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,
      2005





**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 incorporation
            (I.R.S.
                Employeror
                organization)
            Identification
                Number)











400
                108th Avenue N.E., Bellevue, WA
            98004(Address
                of principal executive offices)
            (Zip
                code)








Registrant's
      telephone number, including area code:  (425)
      453-5301








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 an accelerated filer (as defined in
      Rule
      12b-2 of the Exchange Act).





Yes  x  No  o


Indicate
      the number of shares outstanding of each of the issuer's classes of common
      stock, as of the latest practicable date.  August
      4, 2005 5,346,003

















FIRST
          MUTUAL BANCSHARES, INC.
 
 QUARTERLY
          REPORT ON FORM 10-Q
 June
          30,
          2005
 
 TABLE
          OF
          CONTENTS
 
 PagePART
                      I:
                  FINANCIAL
                      INFORMATION
                  1Forward-Looking
                      Statements Disclaimer
                  1ITEM
                      1.
                  Financial
                      Statements
                  2ITEM
                      2.
                  Management’s
                      Discussion and Analysis of Financial Condition andResults
                      of Operations
                  15General
                  15Overview
                  15Results
                      of Operations
                  15Net
                      Income
                  15Net
                      Interest Income
                  15Noninterest
                      Income
                  19Noninterest
                      Expense
                  22Review
                      of Financial Condition
                  25Asset
                      Quality
                  28Portfolio
                      Information
                  29Commercial
                      Real Estate Loans
                  29Sales
                      Finance (Home Improvement) Loans
                  29Residential
                      Lending
                  31Portfolio
                      Distribution
                  32Deposit
                      Information
                  32Business
                      Segments
                  32Consumer
                      Lending
                  33Residential
                      Lending
                  36Business
                      Banking Lending
                  37Income
                      Property Lending
                  38Liquidity
                  39Planned
                      Expenditures for Plant and Equipment
                  42Capital
                  42ITEM
                      3.
                  Quantitative
                      and Qualitative Disclosures About Market Risk
                  43ITEM
                      4.
                  Controls
                      and Procedures
                  50PART
                      II:
                  OTHER
                      INFORMATION
                  50ITEM
                      1.
                  Legal
                      Proceedings
                  50ITEM
                      2.
                  Unregistered
                      Sales of Equity Securities and Use of Proceeds
                  50ITEM
                      3.
                  Defaults
                      Upon Senior Securities
                  50ITEM
                      4.
                  Submission
                      of Matters to a Vote of Security Holders
                  50ITEM
                      5.
                  Other
                      Information
                  52ITEM
                      6.
                  Exhibits
                  52SIGNATURES
                  53CERTIFICATIONS
  
  **PART
          I :**  **FINANCIAL
          INFORMATION**
  **FORWARD-LOOKING
          STATEMENTS DISCLAIMER**
 
 Our
          Form
          10-Q contains statements concerning future operations, trends, expectations,
          plans, capabilities, and prospects of First Mutual Bancshares, Inc. and
          First
          Mutual Bank (together, the “Bank”) that are forward-looking statements for the
          purposes of the safe harbor provisions under the Private Securities Litigation
          Reform Act of 1995. Such forward-looking statements include statements
          regarding
          our goals and expectations regarding earnings growth and return on equity;
          as
          well as references to potential changes in interest income and interest
          rate
          margins, anticipated growth in loan production and modifications of our
          program
          to sell loans, trends in income and expenses and expenditures on our
          headquarters remodel, expectations regarding our Business Banking segment,
          observations pertaining to the potential disparate movement and repricing
          of
          assets and liabilities, and information based on our market risk models,
          simulations 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,
          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 2004 financial statements to conform
          to
          the 2005 presentation. All significant inter-company 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 2004 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
                      31,2005
                  
                  2004**ASSETS:**
                  
                  *(Unaudited)***CASH
                      AND CASH EQUIVALENTS:**Interest-earning
                      deposits
                  
                  $
                  1,817,226
                  
                  $
                  309,125Noninterest-earning
                      demand depositsand
                      cash on hand
                  
                  
                  15,905,252
                  
                  
                  13,536,31617,722,478
                  
                  
                  13,845,441**MORTGAGE-BACKED
                      AND OTHER SECURITIES****AVAILABLE-FOR-SALE**
                  
                  
                  121,429,527
                  
                  
                  124,224,683**LOANS
                      RECEIVABLE, HELD-FOR-SALE**
                  
                  
                  13,408,051
                  
                  
                  10,064,155**MORTGAGE-BACKED
                      AND OTHER SECURITIES HELD-TO-MATURITY****fair
                      value of $7,754,447 and $7,826,994**
                  
                  
                  7,663,048
                  
                  
                  7,719,542**LOANS
                      RECEIVABLE**
                  
                  
                  841,581,851
                  
                  
                  808,642,531**RESERVE
                      FOR LOAN LOSSES**
                  
                  
                  (9,708,806
                  )
                  
                  (9,300,854
                  )**LOANS
                      RECEIVABLE, net**
                  
                  
                  831,873,045
                  
                  
                  799,341,677**ACCRUED
                      INTEREST RECEIVABLE**
                  
                  
                  4,811,218
                  
                  
                  4,300,131**LAND,
                      BUILDINGS AND EQUIPMENT, net**
                  
                  
                  31,127,877
                  
                  
                  27,994,532**FEDERAL
                      HOME LOAN BANK (FHLB) STOCK,**
                  
                  
                  13,122,300
                  
                  
                  12,918,700at
                      cost**SERVICING
                      ASSETS**
                  
                  
                  2,081,571
                  
                  
                  1,525,085**OTHER
                      ASSETS**
                  
                  
                  2,230,847
                  
                  
                  1,849,401**TOTAL**
                  
                  $
                  1,045,469,962
                  
                  $
                  1,003,783,347
 
 
 2
  **FIRST
              MUTUAL BANCSHARES, INC.**
 **CONSOLIDATED
              STATEMENTS OF FINANCIAL CONDITION**
 **(Continued)**
 
 June
                      30,
                  
                  December
                      31,2005
                  
                  2004*(Unaudited)***LIABILITIES:**Deposits:Money
                      market deposit andchecking
                      accounts
                  
                  $
                  253,054,408
                  
                  $
                  254,435,583Savings
                  
                  
                  7,914,360
                  
                  
                  8,434,423Time
                      deposits
                  
                  
                  458,718,154
                  
                  
                  412,498,902Total
                      deposits
                  
                  
                  719,686,922
                  
                  
                  675,368,908Drafts
                      payable
                  
                  
                  541,115
                  
                  
                  377,814Accounts
                      payable and other liabilities
                  
                  
                  12,015,248
                  
                  
                  14,106,402Advance
                      payments by borrowers fortaxes
                      and insurance
                  
                  
                  1,899,938
                  
                  
                  1,676,175FHLB
                      advances
                  
                  
                  228,118,672
                  
                  
                  234,206,775Other
                      advances
                  
                  
                  1,600,000
                  
                  
                  1,600,000Long-term
                      debentures payable
                  
                  
                  17,000,000
                  
                  
                  17,000,000Total
                      liabilities
                  
                  
                  980,861,895
                  
                  
                  944,336,074**STOCKHOLDERS’
                      EQUITY:**Common
                      stock, $1 par value-Authorized,
                      30,000,000 sharesIssued
                      and outstanding, 5,342,191and
                      5,288,489 shares, respectively
                  
                  $
                  5,342,191
                  
                  $
                  5,288,489Additional
                      paid-in capital
                  
                  
                  46,320,662
                  
                  
                  45,595,319Retained
                      earnings
                  
                  
                  13,363,994
                  
                  
                  9,220,450Accumulated
                      other comprehensive income(loss):Unrealized
                      (loss) on securities available-for-saleand
                      interest rate swap, net of federal income tax
                  
                  
                  (418,780
                  )
                  
                  (656,985
                  )Total
                      stockholders’
                      equity
                  
                  
                  64,608,067
                  
                  
                  59,447,273**TOTAL**
                  
                  $
                  1,045,469,962
                  
                  $
                  1,003,783,347
 
 
 3
  **FIRST
              MUTUAL BANCSHARES, INC.**
 **CONSOLIDATED
              STATEMENTS OF INCOME**
 
 Quarter
                      ended June 30,
                  
                  Six
                        months ended June 30,2005
                  
                  2004
                  
                  2005
                  
                  2004*(Unaudited)***INTEREST
                      INCOME:**Loans
                      Receivable
                  
                  $
                  14,823,403
                  
                  $
                  12,322,025
                  
                  $
                  28,755,603
                  
                  $
                  24,202,951Interest
                      on Available For Sale Securities
                  
                  
                  1,266,563
                  
                  
                  885,339
                  
                  
                  2,537,644
                  
                  
                  1,662,287Interest
                      on Held To Maturity Securities
                  
                  
                  102,513
                  
                  
                  107,718
                  
                  
                  196,659
                  
                  
                  216,359Interest
                      Other
                  
                  
                  93,968
                  
                  
                  146,942
                  
                  
                  195,737
                  
                  
                  284,06716,286,447
                  
                  
                  13,462,024
                  
                  
                  31,685,643
                  
                  
                  26,365,664**INTEREST
                      EXPENSE:**Deposits
                  
                  
                  4,253,965
                  
                  
                  2,977,822
                  
                  
                  7,825,379
                  
                  
                  5,858,845FHLB
                      advances and other
                  
                  
                  2,205,743
                  
                  
                  1,627,415
                  
                  
                  4,233,279
                  
                  
                  3,159,9676,459,708
                  
                  
                  4,605,237
                  
                  
                  12,058,658
                  
                  
                  9,018,812Net
                      interest income
                  
                  
                  9,826,739
                  
                  
                  8,856,787
                  
                  
                  19,626,985
                  
                  
                  17,346,852**PROVISION
                      FOR LOAN LOSSES**
                  
                  
                  450,000
                  
                  
                  440,000
                  
                  
                  850,000
                  
                  
                  690,000Net
                      interest income, after provisionfor
                      loan losses
                  
                  
                  9,376,739
                  
                  
                  8,416,787
                  
                  
                  18,776,985
                  
                  
                  16,656,852**NONINTEREST
                      INCOME:**Gain
                      on sales of loans
                  
                  
                  419,956
                  
                  
                  321,884
                  
                  
                  944,493
                  
                  
                  667,263Servicing
                      fees, net of amortization
                  
                  
                  369,259
                  
                  
                  80,767
                  
                  
                  695,553
                  
                  
                  113,641Gain
                      on sales of investments
                  
                  
                  —
                  
                  
                  —
                  
                  
                  —
                  
                  
                  70,870Fees
                      on deposits
                  
                  
                  170,561
                  
                  
                  147,551
                  
                  
                  305,889
                  
                  
                  291,165Other
                  
                  
                  612,127
                  
                  
                  378,149
                  
                  
                  995,731
                  
                  
                  683,100Total
                      noninterest income
                  
                  
                  1,571,903
                  
                  
                  928,351
                  
                  
                  2,941,666
                  
                  
                  1,826,039
 
 
 4
  **FIRST
              MUTUAL BANCSHARES, INC.**
 **CONSOLIDATED
              STATEMENTS OF INCOME**
 **(**
 
 Quarter
                      ended June 30,
                  
                  Six
                        months ended June 30,2005
                  
                  2004
                  
                  2005
                  
                  2004*(Unaudited)***NONINTEREST
                      EXPENSE:**Salaries
                      and employee benefits
                  
                  $
                  4,331,748
                  
                  $
                  3,392,481
                  
                  $
                  8,278,180
                  
                  $
                  6,655,193Occupancy
                  
                  
                  848,828
                  
                  
                  648,804
                  
                  
                  1,632,287
                  
                  
                  1,344,513Other
                  
                  
                  1,962,323
                  
                  
                  1,998,988
                  
                  
                  4,095,340
                  
                  
                  3,680,594Total
                      noninterest expense
                  
                  
                  7,142,899
                  
                  
                  6,040,273
                  
                  
                  14,005,807
                  
                  
                  11,680,300Income
                      before federal income taxes
                  
                  
                  3,805,743
                  
                  
                  3,304,865
                  
                  
                  7,712,844
                  
                  
                  6,802,591**FEDERAL
                      INCOME TAXES**
                  
                  
                  1,288,398
                  
                  
                  1,118,014
                  
                  
                  2,611,239
                  
                  
                  2,301,599**NET
                      INCOME**
                  
                  $
                  2,517,345
                  
                  $
                  2,186,851
                  
                  $
                  5,101,605
                  
                  $
                  4,500,992**PER
                      SHARE DATA:**Basic
                      earnings per common share
                  
                  $
                  0.47
                  
                  $
                  0.42
                  
                  $
                  0.96
                  
                  $
                  0.86Earnings
                      per common share, assuming dilution
                  
                  $
                  0.45
                  
                  $
                  0.40
                  
                  $
                  0.92
                  
                  $
                  0.82**WEIGHTED
                      AVERAGE SHARES OUTSTANDING**
                  
                  
                  5,319,017
                  
                  
                  5,268,108
                  
                  
                  5,310,175
                  
                  
                  5,245,374**WEIGHTED
                      AVERAGE SHARES OUTSTANDING****INCLUDING
                      DILUTIVE STOCK OPTIONS**
                  
                  
                  5,554,215
                  
                  
                  5,511,304
                  
                  
                  5,553,308
                  
                  
                  5,493,889
 
 
 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, 2002
                  
                  
                  4,247,166
                  
                  $
                  4,247,166
                  
                  $
                  24,028,610
                  
                  $
                  15,214,220
                  
                  $
                  793,841
                  
                  $
                  44,283,837Comprehensive
                      income:Net
                      income
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  8,395,738
                  
                  
                  
                  
                  
                  8,395,738Other
                      comprehensive income (loss), net of tax:Unrealized
                      (loss) on securities available-for-sale
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (1,294,797
                  )
                  
                  (1,294,797
                  )Unrealized
                      gain on interest rate swap
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  87,186
                  
                  
                  87,186Total
                      comprehensive income
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  7,188,127Options
                      exercised, including tax benefit of $219,124
                  
                  
                  53,040
                  
                  
                  53,040
                  
                  
                  571,618
                  
                  
                  
                  
                  
                  
                  
                  
                  624,658Issuance
                      of stock through employees' stock plans
                  
                  
                  1,386
                  
                  
                  1,386
                  
                  
                  23,617
                  
                  
                  
                  
                  
                  
                  
                  
                  25,00310%
                      stock dividend
                  
                  
                  428,101
                  
                  
                  428,101
                  
                  
                  9,054,336
                  
                  
                  (9,482,437
                  )
                  
                  
                  
                  
                  —Cash
                      dividend declared ($0.28 per share)
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (1,294,869
                  )
                  
                  
                  
                  
                  (1,294,869
                  )BALANCE,
                      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
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  5,101,605
                  
                  
                  
                  
                  
                  5,101,605Other
                      comprehensive income (loss), net of tax:Unrealized
                      gain on securities available-for-sale
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  161,273
                  
                  
                  161,273Unrealized
                      gain on interest rate swap
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  76,932
                  
                  
                  76,932Total
                      comprehensive income
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  5,339,810Options
                      exercised, including tax benefit of $176,520
                  
                  
                  49,856
                  
                  
                  49,856
                  
                  
                  629,193
                  
                  
                  
                  
                  
                  
                  
                  
                  679,049Issuance
                      of stock through employees' stock plans
                  
                  
                  3,846
                  
                  
                  3,846
                  
                  
                  96,150
                  
                  
                  
                  
                  
                  
                  
                  
                  99,996Cash
                      dividend declared ($0.18 per share)
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (958,061
                  )
                  
                  
                  
                  
                  (958,061
                  )-BALANCE,
                      June 30, 2005
                  
                  
                  5,342,191
                  
                  $
                  5,342,191
                  
                  $
                  46,320,662
                  
                  $
                  13,363,994
                  
                  $
                  (418,780
                  )
                  $
                  64,608,067
 
 
 6
 
 **FIRST
              MUTUAL BANCSHARES, INC.**
 **CONSOLIDATED
              STATEMENTS OF CASH FLOWS**
 Six
                      months ended June 30,2005
                  
                  2004*(Unaudited)***OPERATING
                      ACTIVITIES:**Net
                      income
                  
                  $
                  5,101,605
                  
                  $
                  4,500,992Adjustments
                      to reconcile net income to net cashfrom
                      operating activities:Provision
                      for loan losses
                  
                  
                  850,000
                  
                  
                  690,000Depreciation
                      and amortization
                  
                  
                  773,219
                  
                  
                  642,563Deferred
                      loan origination fees, net of accretion
                  
                  
                  (125,792
                  )
                  
                  (99,833
                  )Amortization
                      of servicing assets
                  
                  
                  454,005
                  
                  
                  312,003Gain
                      on sales of loans
                  
                  
                  (944,493
                  )
                  
                  (667,263
                  )(Gain)
                      loss on sale of repossessed real estate and other assets
                  
                  
                  (2,205
                  )
                  
                  7,200Gain
                      on sale of securities available-for-sale
                  
                  
                  —
                  
                  
                  (70,870
                  )FHLB
                      stock dividends
                  
                  
                  (52,900
                  )
                  
                  (228,200
                  )Changes
                      in operating assets & liabilities:Loans
                      receivable held-for-sale
                  
                  
                  (3,343,896
                  )
                  
                  7,203,460Accrued
                      interest receivable
                  
                  
                  (511,087
                  )
                  
                  (266,116
                  )Other
                      assets
                  
                  
                  (381,446
                  )
                  
                  368,318Drafts
                      payable
                  
                  
                  163,301
                  
                  
                  184,204Accounts
                      payable and other liabilities
                  
                  
                  (2,095,505
                  )
                  
                  (5,096,976
                  )Advance
                      payments by borrowers for taxes and insurance
                  
                  
                  223,763
                  
                  
                  190,817Net
                      cash provided by operating activities
                  
                  
                  108,569
                  
                  
                  7,670,299**INVESTING
                      ACTIVITIES:**Loan
                      originations
                  
                  
                  (221,601,789
                  )
                  
                  (183,350,623
                  )Loan
                      principal repayments
                  
                  
                  177,067,006
                  
                  
                  119,422,652Increase
                      (decrease) in undisbursed loan proceeds
                  
                  
                  11,330,860
                  
                  
                  (5,148,958
                  )Principal
                      repayments & redemptions onmortgage-backed
                      and other securities
                  
                  
                  9,154,203
                  
                  
                  5,979,602Purchase
                      of securities held-to-maturity
                  
                  
                  (1,015,435
                  )
                  
                  (1,126,983
                  )Purchase
                      of securities available-for-sale
                  
                  
                  (4,991,406
                  )
                  
                  (43,282,952
                  )Purchases
                      of premises and equipment
                  
                  
                  (3,902,997
                  )
                  
                  (1,110,551
                  )Purchase
                      of FHLB stock
                  
                  
                  (150,700
                  )
                  
                  (1,269,400
                  )Proceeds
                      from sale of securities
                  
                  
                  —
                  
                  
                  2,228,958Net
                      cash (used) by investing activities
                  
                  
                  (34,110,258
                  )
                  
                  (107,658,255
                  )
 
 
 7
 
 **FIRST
              MUTUAL BANCSHARES, INC.**
 **CONSOLIDATED
              STATEMENTS OF CASH FLOWS**
 (Continued)
 Six
                        months ended June 30,2005
                    
                    2004*(Unaudited)***FINANCING
                        ACTIVITIES:**Net
                        increase in deposit accounts
                    
                    $
                    36,950,365
                    
                    $
                    47,397,620Interest
                        credited to deposit accounts
                    
                    
                    7,367,649
                    
                    
                    5,531,197Issuance
                        of stock through employees's stock plans
                    
                    
                    99,996
                    
                    
                    50,011Proceeds
                        from advances
                    
                    
                    576,770,500
                    
                    
                    436,328,196Repayment
                        of advances
                    
                    
                    (582,858,603
                    )
                    
                    (385,657,855
                    )Dividends
                        paid
                    
                    
                    (953,710
                    )
                    
                    (703,153
                    )Proceeds
                        from exercise of stock options
                    
                    
                    502,529
                    
                    
                    895,703Net
                        cash provided by financing activities
                    
                    
                    37,878,726
                    
                    
                    103,841,719**NET
                        INCREASE (DECREASE) IN CASH AND CASH****EQUIVALENTS**
                    
                    $
                    3,877,037
                    
                    $
                    3,853,763**CASH
                        & CASH EQUIVALENTS:**Beginning
                        of year
                    
                    
                    13,845,441
                    
                    
                    7,427,055End
                        of quarter
                    
                    $
                    17,722,478
                    
                    $
                    11,280,818**SUPPLEMENTAL
                        DISCLOSURES OF CASH FLOW****INFORMATION:**Loans
                        originated for mortgage banking activities
                    
                    $
                    33,679,880
                    
                    $
                    42,262,903Loans
                        originated for investment activities
                    
                    $
                    221,601,789
                    
                    $
                    183,350,623Proceeds
                        from sales of loans held-for-sale
                    
                    $
                    30,335,984
                    
                    $
                    49,466,363Cash
                        paid during the year for:Interest
                    
                    $
                    12,180,884
                    
                    $
                    9,004,628Income
                        taxes
                    
                    $
                    1,667,000
                    
                    $
                    1,457,000**SUPPLEMENTAL
                        DISCLOSURES OF NONCASH****INVESTING
                        ACTIVITIES:**Loans
                        securitized into securities available-for-sale
                    
                    $
                    —
                    
                    $
                    —Loans
                        transferred to real estateheld-for-sale,
                        net
                    
                    $
                    —
                    
                    $
                    —
 
 
 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.
 
 The
            Bank
            has three stock-based employee/director compensation plans, which are
            described
            more fully in the 2004 annual report. The plans are accounted for under
            the
            recognition and measurement principles of APB Opinion No. 25, *Accounting
            for Stock Issued to Employees,* and
            related interpretations. No stock-based employee or director compensation
            cost
            is reflected in net income, as all options granted under those plans
            had 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 the fair value recognition provisions of FASB Statement
            No. 123, *Accounting
            for Stock-Based Compensation* ,
            had
            been adopted.
 
 Quarters
                      Ended June 30,
                  
                  Six
                      Months Ended June 30,2005
                  
                  2004
                  
                  2005
                  
                  2004Net
                      Income, as reported
                  
                  $
                  2,517,345
                  
                  $
                  2,186,851
                  
                  $
                  5,101,605
                  
                  $
                  4,500,992Deduct:
                      Total stock-based employee/director
                      compensation expensedetermined
                      under fair value basedmethod
                      for all awards, net of relatedtax
                      effects
                  
                  
                  (116,621
                  )
                  
                  (98,984
                  )
                  
                  (222,508
                  )
                  
                  (197,135
                  )Pro
                    forma net income
                  
                  $
                  2,400,724
                  
                  $
                  2,087,867
                  
                  $
                  4,879,097
                  
                  $
                  4,303,857Earnings
                      per share:Basic
                      - as reported
                  
                  $
                  0.47
                  
                  $
                  0.42
                  
                  $
                  0.96
                  
                  $
                  0.86Basic
                      - pro forma
                  
                  $
                  0.45
                  
                  $
                  0.40
                  
                  $
                  0.92
                  
                  $
                  0.82Diluted
                      - as reported
                  
                  $
                  0.45
                  
                  $
                  0.40
                  
                  $
                  0.92
                  
                  $
                  0.82Diluted
                      - pro forma
                  
                  $
                  0.43
                  
                  $
                  0.38
                  
                  $
                  0.88
                  
                  $
                  0.78Weighted
                      average shares outstanding:Basic
                  
                  
                  5,319,017
                  
                  
                  5,268,108
                  
                  
                  5,310,175
                  
                  
                  5,245,374Diluted
                  
                  
                  5,554,215
                  
                  
                  5,511,304
                  
                  
                  5,553,308
                  
                  
                  5,493,889
 
 The
            compensation expense included in the pro forma net income and net income
            per
            share figures in the previous table is not likely to be representative
            of the
            effect on reported net income for future years because options vest over
            several
            years and additional awards generally are made each year.
 
 On
            April
            14, 2005 the Securities and Exchange Commission announced a change in
            the
            compliance date for Financial Accounting Standards Board's Statement
            of
            Financial Accounting Standards No. 123 (revised 2004), *Share-Based
            Payment* (Statement 123R). The compliance date has been changed to first quarter
            of 2006
            from July of 2005. We expect to adopt Statement 123R on January 1,
            2006.
 
 9
 
 
 **Note
            2.**
 
 **Mortgage-Backed
            and Other Securities Available-for-Sale**
 
 The
            amortized cost and estimated fair value of securities available-for-sale
            at June
            30, 2005, and December
            31, 2004 are summarized as follows:
 
 Gross
                  
                  GrossGross
                  
                  Unrealized
                  
                  Unrealized
                  
                  EstimatedAmortized
                  
                  Unrealized
                  
                  Losses
                  
                  Losses
                  
                  FairCost
                  
                  Gains
                  
                  <1
                      Year
                  
                  >1
                      Year
                  
                  Value**June
                        30, 2005**Freddie
                        Mac securities
                  
                  $
                  17,962,715
                  
                  $
                  38,355
                  
                  $
                  19,695
                  
                  $
                  176,703
                  
                  $
                  17,804,672Fannie
                        Mae securities
                  
                  
                  36,285,038
                  
                  
                  57,052
                  
                  
                  57,111
                  
                  
                  240,986
                  
                  
                  36,043,993Ginnie
                        Mae securities
                  
                  
                  49,733,071
                  
                  
                  71,611
                  
                  
                  94,479
                  
                  
                  104,614
                  
                  
                  49,605,589US
                      agency securities
                  
                  
                  17,977,037
                  
                  
                  44,268
                  
                  
                  46,032
                  
                  
                  —
                  
                  
                  17,975,273$
                  121,957,861
                  
                  $
                  211,286
                  
                  $
                  217,317
                  
                  $
                  522,303
                  
                  $
                  121,429,527**December
                      31, 2004**Freddie
                      Mac securities
                  
                  $
                  19,127,613
                  
                  $
                  48,719
                  
                  $
                  173,913
                  
                  $
                  115,062
                  
                  $
                  18,887,357Fannie
                      Mae securities
                  
                  
                  39,095,463
                  
                  
                  75,726
                  
                  
                  87,354
                  
                  
                  308,837
                  
                  
                  38,774,998Ginnie
                      Mae securities
                  
                  
                  48,839,639
                  
                  
                  38,712
                  
                  
                  270,022
                  
                  
                  —
                  
                  
                  48,608,329US
                      agency securities
                  
                  
                  17,946,544
                  
                  
                  57,761
                  
                  
                  50,306
                  
                  
                  —
                  
                  
                  17,953,999$
                  125,009,259
                  
                  $
                  220,918
                  
                  $
                  581,595
                  
                  $
                  423,899
                  
                  $
                  124,224,683
 
 
 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, 2005
            and December 31, 2004 there were 21 and 23 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
            3.**
 
 **Mortgage-Backed
            and Other Securities Held-to-Maturity**
 
 The
            amortized cost and estimated fair value of mortgage-backed and other
            securities
            are summarized as follows:
 
 Gross
                  
                  GrossGross
                  
                  Unrealized
                  
                  Unrealized
                  
                  EstimatedAmortized
                  
                  Unrealized
                  
                  Losses
                  
                  Losses
                  
                  FairCost
                  
                  Gains
                  
                  <1
                      Year
                  
                  >1
                      Year
                  
                  Value**June
                      30, 2005**Fannie
                      Mae securities
                  
                  $
                  5,981,632
                  
                  $
                  93,940
                  
                  $
                  —
                  
                  $
                  19,427
                  
                  $
                  6,056,145Freddie
                      Mac securities
                  
                  
                  481,445
                  
                  
                  7,816
                  
                  
                  —
                  
                  
                  —
                  
                  
                  489,261Municipal
                      bonds
                  
                  
                  1,199,971
                  
                  
                  9,070
                  
                  
                  —
                  
                  
                  —
                  
                  
                  1,209,041$
                  7,663,048
                  
                  $
                  110,826
                  
                  $
                  —
                  
                  $
                  19,427
                  
                  $
                  7,754,447**December
                      31, 2004**Fannie
                      Mae securities
                  
                  $
                  6,010,318
                  
                  $
                  125,722
                  
                  $
                  30,472
                  
                  $
                  —
                  
                  $
                  6,105,568Freddie
                      Mac securities
                  
                  
                  492,607
                  
                  
                  13,408
                  
                  
                  —
                  
                  
                  —
                  
                  
                  506,015Municipal
                      bonds
                  
                  
                  1,216,617
                  
                  
                  2,622
                  
                  
                  —
                  
                  
                  3,828
                  
                  
                  1,215,411$
                  7,719,542
                  
                  $
                  141,752
                  
                  $
                  30,472
                  
                  $
                  3,828
                  
                  $
                  7,826,994
 
 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, 2005
            and December 31, 2004 there
            were 2 and 3 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.
 
 10
 
 **Note
            4.**
 **Nonperforming
            Assets**
  Non-performing
              loans are summarized as follows:
 
 June
                      30, 2005
                  
                  December
                      31, 2004Impaired
                      loans with a valuation allowance
                  
                  
                  
                  
                  $
                  308,810
                  
                  $
                  317,023Valuation
                      allowance related to impaired loans
                  
                  
                  
                  
                  
                  172,475
                  
                  
                  177,190Total
                      non-accrual loans
                  
                  
                  
                  
                  
                  656,828
                  
                  
                  864,464Total
                      loans past due 90-days or more and still accruing interest
                  
                  
                  
                  
                  
                  15,000
                  
                  
                  34,000Interest
                      income recognized on impaired loans
                  
                  
                  
                  
                  
                  451
                  
                  
                  1,108
 
 Subsequent
            to June 30, one of the impaired loans with an impaired balance of $5,012
            paid
            off in April 2005.
 
 **Note
            5.**
 **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 ending June
            30, 2005
            and June 30, 2004:
 
 Income
                  
                  Shares
                  
                  Per
                      share(numerator)
                  
                  (denominator)
                  
                  amountQuarter
                      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
                  
                  $
                  0.92Quarter
                      ended June 30, 2004Basic
                      EPS:Income
                      available to common shareholders
                  
                  $
                  2,186,851
                  
                  
                  5,268,108
                  
                  $
                  0.42Effect
                      of dilutive stock options
                  
                  
                  —
                  
                  
                  243,196Diluted
                      EPS:Income
                      available to common shareholdersplus
                      assumed stock options exercised
                  
                  $
                  2,186,851
                  
                  
                  5,511,304
                  
                  $
                  0.40Six
                      months ended June 30, 2004Basic
                      EPS:Income
                      available to common shareholders
                  
                  $
                  4,500,992
                  
                  
                  5,245,374
                  
                  $
                  0.86Effect
                      of dilutive stock options
                  
                  
                  —
                  
                  
                  248,515Diluted
                      EPS:Income
                      available to common shareholdersplus
                      assumed stock options exercised
                  
                  $
                  4,500,992
                  
                  
                  5,493,889
                  
                  $
                  0.82
 
 
 11
 
 
 **Note
            6.**
 
 **Rate
                      Volume Analysis**
                  
                  SECOND
                      QUARTER 2005
                  
                  SIX
                      MONTHS ENDED 2005(Dollars
                      in thousands)
                  
                  VS
                  
                  VSSECOND
                      QUARTER 2004
                  
                  SIX
                      MONTHS ENDED 2004INCREASE
                      (DECREASE) DUE TO
                  
                  INCREASE
                      (DECREASE) DUE TOTOTAL
                  
                  
                  
                  
                  
                  TOTALVOLUME
                  
                  RATE
                  
                  CHANGE
                  
                  VOLUME
                  
                  RATE
                  
                  CHANGEINTEREST
                      INCOMEInvestments:Available-for-sale
                      securities
                  
                  $
                  218
                  
                  $
                  164
                  
                  $
                  382
                  
                  $
                  631
                  
                  $
                  245
                  
                  $
                  876Held-to-maturity
                      securities
                  
                  
                  (7
                  )
                  
                  2
                  
                  
                  (5
                  )
                  
                  (14
                  )
                  
                  (6
                  )
                  
                  (20
                  )Other
                      equity investments
                  
                  
                  31
                  
                  
                  (84
                  )
                  
                  (53
                  )
                  
                  45
                  
                  
                  (133
                  )
                  
                  (88
                  )Total
                      investments
                  
                  
                  242
                  
                  
                  82
                  
                  
                  324
                  
                  
                  662
                  
                  
                  106
                  
                  
                  768Loans:Residential
                  
                  
                  588
                  
                  
                  232
                  
                  
                  820
                  
                  
                  1,207
                  
                  
                  283
                  
                  
                  1,490Residential
                      construction
                  
                  
                  173
                  
                  
                  346
                  
                  
                  519
                  
                  
                  379
                  
                  
                  588
                  
                  
                  967Multifamily
                  
                  
                  (120
                  )
                  
                  292
                  
                  
                  172
                  
                  
                  (174
                  )
                  
                  443
                  
                  
                  269Multifamily
                      construction
                  
                  
                  (84
                  )
                  
                  25
                  
                  
                  (59
                  )
                  
                  (167
                  )
                  
                  48
                  
                  
                  (119
                  )Commercial
                      real estate and business
                  
                  
                  194
                  
                  
                  573
                  
                  
                  767
                  
                  
                  446
                  
                  
                  951
                  
                  
                  1,397Commercial
                      real estate construction
                  
                  
                  62
                  
                  
                  19
                  
                  
                  81
                  
                  
                  123
                  
                  
                  66
                  
                  
                  189Consumer
                      & other
                  
                  
                  159
                  
                  
                  43
                  
                  
                  202
                  
                  
                  333
                  
                  
                  27
                  
                  
                  360Total
                      loans
                  
                  
                  972
                  
                  
                  1,530
                  
                  
                  2,502
                  
                  
                  2,147
                  
                  
                  2,406
                  
                  
                  4,553Total
                      interest income
                  
                  
                  1,214
                  
                  
                  1,612
                  
                  
                  2,826
                  
                  
                  2,809
                  
                  
                  2,512
                  
                  
                  5,321INTEREST
                      EXPENSEDeposits:Money
                      market deposit and checking
                  
                  
                  95
                  
                  
                  244
                  
                  
                  339
                  
                  
                  243
                  
                  
                  357
                  
                  
                  600Savings
                  
                  
                  (1
                  )
                  
                  —
                  
                  
                  (1
                  )
                  
                  (2
                  )
                  
                  (1
                  )
                  
                  (3
                  )Time
                      deposits
                  
                  
                  271
                  
                  
                  668
                  
                  
                  939
                  
                  
                  560
                  
                  
                  810
                  
                  
                  1,370Total
                      deposits
                  
                  
                  365
                  
                  
                  912
                  
                  
                  1,277
                  
                  
                  801
                  
                  
                  1,166
                  
                  
                  1,967FHLB
                      advances and other
                  
                  
                  127
                  
                  
                  452
                  
                  
                  579
                  
                  
                  399
                  
                  
                  675
                  
                  
                  1,074Total
                      interest expense
                  
                  
                  492
                  
                  
                  1,364
                  
                  
                  1,856
                  
                  
                  1,200
                  
                  
                  1,841
                  
                  
                  3,041Net
                      interest income
                  
                  $
                  722
                  
                  $
                  248
                  
                  $
                  970
                  
                  $
                  1,609
                  
                  $
                  671
                  
                  $
                  2,280
 
 
 12
 
 
 **Note
            7.**
 **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, 2005,
            2004, and
            2003:
 
 **Consumer**
                  
                  **Residential**
                  
                  **Business
                      Banking**
                  
                  **Income
                      Property****Quarter
                      ended June 30:**
                  
                  
                  
                  **Lending**
                  
                  **Lending**
                  
                  **Lending**
                  
                  **Lending**
                  
                  **Totals**Interest
                      income
                  
                  
                  2005
                  
                  $
                  2,324,663
                  
                  $
                  5,137,589
                  
                  $
                  2,122,272
                  
                  $
                  6,701,923
                  
                  $
                  16,286,4472004
                  
                  
                  2,059,604
                  
                  
                  3,951,681
                  
                  
                  1,295,871
                  
                  
                  6,154,868
                  
                  
                  13,462,0242003
                  
                  
                  1,507,423
                  
                  
                  2,673,307
                  
                  
                  1,398,463
                  
                  
                  6,697,847
                  
                  
                  12,277,040Interest
                      Expense
                  
                  
                  2005
                  
                  
                  861,286
                  
                  
                  2,201,985
                  
                  
                  650,473
                  
                  
                  2,745,964
                  
                  
                  6,459,7082004
                  
                  
                  546,897
                  
                  
                  1,532,006
                  
                  
                  303,382
                  
                  
                  2,222,952
                  
                  
                  4,605,2372003
                  
                  
                  595,946
                  
                  
                  1,131,325
                  
                  
                  467,886
                  
                  
                  2,644,939
                  
                  
                  4,840,096Net
                      Interest Income
                  
                  
                  2005
                  
                  
                  1,463,377
                  
                  
                  2,935,604
                  
                  
                  1,471,799
                  
                  
                  3,955,959
                  
                  
                  9,826,7392004
                  
                  
                  1,512,707
                  
                  
                  2,419,675
                  
                  
                  992,489
                  
                  
                  3,931,916
                  
                  
                  8,856,7872003
                  
                  
                  911,477
                  
                  
                  1,541,982
                  
                  
                  930,577
                  
                  
                  4,052,908
                  
                  
                  7,436,944Provision
                      for loan losses
                  
                  
                  2005
                  
                  
                  154,500
                  
                  
                  57,070
                  
                  
                  73,115
                  
                  
                  165,315
                  
                  
                  450,0002004
                  
                  
                  156,535
                  
                  
                  47,125
                  
                  
                  55,935
                  
                  
                  180,405
                  
                  
                  440,0002003
                  
                  
                  83,068
                  
                  
                  36,062
                  
                  
                  44,693
                  
                  
                  161,177
                  
                  
                  325,000Net
                      interest income, after provision for loan losses
                  
                  
                  2005
                  
                  
                  1,308,877
                  
                  
                  2,878,534
                  
                  
                  1,398,684
                  
                  
                  3,790,644
                  
                  
                  9,376,7392004
                  
                  
                  1,356,172
                  
                  
                  2,372,550
                  
                  
                  936,554
                  
                  
                  3,751,511
                  
                  
                  8,416,7872003
                  
                  
                  828,409
                  
                  
                  1,505,920
                  
                  
                  885,884
                  
                  
                  3,891,731
                  
                  
                  7,111,944Noninterest
                      income
                  
                  
                  2005
                  
                  
                  610,822
                  
                  
                  311,280
                  
                  
                  277,945
                  
                  
                  371,856
                  
                  
                  1,571,9032004
                  
                  
                  377,095
                  
                  
                  190,428
                  
                  
                  84,624
                  
                  
                  276,204
                  
                  
                  928,3512003
                  
                  
                  84,382
                  
                  
                  323,539
                  
                  
                  97,742
                  
                  
                  377,526
                  
                  
                  883,189Noninterest
                      expense
                  
                  
                  2005
                  
                  
                  1,727,721
                  
                  
                  1,874,550
                  
                  
                  1,589,714
                  
                  
                  1,950,914
                  
                  
                  7,142,8992004
                  
                  
                  1,429,173
                  
                  
                  1,429,456
                  
                  
                  1,283,620
                  
                  
                  1,898,024
                  
                  
                  6,040,2732003
                  
                  
                  982,727
                  
                  
                  1,140,533
                  
                  
                  983,335
                  
                  
                  1,821,954
                  
                  
                  4,928,549Income
                      before federal income taxes
                  
                  
                  2005
                  
                  
                  191,978
                  
                  
                  1,315,264
                  
                  
                  86,915
                  
                  
                  2,211,586
                  
                  
                  3,805,7432004
                  
                  
                  304,094
                  
                  
                  1,133,522
                  
                  
                  (262,442
                  )
                  
                  2,129,691
                  
                  
                  3,304,8652003
                  
                  
                  (69,936
                  )
                  
                  688,926
                  
                  
                  291
                  
                  
                  2,447,303
                  
                  
                  3,066,584Federal
                      income taxes
                  
                  
                  2005
                  
                  
                  64,596
                  
                  
                  445,268
                  
                  
                  28,782
                  
                  
                  749,752
                  
                  
                  1,288,3982004
                  
                  
                  102,766
                  
                  
                  383,672
                  
                  
                  (89,781
                  )
                  
                  721,357
                  
                  
                  1,118,0142003
                  
                  
                  (24,422
                  )
                  
                  232,875
                  
                  
                  (574
                  )
                  
                  829,088
                  
                  
                  1,036,967Net
                      income
                  
                  
                  2005
                  
                  
                  127,382
                  
                  
                  869,996
                  
                  
                  58,133
                  
                  
                  1,461,834
                  
                  
                  2,517,3452004
                  
                  
                  201,328
                  
                  
                  749,850
                  
                  
                  (172,661
                  )
                  
                  1,408,334
                  
                  
                  2,186,8512003
                  
                  
                  (45,514
                  )
                  
                  456,051
                  
                  
                  865
                  
                  
                  1,618,215
                  
                  
                  2,029,617Total
                      Interest Earning assets (ending period balances)
                  
                  
                  2005
                  
                  
                  116,559,900
                  
                  
                  327,186,650
                  
                  
                  131,570,274
                  
                  
                  419,257,639
                  
                  
                  994,574,4632004
                  
                  
                  106,368,450
                  
                  
                  273,980,679
                  
                  
                  99,436,965
                  
                  
                  447,499,013
                  
                  
                  927,285,1072003
                  
                  
                  82,619,989
                  
                  
                  180,249,319
                  
                  
                  89,418,052
                  
                  
                  430,892,240
                  
                  
                  783,179,600
 
 
 13
 
 
 **Note
            7.**
 **Segments
            (continued)**
 
 **Year-to-date
                      ended June 30:****Consumer**
                  
                  **Residential**
                  
                  **Business
                      Banking**
                  
                  **Income
                      Property****Lending**
                  
                  **Lending**
                  
                  **Lending**
                  
                  **Lending**
                  
                  **Totals**Interest
                      income
                  
                  
                  2005
                  
                  $
                  4,570,151
                  
                  $
                  9,682,525
                  
                  $
                  4,075,418
                  
                  $
                  13,357,549
                  
                  $
                  31,685,6432004
                  
                  
                  4,085,733
                  
                  
                  7,534,509
                  
                  
                  2,607,009
                  
                  
                  12,138,413
                  
                  
                  26,365,6642003
                  
                  
                  2,752,513
                  
                  
                  5,316,185
                  
                  
                  2,730,613
                  
                  
                  13,485,791
                  
                  
                  24,285,102Interest
                      Expense
                  
                  
                  2005
                  
                  
                  1,599,534
                  
                  
                  4,084,545
                  
                  
                  1,141,186
                  
                  
                  5,233,393
                  
                  
                  12,058,6582004
                  
                  
                  1,097,506
                  
                  
                  2,912,392
                  
                  
                  632,151
                  
                  
                  4,376,763
                  
                  
                  9,018,8122003
                  
                  
                  1,135,390
                  
                  
                  2,246,725
                  
                  
                  903,927
                  
                  
                  5,486,868
                  
                  
                  9,772,910Net
                      Interest Income
                  
                  
                  2005
                  
                  
                  2,970,617
                  
                  
                  5,597,980
                  
                  
                  2,934,232
                  
                  
                  8,124,156
                  
                  
                  19,626,9852004
                  
                  
                  2,988,227
                  
                  
                  4,622,117
                  
                  
                  1,974,858
                  
                  
                  7,761,650
                  
                  
                  17,346,8522003
                  
                  
                  1,617,123
                  
                  
                  3,069,460
                  
                  
                  1,826,686
                  
                  
                  7,998,923
                  
                  
                  14,512,192Provision
                      for loan losses
                  
                  
                  2005
                  
                  
                  290,215
                  
                  
                  105,775
                  
                  
                  132,240
                  
                  
                  321,770
                  
                  
                  850,0002004
                  
                  
                  249,634
                  
                  
                  69,404
                  
                  
                  81,394
                  
                  
                  289,568
                  
                  
                  690,0002003
                  
                  
                  115,495
                  
                  
                  50,059
                  
                  
                  59,289
                  
                  
                  235,157
                  
                  
                  460,000Net
                      interest income, after provision for loan losses
                  
                  
                  2005
                  
                  
                  2,680,402
                  
                  
                  5,492,205
                  
                  
                  2,801,992
                  
                  
                  7,802,386
                  
                  
                  18,776,9852004
                  
                  
                  2,738,593
                  
                  
                  4,552,713
                  
                  
                  1,893,464
                  
                  
                  7,472,082
                  
                  
                  16,656,8522003
                  
                  
                  1,501,628
                  
                  
                  3,019,401
                  
                  
                  1,767,397
                  
                  
                  7,763,766
                  
                  
                  14,052,192Non
                      interest income
                  
                  
                  2005
                  
                  
                  1,473,077
                  
                  
                  524,434
                  
                  
                  380,777
                  
                  
                  563,378
                  
                  
                  2,941,6662004
                  
                  
                  747,002
                  
                  
                  362,513
                  
                  
                  173,588
                  
                  
                  542,936
                  
                  
                  1,826,0392003
                  
                  
                  206,896
                  
                  
                  629,761
                  
                  
                  205,916
                  
                  
                  826,319
                  
                  
                  1,868,892Non
                      interest expense
                  
                  
                  2005
                  
                  
                  3,376,936
                  
                  
                  3,572,091
                  
                  
                  3,180,234
                  
                  
                  3,876,546
                  
                  
                  14,005,8072004
                  
                  
                  2,625,406
                  
                  
                  2,822,546
                  
                  
                  2,386,135
                  
                  
                  3,846,213
                  
                  
                  11,680,3002003
                  
                  
                  1,892,865
                  
                  
                  2,288,440
                  
                  
                  1,952,486
                  
                  
                  3,566,991
                  
                  
                  9,700,782Income
                      before federal income taxes
                  
                  
                  2005
                  
                  
                  776,543
                  
                  
                  2,444,548
                  
                  
                  2,535
                  
                  
                  4,489,218
                  
                  
                  7,712,8442004
                  
                  
                  860,189
                  
                  
                  2,092,680
                  
                  
                  (319,083
                  )
                  
                  4,168,805
                  
                  
                  6,802,5912003
                  
                  
                  (184,341
                  )
                  
                  1,360,722
                  
                  
                  20,827
                  
                  
                  5,023,094
                  
                  
                  6,220,302Federal
                      income taxes
                  
                  
                  2005
                  
                  
                  262,720
                  
                  
                  827,486
                  
                  
                  (610
                  )
                  
                  1,521,643
                  
                  
                  2,611,2392004
                  
                  
                  291,159
                  
                  
                  708,211
                  
                  
                  (109,668
                  )
                  
                  1,411,897
                  
                  
                  2,301,5992003
                  
                  
                  (63,854
                  )
                  
                  460,052
                  
                  
                  5,759
                  
                  
                  1,701,570
                  
                  
                  2,103,527Net
                      income
                  
                  
                  2005
                  
                  
                  513,823
                  
                  
                  1,617,062
                  
                  
                  3,145
                  
                  
                  2,967,575
                  
                  
                  5,101,6052004
                  
                  
                  569,030
                  
                  
                  1,384,469
                  
                  
                  (209,415
                  )
                  
                  2,756,908
                  
                  
                  4,500,9922003
                  
                  
                  (120,487
                  )
                  
                  900,670
                  
                  
                  15,068
                  
                  
                  3,321,524
                  
                  
                  4,116,775Total
                      Interest Earning assets (Ending period balances)
                  
                  
                  2005
                  
                  
                  113,352,359
                  
                  
                  316,231,162
                  
                  
                  127,556,812
                  
                  
                  429,190,920
                  
                  
                  986,331,2532004
                  
                  
                  102,336,690
                  
                  
                  259,761,399
                  
                  
                  97,826,002
                  
                  
                  439,899,861
                  
                  
                  899,823,9522003
                  
                  
                  77,036,185
                  
                  
                  173,371,863
                  
                  
                  88,051,444
                  
                  
                  434,960,693
                  
                  
                  773,420,185
 
 
 14
 ITEM
          2. Management’s
          Discussion and Analysis of Financial Condition and Results
          of Operations
 
 GENERAL
 
 First
          Mutual Bancshares, Inc. (the "Company"), a Washington corporation, is a
          bank
          holding company owning all of the equity of its wholly owned subsidiary,
          First
          Mutual Bank. The Company is subject to regulation by the Federal Reserve
          Bank of
          San Francisco. This discussion refers to the consolidated statements of
          the
          Company and the Bank, and therefore the references to “Bank” in this discussion
          refer to both entities.
 
 First
          Mutual Bank is a Washington-chartered savings bank subject to regulation
          by the
          State of Washington Department of Financial Institutions and the Federal
          Deposit
          Insurance Corporation ("FDIC"). The Bank conducts business from its headquarters
          in Bellevue, Washington, and has 12 full-service retail banking centers
          located
          in Bellevue (3), Issaquah, Kirkland (2), Monroe, Redmond, Sammamish, Seattle
          (2), and Woodinville. We also have an income property loan production office
          located in Vancouver, Washington and a consumer loan office located in
          Jacksonville, Florida. The Bank's business consists mainly of attracting
          deposits from the general public as well as wholesale funding sources,
          and
          investing those funds primarily in real estate loans, small and mid-sized
          business loans, and consumer loans.
 
 **OVERVIEW**
 
 The
          second quarter of 2005 marked our fifty-first consecutive quarter of
          year-over-year quarterly earnings growth, as net income increased 15% for
          the
          quarter ended June 30, 2005, to $2.5 million, or $0.45 per diluted share,
          compared to $2.2 million, or $0.40 per diluted share in the same quarter
          a year
          ago. Through the first six months of the year, net income increased 13%
          to $5.1
          million, or $0.92 per diluted share, compared to $4.5 million, or $0.82
          per
          diluted share in the first half of 2004.
 
 As
          general corporate goals, we seek to obtain a 15% or better return on equity
          (ROE) and year-over-year net income growth in the range of 10% to 12%.
          This net
          income growth goal was established in the first quarter of 2005, and represented
          a reduction from our previous target of a 15% year-over-year increase.
          We
          elected to reduce our target in response to a number of factors including
          general economic conditions and trends, the current competitive environment
          for
          loan and deposit products in our local market, and the continued investment
          required in our Business Banking division. We consider these targets to
          be our
          corporate goals, and not indicative of current forecasts or expected future
          operating results.
 
 While
          our
          return on equity has typically met or exceeded our corporate objective,
          our net
          income growth has generally fallen short of our target. Over the last several
          years, we have utilized part of our earnings for the purpose of investing
          in new
          business lines. We realized that in order to continue to achieve our goal
          of
          consistent earnings, we needed to expand our business lines from two to
          four. At
          that time, our operations consisted of residential and income property
          (commercial real estate) lending. Those business lines were, and continue
          to be,
          solid operations. However, for the Bank to continue to produce consistent
          earnings, we needed to broaden the operating base with two new lines, Business
          Banking and Consumer Lending. The process of developing these lines has
          been
          expensive and has added to both our staff and other operating costs. The
          encouraging news is that the Consumer Lending business line has been
          contributing to the Bank’s profit goals for some time. Although the Business
          Banking division has not yet achieved its objectives, we remain committed
          to
          developing this business line, 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. Please refer to the “Business Segments” and “Noninterest
          Expense” sections for a further discussion of this topic.
 
 The
          primary source of revenue for each of our business lines is net interest
          income,
          which is generally measured with the net interest margin ratio. Our overall
          net
          interest margin declined to 4.01% in the second quarter of this year compared
          to
          4.08% in the previous quarter, but exceeded the top of our 3.90% to 4.00%
          forecast by one basis point and remained above the 3.97% level achieved
          in the
          second quarter last year. Reflecting the recent increases in short-term
          interest
          rates, the yield on our earning assets grew to 6.39% in the second quarter
          of
          2005, compared to 6.16% in the first quarter, and 5.82% in the second quarter
          of
          2004. Similarly, the cost of interest-bearing liabilities increased to
          2.62% in
          the second quarter, from 2.36% in the first quarter and 2.05% in the second
          quarter of 2004.
 
 Another
          key driver of net interest income is the growth of the business lines’ earning
          assets. On a second quarter 2005 versus 2004 comparison, the growth in
          earning
          assets contributed an additional $722,000 to net interest income, while
          the
          improvement in the margin added $248,000. The results on a year-to-date
          basis
          were comparable, with earning asset growth contributing $1.6 million and
          the
          improvement in the margin adding $671,000. Please see the “Net Interest Income”
          and “Asset and Liability Management” sections for a further discussion of net
          interest income and the processes by which we manage that source of
          revenue.
 
 A
          secondary source of revenue is our noninterest income, which grew 69% from
          the
          level earned in the second quarter of 2004. As was the case in the second
          quarter of last year, the miscellaneous income category was the largest
          contributor to our quarter’s noninterest income, accounting for 39% of the
          total. While an increase in loan fee income made the largest single
          contribution, significant improvements were also observed in late charge
          fees
          received on our loan portfolio, as well as Visa and ATM fees, which are
          expected
          to continue rising as checking accounts become a greater piece of our overall
          deposit mix. Please refer to the “Noninterest Income” section for a further
          discussion of this subject.
 
 A
          critical factor in achieving our goal of consistent earnings is the credit
          quality of our loan portfolio. Fortunately, for many years we have enjoyed
          credit quality that has exceeded the national average. Credit quality remained
          strong in the second quarter of 2005, with total non-performing assets
          (NPAs)
          declining to $797,000, or 0.08% of total assets as of the quarter-end.
          Our
          provision for loan losses totaled $450,000 for the second quarter of 2005,
          while
          net charge-offs amounted to $231,000. As a result, the loan loss reserve
          grew to
          $9.7 million, or 1.14% of gross loans, from $8.9 million, or 1.11% of gross
          loans at the end of the second quarter of last year. For additional information
          regarding our credit quality please refer to the “Asset Quality”
          section.
 
 **RESULTS
          OF OPERATIONS**
 
 **Net
          Income**
 
 Net
          income increased approximately 15%, from $2.2 million in the second quarter
          of
          2004 to $2.5 million in the same period of 2005. Net interest income, after
          provision, rose $960,000, and noninterest income increased $644,000 on
          a second
          quarter comparison. Partially offsetting the growth in revenue was a rise
          of
          $1.1 million in noninterest expense.
 
 **Net
          Interest Income**
  For
          the
          quarter and six months ended June 30, 2005, our net interest income, after
          provision,  increased $960,000 and $2.1 million, respectively, or
          11% and
          13%, relative to the same periods last year. This improvement resulted
          from both
          the growth in our earning assets, which accounted for the majority of the
          improvement, as well as the net effects of asset and liability repricing.
          The
          following table illustrates the impact to our net interest income of 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, 2005 vs. June 30, 2004
                
                June
                    30, 2005 vs. June 30, 2004Increase/(Decrease)
                    due to
                
                Increase/(Decrease)
                    due toVolume
                
                Rate
                
                Total
                
                Volume
                
                Rate
                
                TotalInterest
                    Income
                
                (Dollars
                    in thousands)Total
                    Investments
                
                $
                242
                
                $
                82
                
                $
                324
                
                $
                662
                
                $
                106
                
                $
                768Total
                    Loans
                
                
                972
                
                
                1,530
                
                
                2,502
                
                
                2,147
                
                
                2,406
                
                
                4,553Total
                    Interest Income
                
                $
                1,214
                
                $
                1,612
                
                $
                2,826
                
                $
                2,809
                
                $
                2,512
                
                $
                5,321Interest
                    ExpenseTotal
                    Deposits
                
                $
                365
                
                $
                912
                
                $
                1,277
                
                $
                801
                
                $
                1,166
                
                $
                1,967FHLB
                    and Other
                
                
                127
                
                
                452
                
                
                579
                
                
                399
                
                
                675
                
                
                1,074Total
                    Interest Expense
                
                $
                492
                
                $
                1,364
                
                $
                1,856
                
                $
                1,200
                
                $
                1,841
                
                $
                3,041Net
                    Interest Income
                
                $
                722
                
                $
                248
                
                $
                970
                
                $
                1,609
                
                $
                671
                
                $
                2,280
  **Earning
          Asset Growth (Volume)**
  For
          the
          second quarter of 2005, the growth in our earning assets contributed an
          additional $1.2 million in interest income relative to the second quarter
          of
          last year, which was partially offset by additional interest expense incurred
          from the funding sources used to accommodate the asset growth. The additional
          expense associated with these funding sources totaled $492,000 for the
          quarter.
          Consequently, the net impact of asset growth was an improvement in net
          interest
          income of $722,000, or 74% of the total increase in net interest income
          compared
          to the second quarter of last year.
  15
  Similar
          results were observed for the first six months of 2005, as asset growth
          over the
          prior year resulted in $2.8 million in additional interest income, partially
          offset by a $1.2 million increase in interest expense for the corresponding
          funding sources. This resulted in a $1.6 million net impact from asset
          growth,
          or 71% of the overall improvement in net interest income.
  Quarter
                    Ended
                
                Average
                    Earning Assets
                
                Average
                    Net Loans
                
                Average
                    Deposits(Dollars
                    in thousands)June
                    30, 2004
                
                $
                893,451
                
                $
                773,561
                
                $
                620,606September
                    30, 2004
                
                $
                929,335
                
                $
                790,319
                
                $
                647,560December
                    31, 2004
                
                $
                945,684
                
                $
                801,235
                
                $
                666,835March
                    31, 2005
                
                $
                962,613
                
                $
                816,127
                
                $
                683,521June
                    30, 2005
                
                $
                979,981
                
                $
                834,064
                
                $
                705,680
  Our
          average earning assets totaled $980 million during the second quarter,
          an
          increase of nearly $87 million, or 10% over the second quarter of 2004,
          with
          approximately 70% of the growth attributable to additional balances in
          our loan
          portfolio.
  Most
          of
          our asset growth was funded with additional deposits, including certificates
          issued in institutional markets through deposit brokerage services. To
          the
          extent that deposit growth was not sufficient to fully support our asset
          growth,
          we also utilized advances from the Federal Home Loan Bank of Seattle (FHLB)
          as
          an alternative funding source. For the second quarter, our deposits averaged
          nearly $706 million, representing growth of $85 million over the average
          level
          of second quarter 2004. At June 30, 2005, total deposits were up by $83
          million
          from the end of the second quarter last year, with checking and money market
          balances accounting for $37 million, or 45% of the growth.
  Between
          the 2004 year-end and the March 31, 2005 quarter-end, however, our checking
          and
          money market balances declined by $12 million. This represented a significant
          departure from the previous couple of years, in which growth of checking
          and
          money market balances accounted for the majority of all deposit growth.
          By June
          30, 2005, however, the run-off in checking and money market balances reversed
          and balances had risen to $253 million, approximately $1 million below
          the 2004
          year-end level.
  The
          shift
          in balances from money market accounts to certificates of deposit occurred
          as
          the rate differential between the two product types began to widen. In
          2004,
          with short-term interest rates at historically low levels, the rates offered
          on
          time deposits were only modestly higher than those on money market accounts,
          and
          thus viewed as unattractive by many investors. As a result, these depositors
          often chose to keep their balances in money market accounts, accepting
          slightly
          lower yields in exchange for greater liquidity. Earlier this year, as the
          increases in short-term market interest rates that began in the second
          quarter
          of 2004 started affecting the yields on retail deposits, the rates paid
          on time
          deposits rose to a greater extent than those paid on money market accounts.
          As a
          result, time deposits became more attractive, making it more difficult
          to retain
          or grow checking and money market balances without incurring exorbitant
          marginal
          expense to do so, as any rate increases would apply not only to any newly
          opened
          accounts but all existing balances as well. With checking and money market
          balances showing signs of recovery over the last couple months, we are
          not
          currently anticipating significant future migration from checking and money
          market accounts to time deposits.
  16
 
 **Asset
          Yields and Funding Costs (Rate)**
  For
          the
          quarter and six months ended June 30, 2005, the net effects of repricing
          on our
          assets and liabilities contributed an additional $248,000 and $671,000
          to our
          net interest income, or 26% and 29% of the total differences relative to
          first
          quarter and half of 2004.
  On
          the
          asset side, our loan portfolio accounted for $1.5 million and $2.4 million
          in
          additional interest income for the three and six month periods, or the
          vast
          majority of the total rate-related increase in interest income. As
          adjustable-rate loans account for approximately 90% of our loan portfolio,
          almost all loan types benefited from increases in short-term interest
          rates.
  By
          comparison, very little impact from repricing was observed in our securities
          portfolio due to the percentage of the portfolio invested in fixed-rate
          and
          hybrid ARM securities, which have not yet benefited from rising rate indices.
          Additionally, the rate-related benefits that were recognized from the repricing
          of adjustable-rate securities in our portfolio were largely offset by a
          reduction in the dividend on our holdings of stock in the FHLB.
  As
          a
          member of the FHLB and to utilize FHLB advances as a funding source for
          our
          lending and investment activities, we maintain a position in FHLB stock.
          Our
          position in this stock, which totaled $13 million for both the first and
          second
          quarters, has historically paid dividends on a quarterly basis. Based on
          events
          at the FHLB, however, the dividend rate for the first quarter of 2005 was
          well
          below the rate paid in the first quarter of last year, and no dividend
          was
          received from the FHLB in the second quarter. At this time, we do not anticipate
          receiving any dividend income on our FHLB stock in the foreseeable
          future.
  On
          the
          liability side of the balance sheet, repricing increased our interest expense
          on
          both deposits and FHLB advances for both the quarter and six-month period
          ended
          June 30 relative to the prior year. The interest rate increases that drove
          loan
          and wholesale funding rates higher over the last year began to influence
          the
          deposit rates offered by our competitors in our local market earlier this
          year,
          resulting in rate-related increases in interest expense on both our non-maturity
          and time deposit accounts.
  **Net
          Interest Margin**
  Quarter
                    Ended
                Net
                    Interest MarginJune
                    30, 2004
                3.97%September
                  30, 2004
                3.99%December
                    31, 2004
                3.99%March
                    31, 2005
                4.08%June
                    30, 2005
                4.01%
  Our
          net
          interest margin totaled 4.01% for the second quarter of 2005. While this
          represented a decline from the first quarter level, it exceeded the top
          of our
          3.90% to 4.00% forecast by one basis point. A reduction in the margin had
          been
          expected based on a combination of fixed-rate securities in our portfolio,
          the
          non-payment of dividends on our FHLB stock, and a shifting customer preference
          from lower-rate money market accounts to higher-rate time deposits observed
          in
          the first quarter.
  17
  As
          noted
          above, adjustable-rate loans, which reprice according to terms specified
          in our
          loan agreements with the borrowers, accounted for approximately 90% of
          our loan
          portfolio as of June 30, 2005. For the majority of these loans, repricing
          occurs
          on an annual basis. A notable exception to this would be those loans tied
          to the
          prime rate (about 15% of our portfolio), which typically reprice within
          one or
          two days of any increase in the Federal Funds target rate by the Federal
          Reserve. Consequently, most of the loans in our portfolio benefited from
          increases in short-term market interest rate indices over the last 15 months
          and
          earned additional interest income relative to the quarter and six months
          ended
          June 30, 2004.
  By
          comparison, rates on our retail deposits are managed internally and not
          typically subject to any sort of systematic adjustments based on movements
          in
          market rate indices. Instead, retail deposit rates tend to lag major interest
          rate indices. Retail deposit rates then typically continue to move for
          some time
          after the market rates stabilize or plateau at a given level. Consequently,
          while loan rates systematically repriced upwards, we postponed raising
          our
          retail deposit rates for as long as practical given our funding requirements
          and
          the rates offered by other institutions in our local market. By the end
          of the
          first quarter, however, the deposit rates offered by our competitors had
          begun
          moving upwards in response to increases in market interest rates and were
          rising
          at a faster rate than most major indices used for pricing in our loan portfolio.
          If short-term rates were to stabilize, we could potentially see additional
          compression in our net interest margin in subsequent quarters as the effects
          of
          systematic loan repricing diminish, while deposit rates continue to trend
          upward
          for some time afterwards based on the lagging nature of retail deposit
          rate
          movements. However, given that intense competition earlier this year drove
          deposit rates higher with what seemed to be faster than historically typical
          velocity, it is also possible that these rates would not continue to trend
          upwards as long or as far as in previous rate cycles.
  Additionally,
          the migration of checking and money market balances to time deposit accounts
          could potentially contribute to future compression of our net interest
          margin.
          Our checking and money market account balances typically represent a lower-cost
          source of funding for us, and time deposits a higher-cost source, becoming
          progressively more so as rates rise. Although we have grown our checking
          and
          money market deposits over their June 30, 2004 levels, these balances declined
          in the first quarter of this year, then began to recover over the last
          couple
          months. While we do not anticipate further migration from checking and
          money
          market accounts to time deposits, in the event that movement were to resume
          in a
          manner similar to that observed earlier this year, our net interest margin
          could
          be subject to further compression.
  Our
          net
          interest margin represents our net interest income for a given period,
          divided
          by the average level of earning assets during that same period. For our
          year-to-date net interest margin ratios prior to the second quarter of
          2005, we
          calculated our average level of earning assets using an arithmetic average
          calculation of our balance sheets as of the quarter-end focal date and
          the
          previous year-end. As a result, to the extent that assets grew early within
          a
          given year or that growth slowed or assets declined later in the year,
          this
          methodology would have resulted in a higher margin than a daily average
          calculation, as assets will be on our balance sheet and earning income
          for a
          longer time than implied by the averaging calculation. The opposite would
          have
  18
 occurred
            if the majority of asset growth occurred near the end of the year, or
            if assets
            were to decline early in the year.
 Beginning
          with the second quarter of 2005, we changed this methodology to use an
          arithmetic average calculation of each quarter-end balance sheet within
          the
          subject timeframe, along with the prior year-end. For the six months ended
          June
          30, this translates to a year-to-date average calculation based on three
          points
          in time (December 31, 2004, March 31, 2005, and June 30, 2005) as opposed
          to two
          points (December 31, 2004 and June 30, 2005) using the previous method.
          Year-to-date calculations for prior periods have been recalculated using
          the new
          method to facilitate comparisons. We believe that this change will better
          reflect the evolution of our balance sheet and margin over the course of
          each
          year and improve the overall accuracy of our margin calculation.
  **Noninterest
          Income**
  Noninterest
          income increased by $644,000 for the quarter and $1.1 million for the six
          months
          ended June 30, 2005, compared to the same periods in 2004. The 69% and
          61%
          improvement, respectively, was attributable to higher net servicing income,
          gains on loan sales, and loan fees.
  **Gain
          on Sales of Loans**
  **Gain
                    on Loan Sales**
                
                2Q
                    2005
                
                2Q
                    2004
                
                YTD
                    2005
                
                YTD
                    2004Consumer
                    Loan Sale Gains
                
                $
                201,000
                
                $
                258,000
                
                $
                702,000
                
                $
                532,000Residential
                    Loan Sale Gains
                
                
                38,000
                
                
                36,000
                
                
                62,000
                
                
                64,000Commercial
                    Loan Sale Gains
                
                
                181,000
                
                
                28,000
                
                
                181,000
                
                
                71,000Total
                    Gains on Loan Sales
                
                $
                420,000
                
                $
                322,000
                
                $
                945,000
                
                $
                667,000**Loans
                    Sold**Consumer
                    Loans Sold
                
                $
                5,038,000
                
                $
                7,592,000
                
                $
                15,676,000
                
                $
                15,264,000Residential
                    Loans Sold
                
                
                4,938,000
                
                
                8,336,000
                
                
                12,090,000
                
                
                16,656,000Commercial
                    Loans Sold*
                
                
                2,570,000
                
                
                6,718,000
                
                
                2,570,000
                
                
                17,546,000Total
                    Loans Sold
                
                $
                12,546,000
                
                $
                22,646,000
                
                $
                30,336,000
                
                $
                49,466,000
  *
          The
          commercial loans sold for second quarter 2005 of $2,570,000 represents
          2 loans.
          The first loan for $1,920,000 is fully disbursed. The second loan is a
          construction loan for $7,500,000 of which $650,000 was disbursed at origination.
  For
          the
          second quarter of 2005, gains on loan sales significantly exceeded those
          of the
          prior year, attributable primarily to a large commercial loan transaction
          in
          June. Gains for the quarter and six months totaled $420,000 and $945,000,
          representing increases of 30% and 42% over the same periods last
          year.
  Historically,
          the commercial real estate loans we originate have been retained in our
          portfolio, and sales of participations in these loans have been utilized
          to
          limit our aggregate credit exposure to specific borrowers. During the second
          quarter, however, we experienced increased interest in, and opportunities
          for,
          sales of participations in commercial real estate loans. Consequently,
          we are
          currently considering the merits of expanding our commercial real estate
          loan
          sales and potentially originating credits with the intent to sell, rather
          than
          portfolio the loans. In the event we determine that such a strategy would
          be
          more favorable than our historical practice, we would likely increase our
          sales
          of commercial real estate loans, which could potentially lead to a reduction
          in
          the size of our Income Property Segment’s loan portfolio. We do not anticipate
          that these potential sales would impact the other three segments, where
          we would
  19
  expect
          the loan portfolios to continue to grow.
  With
          gains of $201,000 in the second quarter, consumer loan sales remained the
          largest contributor to our loan sale gains, though only modestly greater
          than
          the commercial category. While this represented a 22% decline from the
          gains
          realized in the second quarter of 2004, our pricing and execution improved,
          as
          the volume of loans sold declined 34% to $5.0 million, versus $7.6 million
          in
          the second quarter of last year. Similarly, through the first six months
          of
          2005, gains on consumer loan sales increased $170,000, or 32%, despite
          the
          volume of loans sold increasing less than 3%.
  As
          with
          the commercial real estate loans, we reconsidered our strategy on the sales
          of
          consumer loans during the second quarter. Previously, our plan had been
          to sell
          approximately $6 million to $8 million in sales finance loans each quarter,
          though actual sales in a given quarter could fall above or below this range
          depending on loan production, market conditions, and other factors. In
          the
          second quarter, we revised our plan such that we now expect to substantially
          reduce our sales of these loans, selling only sufficient volumes to ensure
          the
          continuity of the market. This strategy may be reevaluated and subject
          to
          further modification based on factors including, but not limited to future
          loan
          production and/or market conditions.
  In
          contrast, residential loan sale gains were little changed from the prior
          year,
          up 5% for the quarter and down 4% for the six months ended June 30, 2005,
          as the
          volume of loans sold declined 41% and 28% compared to the same periods
          last
          year. While production volumes for residential loans exceeded those for
          the
          second quarter and first half of last year, a greater percentage of this
          year’s
          production was in custom construction loans, which have been retained within
          our
          portfolio.
  **Service
          Fee Income**
  2Q
                    2005
                
                2Q
                    2004
                
                YTD
                    2005
                
                YTD
                    2004Consumer
                    Loans
                
                $
                341,000
                
                $
                65,000
                
                $
                641,000
                
                $
                88,000Commercial
                    Loans
                
                
                26,000
                
                
                16,000
                
                
                50,000
                
                
                28,000Residential
                    Loans
                
                
                2,000
                
                
                0
                
                
                4,000
                
                
                (2,000
                )Service
                    Fee Income
                
                $
                369,000
                
                $
                81,000
                
                $
                695,000
                
                $
                114,000
  For
          the
          quarter and six months ended June 30, 2005, our total servicing fee income
          rose
          357% and 512% over the levels earned in the same periods of 2004, based
          on
          substantial increases in fees earned on consumer loans serviced for others.
          The
          growth in consumer loan service fees this year is primarily attributable
          to a
          change in the amortization period assumed for the underlying servicing
          asset,
          though additional loan sales over the last several quarters, and corresponding
          growth in our portfolio of consumer loans serviced for others, also contributed
          to the additional servicing income.
  20
  Servicing
          assets are recorded when we sell loans to other investors and continue
          to
          service those loans following the sale. To determine the fair value of
          the
          servicing assets, we utilize a valuation model that calculates the present
          value
          of future cash flows for the loans sold, based on assumptions including
          market
          discount rates, anticipated prepayment speeds, estimated servicing cost
          per
          loan, and other relevant factors. These factors are subject to significant
          fluctuations, and the estimates used in the models are subject to review
          and
          revision based on actual experience and changes in expectations for the
          future.
          The calculated value of the servicing rights is then capitalized and amortized
          in proportion to, and over the period of, estimated future net servicing
          income.
  Based
          on
          a review of our assumptions in the first quarter of 2005, we determined
          that the
          amortization period for the servicing rights on our consumer loan servicing
          portfolio was significantly shorter than the term over which these loans
          would
          be expected to provide net servicing income. Consequently, we revised the
          amortization period such that the average life of the amortization schedule
          would correspond with the average life we are currently observing for the
          underlying loan portfolio. This resulted in a significant increase in our
          net
          servicing income. Note that any projection of servicing asset amortization
          in
          future periods is limited by the conditions that exist at the time the
          calculations are performed, and may not be indicative of actual amortization
          expense that will be recorded in future periods.
  The
          income received for servicing consumer loans grew as a result of the sales
          finance loan sales over the last several quarters, and the corresponding
          growth
          in our portfolio of consumer loans serviced for others. Based on our decision
          to
          reduce sales of consumer loans in the future and instead retain a greater
          percentage of these loans within our portfolio, the rapid growth in fee
          income
          earned on the portfolio of serviced consumer loans in recent quarters is
          not
          expected to continue in future quarters.
  An
          increase was also observed in service fee income earned on our commercial
          loans
          serviced for others based on participations sold in the last half of 2004.
          In
          the event we elect to expand our sales of commercial real estate loans,
          we would
          expect this income to continue to grow in the future. In contrast, 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.
  **Other
          Noninterest Income**
  2Q
                    2005
                
                2Q
                    2004
                
                YTD
                    2005
                
                YTD
                    2004Rental
                    Income
                
                $
                144,000
                
                $
                167,000
                
                $
                310,000
                
                $
                335,000Loan
                    Fees
                
                
                288,000
                
                
                86,000
                
                
                358,000
                
                
                108,000ATM/Wires/Safe
                    Deposit
                
                
                62,000
                
                
                49,000
                
                
                119,000
                
                
                87,000Late
                    Charges
                
                
                46,000
                
                
                38,000
                
                
                94,000
                
                
                74,000Miscellaneous
                
                
                72,000
                
                
                38,000
                
                
                115,000
                
                
                79,000Total
                    Other Noninterest Income
                
                $
                612,000
                
                $
                378,000
                
                $
                996,000
                
                $
                683,000
  21
  Our
          noninterest income from sources other than those described above rose $234,000,
          or 62% over the second quarter of last year, and $313,000, or 46% over
          the first
          six months of 2004. While an increase in loan fee income made the largest
          single
          contribution, significant improvements were also observed in late charge
          fees
          received on our loan portfolio, as well as Visa and ATM fees, which are
          expected
          to continue rising as checking accounts become a greater piece of our overall
          deposit mix.
  Loan
          fees
          increased by $202,000 compared to the second quarter of 2004, as prepayment
          fees
          were $248,000, up from $84,000 last year. On a year-to-date basis, loan
          fees
          rose $250,000 with prepayment fees increasing $212,000. In recent quarters,
          short-term interest rates have risen, while longer-term interest rates,
          such as
          the 10-year U.S. Treasury rate, which are more indicative of fixed-rate
          mortgage
          rates, have tended to move within a range and without any discernible upward
          or
          downward tendency. Combined, these movements have resulted in a flattening
          of
          the yield curve. We believe that this flattening, and expectations that
          rates
          could move upwards in the foreseeable future, have contributed to the higher
          level of loan payoffs and prepayment fees observed over the last few quarters.
          As this flattening of the yield curve reduces the rate differential between
          short- and long-term financing costs, the financial incentive for borrowers
          to
          use shorter-term, adjustable-rate financing rather than longer-term, fixed-rate
          loans diminishes. This, in turn, provides borrowers with short-term or
          adjustable-rate loans an incentive to refinance with long-term fixed rates.
          Given the uncertainties in interest rates and borrower expectations, we
          do not
          know if the higher level of prepayment fees is likely to continue.
  **Noninterest
          Expense**
  **Salaries
          and Employee Benefits Expense**
  Salaries
          and employee benefits expense increased by $940,000, or 28%, from $3.4
          million
          in the second quarter of 2004, to more than $4.3 million for the same period
          in
          2005, accounting for approximately 85% of the increase in total noninterest
          expense. On a year-to-date basis the increase was $1.6 million, or 24%,
          over the
          six-month period ended June 30, 2004.
  2Q
                    2005
                
                2Q
                    2004
                
                YTD
                    2005
                
                YTD
                    2004Salaries
                
                $
                2,526,000
                
                $
                2,239,000
                
                $
                5,147,000
                
                $
                4,438,000Commissions
                    & Incentive Bonuses
                
                
                927,000
                
                
                441,000
                
                
                1,438,000
                
                
                774,000Employment
                    Taxes & Insurance
                
                
                272,000
                
                
                221,000
                
                
                562,000
                
                
                481,000Temporary
                    Office Help
                
                
                70,000
                
                
                48,000
                
                
                112,000
                
                
                83,000Benefits
                
                
                537,000
                
                
                443,000
                
                
                1,019,000
                
                
                879,000Total
                    Salary & Benefit Expenses
                
                $
                4,332,000
                
                $
                3,392,000
                
                $
                8,278,000
                
                $
                6,655,000
  Over
          half
          of the increase in salary and benefit expense relative to the second quarter
          of
          last year was the result of higher incentive compensation accrued for
          administrative and support personnel. Earlier in the year, incentive
          compensation had increased relative to the prior year due to our Business
          Banking and Residential lending divisions returning to a normal level of
          incentive compensation this year, compared to a below average level of
          expense
          in 2004. The incentive compensation plans for loan production tend to vary
          directly with the production of the business lines.
  22
  Also
          contributing to the increase in salary and benefit expense were our annual
          salary increases for existing staff, which took place in April 2005. In
          addition, expenses rose as our full-time-equivalent (FTE) employee count
          grew
          from 201 FTE’s to 218 FTE’s over the past 12 months. These additions consisted
          primarily of positions pertaining to the origination and/or servicing of
          our
          loan portfolio or retail deposits. While incentive compensation expenses
          tend to
          be variable, base salary represents more of a fixed cost, subject to increases
          during times of operational expansion.
  Our
          salary expense declined between the first and second quarters of 2005,
          despite
          the annual salary increases in April, due to the deferral of certain salary
          expenses related to loan originations. In accordance with current accounting
          standards, certain loan origination costs, including some salary expenses
          tied
          to loan origination, are deferred and amortized over the life of each loan
          originated, rather than expensed in the current period. Expenses are then
          reported in the financial statements net of these deferrals. The amount
          of
          expense subject to deferral and amortization can vary from one period to
          the
          next based upon the number of loans originated, the mix of loan types,
          and
          year-to-year changes in “standard loan costs”. In this instance, the number of
          loans originated by our Business Banking, Residential, and Sales Finance
          lending
          areas in the second quarter of 2005 exceeded the number of loans originated
          in
          the first quarter. Consequently, the amount of salary expense to be deferred
          and
          amortized increased between the two quarters, reducing our second quarter
          salary
          expense. Also contributing to the reduction between quarters was the departure
          of a senior vice president-level manager in one of our support departments
          at
          the end of the first quarter. As we are actively recruiting for a replacement
          for this position, this cost reduction is expected to be temporary.
  Quarter
                    Ended
                
                FTE
                    at Quarter End
                
                Salaries
                
                Commissions
                    & Incentive BonusesJune
                    30, 2004
                
                
                201
                
                $
                2,239,000
                
                $
                441,000September
                    30, 2004
                
                
                214
                
                $
                2,276,000
                
                $
                541,000December
                    31, 2004
                
                
                220
                
                $
                2,481,000
                
                $
                855,000March
                    31, 2005
                
                
                219
                
                $
                2,621,000
                
                $
                511,000June
                    30, 2005
                
                
                218
                
                $
                2,526,000
                
                $
                927,000
  **Occupancy
          Expense**
  Occupancy
          expense increased $200,000, or 31% relative to the second quarter of last
          year,
          based primarily on higher software licensing costs and depreciation expense.
          For
          the six months ended June 30, 2005, occupancy expenses increased $288,000,
          or
          21%, from the same period in 2004.
  2Q
                    2005
                
                2Q
                    2004
                
                YTD
                    2005
                
                YTD
                    2004Rent
                    Expense
                
                $
                81,000
                
                $
                78,000
                
                $
                159,000
                
                $
                161,000Utilities
                    & Maintenance
                
                
                140,000
                
                
                138,000
                
                
                329,000
                
                
                313,000Depreciation
                    Expense
                
                
                395,000
                
                
                319,000
                
                
                734,000
                
                
                634,000Other
                    Occupancy Costs
                
                
                233,000
                
                
                114,000
                
                
                411,000
                
                
                237,000Total
                    Occupancy Expenses
                
                $
                849,000
                
                $
                649,000
                
                $
                1,633,000
                
                $
                1,345,000
  Depreciation
          expense rose by $76,000 compared to the second quarter of last year, due
          to
          capital expenditures made over the last 12 months for banking center remodel
          projects, growth in our information systems infrastructure, and investment
          in
          enterprise software. We expect these costs to continue to rise in the second
          half of 2005 as we complete the remodeling projects on our First
  23
  Mutual
          Center headquarters building and additional banking centers and begin
          depreciating those new assets.
  The
          majority of the increase in occupancy expense occurred in “other occupancy
          costs,” which includes items such as real estate and personal property taxes,
          the purchase of non-capitalized equipment, and software licensing. For
          the
          second quarter of 2005, our computer equipment costs accounted for most
          of this
          category’s increase, rising $95,000 over the prior year, primarily as a result
          of non-capitalized equipment expenditures associated with the relocation
          of
          several departments to recently remodeled areas of the First Mutual Center.
          Another factor that increased expenses this quarter was higher software
          licensing fees due to our new licensing agreement with Microsoft.
  **Other
          Noninterest Expense**
  Other
          noninterest expense declined by $37,000, or 2%, and was driven by lower
          expenditures for legal fees, data processing, and business and occupation
          taxes.
          Largely offsetting these reductions were increased marketing, loan processing
          and charitable contributions expenses. For the six-month period ending
          June 30,
          2005, other noninterest expense increased by $415,000, or 11%, over the
          same
          six-month period in 2004.
  
 2Q
                    2005
                
                2Q
                    2004
                
                YTD
                    2005
                
                YTD
                    2004Marketing
                    & Public Relations
                
                $
                350,000
                
                $
                302,000
                
                $
                704,000
                
                $
                588,000Credit
                    Insurance
                
                
                346,000
                
                
                346,000
                
                
                679,000
                
                
                503,000Outside
                    Services
                
                
                154,000
                
                
                168,000
                
                
                352,000
                
                
                317,000Taxes
                
                
                84,000
                
                
                108,000
                
                
                225,000
                
                
                235,000Information
                    Systems
                
                
                226,000
                
                
                283,000
                
                
                473,000
                
                
                499,000Other
                
                
                802,000
                
                
                792,000
                
                
                1,662,000
                
                
                1,538,000Total
                    Other Noninterest Expenses
                
                $
                1,962,000
                
                $
                1,999,000
                
                $
                4,095,000
                
                $
                3,680,000
  The
          most
          significant growth in the second quarter’s other noninterest expense came from
          loan processing costs. These costs which are included in the other noninterest
          expense category above, increased $64,000 relative to the second quarter
          of
          2004. As with salaries, loan processing costs are another category of expense
          subject to deferral and capitalization of loan origination costs, and the
          majority of the increase was attributable to a reduction in the amount
          of
          expenses deferred compared to 2004. The amount of processing expense subject
          to
          deferral for several loan types, most notably custom construction loans,
          declined relative to last year. This caused our net expenses to rise
          substantially as we were unable to defer and amortize as many of these
          costs as
          we did in the second quarter of 2004. On a year-to-date basis, our loan
          processing expenses were up $78,000 over last year.
  Another
          component of our other noninterest expense category, charitable contributions,
          also increased markedly during the second quarter. The increase can be
          attributed to a number of donations that were made to various Eastside
          non-profit organizations. On a year to-date-basis, donations rose $43,000
          from
          last year.
  Advertising
          expenses, which represent the majority of our marketing and public relations
          expenses above, rose $40,000, or 18%, in the second quarter over the same
          period
          in 2004. The growth in these expenses can be attributed to an increase
          in both
          our radio and local newspaper
  24
  advertising.
          On a year-to-date basis, marketing expenses rose $103,000, or nearly 22%,
          from
          the same period last year.
  Additionally,
          although there was no change in our credit insurance expense for the quarter,
          it
          should be noted that in the second quarter of 2004 we incurred an additional
          accrual of $162,000, which greatly increased our credit insurance expenses
          during that period. For the year-to-date period, our credit insurance expenses
          have risen $176,000, or 35%, based on growth in the balances of insured
          sales
          finance loans, including both the loans in our portfolio as well as those
          serviced for other institutions.
  Significant
          decreases in a number of expense categories included our legal expense,
          which
          declined $68,000, or 49%, from the same quarter last year. In addition
          to lower
          legal fees, our expenses were further reduced as a result of receiving
          refunds
          for legal expenses from several borrowers.
  Another
          area where other noninterest expense declined considerably was our information
          systems expenses. In the second quarter these expenses fell $57,000, or
          over
          20%, compared to the same period last year. We received a $25,000 credit
          from
          our primary services provider due to a change in pricing, in addition to
          submitting fewer work orders during the second quarter. For the year-to-date
          period, our information systems expenses declined $26,000, or 5%, compared
          to
          last year.
  Our
          tax
          expenses were also much lower in the second quarter, declining $24,000
          or nearly
          22%, from their second quarter 2004 level. The reduction in these expenses
          was
          largely attributable to an adjustment of $27,000 in B&O taxes and a $10,000
          refund of taxes from the State of Oregon. For year-to-date 2005, our tax
          expenses decreased $10,000, or 4%, compared to the first six months of
          2004.
          These adjustments reflected lower actual payments compared to estimated
          accruals.
  **REVIEW
          OF FINANCIAL CONDITION**
 
 **Assets**
 
 Assets
          increased 4% in the first six months of 2005, totaling $1,045 million at
          June
          30, 2005, up from $1,004 million at the 2004 year-end, based primarily
          on growth
          in our loan portfolio.
 
 **Securities**
 
 We
          classify investment securities in one of the following categories: 1) trading,
          2) available-for-sale, or 3) held-to-maturity. Securities classified as
          available-for-sale are reviewed regularly, and any unrealized gains or
          losses
          are recorded in the shareholders’ equity account. As of June 30, 2005, the
          balance of the unrealized loss, net of federal income taxes, was $349,000,
          compared to an unrealized loss at year-end 2004 of $510,000. Generally,
          falling
          interest rates will increase the amount recorded as unrealized gain, and
          rising
          rates will decrease any unrealized gains, as the market value of securities
          inversely adjusts to the change in interest rates.
  25
 
 **Securities**
                
                **Assets**
                
                **Percentage**
                  **of
                    Assets**(Dollars
                    in thousands)December
                    31, 2004
                
                $
                131,944
                
                $
                1,003,783
                
                
                13
                %June
                    30, 2005
                
                $
                129,093
                
                $
                1,045,470
                
                
                12
                %
  Security
          investments (available-for-sale and held-to-maturity) declined from their
          level
          as of the 2004 year-end, decreasing slightly less than $3 million over
          the last
          six months. With the securities purchased in 2004, we still believe the
          current
          size of our portfolio to be adequate, and do not anticipate additional
          securities purchases, other than the amount necessary to maintain the current
          portfolio level.
 
 **Loans**
 
 Loans
          receivable, excluding loans held-for-sale, increased by $33 million from
          $809
          million at the 2004 year-end to $842 million at the end of the second quarter,
          as loan originations increased 11% over the second quarter of last year
          to $137
          million. Income property loans accounted for 37% of our loan portfolio
          at the
          end of the second quarter, down 3% relative to the 2004 year-end and down
          from
          43% as of June 2004. Business banking loans totaled 13% of the loan portfolio,
          unchanged compared to the 2004 year-end and 2% higher than a year ago,
          while
          commercial construction loans remained unchanged at 3% of loans. Single-family
          mortgage loans, generally non-conforming and including loans held-for-sale,
          increased to 24% of the portfolio at quarter-end, compared to 21% at the
          end of
          the second quarter last year and 22% as of the 2004 year-end. Single-family
          construction loans remained relatively consistent and accounted for 11%
          of total
          loans for this quarter and for the second quarter last year. Construction
          loans
          at year end 2004, however, were slightly lower at 10%. Consumer loans,
          largely
          home-improvement loans originated on a national scale through the Sales
          Finance
          Division, remained at 12% of the loan portfolio for the quarter which was
          unchanged compared to the 2004 year end but slightly higher than the 11%
          that
          was recorded for the first six months of 2004.
 
 When
          taking into account our expected production volumes, payoffs, and loan
          sales for
          all lending divisions, we expect loan growth in the range of $0-$5 million
          for
          the third quarter of 2005. The anticipated increase in commercial loan
          sales is
          projected to offset the loan growth in the other business lines.
 
 **Servicing
          Assets**
 
 Servicing
          assets grew by $557,000 or 36%, in the six-month period ending June 30,
          2005.
          Earlier this year, most of the growth in our servicing assets was attributable
          to sales of consumer loans originated by our Sales Finance lending area,
          as
          illustrated by the “Consumer” servicing assets line in the table below. For the
          quarter-ended June 30, 2005, however, sales of these loans were minimal
          relative
          to prior quarters, after we revised our loan sales strategy and decided
          to
          substantially reduce our loan sales, selling only sufficient volumes to
          ensure
          the continuity of the market. This strategy may be reevaluated and subject
          to
          further modification based on factors including, but not limited to future
          loan
          production and/or market conditions.
 
 26
  For
          the
          second quarter of 2005, the majority of the growth in our servicing assets
          was
          attributable to commercial loan sales, in particular, the sale of a large
          commercial real estate credit in June 2005 that included both the construction
          financing as well as the permanent mortgage to refinance that loan following
          the
          completion of construction.
 
 Historically,
          the commercial real estate loans we originate have been retained in our
          portfolio, and sales of participations in these loans have been utilized
          to
          limit our aggregate credit exposure to specific borrowers. During the second
          quarter, however, we experienced increased interest in and opportunities
          for
          sales of commercial real estate loan participations. Consequently, we are
          currently considering the merits of expanding our commercial real estate
          loan
          sales and potentially originating credits with the intent to sell, rather
          than
          portfolio the loans.
 
 2Q
                    2005
                
                1Q
                    2005
                
                4Q
                    2004
                
                3Q
                    2004**Servicing
                    Assets:**Commercial
                
                $
                311,000
                
                $
                151,000
                
                $
                173,000
                
                $
                134,000Residential
                
                
                11,000
                
                
                12,000
                
                
                13,000
                
                
                17,000Consumer
                
                
                1,760,000
                
                
                1,730,000
                
                
                1,339,000
                
                
                1,085,000Total
                
                $
                2,082,000
                
                $
                1,893,000
                
                $
                1,525,000
                
                $
                1,236,000Loan
                    Balances
                  Serviced
                    for Others
                
                $
                122,154,000
                
                $
                120,898,000
                
                $
                117,852,000
                
                $
                109,226,000
  Servicing
          assets represent the deferred servicing rights generated from sales of
          loans
          that are sold servicing retained, offset by the amortization and prepayments
          of
          loans serviced, as well as any impairment charges that may occur. Although
          the
          increases in servicing assets have not been a major factor in our overall
          asset
          growth, this area is expected to continue increasing with the anticipated
          future
          sales of commercial loans.
 
 **Liabilities**
 
 In
          the
          first six months of this year, our total deposit balances rose 7% from
          their
          year-end levels, totaling $720 million at the end of the second quarter.
          Our
          checking and money market balances, however, declined $1 million from their
          2004
          year-end level as balances migrated from these accounts to time deposits
          earlier
          this year. This migration represented a departure from the trend observed
          over
          the last few years, in which growth of checking and money market balances
          accounted for the majority of all deposit growth. In the second quarter
          of 2005,
          however, the migration appears to have abated, as checking and money market
          balances grew $11 million, or 5%, between the ends of the first and second
          quarters.
 
 The
          shift
          in balances in the first quarter from money market accounts to certificates
          of
          deposit occurred as the rate differential between the two product types
          began to
          widen. In 2004, while short-term interest rates remained at historically
          low
          levels, the rates offered on time deposits were only modestly higher than
          those
          on money market accounts, and consequently viewed by many investors as
          unattractive. As a result, these depositors often chose to keep their balances
          in money market accounts, accepting slightly lower yields in exchange for
          the
          greater liquidity offered by these accounts. Earlier this year, as the
          increases
          in short-term market interest rates that began in the second quarter of
          2004
          started affecting the yields on retail deposits, the rates paid on time
          deposits
          rose at a faster pace than those paid on money market accounts. This
  27
  resulted
          in time deposits becoming more attractive, making it more difficult to
          retain or
          grow checking and money market balances without incurring exorbitant marginal
          expense to do so, as any rate increases would apply not only to any newly
          opened
          accounts, but all existing balances as well. With checking and money market
          balances showing signs of recovery over the last couple months, we are
          not
          currently anticipating significant future migration from checking and money
          market accounts to time deposits.
 
 Utilization
          of FHLB advances, our preferred supplemental funding mechanism, declined
          $6
          million to $228 million for the six-month period ending June 30, 2005 as
          the
          deposit growth described above, along with retained earnings supported
          our asset
          growth. As of June 30, 2005, we had the authority to borrow up to a total
          of
          nearly $418 million in FHLB advances, subject to sufficient collateral
          to
          support those advances.
 
 **ASSET
          QUALITY**
 
 **Provision
          and Reserve for Loan Loss**
  This
          quarter’s provision for reserve for loan losses, which was approved by the Audit
          Committee of the Board of Directors, was little changed from the second
          quarter
          2004 level, increasing from $440,000 last year to $450,000 for the current
          quarter. The provision in the two previous quarters, the fourth quarter
          of 2004
          and first quarter of 2005 were $350,000 and $400,000, respectively. The
          provision for loan losses reflects the amount deemed appropriate to produce
          an
          adequate reserve for possible loan losses inherent in the risk characteristics
          of the loan portfolio. In determining the appropriate reserve balance,
          we
          consider 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
          provision for the second quarter is largely due to the inherent risks identified
          in the portfolio. Net
          portfolio loans totaled $832 million as of June 30, 2005, an increase of
          6% from
          $785 million at the end of June last year . Also
          affecting the level of our reserve for loan losses were our net loan
          charge-offs, which totaled $231,000 for the quarter ended June 30, 2005,
          up
          substantially from the $161,000 level for the same quarter last year. On
          a
          sequential quarterly basis, the net charge-offs totaled $211,000 in the
          previous
          quarter and $206,000 in the fourth quarter of 2004. Due to their unique
          characteristics, our sales finance loans comprise the bulk of our loan
          write-offs, though they only constitute approximately 9% of the total loan
          portfolio. This pattern of sales finance loans representing the largest
          category
          of charge-offs is generally consistent with the trends that we have experienced
          in prior years. Please see the section, “Sales Finance (Home Improvement) Loans”
          for a further discussion of this business line.
 
 **Non-Performing
          Assets**
 
 Our
          non-performing assets declined from $1,154,000 at June 30, 2004 to $797,000
          at
          the end of the second quarter of 2005. The current level of non-performing
          assets also improved relative to the year-end 2004 level of $1,007,000.
          The
          ratio of non-performing assets to total assets was 0.08% as of June 30,
          2005,
          which compares to 0.10% at the end of 2004 and 0.12% as of June 30, 2004.
          By
          comparison, the ratio for all FDIC-insured institutions as of March 31,
          2005
          totaled 0.50%.*
 
 *
          FDIC
          Quarterly Banking Profile, First Quarter 2005
 
 28
  Noted
          below is a summary of our exposure to non-performing loans and repossessed
          assets as of June 30, 2005:
  Three
                    single-family residences, one in Oregon, one in Idaho, and one
                    in
                    Washington. No anticipated loss.
                
                $
                461,000Sixty-two
                    consumer loans. Full recovery anticipated from insurance
                    claims.
                
                
                290,000One
                    consumer loan. No anticipated loss.
                
                
                8,000Six
                    consumer loans. Possible loss of $34,000.
                
                
                34,000TOTAL
                    NON-PERFORMING LOANS
                
                $
                793,000TOTAL
                    REAL ESTATE OWNED AND REPOSSESSED ASSETS
                
                
                4,000TOTAL
                    NON-PERFORMING ASSETS
                
                $
                797,000
  **PORTFOLIO
          INFORMATION**
  **Commercial
          Real Estate Loans** ****
  The
          average loan size (excluding construction loans) in the Commercial Real
          Estate
          portfolio was $753,000 as of June 30, 2005, with an average loan-to-value
          ratio
          of 63% (based upon the appraised value at origination or subsequent appraisal,
          if applicable). 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 44% residential (multi-family or mobile
          home
          parks) and 56% commercial.
  The
          loans
          in our commercial real estate portfolio are well diversified, secured by
          small
          retail shopping centers, office buildings, warehouses, mini-storage facilities,
          restaurants and gas stations, as well as other properties classified as
          general
          commercial use. To diversify our risk and to continue serving our customers,
          we
          sell participation interests in some loans to other financial institutions.
          About 14% 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 $12 million of the
          portfolio, or 3%, has been purchased in this manner.
  **Sales
          Finance (Home Improvement) Loans** ****
  Loan
          production for both the second quarter and first six months of 2005 was
          essentially unchanged over the same periods a year earlier, at $20 million
          and
          $36 million, respectively. However, due to a reduced level of loan sales
          during
          the second quarter, the portfolio increased by $7 million to $74 million.
          Prepayment speeds continue to remain in a range of between 30% and 40%,
          annually.
  
 Bank
                    Portfolio Balance
                Servicing
                    Balance
                Insured
                    Balance (Bank
                  Portfolio
                    and Servicing
                  Balance)June
                    30, 2004
                $67
                    million
                $22
                    million
                $39
                    millionSeptember
                    30, 2004
                $68
                    million
                $31
                    million
                $45
                    millionDecember
                    31, 2004
                $69
                    million
                $37
                    million
                $48
                    millionMarch
                    31, 2005
                $67
                    million
                $44
                    million
                $50
                    millionJune
                    30, 2005
                $74
                    million
                $45
                    million
                $53
                    million
  29
  During
          the second quarter 2005, the average new loan amount was $10,600. The average
          loan balance in the entire portfolio is $9,300. The yield on this portfolio
          is
          9.94%, which has a net interest margin of 6.78%. Loans with principal balances
          representing 40% of the Bank’s portfolio balance have credit insurance in place,
          and 35% (by balance) of the loans originated in the second quarter were
          insured.
  Noted
          below is the charge-off table for the uninsured portfolio and the claims
          experience table for the insured portfolio:
  UNINSURED
                    PORTFOLIOFMB
                    Balance
                Net
                    Charge-Offs
                Charge-offs
                    as a
                  Percent
                    (%)
                  of
                    Portfolio
                Delinquent
                    Loans (% of
                  FMB
                    Portfolio)June
                    30, 2004
                $41
                    million
                $136,000
                0.33%
                0.51%September
                    30, 2004
                $40
                    million
                $ 
                    71,000
                0.18%
                0.75%December
                    31, 2004
                $41
                    million
                $100,000
                0.24%
                0.66%March
                    31, 2005
                $40
                    million
                $141,000
                0.35%
                0.62%June
                    30, 2005
                $44
                    million
                $147,000
                0.33%
                0.77%
   INSURED
                    PORTFOLIOClaims
                    Paid
                Claims
                    as a Percent (%) of
                  Insured
                    Balance
                Delinquent
                    Loans
                  (%
                    of FMB Portfolio)June
                    30, 2004
                $315,000
                0.89%
                1.51%September
                    30, 2004
                $265,000
                0.64%
                2.11%December
                    31, 2004
                $492,000
                1.06%
                2.58%March
                    31, 2005
                $516,000
                1.05%
                2.75%June
                    30, 2005
                $359,000
                0.70%
                3.23%
  Our
          portfolio at June 30, 2005, totaled $74 million, of which $30 million was
          insured. The $44 million of uninsured loans with an average credit score
          of 735
          has performed at a fairly consistent level in terms of loan losses as a
          percent
          of the portfolio over the last five quarters, ranging from 0.18% to 0.35%
          during
          that time. The lower credit score insured portfolio, which has an average
          credit
          score of 669, has performed much differently. Losses incurred in that portfolio
          are submitted to our credit insurer for reimbursement. The claims experience
          in
          the last 12 months has ranged between 0.64% and 1.06% of insured balances.
          The
          delinquency ratios on the insured portfolio have ranged between 1.51% and
          3.23%
          over the last five quarters.
  Our
          contract with the credit insurer provides for a maximum exposure limit
          of 10% of
          the loan balances.  Each year’s loan production that is insured is treated
          as a separate portfolio in terms of the 10% limit. The following table
          shows the
          June 30, 2005 standing of each policy year.
  30
 
 Current
                Original
                
                Remaining
                Limit
                    as % of
                CurrentPolicy
                Loans
                Loan
                Loss
                Claims
                Loss
                Remaining
                DelinquencyYear
                Insured
                Balance
                Limit
                Paid
                Limit
                Balance
                Rate2002/03
                $21,850,000
                $11,500,000
                $2,185,000
                $1,547,000
                $638,000
                5.5%
                4.30%2003/04
                $35,000,000
                $23,700,000
                $3,500,000
                $880,000
                $2,620,000
                11.1%
                5.12%2004/05*
                $19,850,000
                $17,660,000
                NA*
                $9,000
                NA*
                NA*
                1.37%*
                    Policy year closes on 9/30/2005
  Our
          preference is that the remaining lifetime loss limit be at least 10% of
          the
          remaining balance of the loans from that policy year.  Levels below
          10%
          indicate a higher possibility that the remaining lifetime loss limit for
          that
          policy year could be extinguished, resulting in credit risk to the Bank
          on the
          loans remaining from that policy year. The first policy year has not performed
          to expectations. The underwriting approval criteria were tightened in 2004
          in
          reaction to these trends, and the results for both the second and third
          policy
          year appear to reflect these changes positively. We are currently in discussions
          with an insurer about extending the insurance coverage on the first policy
          year
          beyond the 10% limit stated above.
  **Residential
          Lending**
  The
          residential lending portfolio totaled $283 million on June 30, 2005, and
          consisted of $162 million of adjustable-rate permanent loans (57% of the
          total),
          $4.4 million of fixed-rate permanent loans (2% of the total), $76 million
          of
          disbursed balances on custom construction loans (27% of the total), $34.7
          million of loans on residential building lots (12% of the total), and $5
          million
          of loans that are held for immediate sale in the secondary market (2% of
          the
          total). The portfolio has performed in an exceptional manner, and currently
          has
          only three loans, or 0.23% of loan balances, that are delinquent more than
          one
          payment.
  The
          average loan balance in the permanent-loan portfolio is $189,000, and the
          average balance in the building lot portfolio is $113,000. Owner-occupied
          properties constitute 69% of the loan balances. Our portfolio program
          underwriting is typically described as non-conforming. The portfolio generally
          consists of loans that, for a variety of reasons, are not readily salable
          on 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 portfolio 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 assess the loans for compensating
          factors to offset the non-conforming elements of those loans.
  On
          June
          30, 2005, we had $11 million of loans in the portfolio where the borrowers
          are
          making “interest only” payments on the loans until their first interest rate
          change date (at which time the loan converts to normal amortizing payments).
          This represents about 7% of the permanent residential lending portfolio.
          The
          loans with the interest-only feature are underwritten using a payment of
          full
          principal and interest in the calculation of monthly debts. This insures
          that
          loans are not made to borrowers who only qualify due to the interest-only
          payment feature on the loan. Although we believe that those loans are well
          underwritten, and to date our experience with those loans has been favorable,
          we
          recently made the decision to sell a majority of the interest-only loans
          to
          other investors. We are seeking buyers for the pool of loans currently
          on the
          books and for new originations. We do not originate the “Option ARM” product,
          where borrowers are given a variety of monthly payment options, which include
          the possibility of negative amortization.
  31
  As
          of
          June 30, 2005, we held about $1.7 million of low-documentation loans on
          our
          books (or approximately 1% of the permanent-loan portfolio). These loans
          allow
          lower levels of documentation to verify a borrower’s income or assets. Through a
          combination of the borrower’s equity in the property and the purchase of
          mortgage insurance on each individual loan, all low-documentation loans
          have a
          less than 70% loan-to-value exposure to the Bank. Until such time as we
          have an
          established track record with the performance of low-documentation residential
          mortgages, we have established a limit of 1% of the Bank’s loan portfolio for
          them.
  **Portfolio
          Distribution**
  The
          loan
          portfolio distribution at the end of the second quarter was as
          follows:
  Single Family (including loans
                  held-for-sale)
                24%Income Property
                37%Business Banking
                13%Commercial Construction
                3%Single Family Construction:Spec
                2%Custom
                9%Consumer
                12%
 
 Adjustable-rate
          loans accounted for 90% of our total portfolio.
  **DEPOSIT
          INFORMATION**
  The
          number of business checking accounts increased by 19%, from 1,750 at June
          30,
          2004, to 2,088 as of June 30, 2005, a gain of 338 accounts. The deposit
          balances
          for those accounts grew 62%. Consumer checking accounts also increased,
          from
          6,244 in the second quarter of 2004 to 7,183 this year, an increase of
          939
          accounts, or 15%. Our total balances for consumer checking accounts rose
          16%.
  The
          following table shows the distribution of our deposits.
  Time
                    Deposits
                Checking
                Money
                    Market Accounts
                SavingsJune
                    30, 2004
                65%
                12%
                22%
                1%September
                    30, 2004
                63%
                13%
                23%
                1%December
                    31, 2004
                61%
                14%
                24%
                1%March
                    31, 2005
                64%
                13%
                22%
                1%June
                    30, 2005
                64%
                14%
                21%
                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.
  32
  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 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
          principle 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, 2005
                
                $
                127,000
                
                
                5.40
                %
                $
                514,000
                
                
                11.45
                %June
                    30, 2004
                
                
                201,000
                
                
                10.29
                %
                
                569,000
                
                
                14.40
                %June
                    30, 2003
                
                
                (46,000
                )
                
                (3.15
                %)
                
                (120,000
                )
                
                (4.49
                %)
  Net
          income for the Consumer Lending segment totaled $127,000 and $514,000 for
          the
          quarter and six months ended June 30, 2005, representing declines of 37%
          and 10%
          relative to the comparable 2004 results. These declines were attributable
          to
          reductions in the segment’s net interest income combined with growth in
          noninterest expense. The impact of these changes was partially offset by
          additional noninterest income relative to the prior year.
 
 The
          Consumer segment’s earning assets totaled nearly $117 million as of June 30,
          2005, an increase of almost 10% over the prior year level. This represented
          a
          significant reduction from
  33
  the
          29%
          earning asset growth achieved between June 30, 2003 and 2004. The decline
          in
          asset growth can be attributed to a combination of a slow down in the growth
          rate for originations of our sales finance (home improvement) loans and
          the
          increased sales of these loans from our portfolio.
 
 Between
          late 2002 and late 2003, the vast majority of sales finance loans were
          retained
          within our portfolio. As loan production increased and the portfolio gained
          in
          size, we elected to utilize loan sales to manage that growth, with sales
          resuming in late 2003 and continuing through the present time. This resulted
          in
          a significant deceleration in earning asset growth in 2004 and 2005. In
          the
          second quarter of 2005, after evaluating the yields and credit history
          of these
          loans, we revised our plan such that we now expect to substantially reduce
          our
          sales of these loans, selling only sufficient volumes to ensure the continuity
          of the market. As a result, we expect these loans, which represented about
          9% of
          our total loans at the quarter-end, will slowly grow as a percentage of
          total
          loans, and that our interest income will increase accordingly. This strategy
          may
          be reevaluated and subject to further modification based on factors including,
          but not limited to future loan production and/or market conditions.
 
 With
          the
          slowdown in earning asset growth and the primarily fixed-rate nature of
          the
          loans in the portfolio, the Consumer Lending segment’s interest income only
          increased approximately 13% and 12% from the quarter and six months ended
          June
          30, 2004.
 
 By
          comparison, interest expense rose 58% and 46% relative to the quarter and
          six
          months ended June 30, 2004, based on increases in the retail deposit and
          wholesale funding rates, as well as the cost of the additional funds required
          to
          support the growth in earning assets. Funding costs bank-wide had declined
          over
          the 2002 to 2004 timeframe as rates on our time deposits gradually repriced
          at
          lower levels after market interest rate indexes fell between 2001 and 2003.
          Near
          the end of 2004, however, the rates paid on our deposits began to trend
          upwards.
          This upward movement accelerated earlier this year, as competition for
          deposits
          in our local market increased significantly, pushing time-deposit rates
          substantially higher. These effects were then compounded as we observed
          balances
          moving from our lower cost checking and money market accounts to higher
          rate
          certificates.
 
 As
          a
          result of these conditions the Consumer segment’s net interest income declined
          approximately $49,000 and $18,000 from the levels in the second quarter
          and
          first half of 2004. Following a reduction in the provision for loan loss
          of
          $2,000 for the second quarter, and an increase of $41,000 for the first
          half,
          the segment’s net interest income after provision declined $47,000 and $58,000
          relative to the same periods in 2004.
 
 The
          segment’s noninterest income rose 62% for the second quarter and 97% on a
          year-to-date basis, due primarily to a significant increase in service
          fee
          income. Servicing fees earned on the consumer loans serviced for others
          totaled
          $341,000 and $641,000 for the quarter and six months ended June 30, 2005,
          up
          from $65,000 and $88,000 for the same periods in 2004. This increase in
          consumer
          loan service fees was attributable in large part to a change in the amortization
          period assumed for the underlying servicing asset.
 
 Servicing
          assets are recorded when we sell loans from our portfolio to other investors,
          and continue to service those loans for the investors following the sale.
          To
          determine the fair value of the servicing assets, we utilize a valuation
          model
          that calculates the present value of future cash flows for the loans sold
          based
          on assumptions including market discount rates, anticipated prepayment
          speeds,
          estimated servicing cost per loan, and other relevant factors. These factors
  34
  are
          subject to significant fluctuations, and the estimates used in the models
          are
          subject to review and revision based on actual experience and changes in
          expectations for the future. The calculated value of the servicing rights
          is
          then capitalized and amortized in proportion to, and over the period of,
          estimated future net servicing income.
 
 Based
          on
          a review of our assumptions in the first quarter of 2005, we determined
          that the
          amortization period for the servicing rights on our consumer loan servicing
          portfolio was significantly shorter than the term over which these loans
          would
          be expected to provide net servicing income. Consequently, we revised the
          amortization period such that the average life of the amortization schedule
          would correspond with the average life we are currently observing for the
          underlying loan portfolio.
 
 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.
 
 In
          addition to the effects of this change, the income received for servicing
          consumer loans has grown as a result of the increased level of sales finance
          loan sales over the last several quarters, and corresponding growth in
          our
          portfolio of consumer loans serviced for others. Based on our decision
          to reduce
          sales of consumer loans in the future and instead retain a greater percentage
          of
          these loans within our portfolio, the rapid growth in fee income earned
          on the
          portfolio of serviced consumer loans in recent quarters is not expected
          to
          continue in future quarters.
 
 With
          gains of $201,000 in the second quarter, consumer loan sales remained a
          major
          contributor to the Consumer segment’s profitability. While this represented a
          22% decline from the gains realized in the second quarter of 2004, our
          pricing
          and execution improved, as the volume of loans sold declined 34% to $5.0
          million, versus $7.6 million in the second quarter of last year. Similarly,
          through the first six months of 2005, gains on consumer loan sales increased
          $170,000, or 32%, despite the volume of loans sold increasing less than
          3%. As
          noted above, in the second quarter of this year, we revised our plan such
          that
          we now expect to substantially reduce our sales of these loans.
 
 The
          Consumer Lending segment’s noninterest expense increased $299,000, or 21% in the
          second quarter of 2005 compared to the prior year, attributable primarily
          to
          higher administrative and support costs allocated to this segment. Included
          in
          these allocated costs are expenses related to our Consumer Loan Administration
          and Asset Management departments. The Consumer Loan Administration and
          Asset
          Management expenses allocated to this segment have risen based on the increased
          efforts required to manage the growing sales finance portfolio, including
          those
          loans serviced for others.
 
 For
          the
          six months ended June 30, 2005, noninterest expense increased $752,000,
          or 29%
          relative to the prior year. In addition to the allocated expenses described
          above, credit insurance premium expense on the insured part of our sales
          finance
          portfolio contributed significantly to the increase. The insurance premium
          expense pertains to a credit insurance policy which insures us against
          default
          risk on sales finance loans to borrowers with credit scores below 720,
          and has
          risen as our portfolio of insured loans has increased in size. This insurance
          contract contains a variable premium that ranges between a low of 0.60%
          and a
          ceiling of 2.70% (as an annualized percentage of the outstanding insured
          balances). We expect a premium of 2.70%, though the final premium will
          be
          determined at a later date based on our actual loan loss history. While
  35
  there
          is
          the possibility that our loss experience in the future will be more favorable,
          in which case we could receive a rebate on premiums paid, we do not at
          this time
          anticipate any future rebates.
 
 **Residential
          Lending**
 
 Quarter
                    Ended
                
                Six
                    Months EndedNet
                    Income
                
                Return
                    on Equity
                
                Net
                    Income
                
                Return
                    on EquityJune
                    30, 2005
                
                $
                870,000
                
                
                25.07
                %
                $
                1,617,000
                
                
                24.57
                %June
                    30, 2004
                
                
                750,000
                
                
                28.80
                %
                
                1,384,000
                
                
                27.35
                %June
                    30, 2003
                
                
                456,000
                
                
                26.49
                %
                
                901,000
                
                
                27.42
                %
  Net
          income for the Residential Lending segment totaled $870,000 for the second
          quarter of 2005, representing a 16% increase over the second quarter of
          2004.
          Through the first six months of this year, net income of $1.6 million exceeded
          the prior year’s mark by nearly 17%. The increase in net income resulted from
          growth in both net interest and noninterest income, which was partly offset
          by
          rising operating expenses.
 
 Earning
          assets for the Residential segment totaled $327 million as of June 30,
          2005, a
          19% increase over the June 30, 2004 level. With these additional assets,
          interest income earned on the portfolio totaled $5.1 million and $9.7 million
          for the three and six months ended June 30, 2005, representing increases
          of 30%
          and 29% over the same periods last year. Interest expense, however, rose
          44% and
          40% relative to the second quarter and first half of last year due to the
          rising
          funding rates described above and the cost of the additional funds required
          to
          support the earning asset growth. The increase in funding costs, combined
          with
          $10,000 and $36,000 increases in the quarterly and year-to-date provisions
          for
          loan losses, reduced the overall increase in the Residential segment’s net
          interest income after provision to approximately 21% over both the second
          quarter and first half 2004 levels.
 
 The
          Residential Lending segment’s noninterest income increased $121,000 and
          $161,000, or 64% and 45%, relative to the second quarter and first half
          of 2004,
          based largely on higher loan fees, particularly prepayment fees. In recent
          quarters, short-term interest rates have continued to rise, while longer-term
          interest rates, such as the 10-year U.S. Treasury rate, which are more
          indicative of mortgage rates, have tended to move within a range and without
          any
          discernible upward or downward tendency. Combined, these movements have
          resulted
          in a flattening of the yield curve. We believe that this flattening, and
          expectations that rates could move upwards in the foreseeable future, have
          contributed to the higher level of loan payoffs and prepayment fees observed
          over the last several quarters. As this flattening of the yield curve reduces
          the rate differential between short- and long-term financing costs, the
          financial incentive for borrowers to use shorter-term, adjustable-rate
          financing
          rather than longer-term, fixed-rate loans diminishes. This, in turn, provides
          borrowers with short-term or adjustable-rate loans with an incentive to
          refinance with long-term fixed rates. Given the uncertainties in interest
          rates
          and borrower expectations, we do not know if the higher level of prepayment
          fee
          income is likely to continue.
 
 Partially
          offsetting this year’s income growth were increases of $445,000 and $750,000, or
          31% and 27% in the Residential segment’s noninterest expense. Among the
          segment’s direct expenses, the most significant contribution to the increase was
          additional compensation expense, particularly incentive compensation, driven
          by
          higher loan officer commissions resulting from increased loan production
          volumes, along with incentive compensation accrued for
  36
  administrative
          and support personnel in the second quarter. Also contributing to the additional
          expense in 2005 were rising administrative and other allocated costs. The
          administrative costs include expenses for both general corporate activities,
          which are allocated to all the business segments, as well as loan servicing
          and
          administration costs attributable to the Residential Lending segment’s
          originations and portfolio management. Other allocated expenses included
          expenses incurred at the banking centers and allocated to the Residential
          Lending segment. 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, 2005
                
                $
                58,000
                
                
                2.15
                %
                $
                3,000
                
                
                0.06
                %June
                    30, 2004
                
                
                (173,000
                )
                
                (9.55
                %)
                
                (209,000
                )
                
                (5.63
                %)June
                    30, 2003
                
                
                1,000
                
                
                0.05
                %
                
                15,000
                
                
                0.46
                %
  Our
          Business Banking segment is one of the newer business lines in which we
          have
          invested, and 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 2005. 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.
 
 For
          the
          quarter and six months ended June 30, 2005, the Business Banking segment’s net
          interest income after provision for loan losses rose $462,000 and $909,000,
          or
          49% and 48%, relative to the same periods in 2004. These were the highest
          percentage net interest income increases among our four business lines,
          and the
          second highest dollar increases behind the Residential Lending segment.
          Like the
          Consumer and Residential segments, the Business Banking segment succeeded
          in
          building incremental assets over the second quarter of last year, with
          earning
          assets totaling nearly $132 million as of June 30, 2005, an increase of
          32% over
          the level one year earlier.
 
 Also
          contributing to the increase in interest income was the prevalence of
          prime-based loans in the business banking portfolio. Most of the adjustable-rate
          loans in our portfolio reprice according to contractually defined schedules,
          most commonly on an annual basis. The rates on prime-based loans, on the
          other
          hand, typically adjust in response to any change in the prime rate.
          Consequently, these loans reprice within days of any change to the index,
          rather
          than at a specified reset date potentially months into the future, and
          may
          reprice on several occasions over the course of the year, as has been the
          case
          over the last 12 months.
 
 Noninterest
          income for the Business Banking segment increased dramatically, up $193,000
          for
          the quarter and $207,000 for the first half of 2005 relative to the prior
          year,
          driven by a $151,000 gain on the sale of a 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. Given the
          unique
          nature of this transaction, we cannot predict the probability that similar
          deals
          could occur in the future. Also contributing to the segment’s noninterest income
  37
  growth
          has been the expansion of the Business Banking segment’s deposit base, measured
          by both total deposit balances as well as the number of open accounts.
          Fee
          income earned on these additional deposits has contributed to the improvement
          in
          noninterest income, and is expected to generate additional noninterest
          income
          for the segment in the future.
 
 Partially
          offsetting the additional net interest and noninterest income, however,
          were an
          additional $306,000 in noninterest expense for the quarter and $794,000
          for the
          six-month period relative the prior year. The primary drivers of the additional
          noninterest expense were increases in compensation expense, particularly
          loan
          officer commissions and other incentive compensation, as well as expenses
          from
          our retail banking centers allocated to the Business Banking segment. The
          additional compensation expense was due to a combination of a return to
          a normal
          level of loan officer commissions this year, compared to a below average
          level
          of expense in early 2004, along with incentive compensation accrued for
          administrative and support personnel in the second quarter. 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.
 
 **Income
          Property Lending**
 
 Quarter
                    Ended
                
                Six
                    Months EndedNet
                    Income
                
                Return
                    on Equity
                
                Net
                    Income
                
                Return
                    on EquityJune
                    30, 2005
                
                $
                1,462,000
                
                
                19.17
                %
                $
                2,968,000
                
                
                19.53
                %June
                    30, 2004
                
                
                1,408,000
                
                
                19.23
                %
                
                2,757,000
                
                
                19.06
                %June
                    30, 2003
                
                
                1,618,000
                
                
                22.65
                %
                
                3,322,000
                
                
                23.32
                %
  For
          the
          second quarter and first six months of 2005, the Income Property segment’s net
          income rose 4% and 8% from its respective 2004 levels following relatively
          modest increases in net interest and noninterest income and operating
          expenses.
 
 The
          segment’s net interest income after provision for loan loss rose $39,000, or 1%,
          for the quarter and $330,000, or 4% for the year-to-date period relative
          to
          2004, based on 9% and 10% interest income growth and offsetting 24% and
          20%
          increases in interest expense. The Income Property segment has not benefited
          from the sort of year-over-year earning asset growth exhibited by the other
          segments, and instead saw its earning assets fall to $419 million as of
          June 30,
          2005, a decline of 6% relative to June 30 of last year. The decline was
          largely
          attributable to higher than expected prepayments on the loan portfolio,
          likely
          motivated by the same factors described above in the Residential segment
          section, though the segment did conduct some loan sale activity in the
          second
          quarter, following no loan sales in the first quarter of this year.
  Historically,
          the commercial loans we originate have been retained in our portfolio,
          and sales
          of participations in these loans have been utilized for the purpose of
          limiting
          our aggregate credit exposure to specific borrowers. During the second
          quarter,
          however, we experienced increased interest in, and opportunities for, sales
          of
          commercial loan participations. Consequently, we are currently considering
          the
          merits of expanding our commercial loan sales and potentially originating
          credits with the intent to sell, rather than portfolio the loans. Specifically,
          we would continue to portfolio those income property loans that meet our
          credit
          standards and our pricing hurdles, while seeking opportunities to earn
          fees by
          selling those income property loans we choose not to portfolio. In the
          event we
          determine that such a strategy would be more favorable
  38
  than
          our
          historical practice, we would likely increase our sales of commercial loans,
          which could potentially lead to a further reduction in the size of our
          Income
          Property segment’s loan portfolio. We do not anticipate that these potential
          sales would impact the other three segments, where we would expect the
          loan
          portfolios to continue to grow.
 
 Noninterest
          income for the Income Property segment increased $96,000 and $20,000, or
          35% and
          4%, relative to the second quarter and first half of 2004. As with the
          Residential segment, higher loan fees, and specifically prepayment fees,
          were
          responsible for much of the increase relative to the prior year
          levels.
 
 In
          contrast to the other business segments, noninterest expense for the Income
          Property segment exhibited little change compared to the same timeframe
          last
          year, increasing $53,000, or 3% for the quarter and $30,000, or less than
          1% for
          the first six months of the year.  As noted above, the asset growth
          exhibited by the other business lines was not observed with the Income
          Property
          segment.  Instead, the Income Property segment remained relatively
          static
          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 with their activity and asset
          balances, and reduced the percentage allocated to the Income Property segment
          relative to last year.
 
 For
          the
          remainder of 2005, we expect to see the Income Property segment’s noninterest
          expenses increase relative to the levels for the same periods in 2004 based
          on
          recent investment in the business line.  In recent months, we successfully
          recruited experienced lending officers to replace personnel that left the
          Bank
          over the course of 2004.  Additionally, in April 2005, we hired
          a new
          manager for this business line.  This hiring will allow a senior-level
          officer, who previously divided his time between loan production and managing
          the segment, to focus entirely on loan production and growing the segment’s
          earning assets.  We anticipate that these changes will result in
          higher
          noninterest expense for the segment beginning in the near future.
 
 **LIQUIDITY**
 
 Our
          primary sources of liquidity are loan and security sales and repayments,
          deposits, and wholesale funds. A secondary source of liquidity is cash
          from
          operations, which, though not a significant source of liquidity, is a consistent
          source based upon the quality of our earnings. Our principal uses of liquidity
          are the origination and acquisition of loans and securities. Liquidity
          is also
          used to purchase facilities and equipment.
 
 During
          the second quarter of 2005, we originated $137 million in loans and purchased
          no
          securities.
 
 39
  2Q
                      2005
                  
                  2Q
                      2004
                  
                  YTD
                      2005
                  
                  YTD
                      2004(Dollars
                      in thousands)Loan
                      Originations (disbursed)
                  
                  $
                  137,000
                  
                  $
                  123,000
                  
                  $
                  255,000
                  
                  $
                  226,000Security
                      Purchases
                  
                  
                  0
                  
                  
                  33,000
                  
                  
                  6,000
                  
                  
                  43,000Draws
                      on Lines of Credit
                  
                  
                  4,000
                  
                  
                  1,000
                  
                  
                  11,000
                  
                  
                  5,000Total
                      Originations and Purchases
                  
                  
                  141,000
                  
                  
                  157,000
                  
                  
                  272,000
                  
                  
                  274,000Loan
                      and Security Repayments
                  
                  $
                  103,000
                  
                  $
                  78,000
                  
                  $
                  186,000
                  
                  $
                  125,000Sales
                      of Securities
                  
                  
                  0
                  
                  
                  0
                  
                  
                  0
                  
                  
                  2,000Sales
                      of Loans
                  
                  
                  12,000
                  
                  
                  23,000
                  
                  
                  30,000
                  
                  
                  49,000Total
                      Repayments and Sales
                  
                  
                  115,000
                  
                  
                  101,000
                  
                  
                  216,000
                  
                  
                  176,000**Net
                      Difference**
                  
                  **$**
                  **26,000**
                  
                  **$**
                  **56,000**
                  
                  **$**
                  **56,000**
                  
                  **$**
                  **98,000**
 Loan
          and
          security sales and repayments, our primary sources of funding, are heavily
          influenced by trends in mortgage rates. When rates trend downward, our
          prepayment speeds typically increase as borrowers refinance their loans
          at lower
          interest rates. Conversely, as rates move upwards, prepayments will generally
          tend to slow, as fewer borrowers will have a financial incentive to refinance
          their loans. The loan portfolio, excluding loans sold into the secondary
          market
          and spec construction loans, experienced an annualized prepayment rate
          of 34% in
          the first six months of 2005, compared to 30% for the same period one year
          earlier.
 
 Movements
          in rates and the resulting shape of the yield curve have likely contributed
          to
          the sustained high prepayment levels. As short-term rates continued to
          rise in
          the second half of 2004 and the first half of 2005, longer-term rates initially
          declined and then tended to move within a fairly narrow range, with no
          discernible upward or downward tendency. This increase in short-term rates
          and
          decline in longer-term rates resulted in a flattening of the yield curve,
          which
          continued into the second quarter of 2005. With this flattening, the rate
          differential between short- and long-term financing diminished, thus reducing
          the financial incentive for borrowers to use shorter-term, adjustable-rate
          financing rather than longer-term, fixed-rate loans. This, in turn, provides
          borrowers with short-term or adjustable-rate loans with an incentive to
          refinance with long-term fixed rates. We believe this situation contributed
          to
          the acceleration in prepayments observed in the second half of 2004 and
          sustained the higher prepayment rates observed in the first half of
          2005.
 
 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 quarters
          of 2004
          and 2005, growth in funds from deposits and borrowings were as
          follows:
  2Q
                    2005
                
                2Q
                    2004
                
                YTD
                    2005
                
                YTD
                    2004(Dollars
                    in thousands)Deposits
                
                $
                28,000
                
                $
                30,000
                
                $
                44,000
                
                $
                47,000Advances
                
                
                (5,000
                )
                $
                20,000
                
                
                (6,000
                )
                $
                51,000**Total**
                
                **$**
                **23,000**
                
                **$**
                **50,000**
                
                **$**
                **38,000**
                
                **$**
                **98,000**
 
 40
  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 prevailing rates in our
          marketplace.
 
 Our
          other
          major source of liquidity is wholesale funds, which include borrowings
          from the
          FHLB, brokered deposits, reverse repurchase agreements, and a revolving
          line of
          credit at the Holding Company level. We rely significantly upon these wholesale
          funds as sources of liquidity, as doing so allows us to avoid maintaining
          balances of lower-yielding assets for liquidity requirements.
 
 Our
          most
          utilized wholesale funding source is FHLB advances, which totaled $228
          million
          at June 30, 2005 and $234 million at December 31, 2004. Our credit line
          with the
          FHLB is reviewed annually, and our maximum allowable borrowing level is
          currently set at 40% of assets or $418 million. As a percentage of period-ending
          assets, our FHLB borrowings totaled 22% on June 30, 2005 and 23% at the
          end of
          2004. 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 of the line by maintaining the
          credit
          quality of our loans and securities and attending to the quality and consistency
          of our earnings. We presently have sufficient collateral to meet our anticipated
          2005 funding needs.
 
 Brokered
          deposits, which are included in the deposit totals, amounted to $40 million
          at
          the 2004 year-end and $41 million as of June 30, 2005. Internal policies
          limit
          our total usage of these deposits to no more than 10% of all deposits,
          and we
          currently have no plans to substantially increase our use of these
          deposits.
 
 Reverse
          repurchase lines are lines of credit collateralized by securities. We have
          lines
          totaling $60 million, of which the full amount is currently available.
          There has
          been no usage of these lines in the previous three years. The risks associated
          with these lines are the withdrawal of the line based on credit standing
          of the
          Bank and the potential lack of sufficient collateral to support the
          lines.
 
 An
          additional source of liquidity has been our cash from operations, which,
          though
          not a significant source of liquidity, is a consistent source based upon
          the
          quality of our earnings. On a very limited basis it can be viewed as cash
          from
          operations adjusted for items such as the provision for loan loss 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 2005, we invested $3.9 million
          in
          these assets, up from $1.1 million in the first half of 2004.
 
 In
          July
          2005, based on our consistent earnings growth, we determined that we could
          increase our quarterly cash dividend payout and still retain sufficient
          liquidity and capital to fund further growth.  Consequently, on
          August 1,
          2005, we announced an 11% increase in our quarterly cash dividend to $0.10
          per
          share.  The dividend is payable on October 5, 2005, to shareholders
          of
          record September 14, 2005.
 
 41
  **PLANNED
          EXPENDITURES FOR** **** **PLANT
          AND EQUIPMENT**
 
 In
          2005
          we have completed the interior remodel of one banking center, completed
          the
          construction of another, and in third quarter will complete an exterior
          and
          interior remodel on a third banking center. With the completion of these,
          we do
          not anticipate the need for any further banking center remodels. In 2004
          we also
          completed two land acquisitions, one in West Seattle for $1,046,000 and
          one in
          Canyon Park for $1,356,000. We anticipate construction of our new West
          Seattle
          banking center to begin in third quarter, 2005. It is possible that construction
          on our Canyon Park banking center can begin as early as fourth quarter,
          2005,
          but more likely will begin in first quarter, 2006. In 2004 we also began
          a
          maintenance and upgrade plan for our seven-story corporate headquarters,
          and we
          anticipate these plans will be completed by fourth quarter, 2005. We estimate
          that the expenditures in the next two quarters will range from $3.0 million
          to
          $4.5 million depending on what projects are initiated this year and the
          extent
          to which the existing facilities are remodeled.
 
 We
          review
          the utilization of our properties on a regular basis and believe that we
          have
          adequate facilities for current operations. We may open new banking centers
          from
          time-to-time, depending on the availability of capital resources and the
          locations potential for growth and profitability.
 
 We
          regularly analyze demographic and geographic data as well as information
          regarding our competitors and our current loan and deposit customers in
          order to
          locate potential future Bank sites.
 
 **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,
          2005, we exceeded the capital levels required to meet the definition of
          a
          well-capitalized institution:
 
 Minimum
                    to beCategorized
                    as “WellMinimum
                    for
                Capitalized”
                    UnderCapital
                Prompt
                    CorrectiveActual
                Adequacy
                    Purposes
                Action
                    ProvisionsTotal
                    capital (to risk-weightedassets):First
                    Mutual Bancshares, Inc.
                12.12%
                8.00%
                N/AFirst
                    Mutual Bank
                11.75
                8.00
                10.00Tier
                    I capital (to risk-weightedassets):First
                    Mutual Bancshares, Inc.
                10.87
                4.00
                N/AFirst
                    Mutual Bank
                10.50
                4.00
                6.00Tier
                    I capital (to average assets):First
                    Mutual Bancshares, Inc.
                7.53
                4.00
                N/AFirst
                    Mutual Bank
                7.40
                4.00
                5.00
 
 42
  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 or 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.
 
 **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.
  43
  Additionally,
          in 2002 we entered into an interest rate swap with the FHLB. The purpose
          of the
          swap was to protect against potential adverse interest rate volatility
          that
          could be realized from the Trust Preferred Securities (TPS) issued in June
          2002.
          The swap accomplished this by fixing the interest rate payable for the
          first
          five years of the TPS’ life.
 
 
 **Net
          Interest Income (NII) and Economic Value of Equity (EVE) Simulation Model
          Results**
 
 June
                    30, 2005
                
                December
                    31, 2004Percentage
                    Change
                
                Percentage
                    ChangeChange
                    in
                  Interest
                    Rates
                
                Net
                  Interest
                Economic
                  Value
                
                Net
                  Interest
                Economic
                  Value(in
                    basis points)
                
                Income
                Of
                    Equity
                
                Income
                Of
                    Equity+200
                
                (0.87%)
                0.70%
                
                0.89%
                (2.51%)+100
                
                n/a
                1.38%
                
                n/a
                (0.40%)-100
                
                n/a
                (3.65%)
                
                (1.26%)
                (1.26%)-200
                
                (0.48%)
                (9.45%)
                
                *
                *
 
 *
          Because
          a large percentage of our loan portfolio is tied to indexes that were at
          very
          low levels as of December 31, 2004, the downward 200 bps scenario was not
          computed at that time.
 
 **Net
          Interest Income Simulation**
 
 The
          results of our income simulation model constructed using data as of June
          30,
          2005 project modest declines in our net interest income from its “base case”
          level in scenarios in which interest rates are assumed to gradually increase
          or
          decline by 200 bps over a 12-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 12-month horizon, as an impact of 0.48% was
          indicated in the falling rate scenario, and 0.87% in the rising rate
          environment.
 
 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.
  44
 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 additional parallel movements of the yield curve,
          then a
          parallel 200 basis point increase or decrease in rates will not significantly
          degrade 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 12 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
          both the
          rising and falling rate 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 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, 2005 indicate
          that our
          assets would be expected to exhibit less sensitivity to the effects of
          rising
          rates than would liabilities, with the economic value of assets declining
          by an
          estimated 2.39%, compared to a decline of 2.77% for our liabilities. Given
          the
          lesser sensitivity, the reduction in the economic value of liabilities
          was
          greater than the impact on assets. Consequently, the economic value of
          our
          equity was positively impacted in this scenario, increasing 0.70%.
 
 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 present 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
          at
          June 30, 2005 were positively impacted when rates were assumed to fall
          by 200
          bps, assets by 1.71% and liabilities by 3.07%. 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 9.45%.
 
 45
  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. For example, 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.” Additionally, assets such as
          adjustable-rate mortgage loans may 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.
 
 Our
          12-month interest rate sensitivity gap, expressed as a percentage of assets,
          fell from a positive, or asset sensitive 2.6% at December 31, 2004 to a
          negative, or liability sensitive 3.9% at the end of the second quarter.
          These
          results indicated that more liabilities than assets were expected to mature,
          reprice, or prepay within the 12 months, whereas the opposite was true
          at the
          year-end.
 
 **One
          Year Interest Rate Sensitivity Gap**
 **(Dollars
          in thousands)**
 
 June
                    30, 2005
                
                December
                    31, 2004One-Year
                    Repricing/Maturing Assets
                
                $
                696,013
                
                $
                665,665One-Year
                    Repricing/Maturing Liabilities
                
                
                736,713
                
                
                639,430One-Year
                    Gap
                
                
                (40,700
                )
                
                26,235Total
                    Assets
                
                $
                1,045,469
                
                $
                1,012,783(Dec.
                    31, 2004 figure includes a $9 million off-balance-sheet
                    item)One-Year
                    Interest Rate Gap as a Percentage of Assets
                
                
                (3.9
                %)
                
                2.6
                %
 
  46
  The
          significant factors contributing to the reduction in our 12-month gap ratio
          since the year-end have been the continued popularity of our 13-month time
          deposit and 15-month “bump” certificate with our deposit customers, and the
          rolling of existing time deposits and FHLB advances from expected terms
          to
          maturity or repricing of more than 12 months to within the 12-month
          timeframe.
 
 Through
          the first half of 2005, the most significant growth among time deposit
          maturities was observed in our 13-month product, balances of which increased
          from little more than $3 million at the 2004 year-end to over $70 million
          at
          June 30, 2005. Based on the term of these certificates, all balances except
          those originated in the most recent month will mature within the gap report’s
          12-month horizon. Additionally, our 15-month “bump” time deposit has remained a
          popular option with our deposit customers, as balances in this product
          increased
          from $61 million at December 31, 2004 to $80 million at June 30, 2005.
          While
          these certificates are issued with a 15-month term to maturity, the depositor
          is
          granted an option to reprice the certificate to the prevailing 15-month
          certificate rate on one occasion at any time during those 15 months. For
          the
          purposes of the gap report, we assume that the majority of depositors will
          reprice their certificates within one year of issue. Consequently, the
          majority
          of these certificates are considered to be less than one-year instruments
          for
          gap purposes.
 
 Also
          contributing significantly to the reduction in our gap ratio was the rolling
          of
          existing time deposits and FHLB advances from expected terms to maturity
          or
          repricing of more than 12 months to within the 12-month timeframe. While
          total
          FHLB advances declined modestly from the December 31, 2004 year-end, the
          volume
          of advances scheduled to mature or reprice within the following 12 months
          increased $36 million between the year-end and the end of the second quarter.
          A
          similar situation was observed with some of our time deposit products,
          as the
          balances of outstanding 13-month, 15-month “bump,” and 24-month certificates
          scheduled to mature within the next 12 months increased relative to the
          year-end
          levels.
 
 A
          change
          in modeling procedure impacted the total asset base used for the gap ratio
          calculation by $9 million. As previously noted, in 2002 we entered into
          an
          interest rate swap agreement to fix the interest rate on our first trust
          preferred security issue for a period of five years. As of the December
          2004
          year-end, we classified the TPS as a variable rate liability, offset by
          the
          asset side of the swap, under which the Bank receives payments tied to
          the same
          quarterly adjustable-rate as the TPS issue. The other side of the swap,
          under
          which the Bank makes payments based on a fixed interest rate, was applied
          to the
          liability side of the gap report based on the remaining life of the swap.
          For
          the June 30, 2005 model, the fixed-payment side of the swap, formerly a
          $9
          million liability, was moved to the asset side as a $9 million contra-asset.
          As
          a result of this modification, our asset base for gap purposes now corresponds
          to the level of total assets reflected on our financial statements, rather
          than
          exceeding that amount by the $9 million notional principal of the
          swap.
 
 The
          greater increase of liabilities maturing or repricing in the next 12 months
          versus assets resulted in a net $67 million reduction in our dollar gap,
          which
          led to the decline in the one-year gap ratio from 2.6% to (3.9%) of total
          assets.
 47
  **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
                      30,2005
                  
                  2004**Available-for-Sale:**
                  
                  Carrying
                      Value
                  
                  Percent
                      of Total
                  
                  Carrying
                      Value
                  
                  Percent
                      of TotalUS
                      Government Treasury and agency obligations
                  
                  $
                  17,975
                  
                  
                  15
                  %
                  $
                  10,816
                  
                  
                  10
                  %Mortgage
                      backed securities:Freddie
                      Mac
                  
                  
                  17,805
                  
                  
                  14
                  %
                  
                  16,013
                  
                  
                  14
                  %Ginnie
                      Mae
                  
                  
                  49,605
                  
                  
                  41
                  %
                  
                  44,227
                  
                  
                  39
                  %Fannie
                      Mae
                  
                  
                  36,044
                  
                  
                  30
                  %
                  
                  41,344
                  
                  
                  37
                  %Total
                      mortgage-backed securities
                  
                  
                  103,454
                  
                  
                  85
                  %
                  
                  101,584
                  
                  
                  90
                  %**Total
                      securities available-for-sale**
                  
                  **$**
                  **121,429**
                  
                  
                  **100**
                  **%**
                  **$**
                  **112,400**
                  
                  
                  **100**
                  **%**June
                      30,2005
                  2004**Held-to-Maturity:**
                  
                  
                  Carrying
                      Value
                  
                  
                  Percent
                      of Total
                  
                  
                  Carrying
                      Value
                  
                  
                  Percent
                      of TotalMunicipal
                      Bonds
                  
                  $
                  1,200
                  
                  
                  16
                  %
                  $
                  1,278
                  
                  
                  15
                  %Mortgage
                      backed securities:Freddie
                      Mac
                  
                  
                  481
                  
                  
                  6
                  %
                  
                  503
                  
                  
                  6
                  %Fannie
                      Mae
                  
                  
                  5,982
                  
                  
                  78
                  %
                  
                  6,950
                  
                  
                  79
                  %Total
                      mortgage-backed securities
                  
                  
                  6,463
                  
                  
                  84
                  %
                  
                  7,453
                  
                  
                  85
                  %**Total
                      securities held-to-maturity**
                  
                  **$**
                  **7,663**
                  
                  
                  **100**
                  **%**
                  **$**
                  **8,731**
                  
                  
                  **100**
                  **%****Estimated
                      Market Value**
                  
                  **$**
                  **7,754**
                  
                  
                  
                  
                  **$**
                  **8,818**
 
 
 48
 
 
 **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, 2005One
                      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
                  
                  $
                  6,964
                  
                  
                  1.88
                  %
                  $
                  —
                  
                  
                  0.00
                  %
                  $
                  6,030
                  
                  
                  4.08
                  %
                  $
                  —
                  
                  
                  0.00
                  %
                  $
                  4,981
                  
                  
                  4.00
                  %
                  $
                  —
                  
                  
                  0.00
                  %
                  $
                  17,975
                  
                  
                  3.20
                  %Mortgage
                      backed securities:Ginnie
                      Mae
                  
                  
                  —
                  
                  
                  0.00
                  %
                  
                  49,606
                  
                  
                  4.07
                  %
                  
                  —
                  
                  
                  0.00
                  %
                  
                  —
                  
                  
                  0.00
                  %
                  
                  —
                  
                  
                  0.00
                  %
                  
                  
                  
                  
                  
                  
                  
                  49,606
                  
                  
                  4.07
                  %Freddie
                      Mac
                  
                  
                  291
                  
                  
                  4.10
                  %
                  
                  —
                  
                  
                  0.00
                  %
                  
                  6,003
                  
                  
                  3.74
                  %
                  
                  3,531
                  
                  
                  4.60
                  %
                  
                  7,980
                  
                  
                  4.50
                  %
                  
                  —
                  
                  
                  0.00
                  %
                  
                  17,805
                  
                  
                  4.26
                  %Fannie
                      Mae
                  
                  
                  518
                  
                  
                  4.47
                  %
                  
                  —
                  
                  
                  0.00
                  %
                  
                  692
                  
                  
                  5.50
                  %
                  
                  4,143
                  
                  
                  4.12
                  %
                  
                  30,691
                  
                  
                  4.30
                  %
                  
                  —
                  
                  
                  0.00
                  %
                  
                  36,044
                  
                  
                  4.30
                  %Total
                      mortgage-backed securities
                  
                  
                  809
                  
                  
                  4.34
                  %
                  
                  49,606
                  
                  
                  4.07
                  %
                  
                  6,695
                  
                  
                  4.23
                  %
                  
                  7,674
                  
                  
                  4.34
                  %
                  
                  38,671
                  
                  
                  4.34
                  %
                  
                  —
                  
                  
                  0.00
                  %
                  
                  103,455
                  
                  
                  4.20
                  %Total
                      securities available-for-sale -- Carrying Value
                  
                  $
                  7,773
                  
                  
                  2.13
                  %
                  $
                  49,606
                  
                  
                  4.07
                  %
                  $
                  12,725
                  
                  
                  4.00
                  %
                  $
                  7,674
                  
                  
                  4.34
                  %
                  $
                  43,652
                  
                  
                  4.30
                  %
                  $
                  —
                  
                  
                  0.00
                  %
                  **$**
                  **121,430**
                  
                  
                  4.04
                  %Total
                      securities available-for-sale -- Amortized Cost
                  
                  $
                  7,777
                  
                  
                  2.12
                  %
                  $
                  49,733
                  
                  
                  4.07
                  %
                  $
                  12,773
                  
                  
                  3.99
                  %
                  $
                  7,703
                  
                  
                  4.34
                  %
                  $
                  43,972
                  
                  
                  4.30
                  %
                  
                  
                  
                  
                  
                  
                  **$**
                  **121,957**
                  
                  
                  4.04
                  %Held-to-Maturity
                      at June 30, 2005One
                      Year or Less
                  Over
                      One to Three Years
                  Over
                      Three to Five Years
                  Over
                      Five to Ten
                    Years
                  Over
                      Ten to Twenty Years
                  Over
                      Twenty Years
                  TotalCarrying
                      Value
                  
                  
                  Weighted
                      Average Yield
                  
                  
                  Carrying
                      Value
                  
                  
                  Weighted
                      Average Yield
                  
                  
                  Carrying
                      Value
                  
                  
                  Weighted
                      Average Yield
                  
                  
                  Carrying
                      Value
                  
                  
                  Weighted
                      Average Yield
                  
                  
                  Carrying
                      Value
                  
                  
                  Weighted
                      Average Yield
                  
                  
                  Carrying
                      Value
                  
                  
                  Weighted
                      Average Yield
                  
                  
                  Carrying
                      Value
                  
                  
                  Weighted
                      Average Yield**Held-to-Maturity:**Municipal
                      Bonds
                  
                  $
                  —
                  
                  
                  0.00
                  %
                  $
                  —
                  
                  
                  0.00
                  %
                  $
                  —
                  
                  
                  0.00
                  %
                  $
                  —
                  
                  
                  0.00
                  %
                  $
                  220
                  
                  
                  5.38
                  %
                  $
                  980
                  
                  
                  6.27
                  %
                  $
                  1,200
                  
                  
                  6.11
                  %Mortgage
                      backed securities:Freddie
                      Mac
                  
                  
                  481
                  
                  
                  5.21
                  %
                  
                  —
                  
                  
                  0.00
                  %
                  
                  —
                  
                  
                  0.00
                  %
                  
                  —
                  
                  
                  0.00
                  %
                  
                  —
                  
                  
                  0.00
                  %
                  
                  —
                  
                  
                  0.00
                  %
                  
                  481
                  
                  
                  5.21
                  %Fannie
                      Mae
                  
                  
                  2,502
                  
                  
                  5.39
                  %
                  
                  —
                  
                  
                  0.00
                  %
                  
                  1,638
                  
                  
                  4.49
                  %
                  
                  —
                  
                  
                  0.00
                  %
                  
                  1,842
                  
                  
                  4.77
                  %
                  
                  —
                  
                  
                  0.00
                  %
                  
                  5,982
                  
                  
                  4.95
                  %Total
                      mortgage-backed securities
                  
                  
                  2,983
                  
                  
                  5.36
                  %
                  
                  —
                  
                  
                  0.00
                  %
                  
                  1,638
                  
                  
                  4.49
                  %
                  
                  —
                  
                  
                  0.00
                  %
                  
                  1,842
                  
                  
                  4.77
                  %
                  
                  —
                  
                  
                  0.00
                  %
                  
                  6,463
                  
                  
                  4.97
                  %Total
                      securities held-to-maturity -- Carrying Value
                  
                  $
                  2,983
                  
                  
                  5.36
                  %
                  $
                  —
                  
                  
                  0.00
                  %
                  $
                  1,638
                  
                  
                  4.49
                  %
                  $
                  —
                  
                  
                  0.00
                  %
                  $
                  2,062
                  
                  
                  4.84
                  %
                  $
                  980
                  
                  
                  6.27
                  %
                  $
                  7,663
                  
                  
                  5.15
                  %Total
                      securities held-to-maturity -- Fair Market Value
                  
                  $
                  3,065
                  
                  
                  5.36
                  %
                  $
                  —
                  
                  
                  0.00
                  %
                  $
                  1,643
                  
                  
                  4.50
                  %
                  $
                  —
                  
                  
                  0.00
                  %
                  $
                  2,061
                  
                  
                  4.84
                  %
                  $
                  986
                  
                  
                  6.26
                  %
                  $
                  7,754
                  
                  
                  5.16
                  %
 49
  ITEM
          4. Controls and
          Procedures
 
 An
          evaluation of the Company’s disclosure controls and procedures (as defined in
          Rule 13a-15(e) of the Securities Exchange Act of 1934 (the “Act”)) was carried
          out under the supervision and with the participation of the 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 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 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, 2005, 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
          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 28, 2005. 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
                    I DIRECTORS
                VOTES
                    FOR
                VOTES
                    WITHHELD
                TERMJanine Florence
                4,987,326
                127,473
                3
                    YearsF. Kemper Freeman, Jr.
                5,003,028
                111,771
                3
                    YearsRobert J. Herbold
                4,991,245
                123,554
                3
                    YearsVictor E. Parker
                5,003,039
                111,760
                3
                    Years
 
 50
 
 The
          terms
          of the Class II and III directors expire at the Annual Meeting of Shareholders
          for 2006 and 2007, respectively.
 
 CLASS
          II DIRECTORS, term expires in 2006
  James
          J.
          Doud, Jr.
 Richard
          S. Sprague
 Robert
          C.
          Wallace
 
 CLASS
          III DIRECTORS, term expires in 2007
  Mary
          Case
          Dunnam
 George
          W.
          Rowley, Jr.
 John
          R.
          Valaas
 
 The
          proposal to amend the Company’s Articles of Incorporation with respect to the
          quorum for a shareholders meeting, received the following votes:
 
  VOTED
                  PERCENT OF
                    OUTSTANDINGFor
                  4,241,343
                  79.90Against
                  149,660
                  2.82Abstain
                  4,687
                  0.09Broker non votes
                  912,604
                  —
  The
          foregoing proposal was approved.
 
 The
          proposal to amend the Company’s Articles of Incorporation with respect to
          increase the number of authorized shares as described in the proxy statement,
          received the following votes:
 VOTED
                    PERCENT OF
                      OUTSTANDINGFor
                    4,353,021
                    82.00Against
                    844,836
                    15.92Abstain
                    5,213
                    0.10Broker non votes
                    105,224
                    —
 The
          foregoing proposal was approved.
 
 The
          proposal to amend the Company’s 2005 Stock Option and Incentive Plan as
          described in the proxy statement, received the following votes:
 VOTED
                      PERCENT OF FOR, AGAINST,
                        ABSTAINFor
                      3,121,991
                      71.79Against
                      1,198,012
                      27.55Abstain
                      28,701
                      0.66Broker non votes
                      959,590
                      —
 The
          foregoing proposal was approved.
 
 51
 
 ITEM
          5. Other
          Information
 
 None.
 
 
 ITEM
          6. Exhibits
 
  (3.1)
                Amended
                    and Restated Articles of Incorporation, attached as an exhibit
                    to this
                    Report on Form 10Q.(3.3)
                Bylaws
                    (as amended and restated), incorporated by reference on Form
                    10-Q filed
                    with the SEC on August 13, 2004.(11)
                Statement
                    regarding computation of per share earnings. Reference is made
                    to theCompany’s
                    Consolidated Statements of Income attached hereto as part of
                    Item IFinancial
                    Statements, which are incorporated herein by reference.(31.1)
                Certification
                    by President and Chief Executive Officer pursuant to Section
                    302 of the
                    Sarbanes-Oxley Act.(31.2)
                Certification
                    by Executive Vice President and Chief Financial Officer Pursuant
                    to
                    Section 302 of the Sarbanes-Oxley Act.(32)
                Certification
                    by Chief Executive Officer and Chief Financial Officer pursuant
                    toSection
                    906 of the Sarbanes-Oxley Act.
 
 
 
 52
 
 
 
 **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.
  FIRST
                    MUTUAL BANCSHARES, INC.Date: August
                    8, 2005
                  By:
                  /s/ John
                    R. ValaasJohn
                    R. ValaasPresident
                    and Chief Executive Officer
 Date: August
                    8, 2005
                  By:
                  /s/ Roger
                    A. ManderyRoger
                    A. ManderyExecutive
                      Vice President
                    (Principal
                      Financial Officer)




53