning
        Asset Growth (Volume)**
 
 For
        the
        second quarter and first six months of 2006, the growth in our earning assets
        contributed an additional $1.3 million and $2.6 million in interest income
        relative to the same periods last year. Partially offsetting this improvement
        was additional interest expense of $233,000 for the quarter and $510,000
        for the
        first half of the year incurred from the funding sources used to accommodate
        the
        asset growth. Consequently, the net impacts of asset growth were improvements
        in
        net interest income of slightly more than $1.0 million and $2.0 million compared
        to the quarter and six months ended June 30, 2005.
 
 Quarter
                  Ended
              Average
                  Earning
                Assets
              Average
                  Net Loans
              Average
                  Deposits(Dollars
                  in thousands)June
                  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
              $
                  772,168June
                  30, 2006
              $
                  1,027,404
              $
                  902,356
              $
                  771,979
 
 Our
        earning assets totaled nearly $1.04 billion as of the June 2006 quarter-end,
        up
        from $1.02 billion at both December 31, 2005 and March 31, 2006. This growth
        was
        achieved despite sales of over $10 million in home improvement (Sales Finance)
        loans during the quarter and a $13 million reduction in the size of our
        securities portfolio relative to March 31, 2006.
 
 The
        increase in earning assets during the second quarter was attributable to
        growth
        in our loan portfolio, with our Business Banking and Residential Lending
        segments once again making the most significant contributions. Additionally,
        our
        consumer lending segment would likely have shown significant growth for the
        quarter, were it not for the previously mentioned loan sales, which exceeded
        $10
        million for the second quarter.
 
 When
        taking into account our expected production volumes, payoffs, and loan sales
        for
        all business segments, including an estimated $18 million to $21 million
        in
        consumer loan sales, our forecast for the total loan portfolio is for no
        growth,
        or even modest decline in the third quarter of 2006, followed by an increase
        of
        $10 million to $15 million in the fourth quarter.
 
 In
        contrast to the loan portfolio, our securities portfolio continued to contract
        in size, declining nearly $26 million compared to the level as of June 30,
        2005,
        $18 million from the year end level, and $13 million from its level as of
        March
        31, 2006. Over the past several quarters, 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
        have amortized or matured, we have generally not replaced the paid-off
        securities balances, but instead redirected
  -19-
  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.
 
 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 Federal Home
        Loan
        Bank of Seattle (FHLB) as an alternative funding source. In our first quarter
        2006 press release, we noted that the combination of slow asset growth and
        a
        substantial increase in non-maturity deposit balances had allowed us to take
        steps in improving our funding mix by reducing balances borrowed from the
        FHLB
        as well as rates offered on retail certificates of deposit. Were this trend
        to
        have continued, it was our expectation that these factors would have contributed
        to an eventual expansion of our net interest margin, as we would have been
        increasingly funded with less expensive non-maturity deposits while reducing
        our
        reliance on more expensive wholesale funding sources.
  Unfortunately,
        these trends did not continue in the second quarter. Following impressive
        growth
        in the first quarter, our non-maturity deposit balances peaked in mid-April,
        then steadily declined for the next month as a result of outflows for federal
        income tax and state property tax payments, as well as a substantial reduction
        in balances maintained by a large commercial customer. While some recovery
        occurred in June, our non-maturity balances ended the quarter at a level
        lower
        than that at which the quarter began. Additionally, as previously noted,
        following a quarter marked by the absence of asset growth, the size of our
        loan
        portfolio increased significantly in the second quarter, and with it our
        level
        of total assets. Both of these factors resulted in an increased usage of
        higher
        cost wholesale funding sources.
  **Asset
        Yields and Funding Costs (Rate)**
 
 The
        effects of interest rate movements and repricing on our loan portfolio accounted
        for $2.2 million and $4.5 million in additional interest income relative
        to the
        second quarter and first half of last year. Adjustable-rate loans, which
        reprice
        according to terms specified in our loan agreements with the borrowers,
        accounted for approximately 82% of our loan portfolio as of June 30, 2006.
        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 Bank. 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 $3.1 million for the quarter and $5.9 million for the first six
        months
        of the year.
 
 As
        a
        result, for the second quarter and first six months of 2006, the net effects
        of
        rate movements and repricing negatively impacted our net interest income
        by
        $831,000 and $1.4 million relative to the same periods in 2005, as the large
        volumes of maturing/repricing liabilities resulted in a greater increase
        in
        liabilities costs than was observed for asset yields.
  -20-
 
 Quarter
                  Ended
              Net
                  Interest MarginJune
                  30, 2005
              4.01%September
                  30, 2005
              4.03%December
                  31, 2005
              4.18%March
                  31, 2006
              4.02%June
                  30, 2006
              3.91%
 
 As
        had
        been expected, our net interest margin continued to decline in the second
        quarter of 2006. In our first quarter 2006 press release, we had indicated
        that
        we expected to see continued compression in our net interest margin as we
        increased sales of our home improvement (Sales Finance) loans, which are
        generally among our highest yielding assets. It should be noted that while
        the
        sales of these loans negatively impact our net interest margin, these sales
        result in substantial levels of noninterest income, including the gains on
        sales
        recognized at the times of the transactions, as well as servicing fee income
        earned on an ongoing basis following the sale. Also expected to impact the
        margin were large FHLB advance balances that matured over the first quarter
        of
        2006 and large time deposit balances maturing in the second quarter. Based
        on
        increases in rates since the times these advances and time deposits were
        originated, these liabilities were subject to renewal at rates much higher
        than
        their original rates, resulting in increased interest expense and additional
        compression of the margin. Between these two factors, we expected our net
        interest margin to decline over the next two quarters.
 
 At
        3.91%,
        however, the net interest margin achieved for the second quarter fell short
        of
        the 3.95% to 4.00% range we had forecast in our first quarter press release.
        In
        addition to the increased level of home improvement loan sales and large
        liabilities balances repricing throughout the first and second quarters,
        the
        greater than expected decline in the margin was largely attributable to the
        previously mentioned second quarter asset growth, runoff in non-maturity
        deposit
        balances, and the resulting increased use of more expensive wholesale
        funds.
 
 An
        additional factor that has negatively impacted our margin this year has been
        rate modifications on a substantial part of our Income Property multifamily
        and
        commercial mortgage portfolios. As previously noted, the vast majority of
        loans
        in our portfolio are adjustable-rate in nature, and most of our multifamily
        and
        commercial mortgages have historically been subject to repricing on an annual
        basis. The current interest rate and competitive environments, however, in
        which
        we face a flat yield curve and tighter margins, provide financial incentives
        for
        borrowers with such loans to refinance with longer-term, fixed-rate loans.
        Consequently, prepayment rates for these loans had been running at exceptionally
        high levels for quite some time. In an effort to prevent prepayments of certain
        loans, rate modifications were offered to some of our borrowers. While these
        modifications effectively reduced asset yields and negatively impacted the
        net
        interest margin, we believe the impact of these modifications on net interest
        income, and ultimately earnings, to be less than the reduction in net interest
        income would have been had these loans been refinanced elsewhere and paid
        off,
        resulting in an erosion of the Income Property portfolio.
 
 **Noninterest
        Income**
 
 Relative
        to the second quarter of last year, our noninterest income rose $486,000,
        representing growth of nearly 31%, based primarily on the accrual of insurance
        proceeds of $400,000 from a key-man life insurance policy. The accrual of
        these
        proceeds was the result of the unexpected passing of our Eastern Region Sales
        Finance Manager. We currently do not carry key-man life insurance on any
        other
        employees and therefore do not expect to receive funds of this nature in
  -21-
  the
        future. Significant increases in loan sales and resulting gains thereon also
        contributed to the fee income as compared to last year.
 
 For
        the
        six months ended June 30, 2006, noninterest income increased $831,000 relative
        to the prior year level, with the above mentioned insurance proceeds and
        higher
        gains on loan sales again being the most significant contributors to the
        additional income.
 
 Quarter
                  Ended
              
              Six
                  Months EndedJune
                  30, 2006
              
              June
                  30, 2005
              
              June
                  30, 2006
              
              June
                  30, 2005**Gains/(Losses)
                  on Loan Sales:**Consumer
              
              $
              430,000
              
              $
              201,000
              
              $
              1,178,000
              
              $
              702,000Residential
              
              
              18,000
              
              
              38,000
              
              
              (2,000
              )
              
              62,000Commercial
              
              
              106,000
              
              
              181,000
              
              
              134,000
              
              
              181,000Total
                  Gains on Loan Sales
              
              
              554,000
              
              
              420,000
              
              
              1,310,000
              
              
              945,000**Loans
                  Sold:**Consumer
              
              $
              10,028,000
              
              $
              5,038,000
              
              $
              23,043,000
              
              $
              15,676,000Residential
              
              
              13,717,000
              
              
              4,938,000
              
              
              23,113,000
              
              
              12,090,000Commercial
              
              
              4,182,000
              
              
              2,570,000
              
              
              5,192,000
              
              
              2,570,000Total
                  Loans Sold
              
              $
              27,927,000
              
              $
              12,546,000
              
              $
              51,348,000
              
              $
              30,336,000
 
 As
        was
        the case in the first quarter of 2006, our second quarter gains on loan sales
        significantly exceeded those of the prior year based on a substantial increase
        in sales of our consumer loans. For the second quarter, gains on sales totaled
        $554,000, representing a 32% increase over the same period last
        year.
 
 In
        our
        fourth quarter 2005 press release, we noted that we were experiencing an
        increased level of interest in, and favorable opportunities to market our
        consumer loans to other institutional investors, as well as our expectation
        that
        sales of these loans would likely increase in 2006. This expectation
        materialized and our loan sales in the first and second quarters exceeded
        those
        as compared to the like periods in 2005, though second quarter sales totaled
        less than the $14 million to $18 million range estimated in our first quarter
        press release. Based on our current levels of loan production and market
        demand,
        our expectation is for our third quarter consumer loan sales to total in
        the $18
        million to $21 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. Improved execution
        also contributed to the improvement in gains relative to last year, as gains
        increased nearly 114% from the prior year level while the total volume of
        loans
        sold increased 99% from the same period last year.
 
 Based
        on
        high sales levels in May and June, the volume of residential loans sold during
        the quarter and six months ended June 30, 2006 far exceeded the amount sold
        in
        the same periods last year.  Relative to the markets for our consumer and
        commercial loan sales, however, the market for residential loan sales is
        significantly larger and more efficient.  As a result, residential loan
        sales are typically sold for very modest gains or potentially even at slight
        losses in situations in which interest rates are rising quickly.  We
        believe the construction phase to be the most profitable facet of residential
        lending and the primary objective in a residential lending relationship. 
Following the construction process, our practice is to retain in our portfolio
        those residential mortgages that we consider to be beneficial to the Bank,
        but
        to sell those that we consider less attractive assets.  Included in these
        less attractive assets would be those mortgages with fixed rates, which we
        offer
        for competitive reasons.  Additionally, as residential loans are typically
        sold servicing released, sales do not result in future servicing
        income.
  -22-
 
 Following
        relatively modest commercial real estate loan sales volume in recent quarters,
        we sold participations in several commercial real estate loans during the
        second
        quarter, though gains still trailed their year ago levels. In June 2005,
        we sold
        participations in a large commercial real estate credit that included both
        the
        construction financing as well as the permanent mortgage to refinance that
        loan
        following the completion of construction, which resulted in an unusually
        large
        gain on sale. While our current expectation is that we will expand our
        commercial real estate loan sales, we would reiterate our comment made in
        previous quarters 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**
 
 Quarter
                  Ended
              
              Six
                  Months EndedJune
                  30, 2006
              
              June
                  30, 2005
              
              June
                  30, 2006
              
              June
                  30, 2005Consumer
                  Loans
              
              $
              298,000
              
              $
              341,000
              
              $
              630,000
              
              $
              641,000Commercial
                  Loans
              
              
              0
              
              
              26,000
              
              
              9,000
              
              
              50,000Residential
                  Loans
              
              
              2,000
              
              
              2,000
              
              
              (4,000
              )
              
              4,000Total
                  Service Fee Income
              
              $
              300,000
              
              $
              369,000
              
              $
              635,000
              
              $
              695,000
 
 Our
        second quarter servicing fee income declined nearly 19% from the level earned
        in
        the same period last year, with significant reductions observed in servicing
        income from both consumer and commercial loans serviced for other institutions.
        Servicing fee income represents the net of actual servicing income received
        less
        the amortization of servicing assets, which are recorded when we sell loans,
        servicing retained, from our portfolio to other investors. The values of
        these
        servicing assets are determined at the time of the sales using a valuation
        model
        that calculates the present value of future cash flows for the loans sold,
        including cash flows related to the servicing of the loans. The calculated
        present value of the servicing rights is then capitalized and amortized in
        proportion to, and over the period of, the estimated future servicing
        income.
 
 In
        the
        case of consumer loans, net service fee income declined based on an increase
        in
        servicing asset amortization expense relative to the level of gross service
        fee
        income received. The amortization of servicing assets is reviewed on a quarterly
        basis, taking into account market discount rates, anticipated prepayment
        speeds,
        estimated servicing cost per loan, and other relevant factors. These factors
        are
        subject to significant fluctuations, and any projection of servicing asset
        amortization in future periods is limited by the conditions that existed
        at the
        time the calculations were performed, and may not be indicative of actual
        amortization expense that will be recorded in future periods.
 
 Based
        on
        a modest level of sales in recent quarters, fee income earned on our commercial
        loans serviced for others was not a major contributor to our total service
        fee
        income this quarter, as servicing income received was only sufficient to
        offset
        the amortization of servicing assets.
  In
        contrast to consumer and commercial loans, 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.
  -23-
  **Fees
        on Deposits**
  Fee
        income earned on deposit accounts rose by $23,000, or 14%, compared to the
        second quarter of 2005, and $70,000, or 23% relative to the first six months
        of
        last year. The improvements over last year were attributable to increased
        NSF
        fees and checking account service charges, which have grown as we have continued
        our efforts to expand our base of business and consumer checking
        accounts.
  **Other
        Noninterest Income**
 
 Quarter
                  Ended
              
              Six
                  Months EndedJune
                  30, 2006
              
              June
                  30, 2005
              
              June
                  30, 2006
              
              June
                  30, 2005ATM/Wire/Safe
                  Deposit
                Fees
              
              $
              79,000
              
              $
              62,000
              
              $
              154,000
              
              $
              119,000Late
                  Charges
              
              
              66,000
              
              
              45,000
              
              
              117,000
              
              
              94,000Loan
                  Fee Income
              
              
              155,000
              
              
              289,000
              
              
              250,000
              
              
              358,000Rental
                  Income
              
              
              186,000
              
              
              144,000
              
              
              343,000
              
              
              310,000Miscellaneous
                  Fee Income
              
              
              523,000
              
              
              72,000
              
              
              587,000
              
              
              115,000Other
                  Noninterest Income
              
              $
              1,009,000
              
              $
              612,000
              
              $
              1,451,000
              
              $
              996,000
 
 Our
        noninterest income from sources other than those described earlier rose by
        $397,000, or 65% for the quarter and $456,000, or 46% for the six months
        ended
        June 30 relative to the same periods last year. As previously noted, the
        accrual
        of insurance proceeds of $400,000 from a key-man life insurance policy, made
        the
        most significant contribution to the increase over the prior year.
 
 Also
        contributing to the increase in miscellaneous fee income was $50,000 related
        to
        the marking-to-market of two interest-rate derivatives into which we entered
        during the second quarter. This income was essentially matched by $50,000
        of
        mark-to-market losses on offsetting derivatives recorded in our other
        noninterest expense. These derivatives are associated with two commercial
        loans
        totaling approximately $3 million and are marked-to-market each quarter.
        The
        derivatives were utilized to hedge interest rate risk associated with extending
        longer-term, fixed-rate periods on commercial real estate loans, and structured
        such that a gain on any given derivative would be matched against a nearly
        identical loss on an offsetting derivative, resulting in essentially no net
        impact to the Bank. To the extent that we continue to offer similar longer-term,
        fixed-rate periods on commercial real estate loans in the future and use
        similar
        derivative structures to manage interest rate risk, this income, as well
        as the
        offsetting expense, would be expected to increase in future
        periods.
 
 We
        continued to observe significant growth in our ATM/Wire/Safe Deposit Fees,
        which
        totaled $79,000 for the quarter and $154,000 for the six months ended June
        30,
        2006, representing increases of 27% and 30% over the same periods in 2005.
        The
        majority of this growth has been attributable to Visa and ATM fee income,
        which
        we expect to continue rising as checking accounts become a greater piece
        of our
        overall deposit mix.
 
 Rental
        income also increased significantly relative to the prior year, as the second
        quarter of 2006 brought the arrival of a new tenant in the First Mutual Center
        building as well as a recovery of some 2005 operating expenses from other
        tenants in the building. First Mutual Center has a total of 74,000 square
        feet.
        We occupy 55% of the space and tenants occupy 36%, with 9% of the space
        vacant.
  -24-
  Counter
        to the trend observed in recent quarters, loan fee income, which totaled
        $155,000 for the quarter and $250,000 for the first half of the year, declined
        relative to prior year levels due primarily to a reduction in loan prepayment
        fees. In May and June of 2005, we received large prepayment penalties associated
        with the prepayments of some income property loans. In contrast, prepayment
        penalties on income property loans were relatively minimal in the second
        quarter
        of this year.
 
 **Noninterest
        Expense**
  Noninterest
        expense increased $692,000, or 10% in the second quarter of 2006 over the
        like
        period of 2005. On a year-to-date basis noninterest expense grew by $1,517,000,
        or 11% compared to the first two quarters of 2005.
  **Salaries
        and Employee Benefits Expense**
 
 Salary
        and employee benefits expense increased $145,000, or 3% from the second quarter
        of 2005 to the same period this year. Salary and employee benefit expense
        was 8%
        higher after the first two quarters of 2006 compared to the same period last
        year, reflecting an increase of $645,000.
 
 Quarter
                  Ended
              
              Six
                  Months EndedJune
                  30, 2006
              
              June
                  30, 2005
              
              June
                  30, 2006
              
              June
                  30, 2005Salaries
              
              $
              2,994,000
              
              $
              2,526,000
              
              $
              5,966,000
              
              $
              5,147,000Commissions
                  and Incentive Bonuses
              
              
              634,000
              
              
              927,000
              
              
              1,174,000
              
              
              1,438,000Employment
                  Taxes and Insurance
              
              
              267,000
              
              
              272,000
              
              
              568,000
              
              
              562,000Temporary
                  Office Help
              
              
              59,000
              
              
              70,000
              
              
              154,000
              
              
              112,000Benefits
              
              
              523,000
              
              
              537,000
              
              
              1,061,000
              
              
              1,019,000Total
              
              $
              4,477,000
              
              $
              4,332,000
              
              $
              8,923,000
              
              $
              8,278,000
  Salary
        expense increased both on a quarter-to-quarter and a year-to-date basis.
        Part of
        the increase in salary expense is due to the expensing of stock option
        compensation. We adopted Statement of Financial Accounting Standard 123(R),
        an
        accounting standard relating to the valuation and expensing of equity-based
        compensation, on January 1, 2006. Expenses related to stock options were
        $135,000 in the first quarter of 2006 and $125,000 in the second quarter
        of
        2006, for a total of $260,000 year-to-date. Stock option expense was down
        $10,000 from first quarter mainly due to $27,000 in cancelled stock options.
        We
        expect a 15% rise in stock option expense in the third quarter as options
        are
        granted, followed by a comparable level of expense in the fourth quarter.
  Regular
        compensation grew 17%, or $366,000 on a quarter-over-quarter basis. Over
        the
        first half of 2006, regular compensation was up 14%, or $605,000 from the
        same
        period of last year. Some of the growth in regular compensation expense is
        attributed to growth in full-time equivalent (FTE) employees. As of June
        30,
        2006, we employed 237 FTE employees, versus 218 FTE employees as of June
        30,
        2005. This change represents staff growth of 9%. Also contributing to the
        escalation in regular compensation expense were the annual increases in staff
        salaries, taking effect in April 2006 and generally falling within the range
        of
        2% to 4%.
  -25-
  Loan
        officer commissions increased 15% this quarter and 11% in the first half
        of the
        year mainly as a result of larger loan production volume. The incentive
        compensation plans for loan production staff tend to vary directly with the
        production of the business lines. The accrual for the year-end administrative
        and support staff bonus was down $366,000 and $342,000 for the second quarter
        and six months ended June 30, 2006, respectively, as compared to the like
        periods in 2005. The administrative and support staff bonus is paid out at
        the
        end of the year and is accrued throughout the year as the bonus is earned.
        Last
        year, a larger portion of the annual bonus was accrued in the first half
        of 2005
        as compared to this year.
  Expenditures
        on temporary office help decreased in the second quarter of 2006 but increased
        over the first half of 2006 relative to the same periods last year. The business
        areas with the heaviest use of temporary office help during the first six
        months
        of 2006 were the sales finance, consumer loan administration, and customer
        service areas. Temporary office help fills needs in positions affected by
        turnover.
  **Occupancy
        Expense**
 
 Occupancy
        expense increased $194,000, or 23% compared to the second quarter of 2005.
        For
        the six months ended June 30, 2006, occupancy expense grew $421,000 or 26%.
        A
        large part of the rise in occupancy expense in both the second quarter and
        the
        first half of the year was depreciation expense, associated with the remodel
        of
        portions of First Mutual Center, our headquarters, and several of our banking
        centers in 2005 and the relocation of the West Seattle banking center in
        2006.
 
 Quarter
                  Ended
              
              Six
                  Months EndedJune
                  30, 2006
              
              June
                  30, 2005
              
              June
                  30, 2006
              
              June
                  30, 2005Rent
                  Expense
              
              $
              79,000
              
              $
              81,000
              
              $
              158,000
              
              $
              159,000Utilities
                  and Maintenance
              
              
              198,000
              
              
              140,000
              
              
              402,000
              
              
              329,000Depreciation
                  Expense
              
              
              518,000
              
              
              395,000
              
              
              1,028,000
              
              
              734,000Other
                  Occupancy Expenses
              
              
              248,000
              
              
              233,000
              
              
              465,000
              
              
              411,000Total
                  Occupancy Expense
              
              $
              1,043,000
              
              $
              849,000
              
              $
              2,053,000
              
              $
              1,633,000
 
 Rent
        expense was slightly lower in both the second quarter of 2006 and the six
        month
        period ending June 30, 2006. This decrease was due to the relocation of the
        West
        Seattle Banking Center from a space that we rented to a new building that
        we
        own.
 
 Building
        maintenance expenses were $40,000 higher in the second quarter than in the
        same
        period of 2005. The increased expense is attributed to several projects
        completed throughout the banking centers and at our headquarters, First Mutual
        Center. These projects included, among other things, new signage, removing
        old
        signage at the previous West Seattle Banking Center location, landscaping,
        and
        HVAC repairs at First Mutual Center. On a year-to-date basis maintenance
        expenses were $34,000 higher, indicating that the year-to-date increased
        expense
        primarily fell in the second quarter of 2006.
 
 The
        most
        significant growth in occupancy expense was in depreciation expense, which
        rose
        31% from the second quarter and 40% from the first half of 2005. The increase
        in
        depreciation expense was principally the result of depreciation of the
        previously noted new office building assets and office building improvements.
        Besides the depreciation expense associated with these building improvements
        and
        the new office building, depreciation expense related to furniture and
  -26-
  fixtures
        grew by 22% for the quarter as compared to second quarter last year. On a
        sequential quarter basis, depreciation expense showed only modest gains,
        increasing by $9,000 from the first quarter of this year.
 
 Within
        the other occupancy costs category, escalations in real estate taxes, software
        licensing, and the cost of maintenance for computers, furniture, and equipment,
        contributed to the rise in other occupancy costs. A 38% growth in real estate
        taxes was the result of annual increases in taxes paid on Bank properties,
        as
        well as property taxes on the land purchased for our new Canyon Park banking
        center, which is scheduled to open in the third quarter of 2007. Software
        licensing expenses were up on a year-to-date basis as a result of new software
        licenses purchased for new employees, the acquisition of programs to support
        our
        commercial loan business and accounting for stock options. Higher fees on
        our
        licensing agreement with Microsoft, which was initiated late in the first
        quarter of 2005, also added to this expense.
 
 Maintenance
        costs for computers and equipment rose by 18% on a year-to-date basis but
        fell
        on a quarter-to-date basis. The year-to-date increase reflects a strategic
        change in the management of and contract on, office equipment such as printers
        and copy machines.
  **Other
        Noninterest Expense**
 
 Other
        noninterest expense grew by $353,000, or 18% in the second quarter of 2006
        compared to the like period of last year. The largest increases in these
        expenses are attributable to growth in credit insurance costs, outside services
        expenditures, taxes, and legal fees. For the first six months of 2006, other
        noninterest expense was 11%, or $452,000 higher than in the same period of
        last
        year.
 
 Quarter
                  Ended
              
              Six
                  Months EndedJune
                  30, 2006
              
              June
                  30, 2005
              
              June
                  30, 2006
              
              June
                  30, 2005Marketing
                  and Public Relations
              
              $
              268,000
              
              $
              350,000
              
              $
              520,000
              
              $
              704,000Credit
                  Insurance
              
              
              479,000
              
              
              346,000
              
              
              942,000
              
              
              679,000Outside
                  Services
              
              
              255,000
              
              
              154,000
              
              
              423,000
              
              
              352,000Taxes
              
              
              159,000
              
              
              84,000
              
              
              303,000
              
              
              225,000Information
                  Systems
              
              
              226,000
              
              
              226,000
              
              
              430,000
              
              
              473,000Legal
                  Fees
              
              
              118,000
              
              
              72,000
              
              
              305,000
              
              
              207,000Other
              
              
              810,000
              
              
              730,000
              
              
              1,624,000
              
              
              1,455,000Total
                  Other Noninterest Expense
              
              $
              2,315,000
              
              $
              1,962,000
              
              $
              4,547,000
              
              $
              4,095,000
 
 Marketing
        and public relations expenses declined in the second quarter of 2006 compared
        to
        the same period last year, as well as for the first six months of the year
        versus the first six months of 2005. We reduced marketing expenditures in
        our
        Residential, Income Property, and Community Business Banking departments
        during
        the first half of this year. We anticipate that marketing and public relations
        costs will be at a similar, reduced level for the remainder of the
        year.
 
 Credit
        insurance premium costs rose 39% for both the second quarter and the first
        half
        of the year. On a sequential quarter basis, the change is negligible, increasing
        only 4% over the two preceding quarters. The majority of the credit insurance
        premiums are attributable to sales finance loans and, to a lesser extent,
        residential land loans. A small share of the consumer and income property
        loan
        portfolios is also insured. As the portfolios and the percentage of the
        portfolios insured have grown, credit insurance premium expenses have increased.
        To illustrate,
  -27-
  the
        insured sales finance portfolio balance was 21% higher at June 30, 2006 than
        it
        was at the same time last year.
 
 Expenditures
        on outside services increased $101,000 in the second quarter and $71,000
        the
        first half of 2006 compared to the same periods in the prior year. The current
        quarter’s outside services expenses were 52% higher than the preceding quarter
        but only 2% greater than the fourth quarter of 2005. Most of the increase
        in the
        second quarter’s expense was the result of consulting services for evaluating
        efficiency within the commercial loan origination and servicing areas.
 
 Tax
        expense rose 88% in the second quarter of 2006. The rise in taxes in the
        first
        quarter of this year was slight, and as such the increase over the first
        half of
        2006 occurred in the second quarter. Growth in taxes was due to business
        and
        occupation taxes paid on income from sales of consumer loans. Another cause
        of
        the escalation in taxes is a direct result of our expanded footprint of sales
        finance operations across the country. As we extend our sales finance lending
        to
        more states, we are paying additional taxes to those states in which we operate.
        We are also in the process of being audited by the State of Washington
        Department of Revenue, the outcome of which has not been
        determined.
 
 Legal
        fees grew by $46,000 in the second quarter and $98,000 for the six months
        of
        2006, compared to the same time periods last year. In the first quarter of
        2006
        we saw legal cost increases due to fees associated with several non-performing
        loans. We recovered a portion of these expenses early in the second
        quarter.
 
 The
        most
        significant increase in our legal fees for the first half of this year was
        in
        our Sales Finance department. The jump in the department’s legal fees was
        associated with a biennial compliance review of the Bank’s practices in the
        states in which we do business. Sales Finance legal expenses for the second
        quarter of 2006 were $73,000 compared to $17,000 in 2005. For the six months
        ended June 30, 2006, total Sales Finance legal expenses were $128,000 versus
        a
        total of $52,000 for the same period last year.
 
 Included
        in “other” operating expense is $50,000 related to the mark-to-market of two
        interest-rate swaps that we entered into in the second quarter. These two
        swaps
        are associated with commercial loans totaling approximately $3 million.
        Offsetting this expense is $50,000 of mark-to-market revenue recorded in
“other”
income in the noninterest income section.
 
 **FINANCIAL
        CONDITION**
 
 **Assets**
 
 As
        of
        June 30, 2006, our assets totaled $1.103 billion, representing a 2% rise
        over
        both the $1.085 billion level at March 31, 2006 and the $1.086 billion level
        at
        year-end 2005. The increase was largely attributable to loan
        growth.
 
 **Securities**
 
 Security
        investments (available-for-sale and held-to-maturity) declined $13 million
        during the second quarter and $18 million during the first half of 2006,
        to $103
        million as of June 30, 2006. Our expectation for the remainder of 2006 is
        that
        while we may periodically purchase securities throughout the year to replace
        part of the run-off in securities, we do not anticipate increasing the
  -28-
  size
        of
        our securities portfolio at the present time. The decrease in securities
        in the
        second quarter is larger than we anticipate seeing in the remaining two quarters
        of this year, as we had a $7 million Treasury security mature in
        April.
 
 Over
        the
        last several quarters, we have typically found the yields available on
        investment securities to be significantly less favorable than alternative
        earnings 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, 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.
 
 Based
        on
        current accounting literature, any investment security purchased is classified
        in one of the following categories: 1) trading, 2) available-for-sale (AFS),
        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 June 30, 2006,
        the balance of the unrealized loss in comprehensive income, net of federal
        income taxes, related to the AFS securities, totaled $2.7 million, representing
        an increase over the balances at March 31, 2006, and December 31, 2005, which
        were $2.0 million and $1.5 million, respectively. 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 maturity 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 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 growing with expected future loan
        sales.
 
 Servicing
        assets rose by $836,000, or 45% in the first six months of 2006, and $228,000
        or
        9% in the second quarter. Comparatively, servicing assets increased $556,000,
        or
        36% in the first half of 2005, and $188,000, or 10% in the second quarter
        of
        last year. The growth in servicing assets is mainly attributed to higher
        volumes
        of consumer loan sales in the first six months of both the current and past
        years.
  -29-
 
 **Servicing
                  Assets**
              
              2Q
                  2006
              
              1Q
                  2006
              
              4Q
                  2005
              
              2Q
                  2005Commercial
              
              $
              287,000
              
              $
              275,000
              
              $
              292,000
              
              $
              311,000Residential
              
              
              82,000
              
              
              92,000
              
              
              114,000
              
              
              11,000Consumer
              
              
              2,333,000
              
              
              2,107,000
              
              
              1,460,000
              
              
              1,760,000Total
              
              $
              2,702,000
              
              $
              2,474,000
              
              $
              1,866,000
              
              $
              2,082,000Loan
                  Balances Serviced for Others
              
              $
              117,789,000
              
              $
              107,479,000
              
              $
              105,850,000
              
              $
              122,154,000
 
 Decreased
        consumer loan sales in the last three quarters of 2005 followed sizeable
        sales
        in the first quarter of last year. During the current year we have been
        presented with favorable opportunities to sell more consumer loans. As we
        have
        taken advantage of these opportunities, our servicing asset balance for consumer
        loans has risen in both the second quarter and year-to-date. Our consumer
        loan
        sales in the first two quarters of 2006 were comparable, with $13 million
        in
        sales in the first quarter and $10 million in the second. However, servicing
        assets increased by a lesser amount in the second quarter than observed in
        the
        first quarter. The amortization of servicing assets is evaluated on a quarterly
        basis, and at the beginning of the second quarter of 2006, the actual
        amortization of servicing assets changed to reflect a shorter average life
        of
        the consumer loans sold. This condensing of the average life consequently
        increased the amortization amount per time period. As the amortization amount
        increased at a faster rate, the corresponding servicing asset balances grew
        at a
        slower pace.
 
 Servicing
        assets related to commercial loans decreased slightly from the second quarter
        and year-end of 2005 but showed a modest climb from March 31, 2006. Last
        year’s
        second quarter was especially large due to a 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. We continue
        to
        investigate opportunities to sell participations in our commercial real estate
        loans; however, given the unique nature of these sales, the volumes of
        commercial real estate loans and the gains thereon can result in significant
        balance fluctuations across time periods.
 
 Residential
        loans are generally sold servicing released and subsequently, no servicing
        asset
        is acquired. The Bank made a sale in the fourth quarter of 2005 that retained
        servicing rights. Sales since that time were made without maintaining servicing,
        resulting in a decline in the residential servicing assets in the first and
        second quarters of this year.
 
 **Loans**
 
 Loans
        receivable, excluding loans held-for-sale, increased $31 million from $878
        million at the close of 2005 to $909 million at June 30, 2006, with the vast
        majority of this growth, or approximately $27 million, occurring in the second
        quarter. Loan originations rose 15% in the second quarter and 10% in the
        first
        six months of 2006, compared to the same periods last year.
  -30-
 
 **Portfolio
                  Distribution**
              
              Q2
                  2006
              
              Q1
                  2006
              
              Q4
                  2005
              
              Q2
                  2005Single
                  Family (includes held-for-sale)
              
              
              26
              %
              
              26
              %
              
              25
              %
              
              24
              %Income
                  Property
              
              
              28
              %
              
              31
              %
              
              34
              %
              
              37
              %Business
                  Banking
              
              
              16
              %
              
              14
              %
              
              13
              %
              
              13
              %Commercial
                  Construction
              
              
              5
              %
              
              4
              %
              
              3
              %
              
              3
              %Single
                  Family ConstructionSpec
                  Construction
              
              
              3
              %
              
              3
              %
              
              2
              %
              
              2
              %Custom
                  Construction
              
              
              10
              %
              
              10
              %
              
              10
              %
              
              9
              %Consumer
              
              
              12
              %
              
              12
              %
              
              13
              %
              
              12
              %Total
              
              
              100
              %
              
              100
              %
              
              100
              %
              
              100
              %
 
 The
        business banking and residential lending portfolios experienced significant
        increases in the first half of 2006. The business banking portfolio has shown
        substantial, consistent growth in both the first and second quarters of this
        year, rising $25 million in the second quarter and $35 million year-to-date.
 
 The
        residential lending portfolio showed considerable expansion from the first
        of
        the year through April, followed by a slowdown in May and June, resulting
        in
        year-to-date growth of $17 million. The residential loans in our portfolio
        are
        typically non-conforming residential loans that do not meet the requirements
        for
        sale into the secondary market and generally offer higher yields than conforming
        residential mortgages. These non-conforming loans are still considered eligible
        collateral for borrowing from the FHLB.
 
 Income
        property loans, as a percentage of the total portfolio, continue to decline.
        These loans consist of mortgages on investor-owned commercial real estate
        and
        multifamily properties. The steady decrease 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 buyers 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.
 
 We
        have
        undertaken several initiatives to reduce the high prepayment rates in the
        income
        property loan portfolio and to address borrowers’ requests for fixed-rate loans.
        In an effort to prevent prepayments of certain loans, we offered rate
        modifications to some of our borrowers. While these modifications effectively
        reduced asset yields and negatively impacted the net interest margin, we
        believe
        that the benefits outweighed the costs. The impact to net interest income,
        and
        ultimately earnings, as a result of these modifications is less than what
        the
        reduction
  -31-
  in
        net
        interest income would have been had these loans paid off and refinanced
        elsewhere, effectively compressing our income property portfolio. We also
        offer
        interest-rate derivatives to hedge interest rate risk associated with extending
        longer-term, fixed-rate loans to certain commercial real estate borrowers.
        These
        derivatives allow us to provide loans with terms more favorable to certain
        borrowers while offsetting any potential interest rate risk to the Bank as
        a
        consequence of offering loans with these terms.
 
 Consumer
        loans have maintained a stable share of the overall loan portfolio at 12%
        for
        both the first and second quarters of 2006. Worth noting is the fact that
        this
        percentage has held steady despite substantial sales, in the amount of $23
        million, of consumer loans in the first half of the year.
 
 **Deposits
        and Borrowings**
 
 While
        our
        total deposit balances showed only a modest decrease of $376,000 from year-end
        2005 to $760 million at June 30, 2006, deposit balances fell $23 million
        over
        the second quarter.
 
 Checking
        and money market balances declined slightly in the second quarter but increased
        overall during the first six months of the 2006, showing a balance of $286
        million as of June 30, 2006, compared to $291 million at March 31, 2006,
        and
        $263 million at year-end 2005. We consider growth in these types of deposits
        to
        be very favorable, as greater checking and money market deposits typically
        help
        us to decrease our overall cost of funds. To encourage development in this
        area,
        we actively monitor the products and rates offered by our competitors in
        the
        local market and develop new products and/or offer aggressive rates to attract
        new balances in the most cost-effective manner possible.
 
 Retail
        time deposit balances continued to decline in the second quarter, continuing
        the
        trend observed in the first quarter. During the first half of this year we
        have
        undertaken an initiative to move away from offering rates competitive with
        the
        higher rates in the local market. Our aim is to avoid locking in long-term
        deposits at higher rates. While this has resulted, and will persist 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. The larger drop in retail time deposit balances
        in the
        second quarter when compared to the first was partially due to the unusually
        high number of certificates maturing in the second quarter. The impact of
        our
        new pricing initiative on time deposits was more pronounced as this larger
        volume of time deposits was subject to renewal.
 
 Our
        preferred supplemental funding mechanism is borrowing funds from the FHLB.
        After
        declining in the first quarter, advances from the FHLB rose in the second
        quarter, moving from $226 million as of December 31, 2005, to $207 million
        as of
        the first quarter-end, to $248 million at the end of the recent period. With
        the
        higher deposit balance gains in the first three months of 2006, the need
        for
        FHLB borrowings declined. Deposit balance runoff in the second quarter, coupled
        with asset growth, resulted in the use of additional FHLB money. As of June
        30,
        2006, we had the authority to borrow up to $441 million from the FHLB subject
        to
        the level of eligible collateral available.
 
 During
        the first quarter of this year, modest asset growth and substantial non-maturity
        deposit balance increases allowed us to reduce the amount of funding borrowed
        from the FHLB and improve our funding mix. Unfortunately, this trend did
        not
        continue into the second quarter. Non-maturity deposit balances peaked in
        mid-April, then steadily declined for the next month as
  -32-
  a
        result
        of outflows for federal income tax and state property tax payments, as well
        as
        significant reductions in balances retained from a large commercial customer.
        While we did recover some of this loss in June, our non-maturity deposits
        ended
        the quarter at a lower level than at which the quarter began. As our loan
        portfolio, and thus our total assets, grew in the second quarter, our usage
        of
        wholesale funding sources increased to compensate for the larger loan portfolio
        and the diminished deposit growth.
 
 **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 Chief Risk Officer, 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.
 
 For
        the
        quarter, we reserved $135,000 in provisions for loan losses, down significantly
        from the $450,000 provision reserved in the second quarter of 2005. Similarly,
        through the first six months of the year, the $206,000 reserved in 2006
        represented a significant reduction relative to the $850,000 provision for
        the
        first half of 2005. The reductions in this year’s provision were based in large
        part on significant recoveries in the first and second quarters resulting
        in
        very low net charge-off levels relative to historical norms as well as the
        high
        levels of sales of consumer loans, which typically constitute the majority
        of
        our charged-off balances. Our charged-off loan balances, net of recoveries,
        totaled only $60,000 in the second quarter of 2006 and $113,000 for the first
        half of the year. In contrast, net charge-offs totaled $231,000 and $442,000
        in
        the second quarter and first half of 2005. Also contributing to the reduction
        in
        the first quarter provision was a significant slowdown in the rate of loan
        portfolio growth during that quarter, and the fact that the loan growth that
        was
        experienced had been largely attributable to our residential lending segment,
        which is generally considered lower risk than other lending
        segments.
 
 Including
        $341,000 for unfunded commitments, which is included in “accounts payable and
        other liabilities” on our balance sheet, our reserve for loan losses totaled
        approximately $10.2 million at June 30, 2006, up from $9.7 million at June
        30,
        2005 and $10.1 million at the 2005 year-end. At this level, the allowance
        for
        loan losses represented 1.09% of gross loans at June 30, 2006, compared to
        1.13%
        at the 2005 year-end and 1.14% as of June 30, 2005.
  -33-
  Economic
        conditions in the Puget Sound metropolitan area remained favorable, with
        solid,
        though not dramatic growth. Per the FDIC summer 2006 Washington state profile,
        Washington ranked ninth in the nation for job growth in the first quarter
        of
        2006, with a 3.4% annual gain in non-farm employment as the state’s unemployment
        rate declined to 4.7% in first quarter 2006. The FDIC profile further indicated
        that despite signs of the market beginning to slow, the local housing market
        remained strong, with the year-over-year rate home price appreciation of
        19.4%,
        outpacing all but seven states in first quarter 2006.
 
 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. At June 30, 2006, our total non-performing assets (NPAs) declined
        to
        $386,000, or 0.03% of total assets, compared to $897,000, or 0.08% at the
        2005
        year-end and $797,000, also 0.08%, at June 30, 2005. The comparative ratio
        for
        all FDIC-insured institutions was 0.48% at March 31, 2006 (*). 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.
 
 **
        First Quarter 2006 FDIC Quarterly Banking Profile*
  **Non-Performing
        Assets**
  Our
        exposure to non-performing assets as of June 30, 2006 was:
 
 Fifty-four
                  consumer loans. Full recovery anticipated frominsurance
                  claims.
              
              $
              264,000One
                  land loan in Western Washington. *
              
              
              52,000Seven
                  consumer loans. No anticipated loss.
              
              
              39,000Eight
                  consumer loans. Possible loss of the total loan balances.
              
              
              31,000Total
                  Non-Performing Assets
              
              $
              386,000
  *During
        the second quarter an impairment charge was recorded for $110,000 for this
        loan.
        The balance owing on the loan at the time was $162,000. Subsequent to the
        end of
        the second quarter this property was sold at a trustee’s sale for $134,000.
        During the third quarter a recovery of $82,000 will be recorded reflecting
        the
        sale.
 
 **PORTFOLIO
        INFORMATION**
 
 **Commercial
        Real Estate Loans**
 
  The
        average loan size (excluding construction loans) in the Commercial Real Estate
        portfolio was $714,000 as of June 30, 2006, with an average loan-to-value
        ratio
        of 62%. At quarter-end, none of these commercial loans 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 40% residential (multifamily or mobile home
        parks) and 60% 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
  -34-
  financial
        institutions. About 13% 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 increased $3 million to $82 million, based
        on $22
        million in new loan production, $10 million in loan sales, and loan prepayments
        that ranged from 30%-40% (annualized).
  We
        manage
        the portfolio by segregating it into its uninsured and insured balances.
        The
        uninsured balance totaled $50 million at the end of the second 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 741 while the insured loans have an average score
        of
        672. 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 $55,000 in net recoveries for the most recent quarter
        to a
        high of $223,000 in charge-offs in the first quarter 2006. 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.
 
 **UNINSURED
                  PORTFOLIO - BANK BALANCES****Bank
                  Balance**
              **Net
                  Charge-Offs**
              **Charge-offs**
                **(%
                  of Bank**
                **Portfolio)**
              **Delinquent
                  Loans**
                **(%
                  of Bank**
                **Portfolio)**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%June
                  30, 2006
              $50
                  million
              (
                  $55,000)
              (
                  0.11%)
              0.58%
  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 $344,000 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 also largely related to
        bankruptcy filings immediately before the change in bankruptcy laws. 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)**June
                  30, 2005
              $  
                  344,000
              0.67%
              3.23%September
                  30, 2005
              $  
                  493,000
              0.91%
              3.64%December
                  31, 2005
              $1,023,000
              1.87%
              3.60%March
                  31, 2006
              $  
                  985,000
              1.81%
              3.60%June
                  30, 2006
              $  
                  483,000
              0.86%
              3.25%
  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
  -35-
  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 was competitive
        with the premiums that we were paying to Insurer #1, however, beginning July
        1,
        2006 those premiums have been raised by about 60%. Unlike the other insured
        pools, the premium coverage on this pool with Insurer #2 is subject to periodic
        adjustments based on their claims experience.
  **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
              $  8,038,000
              $2,144,000
              $2,144,000
              $0
              0%
              4.50%2003/2004
              $35,242,000
              $16,895,000
              $3,524,000
              $2,671,000
              $853,000
              5.05%
              4.23%2004/2005
              $23,964,000
              $15,725,000
              $2,396,000
              $  
                  795,000
              $1,601,000
              10.18%
              3.60%
  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
              $ 
                  8,038,000
              $1,077,000
              $101,000
              $976,000
              12.14%
              4.50%2005/2006**
              $17,811,000
              $15,367,000
              N/A**
              $ 
                  64,000
              N/A
              N/A
              1.53%
  *Loans
        in
        this policy year are the same loans insured with Insurer #1 during the same
        time
        period.
  **Not
        Applicable. Policy year closes on 7/31 of each year.
  The
        prepayment speeds for the entire portfolio continue to remain in a range
        of 30%
        to 40%. During the second quarter of 2006, the average new loan amount was
        $11,113. The average loan balance in the entire portfolio is $9,100, and
        the
        yield on this portfolio is 10.42%. Loans with credit insurance in place
        represent 39% of our portfolio balance, and 29% (by balance) of the loans
        originated in the second quarter were insured.
  **Residential
        Lending**
  The
        residential lending portfolio (including loans held for sale) totaled $325
        million on June 30, 2006. This represents a decrease of $3 million from the
        end
        of the first quarter, 2006. The breakdown of that portfolio at June 30, 2006
        was:
 Bank
                  Balance
              
              %
                  of PortfolioAdjustable
                  rate permanent loans
              $177
                  million
              
              55%Fixed
                  rate permanent loans
              $
                   10 million
              
              3%
  -36-
  Residential
                  building lots
              $ 
                  43 million
              
              13%Disbursed
                  balances on custom construction loans
              $ 
                  89 million
              
              27%Loans
                  held-for-sale
              $   
                  6 million
              
              2%Total
              $325
                  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. The average
        loan balance in the permanent-loan portfolio is $199,000, and the average
        balance in the building-lot portfolio is $112,000. 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 15%, from 2,088 at June
        30,
        2005, to 2,397 as of June 30, 2006, a gain of 309 accounts. The deposit balances
        for those accounts grew 13%. Consumer checking accounts also increased, from
        7,183 in the second quarter of 2005 to 7,568 this year, an increase of 385
        accounts, or 5%. Our total balances for consumer checking accounts declined
        5%.
  The
        following table shows the distribution of our deposits.
  **Time**
                **Deposits**
              
              **Checking**
              
              **Money
                  Market**
                **Accounts**
              
              **Savings**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%June
                  30, 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:
  -37-
 
 ·
              *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.
 
 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
              
              Six
                  Months EndedNet
                  Income
              
              Return
                  on Equity
              
              Net
                  Income
              
              Return
                  on EquityJune
                  30, 2004
              $
                  201,000
              
              10.29%
              
              $
                  569,000
              
              14.40%June
                  30, 2005
              $
                  127,000
              
              5.40%
              
              $
                  514,000
              
              11.45%June
                  30, 2006
              $
                  353,000
              
              15.24%
              
              $
                  855,000
              
              18.57%
 
 The
        Consumer Lending segment’s net income rose significantly relative to the second
        quarter and first six months of last year based on a combination of earning
        asset growth and net interest income, a reduction in the provision for loan
        losses, and additional noninterest income, particularly gains on loan sales,
        compared to the prior year. These improvements were, however, partially offset
        by a substantial increase in noninterest expense.
 
 As
        of the
        end of the second quarter, the Consumer segment’s earning assets totaled
        approximately $123 million, an increase of nearly 6% over the prior year’s
        level, despite consumer loan sales in excess of $23 million in the first
        half of
        this year. With the additional earning assets relative to the prior year,
        new
        fixed-rate consumer loans bearing higher rates than the older loans in the
        portfolio, and continued increases in the Prime rate benefiting our home
        equity
        line of credit (HELOC) portfolio, the Consumer Lending segment’s interest income
  -38-
  increased
        approximately 17% relative to the second quarter and 19% compared to the
        first
        half of last year.
 
 By
        comparison, however, interest expense rose 38% and 44% relative to the same
        periods last year. In addition to the cost of the additional funds required
        to
        support the growth in earning assets, the increase in interest expense was
        driven by large FHLB advance balances that matured over the first quarter
        of
        2006 and substantial time deposit balances maturing in the second quarter.
        Based
        on increases in interest rates since the times these advances and time deposits
        were originated, these liabilities were subject to renewal at rates much
        higher
        than their original rates, resulting in a significant increase in interest
        expense relative to the prior year.
 
 Combined,
        these factors resulted in an increase of nearly 5% in the Consumer segment’s net
        interest income relative to its second quarter 2005 level and a 6% increase
        from
        its level for the first half of last year. Following a $205,000 reduction
        in the
        second quarter provision for loan loss relative to the prior year, the segment’s
        net interest income after provision increased $273,000 and $504,000, or
        approximately 21% and 19% relative to the second quarter and first half of
        2005.
        Significant recoveries on previously charged-off loans during the second
        quarter, combined with the high level of loan sales and resulting slowdown
        in
        loan portfolio growth, led to the significant reduction in the segment’s
        provision for loan losses. While we expect our improved collection efforts
        will
        contribute to a reduced level of loan losses relative to prior years, we
        believe
        that the recoveries and resulting provision for loan loss this quarter
        represents an unusual situation and expect our provision for loan losses
        to
        return to a level more consistent with historical norms in future
        quarters.
 
 The
        Consumer segment’s noninterest income exceeded the prior year levels by $242,000
        for the second quarter and $537,000 for the first half based on significantly
        higher volumes of loan sales and gains thereon. For the quarter, gains on
        consumer loan sales totaled $430,000 on sales of $10 million, up from $201,000
        on sales of $5 million in the second quarter of last year. Similarly, gains
        on
        sales through the first half of this year totaled $1,178,000 on sales of
        $23
        million, compared to $702,000 on sales of nearly $16 million last year. Based
        on
        our current levels of loan production and market demand, our expectation
        is for
        third quarter consumer loan sales to total in the $18 million to $21 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 $174,000
        and $508,000, or 10% and 15% compared to the second quarter and first half
        of
        last 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, additional expenditures
        for
        temporary office help, and the arrival of new personnel including a new manager
        for our Sales Finance lending area, as well as higher legal expenses for
        our
        Sales Finance operations. The increase in legal expenses was attributable
        to the
        biennial compliance review process that evaluates our practices in the states
        in
        which we do business.
  -39-
  **Residential
        Lending**
 
 Quarter
                  Ended
              
              Six
                  Months EndedNet
                  Income
              
              Return
                  on Equity
              
              Net
                  Income
              
              Return
                  on EquityJune
                  30, 2004
              $
                  750,000
              
              28.80%
              
              $
                  1,384,000
              
              27.35%June
                  30, 2005
              $
                  870,000
              
              25.07%
              
              $
                  1,617,000
              
              24.57%June
                  30, 2006
              $
                  863,000
              
              24.22%
              
              $
                  1,930,000
              
              27.01%
 
 For
        the
        second quarter of 2006, the Residential Lending segment’s net income totaled
        $863,000, virtually unchanged from the same period last year, as improvements
        in
        net interest and noninterest income were essentially offset by increased
        noninterest expenses. For the six months ended June 30, this year’s net income
        totaled over $1.9 million, a 19% increase over the first half of 2005, with
        the
        improvement resulting from growth in both net interest income and noninterest
        income, as well as a reduction in the provision for loan loss. These
        improvements were also, however, partly offset by rising operating
        expenses.
 
 The
        Residential segment has established a track record for consistent earning
        asset
        growth in recent years, which continued through the most recent quarter,
        with
        the segment’s June 30, 2006 balance indicating earning asset growth of
        approximately $37 million relative to the level one year prior. 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 $1.5 million and $3.4 million, or 29% and 35%
        relative to the second quarter and first six months of last year.
 
 As
        with
        the Consumer Lending segment, the rates of increase for the Residential
        segment’s interest expense exceeded the rates of interest income growth,
        totaling 63% and 66% relative to the quarter and six months ended June 30,
        2005
        due to the rising deposit and wholesale funding rates mentioned earlier,
        as well
        as the cost of the additional funds required to support the earning asset
        growth. With the increase in funding costs and a $62,000 increase in the
        segment’s provision for loan loss compared to the second quarter of 2005, the
        segment’s net interest income after provision was virtually unchanged from the
        second quarter of last year, increasing approximately 1%, or $30,000. For
        the
        six months ended June 30, this year’s net interest income after provision
        exceeded the prior year by nearly 15%.
 
 The
        Residential Lending segment’s noninterest income rose $135,000, or 43%, for the
        quarter, and $110,000, or 21%, for the year-to-date period based on an
        allocation to the business segments of insurance proceeds received from a
        key-man life insurance policy.
 
 The
        Residential segment’s noninterest expense increased $174,000, or 9% for the
        quarter, more than offsetting the income growth over the same period last
        year.
        Similarly, for the six months ended June 30, noninterest expense totaled
        $422,000 more in 2006 than in the prior year. In both cases, a reduction
        in the
        amount of loan origination expenses eligible for deferral and amortization
        contributed significantly to the increase relative to last year.
 
 In
        accordance with current accounting standards, certain loan origination costs
        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 as well as the deferred costs associated with each origination
        declined relative to the prior year.
  -40-
  This
        resulted in a lower level of expense being deferred and a higher level of
        expense being recognized in the current period.
 
 Also
        contributing to the additional expense in the first half of 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
              
              Six
                  Months EndedNet
                  Income
              
              Return
                  on Equity
              
              Net
                  Income
              
              Return
                  on EquityJune
                  30, 2004
              ($
                  173,000)
              
              (9.55%)
              
              ($
                  209,000)
              
              (5.63%)June
                  30, 2005
              $ 
                   58,000
              
              2.15%
              
              $    
                  3,000
              
              0.06%June
                  30, 2006
              $  
                  48,000
              
              1.40%
              
              ($  
                  63,000)
              
              (0.98%)
 
 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 help 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.
 
 The
        Business Banking segment’s second quarter net interest income after provision
        for loan losses rose $360,000, or 26% over the same period last year, the
        largest increases of any business segment. Similarly, for the first half
        of
        2006, the segment’s net interest income after provision for loan losses exceeded
        the prior year level by $553,000, or 20%, the highest percentage increase
        among
        the four segments and second largest dollar increase behind the Residential
        segment. Like the Consumer and Residential segments, the Business Banking
        segment succeeded in building incremental assets over the prior year, with
        earning assets totaling $179 million as of June 30, 2006, an increase of
        36%
        over the prior year level and the highest rate of increase for any of the
        four
        business segments.
 
 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. While the majority of adjustable-rate loans in our portfolio reprice
        according to contractually defined schedules, most commonly on an annual
        basis,
        the rates on prime-based loans typically adjust in response to any change
        in the
        prime rate. Consequently, these loans may reprice on several occasions during
        a
        given year, and have done so over the course of 2004, 2005, and the first
        half
        of 2006.
 
 For
        the
        quarter, the Business Banking segment’s noninterest income was virtually
        unchanged from the prior year, increasing less than 1% relative to the second
        quarter 2005 level. On a year-to-date basis, the segment’s noninterest income
        rose $47,000, or more than 12% relative to the prior year. Contributing to
        the
        increase in miscellaneous fee income was $50,000 related to the
        marking-to-market of two interest-rate derivatives into which we entered
        during
        the second quarter. This income was essentially matched by $50,000 of
        mark-to-market losses on offsetting derivatives recorded in our other
        noninterest expense. These derivatives are associated with two commercial
        loans
        totaling approximately $3 million and are marked-to-market each quarter.
        The
        derivatives were utilized to hedge interest rate risk associated with extending
        longer-term, fixed-rate periods on commercial real estate loans, and structured
        such that a gain on any given derivative would be matched against a nearly
        identical loss on an offsetting derivative, resulting in essentially no net
        impact to the Bank. To the extent that we continue to offer similar longer-term,
        fixed-
  -41-
  rate
        periods on commercial real estate loans in the future and use similar derivative
        structures to manage interest rate risk, this income, as well as the offsetting
        expense, would be expected to increase in future periods. The segment’s
        noninterest income has also benefited from the expansion of the 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 additional noninterest
        expense of $375,000 relative the second quarter and $702,000 compared to
        the
        first six months of last year. Increases in expenses from our retail banking
        centers and other administrative departments allocated to the Business Banking
        segment made the most significant contributions to the growth in noninterest
        expense. 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. An increase was
        also
        observed in the segment’s compensation expense due to higher loan officer
        commissions in response to this year’s production of earning asset and deposit
        balances. Additionally, the previously mentioned $50,000 of mark-to-market
        losses on the offsetting derivatives to those described in the discussion
        of the
        segment’s noninterest income were included in the segment’s noninterest
        expense.
 
 **Income
        Property Lending**
 
 Quarter
                  Ended
              
              Six
                  Months EndedNet
                  Income
              
              Return
                  on Equity
              
              Net
                  Income
              
              Return
                  on EquityJune
                  30, 2004
              $
                  1,408,000
              
              19.23%
              
              $
                  2,757,000
              
              19.06%June
                  30, 2005
              $
                  1,462,000
              
              19.17%
              
              $
                  2,968,000
              
              19.53%June
                  30, 2006
              $
                  1,448,000
              
              21.85%
              
              $
                  2,703,000
              
              20.29%
 
 The
        Income Property segment’s net income for the second quarter and first six months
        of 2006 declined relative to the same periods last year, 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.
 
 For
        the
        second quarter, the segment’s net interest income after provision for loan loss
        declined $150,000, or 4%, from the prior year level, based on interest income
        growth of 9% and a more than offsetting 33% increase in interest expense.
        The
        year-to-date results appeared similar, as a 33% increase in interest expense
        exceeded the 7% growth in interest income. Unlike our other business segments,
        the Income Property segment’s portfolio of earning assets declined in the second
        quarter of 2006, continuing a trend observed in recent quarters.
 
 The
        contraction of the segment’s earning assets has been largely attributable to
        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
  -42-
  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.
 
 To
        address these problems, we have begun utilizing interest rate swaps in
        connection with the underwriting of longer-term, fixed-rate commercial real
        estate loans, which address prospective borrowers’ demand for longer-term,
        fixed-rate loans, and the preference of depositors for instruments of
        significantly shorter terms. With these interest rate swaps, we can originate
        commercial mortgage loans with amortization schedules of up to thirty-years
        and
        a fixed-rate for the ten-years until the loan’s contractual maturity. To hedge
        the interest rate risk exposure presented by these ten-year, fixed-rate
        instruments, we utilize interest rate swaps on a loan-by-loan basis to convert
        each loan’s fixed interest rate to an adjustable market index rate subject to
        regular repricing, typically the one-month LIBOR rate, plus a margin determined
        at the time the swap is put in place.
 
 The
        segment’s second quarter noninterest income rose $107,000, or 29%, relative to
        the same period last year, and $137,000, or 24%, for the year-to-date period
        based on an allocation to the business segments of insurance proceeds received
        from a key-man life insurance policy. The allocation of these proceeds offset
        a
        reduction in gains on loan sales relative to the prior year. While we sold
        participations in several commercial real estate loans during the second
        quarter
        of 2006, gains still trailed their year ago levels. In June 2005, we sold
        participations in a large commercial real estate credit that included both
        the
        construction financing as well as the permanent mortgage to refinance that
        loan
        following the completion of construction, which resulted in an unusually
        large
        gain on sale.
 
 In
        contrast to the other business segments, noninterest expense for the Income
        Property segment declined by 2% compared to the second quarter of last year,
        and
        3% relative to the first half of the year. As previously noted, 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
  -43-
  significant
        source of liquidity, is a consistent source based upon the quality of our
        earnings. Our principal uses of liquidity are the origination and acquisition
        of
        loans and securities, and to a lesser extent, to purchase facilities and
        equipment.
 
 Quarter
                  Ended
              
              Six
                  Months EndedJune
                  30,2006
              
              June
                  30,2005
              
              June
                  30,2006
              
              June
                  30,2005(Dollars
                  in thousands)Loan
                  Originations (disbursed)
              
              $
              158,000
              
              $
              137,000
              
              $
              280,000
              
              $
              255,000Increase/(Decrease)
                  in Undisbursed
                Loan
                  Proceeds
              
              
              (3,000
              )
              
              4,000
              
              
              2,000
              
              
              11,000Security
                  Purchases
              
              
              0
              
              
              0
              
              
              7,000
              
              
              6,000Total
                  Originations and Purchases
              
              $
              155,000
              
              $
              141,000
              
              $
              289,000
              
              $
              272,000Loan
                  and Security Repayments
              
              $
              105,000
              
              $
              103,000
              
              $
              217,000
              
              $
              186,000Sales
                  of Loans
              
              
              28,000
              
              
              12,000
              
              
              51,000
              
              
              30,000Total
                  Repayments and Sales
              
              $
              133,000
              
              $
              115,000
              
              $
              268,000
              
              $
              216,000Net
                  Difference
              
              $
              22,000
              
              $
              26,000
              
              $
              21,000
              
              $
              56,000
 
 Loan
        and
        security sales and repayments, our most significant 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
        38% in
        the first half of 2006, compared to 40% for the first quarter and 35% for
        the
        fiscal year 2005.
 
 We
        believe the flat to inverted shape of the yield curve in the first six months
        of
        2006 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.
 
 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 second quarter and
        first
        six months of 2005 and 2006, changes in funds from deposits and borrowings
        were
        as follows:
 
 Quarter
                  Ended
              
              Six
                  Months EndedJune
                  30, 2006
              
              June
                  30, 2005
              
              June
                  30, 2006
              
              June
                  30, 2005(Dollars
                  in thousands)Deposits
              
              $
              (23,000
              )
              $
              28,000
              
              $
              0
              
              $
              44,000Borrowings
              
              
              41,000
              
              
              (5,000
              )
              
              23,000
              
              
              (6,000
              )Total
              
              $
              18,000
              
              $
              23,000
              
              $
              23,000
              
              $
              38,000
  -44-
 
 After
        substantial growth in the first quarter of 2006, our deposits, including
        those
        issued through brokerage services, ended the second quarter of 2006 at virtually
        the same level as December 31, 2005. While the overall level of deposits
        showed
        little change over the last six months, our deposit mix changed significantly,
        with over $21 million in non-maturity deposit growth offsetting a similar
        reduction in time deposit balances. Some of the runoff in retail time deposits
        was offset by the addition of $7 million in brokered deposits, which is the
        net
        of $27 million in new brokered deposits less $20 million which have matured
        since December 31, 2005.
 
 In
        our
        commentary following the first quarter of this year, we noted that a combination
        of slow asset growth and a substantial increase in non-maturity deposit balances
        had allowed us to take steps in improving our funding mix by reducing balances
        borrowed from the FHLB. Unfortunately, these trends did not continue in the
        second quarter. Following the impressive deposit growth in the first quarter,
        balances peaked in mid-April, then steadily declined for the next month as
        a
        result of outflows for federal income tax and state property tax payments,
        as
        well as a substantial reduction in balances maintained by a large commercial
        customer. While some recovery occurred in June, our deposit balances ended
        the
        second quarter at a level lower than that at which the quarter began.
        Additionally, following a quarter marked by the absence of asset growth,
        the
        size of our loan portfolio increased significantly in the second quarter.
        Both
        the deposit runoff and asset growth resulted in an increased usage of wholesale
        borrowings in the second quarter.
 
 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 $248 million at June 30, 2006. Our credit
        line
        with the FHLB is reviewed annually, and our maximum allowable borrowing level
        is
        currently set at 40% of assets or $441 million. As a percentage of quarter-end
        assets, our FHLB borrowings totaled 23%, compared to 22% at June 30, 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 sufficient collateral to utilize our available
        FHLB line as needed is monitored to ensure that ample collateral is available
        to
        meet our funding needs. Eligible collateral to secure our FHLB line totaled
        $302
        million as of June 30, 2006, representing 27% 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
        June 30, 2006, single-family loans represented 26% of our total loan portfolio,
        up from 25% at the year-end and 24% at June 30 of last year. The percentage
        of
        multifamily loans, on the other hand, has fallen from 20% at June 30, 2005,
        to
        17% at the year-end, to 14% at the end of the present quarter. Combined,
        single-family and multifamily loans comprised 40% of our loan portfolio as
        of
        June 30, 2006, which is down from the 44% level at the same period last year.
        Because single-family lending is our most profitable business segment and
        has
        exhibited steady growth in the last few
  -45-
  years,
        we
        are encouraged that the business line will be able to provide sufficient
        collateral to meet our FHLB borrowing requirements.
 
 Brokered
        deposits, which are included in the deposit totals, amounted to $49 million
        as
        of June 30, 2006, compared to $51 million at March 31, 2006, and $41 million
        at
        June 30 of last year. 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 last quarter of 2005 and
        the
        first two quarters of this year, 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 June 30, 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. Policy limits dictate that up to 20%, or $152 million as of June
        30,
        2006, of total deposits may be composed of brokered deposits. A risk associated
        with this type of funding is that the market would be unable to accept a
        high
        enough volume of brokered deposits from our Bank to reach the 20% policy
        limit.
        In addition, any perceived or factual reputation risk associated with the
        Bank
        could endanger our ability to collect deposits from brokered or institutional
        sources. Again, the Bank works to mitigate such risk by actively managing
        the
        credit quality of our loans and securities, and the quality and consistency
        of
        our earnings.
 
 Reverse
        repurchase lines are lines of credit, typically collateralized by securities.
        One available line has a limit of $10 million. While securities are the
        preferred source of collateral on this line, loans may be used as collateral
        as
        well, including loans that are not otherwise eligible for FHLB advances.
        The
        other accessible line does not have a specific borrowing limit, but rather
        the
        borrowing ceiling is dependent on the Bank’s eligible collateral, the source of
        which is non-pledged securities. As of June 30, 2006, eligible collateral
        available was $72 million. 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. Risk mitigation techniques
        include attending to the quality and reliability of our earnings, as well
        as to
        the quality of our credit.
 
 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 half of 2006 we spent $2.7 million
        in
        this area, of which $1.3 million was expended in the second quarter. Last
        year
        we invested $3.9 million in these assets in the first six months of the year.
        Over the remainder of the year we have allocated $1.7 million for facilities
        and
        equipment expenditures. Planned projects include continued renovation of
        portions of First Mutual Center and continuing construction on our new banking
        center at Canyon Park.
  -46-
 
 **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 June 30,
        2006, we exceeded the capital levels required to meet the definition of a
        well-capitalized institution:
 
 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.
              11.10%
              
              8.00%
              
              N/AFirst
                  Mutual Bank
              11.05
              
              8.00
              
              10.00%Tier
                I capital (to risk-weighted assets):First
                  Mutual Bancshares, Inc.
              9.89
              
              4.00
              
              N/AFirst
                  Mutual Bank
              9.84
              
              4.00
              
              6.00Tier I capital
                (to
                average assets):First
                  Mutual Bancshares, Inc.
              7.44
              
              4.00
              
              N/AFirst
                    Mutual Bank
              7.54
              
              4.00
              
              5.00
 
 
 **SUBSEQUENT
        EVENTS**
 
 In
        our
        second quarter 2006 Press Release dated July 19, 2006 we stated that we were
        in
        negotiations to sell our 2002/2003 pool of Sales Finance loans and that it
        was
        our intent to complete the sale during the third quarter.  Subsequent to
        that time the decision has been made to retain those loans within the portfolio.
        We also noted in that release that the insurance rate by Insurer #2 had been
        raised by 60%. We have subsequently canceled the coverage with Insurer #2
        because of the rate increase and currently only carry insurance with the
        original insurer. Because the policy limit of 10% of original loan balances
        has
        been reached with the original insurer we effectively have no coverage for
        loss
        claims on this pool.
 
 On
        July
        28, 2006 we declared a 5-for-4 stock split to be distributed on October 4,
        2006
        to shareholders of record on September 13, 2006.
 
 The
        FDIC
        recently completed a Community Reinvestment Act examination to assess our
        record
        of meeting the credit needs of our entire community, including low- and moderate
        income neighborhoods, consistent with safe and sound operations. We were
        rated
“needs to improve” for the three-year period ending December 31, 2005. The FDIC
        public disclosure performance evaluation is available from the Bank’s CRA
        officer and will be available shortly on the FDIC’s website.
  -47-
 
 This
        rating will be taken into account by the FDIC in considering an application
        for
        approval of the establishment of a new banking center, the relocation of
        our
        main office or a banking center, or the merger, consolidation, acquisition
        of
        assets, or assumption of liabilities. This rating may be the basis for denying
        or conditioning approval of such an application.
  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.
 
 **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
        and
        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.
  -48-
 
 **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 is 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.
 
 In
        the
        second quarter of 2006, we began to utilize interest rate swaps in connection
        with the underwriting of longer-term, fixed-rate commercial real estate loans.
        This decision was the result of prospective borrowers’ demand for longer-term,
        fixed-rate loans, and the preference of depositors for instruments of
        significantly shorter terms. Under this program, we originate commercial
        mortgage loans with amortization schedules of up to thirty-years, with an
        initial ten year fixed rate. To hedge the interest rate risk exposure presented
        by ten-year, fixed-rate instruments, we utilize interest rate swaps on a
        loan-by-loan basis to convert each 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, with the first two such credits
        just originated in the second quarter, 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 will
        not
        be used for any speculative purposes.
 
 **Net
        Interest Income (NII) and Economic Value of Equity (EVE) Simulation Model
        Results**
 
 **June
                  30, 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
              
              0.40%
              (3.52%)
              
              0.06%
              (2.72%)+100
              
              n/a
              (1.11%)
              
              n/a
              (0.55%)-100
              
              n/a
              0.58%
              
              n/a
              (1.94%)-200
              
              1.44%
              (1.06%)
              
              (1.32%)
              (6.54%)
 
 **Net
        Interest Income Simulation**
 
 Our
        income simulation model, based on information as of June 30, 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 0.40% was
        observed in the rising rate environment, and a change of 1.44% was indicated
        in
        the falling rate scenario.
  -49-
 
 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,
        with no growth or contraction regardless of interest rate movements. 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 then 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 June 30, 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 2.52%, compared to a decline of 2.40% 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 3.52%.
  -50-
 
 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
        1.95%
        and liabilities by 2.29%. 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 1.06%.
 
 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.
  -51-
  **One-Year
        Interest Rate Sensitivity Gap**
 
 **June
                  30, 2006**
              
              **December
                  31, 2005**(Dollars
                  in thousands)One-Year
                  Repricing/Maturing Assets
              
              $
              689,212
              
              $
              715,543One-Year
                  Repricing/Maturing Liabilities
              
              
              786,867
              
              
              773,093One-Year
                  Gap
              
              $
              (97,655
              )
              $
              (57,550
              )Total
                  Assets
              
              $
              1,103,168
              
              $
              1,086,165One-Year
                  Interest Rate Gap as a Percentage of Assets
              
              
              (8.9
              %)
              
              (5.3
              %)
 
 At
        a
        negative, or liability sensitive, 8.9% of assets, our twelve-month interest
        rate
        sensitivity gap as of June 30, 2006 indicated increased liability sensitivity
        relative to the 5.3% observed at the 2005 year-end. Impacting the gap ratio
        as
        of June 30 was a timing difference between approximately $19 million of the
        hybrid ARM securities held in our investment portfolio and the FHLB advances
        utilized to fund their purchase. The subject securities were purchased in
        the
        second quarter of 2004 with trade settlement scheduled for late in the quarter
        and a first rate reset date in July 2007. Given the velocity at which market
        interest rates were moving at that time, however, the funding sources for
        these
        securities, and thus our margins on the trades, were locked in at the times
        of
        the trades. Consequently, the funding sources are subject to maturity near
        the
        end of the second quarter of 2007, and are thus included in the “One-Year
        Repricing/Maturing Liabilities” in the above table, while the corresponding
        assets are not subject to reprice until July 2007, and are thus just beyond
        the
        one-year time horizon. The impact of this timing difference on our one-year
        gap
        ratio will be reversed in July 2006, with a corresponding decrease in liability
        sensitivity of approximately 1.7%.
 
 **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).
  June
                      30,2006
                  
                  2005**Available-for-Sale:**
                  
                  Carrying
                      Value
                  
                  Percent
                      of Total
                  
                  Carrying
                      Value
                  
                  Percent
                      of TotalUS
                      Government treasury and agency obligations
                  
                  $
                  10,611
                  
                  
                  11
                  %
                  $
                  17,975
                  
                  
                  15
                  %Mortgage
                      backed securities:Freddie
                      Mac
                  
                  
                  14,847
                  
                  
                  15
                  %
                  
                  17,805
                  
                  
                  14
                  %Ginnie
                      Mae
                  
                  
                  37,871
                  
                  
                  39
                  %
                  
                  49,605
                  
                  
                  41
                  %Fannie
                      Mae
                  
                  
                  33,810
                  
                  
                  35
                  %
                  
                  36,044
                  
                  
                  30
                  %Total
                      mortgage-backed securities
                  
                  
                  86,528
                  
                  
                  89
                  %
                  
                  103,454
                  
                  
                  85
                  %**Total
                      securities available-for-sale**
                  
                  **$**
                  **97,139**
                  
                  
                  **100**
                  **%**
                  **$**
                  **121,429**
                  
                  
                  **100**
                  **%**June
                      30,2006
                  
                  
                  2005**Held-to-Maturity:**
                  
                  
                  Carrying
                      Value
                  
                  
                  Percent
                      of Total
                  
                  
                  Carrying
                      Value
                  
                  
                  Percent
                      of TotalMunicipal
                      bonds
                  
                  $
                  1,166
                  
                  
                  19
                  %
                  $
                  1,200
                  
                  
                  16
                  %Mortgage
                      backed securities:Freddie
                      Mac
                  
                  
                  325
                  
                  
                  5
                  %
                  
                  481
                  
                  
                  6
                  %Fannie
                      Mae
                  
                  
                  4,662
                  
                  
                  76
                  %
                  
                  5,982
                  
                  
                  78
                  %Total
                      mortgage-backed securities
                  
                  
                  4,987
                  
                  
                  81
                  %
                  
                  6,463
                  
                  
                  84
                  %**Total
                      securities held-to-maturity**
                  
                  **$**
                  **6,153**
                  
                  
                  **100**
                  **%**
                  **$**
                  **7,663**
                  
                  
                  **100**
                  **%****Estimated
                      market value**
                  
                  **$**
                  **6,032**
                  
                  
                  
                  
                  **$**
                  **7,754**
  -52-
  **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 June 30, 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
                  
                  $
                  —
                  
                  
                  
                  
                  $
                  —
                  
                  
                  
                  
                  $
                  5,748
                  
                  
                  4.08
                  %
                  $
                  —
                  
                  
                  
                  
                  $
                  4,863
                  
                  
                  4.00
                  %
                  $
                  —
                  
                  
                  
                  
                  $
                  10,611
                  
                  
                  4.05
                  %Mortgage
                      backed securities:Ginnie
                      Mae
                  
                  
                  8,798
                  
                  
                  3.75
                  %
                  
                  29,074
                  
                  
                  4.15
                  %
                  
                  —
                  
                  
                  
                  
                  
                  —
                  
                  
                  
                  
                  
                  —
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  37,872
                  
                  
                  4.06
                  %Freddie
                      Mac
                  
                  
                  280
                  
                  
                  5.46
                  %
                  
                  1,761
                  
                  
                  4.08
                  %
                  
                  2,938
                  
                  
                  3.50
                  %
                  
                  3,245
                  
                  
                  4.61
                  %
                  
                  6,622
                  
                  
                  4.50
                  %
                  
                  —
                  
                  
                  
                  
                  
                  14,846
                  
                  
                  4.29
                  %Fannie
                      Mae
                  
                  
                  364
                  
                  
                  5.62
                  %
                  
                  4,922
                  
                  
                  4.79
                  %
                  
                  3,314
                  
                  
                  4.11
                  %
                  
                  —
                  
                  
                  
                  
                  
                  25,210
                  
                  
                  4.30
                  %
                  
                  —
                  
                  
                  
                  
                  
                  33,810
                  
                  
                  4.36
                  %Total
                      mortgage-backed securities
                  
                  
                  9,442
                  
                  
                  3.87
                  %
                  
                  35,757
                  
                  
                  4.24
                  %
                  
                  6,252
                  
                  
                  3.82
                  %
                  
                  3,245
                  
                  
                  4.61
                  %
                  
                  31,832
                  
                  
                  4.34
                  %
                  
                  —
                  
                  
                  
                  
                  
                  86,528
                  
                  
                  4.22
                  %Total
                      securities available-for-sale -- Carrying Value
                  
                  $
                  9,442
                  
                  
                  3.87
                  %
                  $
                  35,757
                  
                  
                  4.24
                  %
                  $
                  12,000
                  
                  
                  3.95
                  %
                  $
                  3,245
                  
                  
                  4.61
                  %
                  $
                  36,695
                  
                  
                  4.29
                  %
                  $
                  —
                  
                  
                  0.00
                  %
                  $
                  97,139
                  
                  
                  4.20
                  %Total
                      securities available-for-sale -- Amortized Cost
                  
                  $
                  9,658
                  
                  
                  3.87
                  %
                  $
                  36,484
                  
                  
                  4.23
                  %
                  $
                  12,579
                  
                  
                  3.94
                  %
                  $
                  3,360
                  
                  
                  4.61
                  %
                  $
                  39,126
                  
                  
                  4.29
                  %
                  
                  
                  
                  
                  
                  
                  $
                  101,207
                  
                  
                  4.20
                  %Held-to-Maturity
                      at June 30, 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
                  
                  $
                  —
                  
                  
                  
                  
                  $
                  —
                  
                  
                  
                  
                  $
                  —
                  
                  
                  
                  
                  $
                  —
                  
                  
                  
                  
                  $
                  220
                  
                  
                  5.38
                  %
                  $
                  946
                  
                  
                  6.30
                  %
                  $
                  1,166
                  
                  
                  6.12
                  %Mortgage
                      backed securities:Freddie
                      Mac
                  
                  
                  325
                  
                  
                  6.86
                  %
                  
                  —
                  
                  
                  
                  
                  
                  —
                  
                  
                  
                  
                  
                  —
                  
                  
                  
                  
                  
                  —
                  
                  
                  
                  
                  
                  —
                  
                  
                  
                  
                  
                  325
                  
                  
                  6.86
                  %Fannie
                      Mae
                  
                  
                  1,661
                  
                  
                  6.71
                  %
                  
                  1,385
                  
                  
                  4.32
                  %
                  
                  —
                  
                  
                  
                  
                  
                  —
                  
                  
                  
                  
                  
                  1,616
                  
                  
                  4.78
                  %
                  
                  —
                  
                  
                  
                  
                  
                  4,662
                  
                  
                  5.33
                  %Total
                      mortgage-backed securities
                  
                  
                  1,986
                  
                  
                  6.73
                  %
                  
                  1,385
                  
                  
                  4.32
                  %
                  
                  —
                  
                  
                  
                  
                  
                  —
                  
                  
                  
                  
                  
                  1,616
                  
                  
                  4.78
                  %
                  
                  —
                  
                  
                  
                  
                  
                  4,987
                  
                  
                  5.43
                  %Total
                      securities held-to-maturity -- Carrying Value
                  
                  $
                  1,986
                  
                  
                  6.74
                  %
                  $
                  1,385
                  
                  
                  4.32
                  %
                  $
                  —
                  
                  
                  
                  
                  $
                  —
                  
                  
                  
                  
                  $
                  1,836
                  
                  
                  4.85
                  %
                  $
                  946
                  
                  
                  6.30
                  %
                  $
                  6,153
                  
                  
                  5.57
                  %Total
                      securities held-to-maturity -- Fair Market Value
                  
                  $
                  2,024
                  
                  
                  6.74
                  %
                  $
                  1,329
                  
                  
                  4.34
                  %
                  $
                  —
                  
                  
                  
                  
                  $
                  —
                  
                  
                  
                  
                  $
                  1,743
                  
                  
                  4.85
                  %
                  $
                  936
                  
                  
                  6.31
                  %
                  $
                  6,032
                  
                  
                  5.60
                  %
   -53-
  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
        June
        30, 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
 
 The
        Annual Meeting of Shareholders of First Mutual Bancshares, Inc. was held
        on
        April 27, 2006. The results of votes on the matters presented at the Meeting
        are
        as follows:
 
 The
        following individuals were elected as directors for the term noted:
  **CLASS
                    II DIRECTORS**
                **VOTES
                    FOR**
                **VOTES
                    WITHHELD**
                **TERM**James
                    J. Doud Jr.
                5,181,927
                25,515
                3
                    YearsRichard
                    S. Sprague
                5,155,844
                51,598
                3
                    YearsRobert
                    C. Wallace
                5,187,927
                19,515
                3
                    Years
  The
        terms
        of the Class I and III directors expire at the Annual Meeting of Shareholders
        for 2008 and 2007, respectively.
 
 CLASS
        I DIRECTORS, term expires in 2008
 
 Janine
        Florence
 F.
        Kemper
        Freeman, Jr.
 Robert
        J.
        Herbold
 Victor
        E.
        Parker
 
 CLASS
        III DIRECTORS, term expires in 2007
 
 Mary
        Case
        Dunnam
 George
        W.
        Rowley, Jr.
 John
        R.
        Valaas
  -54-
  ITEM
                5.
              Other
                  Information
 
 None.
 
 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 theSarbanes-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.
 
   -55-
  
 **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:
                August 8, 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)
  -56-