**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, 2007**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**
              (State
                or other jurisdiction of incorporation
                or
                organization)
            **91-2005970**
              (I.R.S.
                Employer Identification
                Number)**400
                108th Avenue N.E., Bellevue, WA**
              (Address
                of principal executive
                offices)
            **98004**
              (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 a large accelerated filer, an
      accelerated filer,
      or
      a non-accelerated filer.  See definition of “accelerated
      filer
      and large accelerated filer”
      in Rule 12b-2 of
      the Exchange Act).





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




Indicate
      by check mark whether the registrant is a shell company (as defined in Rule 12b-2
      of
      the Exchange Act).      Yes   o   
No   x




Indicate
      the number of shares outstanding of each of the issuer’s classes of common
      stock, as
      of the
      latest practicable date.      August
      3, 2007  6,697,628













FIRST
            MUTUAL BANCSHARES, INC.
 
 QUARTERLY
            REPORT ON FORM 10-Q
 June
            30,
            2007
 
 TABLE
            OF
            CONTENTS
 PagePART
                        I: FINANCIAL INFORMATION
                    1Forward-Looking
                        Statements Disclaimer
                    1ITEM
                        1. Financial Statements
                    1ITEM
                        2. Management’s Discussion and Analysis of Financial Condition and Results
                        of Operations
                    23General
                    23Overview
                    23Results
                        of Operations
                    24Net
                        Income
                    24Net
                        Interest Income
                    25Noninterest
                        Income
                    27Noninterest
                        Expense
                    30Financial
                        Condition
                    33Asset
                        Quality
                    36Business
                        Segments
                    38Retail
                        Banking
                    40Sales
                        Finance
                    41Residential
                        Lending
                    42Business
                        Banking Lending
                    43Income
                        Property Lending
                    44Investments
                        and Treasury
                    45Liquidity
                    46Capital
                    48Subsequent
                        Events
                    49ITEM
                        3. Quantitative and Qualitative Disclosures About Market
                        Risk
                    50ITEM
                        4. Controls and Procedures
                    56PART
                        II: OTHER INFORMATION
                    56ITEM
                        1. Legal Proceedings
                    56ITEM
                        1A. Risk Factors
                    56ITEM
                        2. Unregistered Sales of Equity Securities and Use of
                        Proceeds
                    56ITEM
                        3. Defaults Upon Senior Securities
                    56ITEM
                        4. Submission of Matters to a Vote of Security Holders
                    56ITEM
                        5. Other Information
                    56ITEM
                        6. Exhibits
                    57SIGNATURES
                    58CERTIFICATIONS
 **PART
            I: FINANCIAL
            INFORMATION**
  **FORWARD-LOOKING
            STATEMENTS DISCLAIMER**
 
 Our
            Form
            10-Q for the quarter ended June 30, 2007, contains statements concerning
            forecasts of our financial results and condition, expectations of our
            operations
            and business and our assumptions for those forecasts and expectations
            that are
            forward-looking statements for the purposes of the safe harbor provisions
            under
            the Private Securities Litigation Reform Act of 1995.  Such
            forward-looking statements include statements regarding our anticipated
            securities transactions and sale of loans, our expectations for the Business
            Banking segment, our observations regarding our loan collections and
            provision
            for loan losses, information regarding our intentions to move away from
            offering
            rates competitive with higher rates in our area and the effects of such
            a move,
            information regarding the possible effects of hedging our trading portfolio,
            information based upon our market risk models and analysis and information
            regarding our merger agreement with Washington Federal.  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,
            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, stockholders’
equity and comprehensive income 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 2006 financial statements to
            conform to
            the 2007 presentation.  There is no effect on net income, earnings per
            share, or equity.  All significant intercompany transactions and
            balances have been eliminated.
  The
            information included in this Form 10-Q should be read in conjunction
            with the
            First Mutual Bancshares, Inc. Year 2006 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
                -
 FIRST
          MUTUAL BANCSHARES, INC.
 CONSOLIDATED
          STATEMENTS OF FINANCIAL
          CONDITION
 **(Dollars
            in thousands)**
 June
                    30,
                
                
                December
                    31,2007
                
                
                2006**Assets**
                
                *(Unaudited)*Cash
                    and Cash Equivalents:Interest-earning
                    deposits
                
                $
                4,616
                
                
                $
                6,990Noninterest-earning
                    demand deposits and cash on hand
                
                
                16,765
                
                
                
                18,372Total
                    cash and cash equivalents
                
                
                21,381
                
                
                
                25,362Mortgage-backed
                    and other securities available-for-sale (at fair value)
                
                
                4,181
                
                
                
                89,728Mortgage-backed
                    and other securities held for trading (at fair value)
                
                
                54,696
                
                
                
                —Mortgage-backed
                      and other securities held-to-maturity fair value of $7,819 and
                      $5,585, respectively
                
                
                7,892
                
                
                
                5,620Loans
                    held for sale
                
                
                21,391
                
                
                
                13,733Loans
                    receivable
                
                
                866,858
                
                
                
                893,431Reserve
                    for loan and lease losses
                
                
                (9,759
                )
                
                
                (9,728
                )Loans
                    receivable, net
                
                
                857,099
                
                
                
                883,703Accrued
                    interest receivable
                
                
                5,245
                
                
                
                5,534Land,
                    buildings and equipment, net
                
                
                35,435
                
                
                
                35,566Federal
                    Home Loan Bank (FHLB) stock, at cost
                
                
                13,122
                
                
                
                13,122Servicing
                    assets
                
                
                4,984
                
                
                
                4,011Other
                    assets
                
                
                3,603
                
                
                
                2,884**Total
                    Assets**
                
                $
                1,029,029
                
                
                $
                1,079,263
       See
          Notes
          to the Financial Statements
    -
            2
            -
 
 **FIRST
          MUTUAL BANCSHARES, INC.**
 **CONSOLIDATED
            STATEMENTS OF FINANCIAL CONDITION**
 **(Dollars
            in thousands)**
 **(Continued)**
  
 June
                    30,
                
                
                December
                    31,2007
                
                
                2006*(Unaudited)***Liabilities**Deposits:Non-interest-bearing
                
                $
                61,543
                
                
                $
                56,566Interest-bearing
                    transactions and savings accounts
                
                
                275,677
                
                
                
                263,830Interest-bearing
                    time deposits
                
                
                422,565
                
                
                
                485,399Total
                    deposits
                
                
                759,785
                
                
                
                805,795Drafts
                    payable
                
                
                1,199
                
                
                
                1,314Accounts
                    payable and other liabilities
                
                
                7,511
                
                
                
                7,018Advance
                    payments by borrowers for taxes and insurance
                
                
                1,679
                
                
                
                1,583FHLB
                    advances
                
                
                163,468
                
                
                
                171,932Other
                    advances
                
                
                4,600
                
                
                
                4,600Junior
                    subordinated long-term debentures (at fair value)
                
                
                9,048
                
                
                
                —Junior
                    subordinated long-term debentures
                
                
                8,000
                
                
                
                17,000Total
                    liabilities
                
                
                955,290
                
                
                
                1,009,242**Stockholders’
                    Equity**Common
                    stock, $1 par value, 30,000,000 shares authorized,6,694,510
                    and 6,673,528 shares issued and outstanding
                
                $
                6,695
                
                
                $
                6,674Additional
                    paid-in capital
                
                
                45,755
                
                
                
                45,119Retained
                    earnings
                
                
                21,303
                
                
                
                19,589Accumulated
                    other comprehensive income(loss):Unrealized
                    (loss) on securities available-for-sale,net
                    of federal income tax
                
                
                (14
                )
                
                
                (1,361
                )Total
                    stockholders’ equity
                
                
                73,739
                
                
                
                70,021**Total
                    Liabilities and Stockholders’ Equity**
                
                $
                1,029,029
                
                
                $
                1,079,263
     See
          Notes
          to the Financial Statements
    -
              3
              -
 **FIRST
              MUTUAL BANCSHARES, INC.**
 **CONSOLIDATED
                STATEMENTS OF INCOME**
 **(Dollars
                in thousands)**
 Quarter
                    ended June 30,
                
                
                Six
                    months ended June 30,2007
                
                
                2006
                
                
                2007
                
                
                2006*(Unaudited)***Interest
                    Income**Loans
                    receivable
                
                $
                18,092
                
                
                $
                18,518
                
                
                $
                36,592
                
                
                $
                36,065Interest
                    on available-for-sale securities
                
                
                51
                
                
                
                1,088
                
                
                
                105
                
                
                
                2,281Interest
                    on held-to-maturity securities
                
                
                75
                
                
                
                87
                
                
                
                152
                
                
                
                177Interest
                    on held-for-trading securities
                
                
                810
                
                
                
                —
                
                
                
                1,755
                
                
                
                —Interest
                    other
                
                
                543
                
                
                
                132
                
                
                
                749
                
                
                
                250Total
                    interest income
                
                
                19,571
                
                
                
                19,825
                
                
                
                39,353
                
                
                
                38,773**Interest
                    Expense**Deposits
                
                
                7,487
                
                
                
                6,447
                
                
                
                15,197
                
                
                
                12,363FHLB
                    and other advances
                
                
                3,223
                
                
                
                3,353
                
                
                
                5,944
                
                
                
                6,154Total
                    interest expense
                
                
                10,710
                
                
                
                9,800
                
                
                
                21,141
                
                
                
                18,517Net
                    interest income
                
                
                8,861
                
                
                
                10,025
                
                
                
                18,212
                
                
                
                20,256Provision
                    for loan and lease losses
                
                
                (86
                )
                
                
                (135
                )
                
                
                (238
                )
                
                
                (206
                )Net
                    interest income, after provisionfor
                    loan and lease losses
                
                
                8,775
                
                
                
                9,890
                
                
                
                17,974
                
                
                
                20,050**Noninterest
                    Income**Gain
                    on sales of loans
                
                
                873
                
                
                
                554
                
                
                
                1,846
                
                
                
                1,310Gain
                    (loss) from mark to market (SFAS 159)
                
                
                (211
                )
                
                
                —
                
                
                
                236
                
                
                
                —Servicing
                    fees, net of amortization
                
                
                399
                
                
                
                300
                
                
                
                836
                
                
                
                635Gain
                    on sales of investments
                
                
                116
                
                
                
                —
                
                
                
                116
                
                
                
                —Fees
                    on deposits
                
                
                208
                
                
                
                194
                
                
                
                396
                
                
                
                376Other
                
                
                746
                
                
                
                1,009
                
                
                
                1,364
                
                
                
                1,451Total
                    noninterest income
                
                
                2,131
                
                
                
                2,057
                
                
                
                4,794
                
                
                
                3,772
     See
          Notes
          to the Financial Statements
  -
              4
              -
 **FIRST
        MUTUAL BANCSHARES, INC.**
 **CONSOLIDATED
            STATEMENTS OF INCOME**
 **(Dollars
            in thousands except per share amounts)**
 **(Continued)**
  
 Quarter
                    ended June 30,
                
                
                Six
                    months ended June 30,2007
                
                
                2006
                
                
                2007
                
                
                2006*(Unaudited)***Noninterest
                    Expense**Salaries
                    and employee benefits
                
                $
                4,617
                
                
                $
                4,477
                
                
                $
                9,126
                
                
                $
                8,923Occupancy
                
                
                968
                
                
                
                1,043
                
                
                
                1,950
                
                
                
                2,053Credit
                    insurance premiums
                
                
                380
                
                
                
                479
                
                
                
                806
                
                
                
                942Other
                
                
                2,276
                
                
                
                1,836
                
                
                
                4,095
                
                
                
                3,605Total
                    noninterest expense
                
                
                8,241
                
                
                
                7,835
                
                
                
                15,977
                
                
                
                15,523Income
                    before provision for federal income tax
                
                
                2,665
                
                
                
                4,112
                
                
                
                6,791
                
                
                
                8,299Provision
                    for federal income tax
                
                
                908
                
                
                
                1,400
                
                
                
                2,319
                
                
                
                2,873**Net
                    Income**
                
                
                $
                1,757
                
                
                $
                2,712
                
                
                $
                4,472
                
                
                $
                5,426**Per
                    Share Data(1):**Basic
                    earnings per common share
                
                $
                0.26
                
                
                $
                0.41
                
                
                $
                0.67
                
                
                $
                0.82Diluted
                    earnings per common share
                
                $
                0.25
                
                
                $
                0.40
                
                
                $
                0.64
                
                
                $
                0.80**Weighted
                    Average Number of Shares Outstanding**
                
                
                6,690,810
                
                
                
                6,644,804
                
                
                
                6,686,429
                
                
                
                6,636,099**Weighted
                    Average Number of Shares Outstanding****Including
                    Dilutive Stock Options**
                
                
                6,934,848
                
                
                
                6,790,098
                
                
                
                6,935,726
                
                
                
                6,813,695
  (1)
          Shares and EPS have been adjusted to reflect the five-for-four stock split
          paid
          on October 4, 2006.
  See
          Notes
          to the Financial Statements
 
 -
              5
              -
 **First
            Mutual Bancshares, Inc. and Subsidiaries**
 **Consolidated
          Statements of Stockholders’ Equity and Comprehensive
          Income**
 **(Dollars
          in thousands except per share amounts)**
   AccumulatedAdditional
                
                
                
                
                
                ComprehensiveCommon
                    Stock (1)
                
                
                Paid-in
                
                
                Retained
                
                
                IncomeShares
                
                
                Amount
                
                
                Capital
                    (1)
                
                
                Earnings
                
                
                (Loss)
                
                
                TotalBALANCE,
                    December 31, 2004
                
                
                6,611
                
                
                $
                6,611
                
                
                $
                44,273
                
                
                $
                9,220
                
                
                $
                (657
                )
                
                $
                59,447Comprehensive
                    income:Net
                    income
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                10,319
                
                
                
                
                
                
                
                10,319Other
                    comprehensive income (loss), net of tax:Unrealized
                    (loss) on securities available-for-sale
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                (945
                )
                
                
                (945
                )Unrealized
                    gain on interest rate swap
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                166
                
                
                
                166Total
                    comprehensive income
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                9,540Options
                    exercised, including tax benefit of $479
                
                
                185
                
                
                
                185
                
                
                
                1,727
                
                
                
                
                
                
                
                
                
                
                
                1,912Retirement
                    of shares repurchased
                
                
                (180
                )
                
                
                (180
                )
                
                
                (2,130
                )
                
                
                (1,344
                )
                
                
                
                
                
                
                (3,654
                )Issuance
                    of stock through employees’ stock plans
                
                
                5
                
                
                
                5
                
                
                
                95
                
                
                
                
                
                
                
                
                
                
                
                100Cash
                    dividend declared ($1.11 per share)
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                (7,318
                )
                
                
                
                
                
                
                (7,318
                )BALANCE,
                    December 31, 2005
                
                
                6,621
                
                
                $
                6,621
                
                
                $
                43,965
                
                
                $
                10,877
                
                
                $
                (1,436
                )
                
                $
                60,027Comprehensive
                    income:Net
                    income
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                10,980
                
                
                
                
                
                
                
                10,980Other
                    comprehensive income, net of tax:Unrealized
                    gain on securities available-for-sale
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                75
                
                
                
                75Total
                    comprehensive income
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                11,055Compensation
                    related to stock options
                
                
                
                
                
                
                
                
                
                
                632
                
                
                
                
                
                
                
                
                
                
                
                632Options
                    exercised, including tax benefit of $110
                
                
                48
                
                
                
                48
                
                
                
                427
                
                
                
                
                
                
                
                
                
                
                
                475Issuance
                    of stock through employees’ stock plans
                
                
                5
                
                
                
                5
                
                
                
                95
                
                
                
                
                
                
                
                
                
                
                
                100Cash
                    dividend declared ($0.32 per share)
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                (2,268
                )
                
                
                
                
                
                
                (2,268
                )BALANCE,
                    December 31, 2006
                
                
                6,674
                
                
                $
                6,674
                
                
                $
                45,119
                
                
                $
                19,589
                
                
                $
                (1,361
                )
                
                $
                70,021Cumulative-effect
                    adjustment for the initial adoption of SFAS No. 159
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                (1,554
                )
                
                
                
                
                
                
                (1,554
                )Comprehensive
                    income:Net
                    income
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                4,472
                
                
                
                
                
                
                
                4,472Other
                    comprehensive income (loss), net of tax:Unrealized
                    gain on securities available-for-sale
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                1,347
                
                
                
                1,347Total
                    comprehensive income
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                5,819Compensation
                    related to stock options
                
                
                
                
                
                
                
                
                
                
                326
                
                
                
                
                
                
                
                
                
                
                
                326Options
                    exercised, including tax benefit of $47
                
                
                16
                
                
                
                16
                
                
                
                195
                
                
                
                
                
                
                
                
                
                
                
                211Issuance
                    of stock through employees’ stock plans
                
                
                5
                
                
                
                5
                
                
                
                115
                
                
                
                
                
                
                
                
                
                
                
                120Cash
                    dividend declared ($0.18 per share)
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                (1,204
                )
                
                
                
                
                
                
                (1,204
                )BALANCE,
                    June 30, 2007
                
                
                6,695
                
                
                $
                6,695
                
                
                $
                45,755
                
                
                $
                21,303
                
                
                $
                (14
                )
                
                $
                73,739
 
    (1)
          The
          number and amount of common shares issued and outstanding have been adjusted
          to
          reflect the five-for-four stock split paid on October 4,
          2006.
   See
          Notes
          to the Financial Statements
 -
            6
            -
 **FIRST
            MUTUAL BANCSHARES, INC.**
 **CONSOLIDATED
              STATEMENTS OF CASH FLOWS**
 **(Dollars
                in thousands)**
 Six
                    months ended June 30,2007
                
                
                2006*(Unaudited)***Cash
                    Flows from Operating Activities**Net
                    income
                
                $
                4,472
                
                
                $
                5,426Adjustments
                    to reconcile net income to net cash from operating
                    activities:Provision
                    for loan and lease losses
                
                
                238
                
                
                
                206Depreciation
                    and amortization
                
                
                947
                
                
                
                1,028Deferred
                    loan origination fees, net of accretion
                
                
                (122
                )
                
                
                645Amortization
                    of servicing assets
                
                
                1,167
                
                
                
                599Gain
                    on sales of loans
                
                
                (1,846
                )
                
                
                (1,311
                )Gain
                    on sale of securities held for trading
                
                
                (116
                )
                
                
                —Gain
                    on mark to market (SFAS 159)
                
                
                (236
                )
                
                
                —Stock-based
                    compensation
                
                
                326
                
                
                
                260Excess
                    tax benefit from stock-based compensation
                
                
                (47
                )
                
                
                (5
                )Changes
                    in operating assets and liabilities:Loans
                    held-for-sale
                
                
                (7,658
                )
                
                
                (5,817
                )Accrued
                    interest receivable
                
                
                289
                
                
                
                (14
                )Other
                    assets
                
                
                (207
                )
                
                
                (1,329
                )Drafts
                    payable
                
                
                (115
                )
                
                
                (266
                )Accounts
                    payable and other liabilities
                
                
                (156
                )
                
                
                (3,024
                )Advance
                    payments by borrowers for taxes and insurance
                
                
                96
                
                
                
                198Net
                    cash (used) by operating activities
                
                
                (2,968
                )
                
                
                (3,404
                )**Cash
                    Flows from Investing Activities**Loan
                    originations
                
                
                (149,836
                )
                
                
                (222,705
                )Loan
                    principal repayments
                
                
                193,166
                
                
                
                192,965Decrease
                    in undisbursed loan proceeds
                
                
                (17,174
                )
                
                
                (1,817
                )Principal
                      repayments and redemptions on mortgage-backed and other
                      securities
                
                
                12,761
                
                
                
                23,535Purchase
                    of securities held-to-maturity
                
                
                (3,000
                )
                
                
                —Purchase
                    of securities held-for-trading
                
                
                (39,303
                )
                
                
                (7,170
                )Purchases
                    of premises and equipment
                
                
                (816
                )
                
                
                (2,664
                )Proceeds
                    from sale of securities held-for-trading
                
                
                58,034
                
                
                
                —Proceeds
                    from sale of impaired loans
                
                
                502
                
                
                
                340Net
                    cash provided/(used) by investing activities
                
                
                54,334
                
                
                
                (17,516
                )
   See
          Notes
          to the Financial Statements
 -
              7
              -
 **FIRST
        MUTUAL BANCSHARES, INC.**
 **CONSOLIDATED
            STATEMENTS OF CASH FLOWS**
 **(Dollars
            in thousands)**
 (Continued)
  
 Six
                    months ended June 30,2007
                
                
                2006*(Unaudited)***Cash
                    Flows from Financing Activities**Net
                    increase (decrease) in deposit accounts
                
                $
                (60,370
                )
                
                $
                (11,601
                )Interest
                    credited to deposit accounts
                
                
                14,360
                
                
                
                11,224Issuance
                    of stock through employees’ stock plans
                
                
                120
                
                
                
                100Proceeds
                    from advances
                
                
                305,325
                
                
                
                452,901Repayment
                    of advances
                
                
                (313,789
                )
                
                
                (430,274
                )Dividends
                    paid
                
                
                (1,204
                )
                
                
                (6,354
                )Proceeds
                    from exercise of stock options and excess tax benefitof
                    $47 and $5 from stock-based compensation
                
                
                211
                
                
                
                145Net
                    cash provided/(used) by financing activities
                
                
                (55,347
                )
                
                
                16,141**Increase/(decrease)
                    in cash and cash equivalents**
                
                $
                (3,981
                )
                
                $
                (4,779
                )Cash
                    and cash equivalents, beginning of the year
                
                
                25,362
                
                
                
                25,781Cash
                    and cash equivalents, end of quarter
                
                $
                21,381
                
                
                $
                21,002**Supplemental
                    Disclosures of Cash Flow Information**Loans
                    originated for sale in the secondary market
                
                $
                73,526
                
                
                $
                57,165Loans
                    originated for investment activities
                
                
                149,836
                
                
                
                222,705Proceeds
                    from sale of loans held-for-sale
                
                
                65,868
                
                
                
                51,348Additions
                    to servicing assets
                
                
                2,140
                
                
                
                1,436Cash
                    paid during the year for:Interest
                
                
                21,065
                
                
                
                17,923Income
                    taxes
                
                
                2,910
                
                
                
                2,333
     See
          Notes
          to the Financial Statements
   -
              8
              -
 **NOTES
          TO CONSOLIDATED FINANCIAL
          STATEMENTS**
 **(Unaudited)**
  
 **Note
              1.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**
 
 The
              results of operations for the interim periods shown in this report
              are not
              necessarily indicative of results to be expected for the fiscal
              year.  In the opinion of management, the information contained herein
              reflects all adjustments necessary to make the results of operations
              for the
              interim periods a fair statement of such operations.
   **Note
              2.  ADOPTION OF NEW ACCOUNTING STANDARDS**
 
 **Financial
              Accounting Standards Board Interpretation No. 48,*Accounting for
              Uncertainty in Income Taxes*(FIN No. 48)**
 
 In
              June
              2006, the Financial Accounting Standards Board (FASB) issued FIN No.
              48 - an
              interpretation of FASB Statement No. 109, *Accounting for Income
              Taxes*.  FIN No. 48 establishes a single model to address
              accounting for uncertain tax positions.  FIN No. 48 clarifies the
              accounting for income taxes by prescribing a minimum recognition threshold
              a tax
              position is required to meet before being recognized in the financial
              statements.  FIN No. 48 also provides guidance on derecognition,
              measurement classification, interest and penalties, accounting in interim
              periods, disclosure and transition.  We adopted FIN No. 48 on January
              1, 2007; no adjustments have been made to our financial statements
              as a result
              of this adoption.  We do not believe that we have any uncertain tax
              positions that would rise to the level of having a material impact
              on our
              financial statements.
 
 Our
              continuing practice is to recognize interest and/or penalties related
              to income
              tax matters in income tax expense.
 
 **Statement
              of Financial Accounting Standards No. 156, *Accounting for Servicing of
              Financial Assets*(SFAS 156)**
 
 In
              March
              of 2006, the FASB published SFAS No. 156, which amends SFAS No. 140,
              *Accounting for Transfers and Servicing of Financial Assets and
              Extinguishments of Liabilities*, with respect to the accounting for
              servicing of financial assets. SFAS No. 156 requires that all separately
              recognized servicing rights be initially measured at fair value, if
              practicable.  For each class of separately recognized servicing assets
              and liabilities, SFAS No. 156 permits an entity to choose either of
              the
              following subsequent measurement methods:  (1) the amortization of
              servicing assets or liabilities in proportion to and over the period
              of
              estimated net servicing income or net servicing loss or (2) the reporting
              of
              servicing assets or liabilities at fair value at each reporting date
              and
              reporting changes in fair value in earnings in the period in which
              the changes
              occur. SFAS No. 156 also requires additional disclosures for all separately
              recognized servicing rights.  We adopted SFAS No. 156 on January 1,
              2007 and have elected to continue to amortize our servicing assets
              or
              liabilities in proportion to and over the period of estimated net servicing
              income or net servicing loss.
 
 Originated
              servicing assets are recorded when loans are originated and subsequently
              sold or
              securitized (and held as available-for-sale securities) with the servicing
              rights retained.  Servicing assets are initially recognized at fair
              value on the balance sheet.  Fair value is based on market prices for
              comparable servicing contracts when available, or alternatively, is
              based on a
              valuation model that calculates the present value of the estimated
              future cash
              flows.  Assumptions used in the valuation model include market
              discount rates and anticipated prepayment speeds.  The prepayment
              speeds of the servicing portfolio are based on our prepayment experience
              for
              those strata for which market data are not readily available.  These
              servicing assets include sales finance loans, construction loan participations,
              lot loans, and other commercial loans for which there are no readily
              available
              online quotation data.  In addition, estimates of the cost of
              servicing per loan, an inflation rate, ancillary income per loan, and
              default
              rates are used.  The cost relating to the servicing rights is
              capitalized and amortized into noninterest income in proportion to,
              and over the
              period of, estimated future net servicing income. Amounts capitalized
              are
              recorded at cost, net of accumulated amortization and valuation
              allowance.
 
 We
              assess
              impairment of the capitalized servicing assets based on recalculations
              of the
              present value of the remaining future
              cash flows using updated market discount rates and prepayment
              speeds.  Subsequent loan prepayments and changes
              in prepayment assumptions in excess of those forecasted can adversely
              impact the
              carrying value of the servicing
              assets.  Impairment is assessed on a stratum-by-stratum basis with any
              impairment recognized through a valuation
              allowance for each impaired stratum.  The servicing assets are
              stratified based on the types of loans and the
              underlying collateral.  We have three strata or classes of servicing
              assets:  consumer (sales finance), commercial, and
              residential.
 
 The
              effect of changes in market interest rates on estimated rates of loan
              prepayments is the predominant risk characteristic for
              mortgage servicing rights.  For those loans that do not have quoted
              prepayment rates we utilize our own prepayment experience
              over the previous three months to reflect the actual prepayment environment
              in
              our underlying assumptions of the estimated
              fair value of the servicing rights upon recognition.  The significant
              assumption used in the valuation model is
              the
              discount rate.  This is generally the weighted average note rate of
              the underlying loans.
  Changes
              in the servicing asset balances, the fair values, discount and prepayment
              assumptions by strata are as follows:
 
 -
                  9
                  -
 Second
                    Quarter 2007Consumer
                
                
                Commercial
                
                
                Residential
                
                
                Total(Dollars
                    in thousands)Balance,
                    beginning of quarter
                
                $
                4,386
                
                
                $
                165
                
                
                $
                57
                
                
                $
                4,608Additions
                
                
                1,014
                
                
                
                16
                
                
                
                18
                
                
                
                1,048Amortization
                
                
                (562
                )
                
                
                (38
                )
                
                
                (3
                )
                
                
                (603
                )Impairment
                
                
                (40
                )
                
                
                (29
                )
                
                
                —
                
                
                
                (69
                )Balance
                    at June 30, 2007
                
                $
                4,798
                
                
                $
                114
                
                
                $
                72
                
                
                $
                4,984Fair
                    values atApril
                    1, 2007
                
                $
                4,544
                
                
                $
                136
                
                
                $
                97Fair
                    values atJune
                    30, 2007
                
                $
                4,786
                
                
                $
                127
                
                
                $
                96Discount
                    rate
                
                
                11.5
                %
                
                
                9.2
                %
                
                
                7.7
                %Prepayment
                    speed
                
                
                36.4
                %
                
                
                36.2
                %
                
                
                30.8
                %
  
 Second
                    Quarter 2006Consumer
                
                
                Commercial
                
                
                Residential
                
                
                Total(Dollars
                    in thousands)Balance,
                    beginning of quarter
                
                $
                2,107
                
                
                $
                275
                
                
                $
                92
                
                
                $
                2,474Additions
                
                
                522
                
                
                
                55
                
                
                
                —
                
                
                
                577Amortization
                
                
                (296
                )
                
                
                (43
                )
                
                
                (10
                )
                
                
                (349
                )Impairment
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                —Balance
                    at June 30, 2006
                
                $
                2,333
                
                
                $
                287
                
                
                $
                82
                
                
                $
                2,702Fair
                    values atApril
                    1, 2006
                
                $
                2,314
                
                
                $
                488
                
                
                $
                160Fair
                    values atJune
                    30, 2006
                
                $
                2,697
                
                
                $
                472
                
                
                $
                88Discount
                    rate
                
                
                10.9
                %
                
                
                9.1
                %
                
                
                8.8
                %Prepayment
                    speed
                
                
                38.1
                %
                
                
                33.2
                %
                
                
                45.4
                %
   Servicing
            fee income, net of amortization, consisted of the following for the quarters
            ended June 30, 2007 and 2006:
 Second
                    Quarter 2007Consumer
                
                
                Commercial
                
                
                Residential
                
                
                Total(Dollars
                    in thousands)Servicing
                    fees
                
                $
                1,033
                
                
                $
                31
                
                
                $
                7
                
                
                $
                1,071Amortization
                
                
                (602
                )
                
                
                (67
                )
                
                
                (3
                )
                
                
                (672
                )Loan
                    servicing fees, net
                
                $
                431
                
                
                $
                (36
                )
                
                $
                4
                
                
                $
                399Second
                    Quarter 2006Consumer
                
                
                Commercial
                
                
                Residential
                
                
                Total(Dollars
                    in thousands)Servicing
                    fees
                
                $
                594
                
                
                $
                43
                
                
                $
                12
                
                
                $
                649Amortization
                
                
                (296
                )
                
                
                (43
                )
                
                
                (10
                )
                
                
                (349
                )Loan
                    servicing fees, net
                
                $
                298
                
                
                $
                —
                
                
                $
                2
                
                
                $
                300
  -
            10
            -
 **NOTES
            TO CONSOLIDATED FINANCIAL
            STATEMENTS**
 **(Unaudited)**
 
 **Note
            2.  ADOPTION OF
            NEW ACCOUNTING STANDARDS (Continued)**
 **Statement
            of Financial
            Accounting Standards No. 157,*****Fair
            Value
            Measurements*** **and
            No. 159,*****The
            Fair Value Option for Financial Assets and Financial
            Liabilities*****,** **(SFAS
            No. 157 and SFAS No.
            159)**
 We
              elected early adoption of SFAS No. 157 and SFAS No. 159 effective January
              1,
              2007.
 
 In
              September 2006, the FASB issued SFAS No. 157 which defines fair value,
              establishes a framework for measuring fair value in Generally Accepted
              Accounting Principles, and expands disclosure requirements about fair
              value
              measurements.  SFAS No. 157, among other things, requires us to
              maximize the use of observable inputs and minimize the use of unobservable
              inputs when measuring fair values.
 
 Valuation
              techniques are based upon observable and unobservable
              inputs.  Observable inputs reflect market data obtained from
              independent sources, while unobservable inputs reflect our market
              assumptions.  These two types of inputs create the following fair
              value hierarchy.
 
 Level
              1 -
              Quoted prices for identical instruments in active markets.
 
 Level
              2 -
              Quoted prices for similar instruments in active markets; quoted prices
              for
              identical or similar instruments in markets that are not active; and
              model-derived valuations whose inputs are observable.
 
 Level
              3 -
              Instruments whose significant value drivers are unobservable.
 
 In
              February 2007, the FASB issued SFAS No. 159.  SFAS 159 allows entities
              to voluntarily choose, at specified election dates, to measure many
              financial
              assets and financial liabilities at fair value.  The election is made
              on an instrument-by-instrument basis and is irrevocable.  If the fair
              value option is elected for an instrument, all subsequent changes in
              fair value
              for that instrument shall be reported in earnings.
 
 The
              following is a breakdown of the cumulative effect adjustment that was
              made to
              retained earnings upon adoption of SFAS 159:
 **Description**
                      
                      **Balance
                          Sheet at January 1, 2007 prior to Adoption**
                      
                      
                      **Net
                          Gain/(Loss) upon Adoption**
                      
                      
                      **Balance
                          Sheet at January 1, 2007 after Adoption of the Fair Value
                          Option**(Dollars
                          in thousands)Mortgage-backed
                          and agency securities - gross
                      
                      $
                      87,148
                      
                      
                      $
                      (2,149
                      )
                      
                      $
                      84,999(excluding
                          premiums and discounts)Premiums
                          and discounts related to securities
                      
                      
                      (97
                      )
                      
                      
                      97
                      
                      
                      
                      —Long-term
                          debentures payable (trust preferred securities)
                      
                      
                      9,000
                      
                      
                      
                      (89
                      )
                      
                      
                      8,911Issuance
                          costs related to long-term debentures
                      
                      
                      249
                      
                      
                      
                      (249
                      )
                      
                      
                      —Pretax
                          cumulative effect of adoption ofthe
                          fair value option
                      
                      
                      
                      
                      
                      
                      (2,390
                      )Increase
                          in deferred tax asset
                      
                      
                      
                      
                      
                      
                      836Cumulative
                          effect of adoption of the fair valueoption
                          (charge to retained earnings)
                      
                      
                      
                      
                      
                      $
                      (1,554
                      )
 -
              11
              -
 
 **Mortgage-Backed
              and Agency Securities**
 Upon
              adoption, the mortgage-backed and agency securities selected for treatment
              under
              SFAS No. 159 consisted of $87.1 million or 89% of the securities
              portfolio.  Securities with a remaining balance less than one million
              dollars and instruments held for Community Reinvestment Act (CRA) investments
              were not included in the adoption of SFAS No. 159.  Securites with
              small balances are much less attractive to potential purchasers and
              the CRA
              investments were purchased to facilitate compliance with the Community
              Reinvestment Act.  The initial fair value of the securities selected
              for SFAS No. 159 adoption resulted in a $1,334,000 cumulative-effect
              adjustment,
              net of tax, recorded as a reduction in retained earnings as of January
              1,
              2007.  Under SFAS No. 159, this one-time charge was not recognized in
              earnings.  As a result of the fair value measurement election for
              these securities, we recorded gains in the first quarter 2007 earnings
              of
              $402,000 and a loss of $211,000 in the second quarter. The standard
              was adopted
              early as we believed that it would enable us to more effectively manage
              interest
              rate risk. However, because of the volatility observed in the second
              quarter we
              have reduced, through security sales, most of the securities originally
              selected
              for treatment under SFAS No. 159. Our current balance for securities
              held in the
“held
              for
              trading”
              account as of July 30, 2007 is $13.7 million.
 
 The
              securities selected to be accounted for under SFAS No. 159 are presented
              separately from the securities that are accounted for at cost and titled
“Held
              for Trading (at fair value)”.
 
 **Junior
              Subordinated Long-Term Debentures Payable (Trust Preferred
              Securities)**
 The
              junior subordinated long-term debentures selected for treatment under
              SFAS No.
              159 totaled $9 million.  The initial fair value measurement resulted
              in a $220,000, net of tax, charge to retained earnings for unamortized
              issuance
              costs and excess interest.  In the first quarter of 2007, we recorded
              $45,000 in pre-tax mark-to-market gains, and a loss of $4,000 in the
              second
              quarter. We elected to account for our first $9 million junior subordinated
              long-term debenture issuance and not the other two issuances of $4
              million each
              under SFAS No. 159 because this particular security is hedged with
              an
              interest-rate swap that is carried at fair value with changes in value
              reflected
              in our earnings (the other two debentures are not hedged). The election
              to fair
              value the debentures matches the change in value of the interest-rate
              swap with
              the change in value of the debentures - effectively reducing the volitility
              in
              earnings.  This security is eligible for prepayment on September 30,
              2007 and it is our current intention to prepay the instrument.
 
 The
              long-term debentures payable selected to be accounted for under SFAS
              No. 159 are
              presented seperately from the long-term debentures payable that are
              accounted
              for at cost and titled “long-term debentures payable (at fair
              value)”.
 
 **Interest-Rate
              Swaps and Loans**
 The
              interest-rate swaps and related commercial loans were included in the
              early
              adoption of SFAS 159 for administrative reasons.  We have two fair
              value swaps that are hedged with commercial loans and are evaluated
              quarterly in
              accordance with SFAS 133, the hedge accounting statement.  The
              inclusion of these two swaps and loans in the adoption of SFAS 159
              did not
              impact retained earnings or net income, however, the administrative
              burden
              associated with accounting for these instruments will be greatly reduced
              under
              the new accounting statement.  These two swaps were the only swaps
              that were accounted for in accordance with the “long-haul accounting method”,
              under SFAS No. 133, as amended.
 
 The
              fair
              value of the swaps is included in “Accounts Payable and Other” and the fair
              value of the commercial loans that are being hedged is included in
“Loans
              Receivable” on the balance sheet. On January 1, 2007, the fair value of the two
              swaps was $23,517 and the fair value of the loans totaled $22,742.  On
              June 30, 2007, the fair value of the swaps included in “Accounts Payable and
              Other” totaled $19,480 and the fair value of the loans amounted to
              $19,344.
 -
              12
              -
 
 Fair
                      Value Measurements at June 30, 2007
                  
                  
                  Changes
                      in Fair Values for the 3-Month Period Ended June 30, 2007,
                      for Items Measured at Fair Value Pursuant to Election of the
                      Fair Value
                      OptionDescription
                  
                  Fair
                      Value Measurements 6/30/07
                  
                  
                  Quoted
                      Prices in Active Markets for Identical Assets (Level 1)
                  
                  
                  Significant
                      Other Observable Inputs (Level 2)
                  
                  
                  Significant
                      Unobservable Inputs (Level 3)
                  
                  
                  Interest
                      Expense - FHLB and Other Advances
                  
                  
                  Interest
                      Income on Loans
                  
                  
                  Loss
                      from Mark to Market (SFAS 159) - Noninterest Income
                  
                  
                  Total
                      Changes in Fair Values Included in Current-Period Earnings(Dollars
                      in thousands)Trading
                      securities
                  
                  $
                  54,696
                  
                  
                  $
                  54,696
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  $
                  (207
                  )
                  
                  $
                  (207
                  )Long-term
                      debentures payable
                  
                  
                  9,048
                  
                  
                  
                  
                  
                  
                  
                  9,048
                  
                  
                  
                  
                  
                  
                  
                  209
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  209Loans
                      Receivable
                  
                  
                  19
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  19
                  
                  
                  
                  
                  
                  
                  
                  27
                  
                  
                  
                  
                  
                  
                  
                  27
 The
          contractual long-term debentures payable totaled $9.0 million and the unpaid
          principal balance on the two loans that were selected to be carried
          at fair value totaled $1.4 million at June 30, 2007.
         -
            13
            -
 **Note
          3.**
 **Mortgage-Backed
          and Other Securities Available-for-Sale**
  The
            amortized cost and estimated fair value of securities available-for-sale
            at June
            30, 2007 and December 31, 2006 are summarized as follows:
 Gross
                
                
                GrossGross
                
                
                Unrealized
                
                
                Unrealized
                
                
                EstimatedAmortized
                
                
                Unrealized
                
                
                Losses
                
                
                Losses
                
                
                FairCost
                
                
                Gains
                
                
                <1
                    Year
                
                
                >1
                    Year
                
                
                Value**June
                    30, 2007**
                
                (Dollars
                    in thousands)Freddie
                    Mac securities
                
                $
                467
                
                
                $
                5
                
                
                $
                —
                
                
                $
                —
                
                
                $
                472Fannie
                    Mae securities
                
                
                1,148
                
                
                
                5
                
                
                
                0
                
                
                
                32
                
                
                
                1,121Ginnie
                    Mae securities
                
                
                2,587
                
                
                
                3
                
                
                
                0
                
                
                
                2
                
                
                
                2,588$
                4,202
                
                
                $
                13
                
                
                $
                —
                
                
                $
                34
                
                
                $
                4,181**December
                    31, 2006**Freddie
                    Mac securities
                
                $
                14,657
                
                
                $
                9
                
                
                $
                —
                
                
                $
                565
                
                
                $
                14,101Fannie
                    Mae securities
                
                
                32,222
                
                
                
                8
                
                
                
                —
                
                
                
                1,090
                
                
                
                31,140Ginnie
                    Mae securities
                
                
                34,053
                
                
                
                2
                
                
                
                —
                
                
                
                397
                
                
                
                33,658US
                    agency securities
                
                
                10,990
                
                
                
                —
                
                
                
                —
                
                
                
                161
                
                
                
                10,829$
                91,922
                
                
                $
                19
                
                
                $
                —
                
                
                $
                2,213
                
                
                $
                89,728
   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, 2007 and December 31, 2006, there
            were 4 and 32 investment securities with unrealized losses,
            respectively.  The Bank anticipates full recovery of amortized cost
            with respect to
            these
            securities at maturity or sooner in the event of a more favorable market
            interest rate environment.
    **Note
          4.**
 **Mortgage-Backed
            and Other Securities Held-to-Maturity**
  The
          amortized cost and estimated fair value of securities held-to-maturity
          at June
          30, 2007 and December 31, 2006 are summarized as follows:
  Gross
                
                
                GrossGross
                
                
                Unrealized
                
                
                Unrealized
                
                
                EstimatedAmortized
                
                
                Unrealized
                
                
                Losses
                
                
                Losses
                
                
                FairCost
                
                
                Gains
                
                
                <1
                    Year
                
                
                >1
                    Year
                
                
                Value**June
                    30, 2007**
                
                (Dollars
                    in thousands)Fannie
                    Mae securities
                
                $
                3,660
                
                
                $
                23
                
                
                $
                —
                
                
                $
                89
                
                
                $
                3,594Freddie
                    Mac securities
                
                
                96
                
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                96Municipal
                    bonds
                
                
                4,136
                
                
                
                —
                
                
                
                —
                
                
                
                7
                
                
                
                4,129$
                7,892
                
                
                $
                23
                
                
                $
                —
                
                
                $
                96
                
                
                $
                7,819**December
                    31, 2006**Fannie
                    Mae securities
                
                $
                4,176
                
                
                $
                35
                
                
                $
                —
                
                
                $
                74
                
                
                $
                4,137Freddie
                    Mac securities
                
                
                300
                
                
                
                7
                
                
                
                —
                
                
                
                —
                
                
                
                307Municipal
                    bonds
                
                
                1,144
                
                
                
                1
                
                
                
                —
                
                
                
                4
                
                
                
                1,141$
                5,620
                
                
                $
                43
                
                
                $
                —
                
                
                $
                78
                
                
                $
                5,585
  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, 2007 and December 31, 2006, there
          were 4 investment securities with unrealized losses.  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.
  -
            14
            -
 
 **Note
            5.**
 **Nonperforming
            Assets**
  Nonperforming
              loans are summarized as follows:
 June
                    30, 2007
                
                
                December
                    31, 2006(Dollars
                    in thousands)Impaired
                    loans with a valuation allowance
                
                $
                390
                
                
                $
                1,283Valuation
                    allowance related to impaired loans
                
                
                (139
                )
                
                
                (236
                )Net
                    impaired loans
                
                
                251
                
                
                
                1,047Non
                    accrual loans
                
                
                3,231
                
                
                
                2,415Total
                    nonperforming or non-accrual loans
                
                
                3,482
                
                
                
                3,462Real
                    estate owned
                
                
                —
                
                
                
                —Nonperforming
                    assets
                
                $
                3,482
                
                
                $
                3,462Total
                    loans past due 90-days or more and still accruing interest
                
                $
                4
                
                
                $
                —Average
                    balance of impaired loans
                
                $
                657
                
                
                $
                592Interest
                    income recognized on impaired loans
                
                $
                —
                
                
                $
                1
   **Note
          6.**
 **Earnings
          Per Share**
  Basic
          Earnings Per Share is computed by dividing net income by the weighted-average
          number of shares outstanding
          during the period.  Diluted EPS reflects the potential dilutive effect
          of stock options and is computed by
          dividing net income by the weighted-average number of shares outstanding
          during
          the period, plus the dilutive common
          shares that would have been outstanding had the stock options been
          exercised. The
                  following is a reconciliation of the numerators and denominators
                  of the basic
                  and diluted earnings per share computations
                  for the quarters and six months ending June 30, 2007 and June 30,
                  2006:
 Income
                
                
                Shares
                
                
                Per
                    share(numerator)
                
                
                (denominator)
                
                
                amount(Dollars
                    and shares in thousands except per share amounts)Quarter
                    ended June 30, 2007Basic
                    EPS:Income
                    available to common shareholders
                
                $
                1,757
                
                
                
                6,691
                
                
                $
                0.26Effect
                    of dilutive stock options
                
                
                —
                
                
                
                244Diluted
                    EPS:Income
                    available to common shareholdersplus
                    assumed stock options exercised
                
                $
                1,757
                
                
                
                6,935
                
                
                $
                0.25Six
                    months ended June 30, 2007Basic
                    EPS:Income
                    available to common shareholders
                
                $
                4,472
                
                
                
                6,686
                
                
                $
                0.67Effect
                    of dilutive stock options
                
                
                —
                
                
                
                250Diluted
                    EPS:Income
                    available to common shareholdersplus
                    assumed stock options exercised
                
                $
                4,472
                
                
                
                6,936
                
                
                $
                0.64Quarter
                    ended June 30, 2006 (2)Basic
                    EPS:Income
                    available to common shareholders
                
                $
                2,712
                
                
                
                6,645
                
                
                $
                0.41Effect
                    of dilutive stock options
                
                
                —
                
                
                
                145Diluted
                    EPS:Income
                    available to common shareholdersplus
                    assumed stock options exercised
                
                $
                2,712
                
                
                
                6,790
                
                
                $
                0.40Six
                    months ended June 30, 2006 (2)Basic
                    EPS:Income
                    available to common shareholders
                
                $
                5,426
                
                
                
                6,636
                
                
                $
                0.82Effect
                    of dilutive stock options
                
                
                —
                
                
                
                178Diluted
                    EPS:Income
                    available to common shareholdersplus
                    assumed stock options exercised
                
                $
                5,426
                
                
                
                6,814
                
                
                $
                0.80
 
 (2)
          Shares and EPS have been adjusted to reflect the five-for-four stock split
          paid
          on October 4, 2006.
 -
            15
            -
 
 **Note
            7.**
 **Rate
            Volume Analysis**
 SECOND
                    QUARTER 2007
                
                
                SIX
                    MONTHS ENDED 2007VS
                
                
                VSSECOND
                    QUARTER 2006
                
                
                SIX
                    MONTHS ENDED 2006INCREASE
                    (DECREASE) DUE TO
                
                
                INCREASE
                    (DECREASE) DUE TOTOTAL
                
                
                
                
                
                
                
                
                TOTALVOLUME
                
                
                RATE
                
                
                CHANGE
                
                
                VOLUME
                
                
                RATE
                
                
                CHANGEINTEREST
                    INCOME
                
                (Dollars
                    in thousands)Investments:Available-for-sale
                    securities
                
                $
                (1,042
                )
                
                $
                5
                
                
                $
                (1,037
                )
                
                $
                (1,734
                )
                
                $
                (442
                )
                
                $
                (2,176
                )Held-for-trading
                    securities
                
                
                810
                
                
                
                —
                
                
                
                810
                
                
                
                1,755
                
                
                
                —
                
                
                
                1,755Held-to-maturity
                    securities
                
                
                4
                
                
                
                (16
                )
                
                
                (12
                )
                
                
                (13
                )
                
                
                (12
                )
                
                
                (25
                )Other
                    equity investments
                
                
                32
                
                
                
                379
                
                
                
                411
                
                
                
                37
                
                
                
                462
                
                
                
                499Total
                    investments
                
                
                (196
                )
                
                
                368
                
                
                
                172
                
                
                
                45
                
                
                
                8
                
                
                
                53Loans:Residential
                
                $
                690
                
                
                $
                295
                
                
                $
                985
                
                
                $
                1,391
                
                
                $
                817
                
                
                $
                2,208Residential
                    construction
                
                
                (899
                )
                
                
                6
                
                
                
                (893
                )
                
                
                (1,346
                )
                
                
                118
                
                
                
                (1,228
                )Multifamily
                
                
                (585
                )
                
                
                109
                
                
                
                (476
                )
                
                
                (1,148
                )
                
                
                436
                
                
                
                (712
                )Multifamily
                    construction
                
                
                78
                
                
                
                (57
                )
                
                
                21
                
                
                
                163
                
                
                
                (48
                )
                
                
                115Commercial
                    real estate and business
                
                
                253
                
                
                
                145
                
                
                
                398
                
                
                
                558
                
                
                
                212
                
                
                
                770Commercial
                    real estate construction
                
                
                (49
                )
                
                
                10
                
                
                
                (39
                )
                
                
                137
                
                
                
                65
                
                
                
                202Consumer
                    and other
                
                
                (279
                )
                
                
                (143
                )
                
                
                (422
                )
                
                
                (625
                )
                
                
                (203
                )
                
                
                (828
                )Total
                    loans
                
                
                (791
                )
                
                
                365
                
                
                
                (426
                )
                
                
                (870
                )
                
                
                1,397
                
                
                
                527Total
                    interest income
                
                $
                (987
                )
                
                $
                733
                
                
                $
                (254
                )
                
                $
                (825
                )
                
                $
                1,405
                
                
                $
                580INTEREST
                    EXPENSEDeposits:Money
                    market deposit and checking
                
                $
                247
                
                
                $
                435
                
                
                $
                682
                
                
                $
                451
                
                
                $
                950
                
                
                $
                1,401Savings
                
                
                (2
                )
                
                
                —
                
                
                
                (2
                )
                
                
                (5
                )
                
                
                —
                
                
                
                (5
                )Time
                    deposits
                
                
                (438
                )
                
                
                798
                
                
                
                360
                
                
                
                (549
                )
                
                
                1,987
                
                
                
                1,438Total
                    deposits
                
                
                (193
                )
                
                
                1,233
                
                
                
                1,040
                
                
                
                (103
                )
                
                
                2,937
                
                
                
                2,834FHLB
                    advances and other
                
                
                (848
                )
                
                
                718
                
                
                
                (130
                )
                
                
                (1,532
                )
                
                
                1,322
                
                
                
                (210
                )Total
                    interest expense
                
                
                (1,041
                )
                
                
                1,951
                
                
                
                910
                
                
                
                (1,635
                )
                
                
                4,259
                
                
                
                2,624Net
                    interest income
                
                $
                54
                
                
                $
                (1,218
                )
                
                $
                (1,164
                )
                
                $
                810
                
                
                $
                (2,854
                )
                
                $
                (2,044
                )
      -
            16
            -
 **Note
          8.**
 **Business
            Segments**
 Beginning
            January 1, 2007, we changed the presentation of our Business Segments
            to more
            accurately reflect the way these segments are managed within the
            Bank.  Prior to 2007, we recognized four business
            segments:  1) Consumer Lending, 2) Residential Lending, 3) Business
            Banking Lending, and 4) Income Property Lending.  All other
            departments, including our Banking Centers and investment portfolio were
            assumed
            to support these business lines.  Consequently, all income generated
            and expenses incurred at these support centers were allocated to the
            four
            business segments, resulting in no net income or loss at any department
            except
            the four lending units.
 
 To
            better
            reflect how we manage the Bank, we have changed our business segments
            as
            follows:
 
 ·
                  Established
                      a “Retail Banking” segment which includes our banking centers and direct
                      consumer lending.  The Home Equity Lines of Credit (HELOC’s) and
                      other consumer lending originated through the Banking Centers,
                      which were
                      previously included in the “Consumer Lending” segment, are included in
                      this segment.  The “Retail Banking” segment does not include
                      Sales Finance lending.  This segment also includes Community
                      Business Banking (small business lending) which had been previously
                      included in the “Business Banking”
segment.
 
 ·
                  Isolated
                      our Investment Securities activities as a separate business
                      segment so
                      that any changes in the investment portfolio’s market value or level of
                      earning assets do not distort the reported operating results
                      of our other
                      business segments.
 
 In
            moving
            the banking centers, our primary source of funds generation, from an
            allocated
            overhead category to an operating segment, it became necessary to implement
            a
            new process for transferring funds from our funds-generating operations
            to the
            users of such funds.  The objective of the funds transfer process is
            to isolate the true profit contribution of each side of the balance
            sheet.  Prior to 2007, the profitability of the funds-generating
            operations, such as the banking centers, was defined as break-even with
            the
            lending segments collectively compensating the funds-generating operations
            such
            that this result was achieved.  Under the new methodology, the rates
            at which funds are transferred between the generators and users of funds
            are
            based on market rates of interest.  The profitability of the business
            segments, including retail banking, then varies depending on the actual
            rates
            earned on assets and paid on liabilities as well as expenses incurred
            in the
            segments’ operations.  To assist in tracking and evaluating the
            profitability of such funds transfers, we now utilize four line items
            in
            determining each segment’s net interest income:
 
 ·
                  Interest
                      Income – This represents the actual interest received from the segment’s
                      loans or securities.
 
 ·
                  Interest
                      Income on Funding Sources – This represents the interest income received
                      from selling funding sources generated by the segment (i.e.
                      deposits or
                      FHLB advances) to a centralized treasury function.  The interest
                      rate paid to the segment is based on the point on the FHLB
                      rate curve for
                      advances of a duration comparable to the segment’s funding
                      source.
  ·
                  Funding
                      Costs – This represents the interest paid to the centralized treasury
                      function by each business segment for the funding sources necessary
                      to
                      support earning asset balances.  Again, the interest rate
                      charged to the segment is based on the point on the FHLB rate
                      curve for
                      advances of a duration comparable to the segment’s earning
                      assets.
 
 ·
                  Interest
                      Expense – This represents the actual interest paid on the segment’s
                      liabilities (i.e. deposits or FHLB
                      advances).
 
 -
                17
                -
 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:
 
 ·
                  Retail
                      Banking – Retail Banking is the segment primarily responsible for the
                      generation of funding sources, specifically our consumer and
                      small
                      business deposit accounts.  In addition to our banking centers,
                      the segment includes our direct consumer and Community Business
                      Banking
                      (small business) lending
                      departments.
 
 ·
                  Sales
                      Finance Lending – Sales Finance generates indirect unsecured consumer
                      loans in connection with home improvement projects.  A large
                      percentage of this segment’s loan volume is sold into the secondary market
                      on a servicing-retained basis, meaning we continue to process
                      payments and
                      service the loan following the
                      sale.
 
 ·
                  Residential
                      Lending - Residential Lending offers loans to borrowers to
                      purchase,
                      refinance, or build homes secured by one-to-four-unit family
                      dwellings.  This segment 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.
 
 ·
                  Business
                      Banking Lending – Business Banking offers a full range of banking services
                      to middle-market 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)
                      and
                      commercial real estate properties.  The underlying real estate
                      collateral being financed typically secures these
                      loans.
 
 ·
                  Investment
                      Securities - The investment securities segment includes the
                      investment
                      securities portfolio, FHLB stock, and interest-earning cash
                      balances.  Although management does not consider this to be an
                      operating business line, security investments represent a necessary
                      part
                      of liquidity management for the
                      Bank.
 
 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.
 -
                18
                -
 **Quarter
                    ended June 30,**RetailBanking
                
                
                SalesFinance
                
                
                ResidentialLending
                
                
                BusinessBanking
                
                
                IncomeProperty
                
                
                Investment
                      &Treasury
                
                
                ConsolidatedTotals(Dollars
                    in thousands)**Interest
                    income**
                2005
                
                $
                677
                
                
                $
                1,726
                
                
                $
                4,643
                
                
                $
                1,638
                
                
                $
                6,139
                
                
                $
                1,464
                
                
                $
                16,2872006
                
                
                858
                
                
                
                2,036
                
                
                
                6,178
                
                
                
                2,578
                
                
                
                6,869
                
                
                
                1,306
                
                
                
                19,8252007
                
                
                892
                
                
                
                1,558
                
                
                
                5,958
                
                
                
                3,186
                
                
                
                6,553
                
                
                
                1,424
                
                
                
                19,571**Treasury
                    and interest income **on
                    funding sources****
                2005
                
                
                5,874
                
                
                
                36
                
                
                
                186
                
                
                
                302
                
                
                
                162
                
                
                
                2,902
                
                
                
                9,4622006
                
                
                9,013
                
                
                
                41
                
                
                
                203
                
                
                
                619
                
                
                
                136
                
                
                
                4,176
                
                
                
                14,1882007
                
                
                9,186
                
                
                
                28
                
                
                
                189
                
                
                
                931
                
                
                
                178
                
                
                
                2,923
                
                
                
                13,435**Funding
                    costs**
                2005
                
                
                335
                
                
                
                667
                
                
                
                2,749
                
                
                
                752
                
                
                
                3,398
                
                
                
                1,561
                
                
                
                9,4622006
                
                
                564
                
                
                
                1,117
                
                
                
                4,533
                
                
                
                1,653
                
                
                
                4,609
                
                
                
                1,712
                
                
                
                14,1882007
                
                
                572
                
                
                
                914
                
                
                
                4,361
                
                
                
                2,138
                
                
                
                4,223
                
                
                
                1,227
                
                
                
                13,435**Interest
                    expense**
                2005
                
                
                3,933
                
                
                
                —
                
                
                
                —
                
                
                
                126
                
                
                
                17
                
                
                
                2,384
                
                
                
                6,4602006
                
                
                5,618
                
                
                
                —
                
                
                
                —
                
                
                
                260
                
                
                
                16
                
                
                
                3,906
                
                
                
                9,8002007
                
                
                6,748
                
                
                
                —
                
                
                
                —
                
                
                
                546
                
                
                
                54
                
                
                
                3,362
                
                
                
                10,710**Net
                    interest income/(loss)**
                2005
                
                
                2,283
                
                
                
                1,095
                
                
                
                2,080
                
                
                
                1,062
                
                
                
                2,886
                
                
                
                421
                
                
                
                9,8272006
                
                
                3,689
                
                
                
                960
                
                
                
                1,848
                
                
                
                1,284
                
                
                
                2,380
                
                
                
                (136
                )
                
                
                10,0252007
                
                
                2,758
                
                
                
                672
                
                
                
                1,786
                
                
                
                1,433
                
                
                
                2,454
                
                
                
                (242
                )
                
                
                8,861**Provision
                    for loan and lease losses**
                2005
                
                
                26
                
                
                
                136
                
                
                
                57
                
                
                
                65
                
                
                
                166
                
                
                
                —
                
                
                
                4502006
                
                
                7
                
                
                
                (50
                )
                
                
                119
                
                
                
                22
                
                
                
                37
                
                
                
                —
                
                
                
                1352007
                
                
                (75
                )
                
                
                288
                
                
                
                (117
                )
                
                
                (5
                )
                
                
                (5
                )
                
                
                —
                
                
                
                86**Net
                    interest income/(loss), after **provision
                    for loan and **lease
                    losses******
                2005
                
                
                2,257
                
                
                
                959
                
                
                
                2,023
                
                
                
                997
                
                
                
                2,720
                
                
                
                421
                
                
                
                9,3772006
                
                
                3,682
                
                
                
                1,010
                
                
                
                1,729
                
                
                
                1,262
                
                
                
                2,343
                
                
                
                (136
                )
                
                
                9,8902007
                
                
                2,833
                
                
                
                384
                
                
                
                1,903
                
                
                
                1,438
                
                
                
                2,459
                
                
                
                (242
                )
                
                
                8,775**Noninterest
                    income**
                2005
                
                
                344
                
                
                
                585
                
                
                
                215
                
                
                
                185
                
                
                
                242
                
                
                
                1
                
                
                
                1,5722006
                
                
                586
                
                
                
                833
                
                
                
                264
                
                
                
                118
                
                
                
                252
                
                
                
                4
                
                
                
                2,0572007
                
                
                448
                
                
                
                1,237
                
                
                
                284
                
                
                
                (53
                )
                
                
                83
                
                
                
                132
                
                
                
                2,131**Noninterest
                    expense**
                2005
                
                
                3,128
                
                
                
                1,325
                
                
                
                1,060
                
                
                
                677
                
                
                
                920
                
                
                
                33
                
                
                
                7,1432006
                
                
                3,241
                
                
                
                1,492
                
                
                
                1,160
                
                
                
                950
                
                
                
                963
                
                
                
                29
                
                
                
                7,8352007
                
                
                3,639
                
                
                
                1,539
                
                
                
                1,181
                
                
                
                815
                
                
                
                1,034
                
                
                
                33
                
                
                
                8,241**Income/(loss)
                    before provision **for
                    federal income taxes****
                2005
                
                
                (527
                )
                
                
                219
                
                
                
                1,178
                
                
                
                505
                
                
                
                2,042
                
                
                
                389
                
                
                
                3,8062006
                
                
                1,027
                
                
                
                351
                
                
                
                833
                
                
                
                430
                
                
                
                1,632
                
                
                
                (161
                )
                
                
                4,1122007
                
                
                (358
                )
                
                
                82
                
                
                
                1,006
                
                
                
                570
                
                
                
                1,508
                
                
                
                (143
                )
                
                
                2,665**Provision
                    for federal **income
                    taxes****
                2005
                
                
                (180
                )
                
                
                74
                
                
                
                401
                
                
                
                172
                
                
                
                696
                
                
                
                125
                
                
                
                1,2882006
                
                
                351
                
                
                
                119
                
                
                
                283
                
                
                
                147
                
                
                
                558
                
                
                
                (58
                )
                
                
                1,4002007
                
                
                (123
                )
                
                
                28
                
                
                
                345
                
                
                
                195
                
                
                
                518
                
                
                
                (55
                )
                
                
                908**Net
                    income/(loss)**
                2005
                
                
                (347
                )
                
                
                145
                
                
                
                777
                
                
                
                333
                
                
                
                1,346
                
                
                
                264
                
                
                
                2,5182006
                
                
                676
                
                
                
                232
                
                
                
                550
                
                
                
                283
                
                
                
                1,074
                
                
                
                (103
                )
                
                
                2,7122007
                
                
                (235
                )
                
                
                54
                
                
                
                661
                
                
                
                375
                
                
                
                990
                
                
                
                (88
                )
                
                
                1,757**Total
                    interest earning assets (ending balances)**
                2005
                
                
                38,877
                
                
                
                73,994
                
                
                
                279,800
                
                
                
                99,339
                
                
                
                358,548
                
                
                
                148,478
                
                
                
                999,0362006
                
                
                42,116
                
                
                
                81,549
                
                
                
                323,166
                
                
                
                144,786
                
                
                
                337,633
                
                
                
                117,339
                
                
                
                1,046,5892007
                
                
                43,190
                
                
                
                66,669
                
                
                
                312,334
                
                
                
                162,459
                
                
                
                304,823
                
                
                
                83,305
                
                
                
                972,780**Total
                    interest bearing liabilities (ending balances)**
                2005
                
                
                635,888
                
                
                
                —
                
                
                
                —
                
                
                
                29,647
                
                
                
                6,705
                
                
                
                290,016
                
                
                
                962,2562006
                
                
                660,759
                
                
                
                —
                
                
                
                —
                
                
                
                40,148
                
                
                
                3,294
                
                
                
                321,925
                
                
                
                1,026,1262007
                
                
                674,361
                
                
                
                —
                
                
                
                —
                
                
                
                65,934
                
                
                
                7,236
                
                
                
                197,371
                
                
                
                944,902**Allocated
                    equity (ending balances)**
                2005
                
                
                14,402
                
                
                
                5,568
                
                
                
                10,729
                
                
                
                7,491
                
                
                
                24,184
                
                
                
                2,234
                
                
                
                64,6082006
                
                
                13,340
                
                
                
                5,578
                
                
                
                11,218
                
                
                
                10,193
                
                
                
                21,766
                
                
                
                1,606
                
                
                
                63,7012007
                
                
                16,252
                
                
                
                5,572
                
                
                
                13,114
                
                
                
                13,467
                
                
                
                23,938
                
                
                
                1,396
                
                
                
                73,739**Return
                    on equity**
                2005
                
                
                -9.64
                %
                
                
                10.42
                %
                
                
                28.97
                %
                
                
                17.78
                %
                
                
                22.26
                %
                
                
                47.25
                %
                
                
                15.59
                %2006
                
                
                20.27
                %
                
                
                16.64
                %
                
                
                19.61
                %
                
                
                11.11
                %
                
                
                19.74
                %
                
                
                -25.65
                %
                
                
                17.03
                %2007
                
                
                -5.78
                %
                
                
                3.88
                %
                
                
                20.16
                %
                
                
                11.14
                %
                
                
                16.54
                %
                
                
                -25.23
                %
                
                
                9.53
                %**Net
                    interest margin**
                2005
                
                
                23.49
                %
                
                
                5.92
                %
                
                
                2.97
                %
                
                
                4.28
                %
                
                
                3.22
                %
                
                
                1.13
                %
                
                
                3.93
                %2006
                
                
                35.04
                %
                
                
                4.71
                %
                
                
                2.29
                %
                
                
                3.55
                %
                
                
                2.82
                %
                
                
                -0.46
                %
                
                
                3.83
                %2007
                
                
                25.54
                %
                
                
                4.03
                %
                
                
                2.29
                %
                
                
                3.53
                %
                
                
                3.22
                %
                
                
                -1.16
                %
                
                
                3.64
                %
  -
            19
            -
 **Note
          8.**
 **Business
          Segments(continued)**
  **Six
                    months ended June 30,**RetailBanking
                
                
                SalesFinance
                
                
                ResidentialLending
                
                
                BusinessBanking
                
                
                IncomeProperty
                
                
                Investment
                      &Treasury
                
                
                ConsolidatedTotals(Dollars
                    in thousands)**Interest
                    income**
                2005
                
                $
                1,293
                
                
                $
                3,419
                
                
                $
                8,742
                
                
                $
                3,148
                
                
                $
                12,153
                
                
                $
                2,931
                
                
                $
                31,6862006
                
                
                1,678
                
                
                
                4,083
                
                
                
                12,135
                
                
                
                4,819
                
                
                
                13,350
                
                
                
                2,708
                
                
                
                38,7732007
                
                
                1,746
                
                
                
                3,174
                
                
                
                12,268
                
                
                
                6,053
                
                
                
                13,450
                
                
                
                2,662
                
                
                
                39,353**Treasury
                    and interest income** **on
                    funding sources**
                2005
                
                
                11,146
                
                
                
                84
                
                
                
                413
                
                
                
                596
                
                
                
                366
                
                
                
                5,662
                
                
                
                18,2672006
                
                
                17,544
                
                
                
                62
                
                
                
                304
                
                
                
                1,175
                
                
                
                229
                
                
                
                7,914
                
                
                
                27,2282007
                
                
                18,325
                
                
                
                45
                
                
                
                291
                
                
                
                1,811
                
                
                
                315
                
                
                
                6,165
                
                
                
                26,952**Funding
                    costs**
                2005
                
                
                621
                
                
                
                1,310
                
                
                
                5,250
                
                
                
                1,366
                
                
                
                6,573
                
                
                
                3,147
                
                
                
                18,2672006
                
                
                1,093
                
                
                
                2,183
                
                
                
                8,598
                
                
                
                3,019
                
                
                
                8,872
                
                
                
                3,463
                
                
                
                27,2282007
                
                
                1,115
                
                
                
                1,856
                
                
                
                8,668
                
                
                
                4,093
                
                
                
                8,547
                
                
                
                2,673
                
                
                
                26,952**Interest
                    expense**
                2005
                
                
                7,196
                
                
                
                —
                
                
                
                —
                
                
                
                218
                
                
                
                33
                
                
                
                4,612
                
                
                
                12,0592006
                
                
                10,860
                
                
                
                —
                
                
                
                —
                
                
                
                542
                
                
                
                30
                
                
                
                7,085
                
                
                
                18,5172007
                
                
                13,364
                
                
                
                —
                
                
                
                —
                
                
                
                1,101
                
                
                
                107
                
                
                
                6,569
                
                
                
                21,141**Net
                    interest income/(loss)**
                2005
                
                
                4,622
                
                
                
                2,193
                
                
                
                3,905
                
                
                
                2,160
                
                
                
                5,913
                
                
                
                834
                
                
                
                19,6272006
                
                
                7,269
                
                
                
                1,962
                
                
                
                3,841
                
                
                
                2,433
                
                
                
                4,677
                
                
                
                74
                
                
                
                20,2562007
                
                
                5,592
                
                
                
                1,363
                
                
                
                3,891
                
                
                
                2,670
                
                
                
                5,111
                
                
                
                (415
                )
                
                
                18,212**Provision
                    for loan and lease losses**
                2005
                
                
                48
                
                
                
                256
                
                
                
                106
                
                
                
                118
                
                
                
                322
                
                
                
                —
                
                
                
                8502006
                
                
                18
                
                
                
                (32
                )
                
                
                (13
                )
                
                
                82
                
                
                
                151
                
                
                
                —
                
                
                
                2062007
                
                
                (80
                )
                
                
                449
                
                
                
                (151
                )
                
                
                9
                
                
                
                11
                
                
                
                —
                
                
                
                238**Net
                    interest income/(loss), after** **provision
                    for loan and** **lease
                    losses**
                2005
                
                
                4,574
                
                
                
                1,937
                
                
                
                3,799
                
                
                
                2,042
                
                
                
                5,591
                
                
                
                834
                
                
                
                18,7772006
                
                
                7,251
                
                
                
                1,994
                
                
                
                3,854
                
                
                
                2,351
                
                
                
                4,526
                
                
                
                74
                
                
                
                20,0502007
                
                
                5,672
                
                
                
                914
                
                
                
                4,042
                
                
                
                2,661
                
                
                
                5,100
                
                
                
                (415
                )
                
                
                17,974**Noninterest
                    income**
                2005
                
                
                642
                
                
                
                1,429
                
                
                
                349
                
                
                
                221
                
                
                
                299
                
                
                
                2
                
                
                
                2,9422006
                
                
                948
                
                
                
                1,959
                
                
                
                347
                
                
                
                164
                
                
                
                349
                
                
                
                5
                
                
                
                3,7722007
                
                
                863
                
                
                
                2,690
                
                
                
                488
                
                
                
                10
                
                
                
                180
                
                
                
                563
                
                
                
                4,794**Noninterest
                    expense**
                2005
                
                
                6,254
                
                
                
                2,592
                
                
                
                1,991
                
                
                
                1,399
                
                
                
                1,708
                
                
                
                62
                
                
                
                14,0062006
                
                
                6,568
                
                
                
                3,001
                
                
                
                2,219
                
                
                
                1,842
                
                
                
                1,837
                
                
                
                56
                
                
                
                15,5232007
                
                
                7,036
                
                
                
                3,012
                
                
                
                2,350
                
                
                
                1,647
                
                
                
                1,876
                
                
                
                56
                
                
                
                15,977**Income/(loss)
                    before provision** **for
                    federal income taxes**
                2005
                
                
                (1,038
                )
                
                
                774
                
                
                
                2,157
                
                
                
                864
                
                
                
                4,182
                
                
                
                774
                
                
                
                7,7132006
                
                
                1,631
                
                
                
                952
                
                
                
                1,982
                
                
                
                673
                
                
                
                3,038
                
                
                
                23
                
                
                
                8,2992007
                
                
                (501
                )
                
                
                592
                
                
                
                2,180
                
                
                
                1,024
                
                
                
                3,404
                
                
                
                92
                
                
                
                6,791**Provision
                    for federal income taxes**
                2005
                
                
                (353
                )
                
                
                263
                
                
                
                734
                
                
                
                294
                
                
                
                1,423
                
                
                
                250
                
                
                
                2,6112006
                
                
                564
                
                
                
                330
                
                
                
                689
                
                
                
                234
                
                
                
                1,055
                
                
                
                1
                
                
                
                2,8732007
                
                
                (172
                )
                
                
                203
                
                
                
                748
                
                
                
                351
                
                
                
                1,169
                
                
                
                20
                
                
                
                2,319**Net
                    income/(loss)**
                2005
                
                
                (685
                )
                
                
                511
                
                
                
                1,423
                
                
                
                570
                
                
                
                2,759
                
                
                
                524
                
                
                
                5,1022006
                
                
                1,067
                
                
                
                622
                
                
                
                1,293
                
                
                
                439
                
                
                
                1,983
                
                
                
                22
                
                
                
                5,4262007
                
                
                (329
                )
                
                
                389
                
                
                
                1,432
                
                
                
                673
                
                
                
                2,235
                
                
                
                72
                
                
                
                4,472**Interest
                    earning assets (average balances)**
                2005
                
                
                39,508
                
                
                
                68,782
                
                
                
                263,551
                
                
                
                95,925
                
                
                
                371,105
                
                
                
                150,297
                
                
                
                989,1682006
                
                
                41,472
                
                
                
                81,486
                
                
                
                318,674
                
                
                
                124,852
                
                
                
                336,999
                
                
                
                129,838
                
                
                
                1,033,3212007
                
                
                41,453
                
                
                
                67,385
                
                
                
                322,264
                
                
                
                150,595
                
                
                
                313,934
                
                
                
                102,662
                
                
                
                998,293**Interest
                    bearing liabilities (average balances)**
                2005
                
                
                616,242
                
                
                
                —
                
                
                
                —
                
                
                
                27,416
                
                
                
                6,639
                
                
                
                303,603
                
                
                
                953,9002006
                
                
                664,040
                
                
                
                —
                
                
                
                —
                
                
                
                42,300
                
                
                
                4,090
                
                
                
                301,017
                
                
                
                1,011,4472007
                
                
                672,942
                
                
                
                —
                
                
                
                —
                
                
                
                64,899
                
                
                
                6,924
                
                
                
                220,154
                
                
                
                964,919**Allocated
                    equity (average balances)**
                2005
                
                
                13,786
                
                
                
                5,043
                
                
                
                9,931
                
                
                
                7,085
                
                
                
                24,148
                
                
                
                2,203
                
                
                
                62,1962006
                
                
                13,521
                
                
                
                5,597
                
                
                
                11,114
                
                
                
                8,637
                
                
                
                21,552
                
                
                
                1,784
                
                
                
                62,2052007
                
                
                15,650
                
                
                
                5,459
                
                
                
                13,129
                
                
                
                12,495
                
                
                
                23,875
                
                
                
                1,661
                
                
                
                72,269**Return
                    on equity**
                2005
                
                
                -9.94
                %
                
                
                20.27
                %
                
                
                28.66
                %
                
                
                16.09
                %
                
                
                22.85
                %
                
                
                47.57
                %
                
                
                16.41
                %2006
                
                
                15.78
                %
                
                
                22.23
                %
                
                
                23.27
                %
                
                
                10.17
                %
                
                
                18.40
                %
                
                
                2.47
                %
                
                
                17.45
                %2007
                
                
                -4.20
                %
                
                
                14.25
                %
                
                
                21.81
                %
                
                
                10.77
                %
                
                
                18.72
                %
                
                
                8.67
                %
                
                
                12.38
                %**Net
                    interest margin**
                2005
                
                
                23.40
                %
                
                
                6.38
                %
                
                
                2.96
                %
                
                
                4.50
                %
                
                
                3.19
                %
                
                
                1.11
                %
                
                
                3.97
                %2006
                
                
                35.05
                %
                
                
                4.82
                %
                
                
                2.41
                %
                
                
                3.90
                %
                
                
                2.78
                %
                
                
                0.11
                %
                
                
                3.92
                %2007
                
                
                26.98
                %
                
                
                4.05
                %
                
                
                2.41
                %
                
                
                3.55
                %
                
                
                3.26
                %
                
                
                -0.81
                %
                
                
                3.65
                %
  -
            20
            -
 **Note
          9.**
 **Trading
          Securities**
  The
          Company’s short-term investments in debt securities, all of which are classified as
          trading securities, are carried at their fair value based on the quoted
          prices
          of the securities
          at June 30, 2007.  Net realized and unrealized gains and losses on
          trading securities
          are included in net earnings.  For purpose of determining realized
          gains and losses,
          the cost of securities sold is based on specific
          identification.
  The
            composition of trading securities is as follows at June 30, 2007. There
            were no trading securities in 2006.
  June
                    30, 2007Cost
                
                
                Fair
                    Value(Dollars
                    in thousands)Freddie
                    Mac securities
                
                $
                9,814
                
                
                $
                9,786Fannie
                    Mae securities
                
                
                6,840
                
                
                
                6,823Ginnie
                    Mae securities
                
                
                31,974
                
                
                
                32,234US
                    agency securities
                
                
                5,873
                
                
                
                5,853Total
                    trading securities
                
                $
                54,501
                
                
                $
                54,696
   Investment
            income for the quarter ended June 30, 2007 consists
            of the following:
 2007Dividend
                    and interest income
                
                $
                407Net
                    unrealized holding gains
                
                
                195Net
                    investment income
                
                $
                602
      -
            21
            -
  **Note
          10.**
 **Subsequent
          Events**
 
 **Merger
          with Washington
          Federal**
 On
          July
          2, 2007 we announced the signing of a definitive merger agreement. The
          merger
          agreement calls for the merger of First Mutual with and into the Company,
          followed by the merger of First Mutual Bank into the Company’s wholly
          owned
          subsidiary, Washington Federal Savings, in a stock and cash transaction
          valued
          at approximately $189.8 million. After consummation of the merger, the
          combined
          Company will have 148 offices in eight western states with total assets
          of
          approximately $11 billion and total deposits of approximately $6.8
          billion.
 
 **Securities**
 Based
          on
          our observations of the portfolio and hedge over the course of the quarter,
          we
          elected to further reduce the size of the portfolio and unwind the hedge
          position.  Consequently, in early July we sold securities with market
          values totaling approximately $41 million and unwound the hedge position.
          Our
          net losses from those activities totaled $213,000.  At the present
          time, we do not anticipate conducting any further securities
          transactions.
 
 **Trust
          Preferred
          Securities**
 In
          June
          of 2002, we issued our first Trust Preferred Security (TPS) in the amount
          of $9
          million with an interest rate adjustable on a quarterly basis.  At the
          same time, we entered into an interest rate swap with the FHLB in order
          to
          protect against potential adverse interest rate volatility from the TPS
          by
          fixing the interest rate payable for the first five years of the TPS’
life.  The swap matured in July of this year, resulting in a funding
          cost subject to adjustment on a quarterly basis at 3.65% over the current
          three-month LIBOR rate.
 
 As
          margins on current TPS issues have declined to approximately 1.35% to 1.65%
          over
          three-month LIBOR, we had previously expressed an intention to call the
          outstanding $9 million TPS at the earliest contractual redemption date,
          in this
          case September 2007, and replace the issue with a new TPS at a lower
          margin.  We have since,  in consideration of the pending
          merger with Washington Federal Inc., elected instead to call the outstanding
          $9
          million TPS without replacement.  However, because we issued a
          commitment to replace the redeemed TPS we were required to pay a cancellation
          fee of $55,000.
 
 Even
          with
          the retirement and non-replacement of the TPS, we expect to remain “well
          capitalized” in accordance with regulatory guidelines.
 
  -
              22
              -
 ITEM
            2. Management’s
            Discussion and Analysis of Financial Condition and Results
            of Operations
 
 **GENERAL**
 
 First
            Mutual Bancshares, Inc. (the “Company”), a Washington corporation, is a bank
            holding company owning all of the equity of its wholly owned subsidiary,
            First
            Mutual Bank.  The Company is subject to regulation by the Federal
            Reserve Bank of San Francisco.  This discussion refers to the
            consolidated statements of the Company and the Bank, and therefore the
            references to “Bank” in this discussion refer to both entities.
 
 First
            Mutual Bank is a Washington-chartered savings bank subject to regulation
            by the
            State of Washington Department of Financial Institutions and the Federal
            Deposit
            Insurance Corporation (“FDIC”).  The Bank conducts business from its
            headquarters in Bellevue, Washington, and has 12 full-service retail
            banking
            centers located in Bellevue (3), Issaquah, Kirkland (2), Monroe, Redmond,
            Sammamish, Seattle (2), and Woodinville.  We also have consumer loan
            offices located in Orange Park, Florida and Mt. Clemens,
            Michigan.  The Bank’s
            business
            consists mainly of attracting deposits from the general public as well
            as
            wholesale funding sources, and investing those funds primarily in real
            estate
            loans, small and mid-sized business loans, and consumer loans.
  **OVERVIEW**
 
 For
            the
            second quarter and first half of 2007, our net income declined significantly
            relative to the same periods last year, totaling $1.8 million and $4.5
            million,
            down from $2.7 million and $5.4 million for the quarter and six months
            ended
            June 30, 2006.  Our earnings per diluted share fell to $0.25 and
            $0.64, compared to $0.40 and $0.80 per diluted share in the second quarter
            and
            first six months of last year.  Our return on average equity (ROE)
            totaled 9.62% for the quarter and 12.41% on a year-to-date basis, compared
            to
            17.25% and 17.52% in the prior year.  As a result, we were
            unsuccessful in achieving our general corporate goals, an ROE of at least
            15%
            and year-over-year net income growth in the range of 10% to 12%.  On
            July 2, 2007, we announced that we had entered into a definitive merger
            agreement with Washington Federal, Inc. (NASDAQ: WFSL) which provides,
            subject
            to certain conditions, for a merger of First Mutual with and into Washington
            Federal.
 
 Our
            performance for the quarter was negatively impacted by several one-time
            expenses, including $175,000 in legal and other fees related to the Washington
            Federal transaction, a $158,000 retention bonus to our CFO for remaining
            with
            the Bank past his retirement date, $163,000 in expenditures for the payoff
            of a
            contract for an outside operations consultant, and a charitable contribution
            in
            the amount of $188,000.  We had originally intended to make this
            contribution in a series of installments, but instead elected to lump-sum
            the
            remaining contribution during the second quarter because of the pending
            merger
            with Washington Federal.
 
 -
                23
                -
 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.  For
            the second quarter and first half of 2007, our net interest income totaled
            $8.9
            million and $18.2 million, down $1.2 million and $2.0 million from the
            levels
            earned in the prior year, as our net interest margin for the quarter
            declined to
            3.62%, down from 3.73% in the previous quarter.  A key driver of net
            interest income is the level of our earning assets, which declined in
            the second
            quarter of 2007, averaging $979 million, representing a decrease of more
            than of
            $48 million from the second quarter of last year. The drop in earning
            assets was
            due largely to securities sales, which reduced the size of the portfolio
            as of
            June 30, 2007 by nearly $37 million compared to the level at the June
            2006
            quarter-end.  Also contributing to the decline in earning assets was a
            substantial reduction in loan originations, which fell from $158 million
            in the
            second quarter of last year to $128 million in the most recent quarter,
            along
            with continued high levels of loan payoffs and sales.  Please see the
“Net Interest Income” and “Business Segments” sections for further discussions
            of net interest income and earning assets.
 
 A
            secondary source of revenue is our noninterest income, which increased
            $74,000
            and $1.0 million compared to the second quarter and first half of last
            year,
            based on increases in loan and securities sales and the resulting gains
            thereon
            as well as a higher level of service fees collected on assets serviced
            for other
            institutions.  During the second quarter and first half of 2007, we
            sold approximately $14 million and $30 million of sales finance loans,
            which
            resulted in significant increases in gains on sales of loans and should
            contribute incremental servicing fee income in future
            quarters.  Please see the “Noninterest Income” section for additional
            discussion.
 
 Despite
            the one-time items mentioned above, our operating expenses remained comparable
            to those of the prior year, rising only $406,000 for the second quarter,
            or 5%
            over the same period last year, and by $454,000, or 3% on a year-to-date
            basis,
            as reductions in occupancy and credit insurance expenses partially offset
            increases in personnel and other noninterest expenses.  Please refer
            to the “Noninterest Expense” section for additional information.
 
 For
            the
            quarter ended June 30, 2007, our credit quality remained acceptable,
            with
            non-performing assets (NPAs) totaling $3.5 million, or 0.34% of total
            assets,
            little changed compared to the similar $3.5 million, or 0.32% at the
            2006
            year-end.  For the quarter, we reserved $86,000 in provisions for loan
            losses and our reserve for loan losses, including unfunded commitments,
            totaled
            approximately $10.0 million, down from $10.1 million the year-end
            level.  The allowance for loan losses represented 1.12% of gross loans
            at the quarter-end, up from 1.11% at the 2006 year-end.  For
            additional information regarding our credit quality please refer to the
“Asset
            Quality” section.
 
 **RESULTS
            OF OPERATIONS**
 
 **Net
            Income**
 
 Net
            income declined $955,000 or 35% for the second quarter of 2007 as compared
            to
            the like quarter last year.  Year-to-date net income decreased
            $954,000 or 18%.  Net interest income, after provision for loan
            losses, declined $1.1 million for the quarter and $2.1 million for the
            first six
            months of 2007.  Noninterest income increased $74,000 on a
            second-quarter comparison and $1.0 million year-to-date, while noninterest
            expense increased $406,000 for the quarter and $454,000 for the first
            six months
            of the year.
 
 -
                24
                -
 **Net
            Interest
            Income**
  
 For
            the
            quarter and six months ended June 30, 2007, our net interest income declined
            $1.2 million and $2.0 million relative to the same periods last
            year.  The net effects of asset and liability repricing negatively
            impacted net interest income for both periods, while the contraction
            of earning
            asset levels reduced second quarter income, after resulting in improvement
            in
            the first quarter.  The following table illustrates the impacts to our
            net interest income from our level of earning assets and rate changes
            on our
            assets and liabilities, with the results attributable to asset levels
            classified
            as “volume” and the effect of asset and liability repricing labeled
“rate.”
 
 **Rate/Volume
            Analysis**
  Quarter
                        EndedJune 30, 2007 vs. June 30, 2006
                  
                  
                  Six
                        Months EndedJune 30, 2007 vs. June 30, 2006Increase/(Decrease)
                      due to
                  
                  
                  Increase/(Decrease)
                      due toVolume
                  
                  
                  Rate
                  
                  
                  Total
                  
                  
                  Volume
                  
                  
                  Rate
                  
                  
                  Total(Dollars
                      in thousands)Total
                      Investments
                  
                  $
                  (196
                  )
                  
                  $
                  368
                  
                  
                  $
                  172
                  
                  
                  $
                  45
                  
                  
                  $
                  8
                  
                  
                  $
                  53Total
                      Loans
                  
                  
                  (791
                  )
                  
                  
                  365
                  
                  
                  
                  (426
                  )
                  
                  
                  (870
                  )
                  
                  
                  1,397
                  
                  
                  
                  527Total
                      Interest Income
                  
                  $
                  (987
                  )
                  
                  $
                  733
                  
                  
                  $
                  (254
                  )
                  
                  $
                  (825
                  )
                  
                  $
                  1,405
                  
                  
                  $
                  580Interest
                      ExpenseTotal
                      Deposits
                  
                  
                  (193
                  )
                  
                  
                  1,233
                  
                  
                  
                  1,040
                  
                  
                  
                  (103
                  )
                  
                  
                  2,937
                  
                  
                  
                  2,834FHLB
                      and Other
                  
                  
                  (848
                  )
                  
                  
                  718
                  
                  
                  
                  (130
                  )
                  
                  
                  (1,532
                  )
                  
                  
                  1,322
                  
                  
                  
                  (210
                  )Total
                      Interest Expense
                  
                  $
                  (1,041
                  )
                  
                  $
                  1,951
                  
                  
                  $
                  910
                  
                  
                  $
                  (1,635
                  )
                  
                  $
                  4,259
                  
                  
                  $
                  2,624Net
                    Interest Income
                  
                  $
                  54
                  
                  
                  $
                  (1,218
                  )
                  
                  $
                  (1,164
                  )
                  
                  $
                  810
                  
                  
                  $
                  (2,854
                  )
                  
                  $
                  (2,044
                  )
  **Earning
            Asset Growth (Volume)**
 
 For
            the
            second quarter and first six months of 2007, declines in our levels of
            earning
            assets resulted in reductions of $987,000 and $825,000 in interest income
            relative to the same periods last year.  More than offsetting the
            second quarter and year-to-date reductions, however, were lower levels
            of
            interest expense resulting from the elimination of funding sources previously
            needed to accommodate asset levels.  Consequently, the net impacts of
            earning asset levels were an improvement in second-quarter net interest
            income
            of approximately $54,000 and a year-to-date improvement of $810,000 compared
            to
            the quarter and six months ended June 30, 2006.
 
 Quarter
                      Ending
                  Earning
                      Assets
                  Net
                      Loans (incl.LHFS)
                  Deposits(Dollars
                      in thousands)June
                        30, 2006
                  $
                      1,036,750
                  $
                      919,418
                  $
                      760,344September
                        30, 2006
                  $
                      1,034,332
                  $
                      919,837
                  $
                      774,914December
                        31, 2006
                  $
                      1,012,896
                  $
                      897,436
                  $
                      805,795March
                        31, 2007
                  $    995,058
                  $
                      881,849
                  $
                      771,659June
                        30, 2007
                  $    962,998
                  $
                      878,490
                  $
                      759,786
  As
            can be
            seen in the table above, our loan portfolio and overall level of earning
            assets
            have exhibited declining trends over the last several quarters.
 
 -
                25
                -
 The
            decline observed in the loan portfolio during the first half of 2007
            was
            disappointing and contrary to our expectation for loan growth of approximately
            $0 to $5 million in each of the first two quarters.  In the first six
            months of this year, we experienced declines in our income property,
            consumer,
            and residential construction loans.  On a positive note, our balances
            of business banking loans and single-family permanent loans ended the
            second
            quarter at levels higher than those observed at the 2006 year-end. Additionally,
            while consumer loan balances declined relative to the year-end, they
            did so
            largely as a result of high loan sales volumes, which totaled approximately
            $30
            million in the first half of the year.  Were it not for these sales,
            growth would likely have been observed in this portfolio segment as
            well.
 
 Further
            contributing to the decline in earning assets, the balance of our securities
            portfolio (including trading, available-for-sale, and held-to-maturity
            securities) totaled approximately $67 million as of June 30, 2007, down
            from its
            year-end and first-quarter 2007 levels of $95 million and nearly $97
            million,
            respectively.  The portfolio contraction followed significant trading
            volumes and portfolio turnover resulting from our election to adopt
            early  SFAS 159.
 
 Following
            the end of the first quarter, we sold several longer-maturity securities
            from
            the newly established trading portfolio, replaced the sold issues with
            approximately $34 million in shorter-term hybrid ARM securities, and
            began
            evaluating the potential risks and benefits of employing strategies to
            hedge
            against movements in the market value of the trading portfolio. In the
            first
            week of May, based on the earnings volatility presented by the new accounting
            treatment, we elected to proceed with a plan to reduce the volatility
            of the
            portfolio by reselling these recently purchased securities, leaving the
            portfolio at a much smaller size than that at which it began the
            quarter.
  On
            the
            liabilities side of the balance sheet, our total deposit balances declined
            $46
            million, or approximately 6% in the first half of the year, including
            $12
            million in the second quarter.  Our non-maturity deposit balances rose
            nearly $17 million in the first half of the year, with $5 million occurring
            in
            the second quarter, while time deposits, including certificates issued
            through
            brokerage services, declined nearly $63 million, with $17 million occurring
            in
            the most recent quarter.  Brokered and other institutional
            certificates of deposit accounted for approximately $34 million of the
            year-to-date reduction.  The decrease in retail certificate balances
            occurred as we attempted to move away from offering rates competitive
            with the
            higher rates in the local market. While this has resulted in some of
            the more
            rate-sensitive depositors exiting the Bank for higher rates elsewhere,
            most of
            these funds have remained on our books at significantly lower costs to
            the
            Bank.
  **Asset
            Yields and Funding Costs (Rate)**
 
 Quarter
                      Ended
                  Net
                      Interest MarginJune
                      30, 2006
                  3.91%September
                      30, 2006
                  3.94%December
                      31, 2006
                  3.78%March
                      31, 2007
                  3.73%June
                      30, 2007
                  3.62%
  -
                26
                -
 The
            effects of interest rate movements and repricing on our loan portfolio
            accounted
            for $365,000 and $1.4 million in additional interest income relative
            to the
            second quarter and first half of last year.  Adjustable-rate loans,
            which reprice according to terms specified in our loan agreements with
            the
            borrowers, accounted for approximately 77% of our loan portfolio as of
            June 30,
            2007, down from 80% at the 2006 year-end.  While most of the repricing
            of these loans occurs on an annual basis, a notable exception is those
            loans
            tied to the prime rate, which typically reprice within one or two days
            of any
            change in the Federal Funds target rate by the Federal Reserve.
 
 On
            the
            liability side of the balance sheet, however, the effects of interest
            rate
            movements and repricing were more pronounced, increasing our interest
            expense on
            deposits and wholesale funding by nearly $2.0 million for the quarter
            and $4.3
            million for the first six months of the year.
 
 As
            a
            result, for the second quarter and first six months of 2007, the net
            effects of
            rate movements and repricing negatively impacted our net interest income
            by $1.2
            million and $2.9 million relative to the same periods in the prior year,
            as the
            large volumes of maturing/repricing liabilities resulted in a greater
            increase
            in liability costs than was observed for asset yields.
 
 Contrary
            to our expectations, we observed continued compression of our net interest
            margin in the second quarter of 2007.  In our first-quarter press
            release, we indicated that we expected to see modest improvement in our
            net
            interest margin, forecasting a second-quarter margin in the 3.80% to
            3.85%
            range. This forecast had been based on the assumptions that we would
            experience
            no significant changes in our loan or deposit portfolios in the quarter,
            with
            estimated growth of $0 to $5 million for each. Instead, as previously
            noted, we
            have experienced substantial declines in both our loan and deposit portfolios
            in
            recent quarters, continuing through the second quarter of this
            year.
  **Noninterest
            Income**
 
 Relative
            to the second quarter of last year, our noninterest income rose $74,000,
            or
            approximately 4%, as increases in loan and securities sales and the resulting
            gains thereon were more than sufficient to offset a reduction in miscellaneous
            operating income and the negative impact of marking certain financial
            instruments to market under SFAS No. 159.
 
 On
            a
            year-to-date basis, noninterest income increased by slightly more than
            $1
            million as compared to the prior year, with loan sales being the most
            significant contributor to the additional income, followed by a positive
            year-to-date SFAS No. 159 impact and higher servicing fee income.
 
 **SFAS
            No. 157 and 159 Related Gains/(Losses)**
 
 Effective
            January 1, 2007, we elected early adoption of SFAS No. 157 and 159, which
            were
            issued in February 2007, and generally permit the mark-to-market of selected
            eligible financial instruments.  In our case, we elected to apply the
            standards to certain investments held in our securities portfolio and
            a $9
            million long term debenture payable (trust preferred security).  With
            the early adoption, we recorded total pre-tax, SFAS No. 159-related,
            mark-to-market gains of $447,000 for the first quarter.  In the second
            quarter, however, we experienced net SFAS No. 159-related losses totaling
            $211,000 resulting primarily from adverse movements in the prices of
  -
                27
                -
 our
            securities.  This net loss was offset by a $244,000 gain from a hedge
            position against those securities, which had been established in the
            second week
            of May.
  Based
            on
            our observations of the portfolio and hedge over the course of the quarter,
            we
            elected to further reduce the size of the portfolio and unwind the hedge
            position.  Consequently, in early July we sold securities with market
            values totaling approximately $41 million and unwound the hedge position.
            Our
            net losses from those activities totaled $213,000.  At the present
            time, we do not anticipate conducting any further securities
            transactions.
 
 **Gains/(Losses)
            on Sales of Loans**
 
 Quarter
                      Ended June 30,
                  
                  
                  Six
                      Months Ended June 30,2007
                  
                  
                  2006
                  
                  
                  2007
                  
                  
                  2006Gains/(Losses)
                      on Sales:Consumer
                  
                  $
                  746,000
                  
                  
                  $
                  430,000
                  
                  
                  $
                  1,679,000
                  
                  
                  $
                  1,178,000Residential
                  
                  
                  73,000
                  
                  
                  
                  18,000
                  
                  
                  
                  114,000
                  
                  
                  
                  (2,000
                  )Commercial
                  
                  
                  54,000
                  
                  
                  
                  106,000
                  
                  
                  
                  53,000
                  
                  
                  
                  134,000Total
                      Gains on Loan Sales
                  
                  $
                  873,000
                  
                  
                  $
                  554,000
                  
                  
                  $
                  1,846,000
                  
                  
                  $
                  1,310,000Loans
                      Sold:Consumer
                  
                  $
                  14,364,000
                  
                  
                  $
                  10,028,000
                  
                  
                  $
                  30,013,000
                  
                  
                  $
                  23,043,000Residential
                  
                  
                  20,920,000
                  
                  
                  
                  13,717,000
                  
                  
                  
                  31,798,000
                  
                  
                  
                  23,113,000Commercial
                  
                  
                  4,057,000
                  
                  
                  
                  4,182,000
                  
                  
                  
                  4,057,000
                  
                  
                  
                  5,192,000Total
                      Loans Sold
                  
                  $
                  39,341,000
                  
                  
                  $
                  27,927,000
                  
                  
                  $
                  65,868,000
                  
                  
                  $
                  51,348,000
  Continuing
            the trend observed in the first quarter of this year, our second quarter
            gains
            on loan sales significantly exceeded those of 2006 based primarily on
            a
            substantial increase in sales of our consumer loans.  Following an
            increase of $217,000, or 29% in the first quarter of this year, gains
            on sales
            for the second quarter totaled $873,000, representing a 58% increase
            over the
            same period last year.
 
 Following
            first quarter 2007 sales of nearly $16 million, second quarter consumer
            loan
            sales totaled more than $14 million, which was within the $12 million
            to $18
            million range estimated in the outlook presented in our first-quarter
            2007 press
            release.  Although current levels of loan production are consistent
            with what we have experienced in prior periods, we are seeing a softening
            in
            market demand for loan sales resulting from the issues affecting subprime
            lending. Whether or not loan sales in the third quarter will approximate
            prior
            quarters is unknown at this time.
 
 Compared
            to the markets for our consumer and commercial loan sales, the market
            for
            residential loan sales is significantly larger and more efficient. As
            a result,
            residential loan sales are typically sold for very modest gains or potentially
            even at slight losses when interest rates are rising quickly. We believe
            the
            construction phase to be the most profitable facet of residential lending
            and
            the primary objective in a residential lending relationship. Following
            the
            construction process, our practice is to retain in our portfolio those
            residential mortgages that we consider to be beneficial to the Bank,
            but to sell
            those that we consider less attractive assets. Included in these less
            attractive
            assets would be those mortgages with fixed rates, which we offer
  -
                28
                -
 for
            competitive reasons. Additionally, as residential loans are typically
            sold
            servicing released, sales do not result in future servicing income.
  Following
            an absence of commercial real estate loan sales in the first quarter
            of 2007, we
            sold participations in commercial real estate loans during the second
            quarter,
            though gains trailed their year-ago levels.  Commercial real estate
            loan transactions, particularly those that are candidates for sales of
            participations to other institutions, tend to be larger-dollar credits
            and
            unpredictable in their timing and frequency of occurrence. As a result,
            the
            volumes of commercial real estate loans sold, and gains thereon, can
            be expected
            to vary considerably from one quarter to the next depending on the timing
            of the
            loan and sales transactions.
  **Service
            Fee Income/(Expense)**
  Quarter
                      Ended June 30,
                  
                  
                  Six
                      Months Ended June 30,2007
                  
                  
                  2006
                  
                  
                  2007
                  
                  
                  2006Consumer
                      Loans
                  
                  $
                  431,000
                  
                  
                  $
                  298,000
                  
                  
                  $
                  892,000
                  
                  
                  $
                  630,000Commercial
                      Loans
                  
                  
                  (36,000
                  )
                  
                  
                  0
                  
                  
                  
                  (62,000
                  )
                  
                  
                  9,000Residential
                      Loans
                  
                  
                  4,000
                  
                  
                  
                  2,000
                  
                  
                  
                  6,000
                  
                  
                  
                  (4,000
                  )Service
                      Fee Income
                  
                  $
                  399,000
                  
                  
                  $
                  300,000
                  
                  
                  $
                  836,000
                  
                  
                  $
                  635,000
 
 Our
            servicing fee income rose 33% from the level earned in the second quarter
            of
            last year and 32% on a year-to-date basis, as servicing income from consumer
            loans serviced for other institutions increased in response to higher levels of
            loan sales.  Servicing fee income represents the net of servicing
            income received less the amortization of servicing assets, which are
            recorded
            when we sell loans from our portfolio to other investors. The values
            of these
            servicing assets are determined at the time of the sale using a valuation
            model
            that calculates the present value of future cash flows for the loans
            sold,
            including cash flows related to the servicing of the loans. The servicing
            asset
            is recorded based on fair value. The servicing rights are then amortized
            in
            proportion to, and over the period of, the estimated future servicing
            income.
 
 For
            the
            second quarter and first six months of 2007, service fee income earned
            on
            consumer loans serviced for other investors exceeded that earned in the
            same
            periods of the prior year by 45% and 42%. This improvement was based
            on a
            significant increase in the balances of consumer loans serviced, which
            was in
            turn a product of the increased volume of loan sales in 2006 and the
            first half
            of 2007.
 
 In
            the
            case of commercial loans serviced, payoffs during the quarter of balances
            sold
            to and serviced for other institutional investors required us to immediately
            write-off the related servicing assets, which resulted in the loss presented
            above.
  In
            contrast to consumer and commercial loans, residential loans are typically
            sold
            servicing released, which means we no longer service those loans once
            they are
            sold. Consequently, we do not view these loans as a significant source
            of
            servicing fee income.
  **Fees
            on Deposits**
 
 Fee
            income earned on deposit accounts rose by $14,000, or 7%, compared to
            the second
            quarter of last year, and $20,000, or 5% on a year-to-date basis, based
            primarily on a higher level of
  -
                29
                -
 checking
            account service charges.  This source of fee income has grown as we
            have continued our efforts to expand our base of business and consumer
            checking
            accounts.  A higher level of IRA service fees also contributed to the
            improvement.
  **Other
            Noninterest Income**
  Quarter
                      Ended June 30,
                  
                  
                  Six
                      Months Ended June 30,2007
                  
                  
                  2006
                  
                  
                  2007
                  
                  
                  2006ATM/Wire/Safe
                    Deposit
                      Fees
                  
                  $
                  96,000
                  
                  
                  $
                  79,000
                  
                  
                  $
                  184,000
                  
                  
                  $
                  154,000Late
                      Charges
                  
                  
                  72,000
                  
                  
                  
                  66,000
                  
                  
                  
                  144,000
                  
                  
                  
                  117,000Loan
                      Fee Income
                  
                  
                  182,000
                  
                  
                  
                  155,000
                  
                  
                  
                  399,000
                  
                  
                  
                  250,000Rental
                      Income
                  
                  
                  189,000
                  
                  
                  
                  186,000
                  
                  
                  
                  357,000
                  
                  
                  
                  343,000Miscellaneous
                  
                  
                  207,000
                  
                  
                  
                  523,000
                  
                  
                  
                  280,000
                  
                  
                  
                  587,000Other
                      Noninterest
                    Income
                  
                  $
                  746,000
                  
                  
                  $
                  1,009,000
                  
                  
                  $
                  1,364,000
                  
                  
                  $
                  1,451,000
 
 Our
            noninterest income from sources other than those described earlier declined
            $263,000, or 26% for the quarter and $88,000, or 6% on a year-to-date
            basis
            relative to the same periods last year.  The decline, however, was
            primarily attributable to an extraordinary item, specifically the receipt
            of
            $400,000 in insurance proceeds from a key-man life insurance policy,
            in the
            second quarter of last year as opposed to any adverse changes in our
            2007
            operations.
 
 We
            continued to observe growth in our ATM/Wire/Safe Deposit Fees, which
            totaled
            $96,000 for the quarter and $184,000 on a year-to-date basis, representing
            increases of 21% and 20% over the same periods last year.  Most of
            this growth is attributable to Visa and ATM fee income, which we expect
            to
            continue rising as checking accounts become a greater piece of our overall
            deposit mix.
  Loan
            fee
            income increased compared to the prior year based on a higher level of
            non-deferred loan fees. These typically include fees collected in connection
            with loan modifications or extensions, non-conversion of construction
            loans to
            permanent mortgages, and letters of credit originated for commercial
            borrowers.  Further contributing to the additional income were
            quarterly and year-to-date increases of $6,000 and $37,000 in loan brokerage
            fees and $7,000 and $15,000 in loan prepayment fees relative to the prior
            year.
 
 **Noninterest
            Expense**
 
 Noninterest
            expense increased $406,000 for the second quarter, or 5% over the same
            period
            last year, and by $454,000, or 3% on a year-to-date basis.
  **Salaries
            and Employee Benefits Expense**
 
 Our
            personnel-related expenses remained well contained in the first half
            of 2007,
            increasing slightly more than 2% relative to the first six months of
            last year,
            as the majority of a 7% increase in compensation expense was offset by
            improvements across other expense categories.
  -
                30
                -
 For
            the
            quarter, salary expense increased 8% and commission and incentive compensation
            by 5% as total personnel expense increased by 3%.
  Quarter
                      Ended June 30,
                  
                  
                  Six
                      Months Ended June 30,2007
                  
                  
                  2006
                  
                  
                  2007
                  
                  
                  2006Salaries
                  
                  $
                  3,238,000
                  
                  
                  $
                  2,994,000
                  
                  
                  $
                  6,399,000
                  
                  
                  $
                  5,966,000Commissions
                      and
                    Incentives
                  
                  
                  663,000
                  
                  
                  
                  634,000
                  
                  
                  
                  1,189,000
                  
                  
                  
                  1,174,000Employment
                      Taxes
                    and
                      Insurance
                  
                  
                  269,000
                  
                  
                  
                  267,000
                  
                  
                  
                  558,000
                  
                  
                  
                  568,000Temporary
                      Office
                    Help
                  
                  
                  72,000
                  
                  
                  
                  59,000
                  
                  
                  
                  150,000
                  
                  
                  
                  154,000Benefits
                  
                  
                  375,000
                  
                  
                  
                  523,000
                  
                  
                  
                  830,000
                  
                  
                  
                  1,061,000Total
                  
                  $
                  4,617,000
                  
                  
                  $
                  4,477,000
                  
                  
                  $
                  9,126,000
                  
                  
                  $
                  8,923,000
 
 The
            increase in overall personnel-related expenses was primarily attributable
            to
            salaries expense, which increased 8% and 7% relative to the second quarter
            and
            first six months of 2006.  For the quarter, Directors’ compensation
            increased $124,000 as compared to the same quarter last year, primarily
            as a
            result of a $100,000 payment to one of our directors for consulting services
            regarding the upcoming Washington Federal acquisition.  Also
            contributing to compensation expense was a retention bonus paid to the
            CFO for
            staying on past his retirement date.  On a year-to-date basis, the
            most significant contribution to salary costs came from regular compensation
            expense, which grew largely as a result of annual increases in staff
            salaries.
            The annual compensation adjustments take effect in April of each year
            and
            generally fall within a 2% to 4% range.  Further adding to the
            increase in salaries expense was a higher level of stock option compensation
            expense, which rose from $260,000 in the first half of 2006 to $326,000
            this
            year.
  In
            contrast to other categories, employee benefit expense declined significantly
            relative to the second quarter of last year, falling nearly $147,000,
            or 28%.
            The reduction was largely attributable to a decision to forego contributions
            to
            our 401K profit sharing plan and ESOP for the quarter.  By comparison,
            $105,000 and $189,000 was contributed in the second quarter and first
            half of
            2006, while this year’s contributions were a recovery of $21,000 in the second
            quarter and an expense of $18,000 in the first half.
  **Occupancy
            Expense**
  Occupancy
            expense declined by $75,000 and $103,000, or more than 7% and 5%, compared
            to
            the second quarter and first half of last year, based on reductions across
            the
            various categories of occupancy expense.
 
 Quarter
                      Ended June 30,
                  
                  
                  Six
                      Months Ended June 30,2007
                  
                  
                  2006
                  
                  
                  2007
                  
                  
                  2006Rent
                  
                  $
                  70,000
                  
                  
                  $
                  79,000
                  
                  
                  $
                  140,000
                  
                  
                  $
                  158,000Utilities
                      and
                    Maintenance
                  
                  
                  178,000
                  
                  
                  
                  198,000
                  
                  
                  
                  406,000
                  
                  
                  
                  402,000Depreciation
                  
                  
                  486,000
                  
                  
                  
                  518,000
                  
                  
                  
                  947,000
                  
                  
                  
                  1,028,000Other
                      Occupancy
                  
                  
                  234,000
                  
                  
                  
                  248,000
                  
                  
                  
                  457,000
                  
                  
                  
                  465,000Total
                      Occupancy Expense
                  
                  $
                  968,000
                  
                  
                  $
                  1,043,000
                  
                  
                  $
                  1,950,000
                  
                  
                  $
                  2,053,000
 
 -
                31
                -
 The
            reduction in rent expense was attributable to the closings of Income
            Property
            lending offices as well as the relocation of the West Seattle Banking
            Center
            from a leased space to a new building that we own, all of which occurred
            in
            2006.
  For
            the
            second quarter, depreciation expense declined $32,000, or 6% relative
            to the
            2006 level, based on reductions in software, furniture, and other PC
            and network
            depreciation expense.  On a year-to-date basis, depreciation expense
            was down $80,000, or nearly 8%.  In the first quarter, depreciation
            expense declined $48,000 due to the correction of a booking error associated
            with the purchase of our Juanita Banking Center.  In that transaction,
            the value of the land had been included in the cost of the building and
            consequently depreciated based on the building’s amortization
            schedule.  As land is not depreciable, this error was corrected upon
            its discovery and resulted in a one-time $40,000 credit to depreciation
            for the
            quarter.
  **Credit
            Insurance**
  Credit
            insurance premium costs fell nearly 21% in the second quarter, and more
            than 14%
            on a year-to-date basis compared to the same periods in 2006. As we stated
            in
            our 2006 year-end press release, we expected that expenditures for credit
            insurance would decline over the course of 2007. The majority of credit
            insurance premiums is attributable to our sales finance loans, including
            both
            those loans retained in our portfolio as well as those loans serviced
            for other
            institutions.  In mid-2006, after evaluating our use of credit
            insurance, we concluded that the benefits of the insurance no longer
            outweighed
            the costs and chose to forego the insurance and assume the credit risk
            on future
            sales finance loan production.  Those loans insured prior to August 1,
            2006 remain insured under their existing policies.  Additionally, some
            loans originated on or after August 1, 2006 were sold to institutional
            investors
            with insurance placed prior to sale and remain insured under the policy
            effective August 1, 2006.  All other loan volumes originated on or
            after August 1 have not been insured. To a much lesser extent, residential
            land
            loans and a small percentage of the consumer and income property loan
            portfolios
            are also insured. While these insured balances may continue to increase
            in
            future quarters, the premiums paid on these balances are sufficiently
            small
            relative to those paid on sales finance loans such that total premiums
            paid are
            still expected to decline.
  **Other
            Noninterest Expense**
 
 Other
            noninterest expense grew by $440,000, or 24% relative to the second quarter
            of
            2006, and $490,000, or nearly 14% on a year-to-date basis with a number
            of
            unique and/or merger-related items contributing to the increase in the
            second
            quarter.
  Quarter
                      Ended June 30,
                  
                  
                  Six
                      Months Ended June 30,2007
                  
                  
                  2006
                  
                  
                  2007
                  
                  
                  2006Marketing
                      and
                    Investor
                      Relations
                  
                  $
                  234,000
                  
                  
                  $
                  268,000
                  
                  
                  $
                  456,000
                  
                  
                  $
                  520,000Outside
                      Services
                  
                  
                  344,000
                  
                  
                  
                  255,000
                  
                  
                  
                  526,000
                  
                  
                  
                  423,000Information
                      Systems
                  
                  
                  257,000
                  
                  
                  
                  226,000
                  
                  
                  
                  499,000
                  
                  
                  
                  430,000Taxes
                  
                  
                  193,000
                  
                  
                  
                  159,000
                  
                  
                  
                  356,000
                  
                  
                  
                  303,000Legal
                  
                  
                  191,000
                  
                  
                  
                  118,000
                  
                  
                  
                  364,000
                  
                  
                  
                  305,000Other
                  
                  
                  1,057,000
                  
                  
                  
                  810,000
                  
                  
                  
                  1,894,000
                  
                  
                  
                  1,624,000Total
                  
                  $
                  2,276,000
                  
                  
                  $
                  1,836,000
                  
                  
                  $
                  4,095,000
                  
                  
                  $
                  3,605,000
 
 -
                32
                -
 Expenditures
            on outside services increased $90,000 in the second quarter and $104,000
            for the
            first half of 2007 as compared to the same periods in the prior
            year.  The increase in the second quarter’s expense was the result of
            a final $163,000 payment on a consulting service contract.
 
 Legal
            fees grew by $73,000 in the second quarter and $59,000 for the first
            six months
            of the year, as approximately $46,000 in legal expenses related to the
            Washington Federal transaction were recognized during the second quarter
            of
            2007.
 
 Partially
            offsetting the overall increase in other noninterest expenses, our marketing
            and
            investor relations costs declined $34,000 for the quarter and $64,000
            on a
            year-to-date basis relative to the same periods last year.
 
 Other
            miscellaneous operating expenses rose significantly in the second quarter,
            totaling $247,000, or almost 31% more than in the same quarter last
            year.  On a year-to-date basis, these expenses increased $270,000, or
            nearly 17%.  Driving this increase were an additional $199,000 in
            charitable contributions and $159,000 in recruiting expenses compared
            to the
            second quarter of last year.  The increase in charitable contributions
            was the result of a $188,000 contribution to a local performing arts
            organization.  We had originally expected to make this contribution in
            several installments over time, but given the pending merger with Washington
            Federal Savings, we elected to go ahead and lump-sum the remaining
            contribution.  The unusually high level of recruiting expense resulted
            from the use of employment services in connection with our search for
            a new CFO,
            as well as the hiring of a new business banking officer, income property
            lending
            officer and production assistant, treasury management officer, as well
            as
            various other personnel including accounting and IS staff.
 
 **FINANCIAL
            CONDITION**
 
 **Assets**
 
 Because
            of a decline in security and loan portfolio balances, our assets totaled
            $1.029
            billion at June 30, 2007, down from $1.057 billion at the start of the
            quarter
            and representing a decline of approximately 5% from the $1.079 billion
            2006
            year-end level.  The reduction in the securities portfolio was an
            indirect result of our decision to elect early adoption of SFAS 159,
            while the
            decline in the loan portfolio was attributable to a substantial reduction
            in
            loan originations relative to the previous year combined with continued
            high
            levels of loan payoffs and sales.
 
 **Securities**
 
 Following
            significant trading volumes and portfolio turnover resulting from our
            election
            to early adopt SFAS 159, the balance of our securities portfolio (including
            trading, available-for-sale, and held-to-maturity securities) totaled
            approximately $67 million as of June 30, 2007, down from its year-end
            and
            first-quarter 2007 levels of $95 million and nearly $97 million.
 
 Following
            the end of the first quarter, we sold several longer-maturity securities
            from
            the newly established trading portfolio, replaced the sold issues with
            approximately $34 million in shorter-term hybrid ARM securities, and
            began
            evaluating the potential risks and benefits of employing
  -
                33
                -
 strategies
            to hedge against movements in the market value of the trading portfolio.
            In the
            first week of May, based on the earnings volatility presented by the
            new
            accounting treatment, we elected to proceed with a plan to reduce the
            volatility
            of the portfolio by reselling our recently purchased securities in the
            secondary
            market and utilizing an interest rate swap to partially hedge against
            movements
            in the market value of the remaining trading portfolio.  Based on our
            observations of the portfolio and hedge over the remainder of the quarter,
            we
            elected to further reduce the size of the portfolio and unwind the hedge
            position.  Consequently, in early July we sold additional securities
            with market values totaling approximately $41 million and unwound the
            hedge
            position.  These securities were seasoned hybrid ARM securities and
            two FHLB agency bullet securities that had been moved from the
            available-for-sale or held-to-maturity category to the trading portfolio
            at the
            time of our SFAS 159 adoption.  At the present time, we do not
            anticipate conducting any further significant securities
            transactions.
 
 Any
            investment security purchased is classified in one of the following categories:
            1) trading, 2) available-for-sale, or 3) held-to-maturity. Prior to our
            early
            adoption of SFAS 159, the majority of the securities in our present portfolio
            had been classified as available-for-sale, while no securities were classified
            in the trading category. Available-for-sale securities are reviewed regularly,
            and any unrealized gains or losses are recorded in comprehensive income
            in the
            shareholders’ equity account. In contrast, any change in market value of trading
            securities during the period is reflected in current period income. Generally,
            falling interest rates will increase the market values of securities,
            thus
            enhancing the amounts recorded as gains or reducing losses, while rising
            rates
            will have the opposite effect. The passage of time partially counteracts
            these
            interest rate effects, as the unrealized gain or loss on a given security
            will
            gradually decline to zero as the security approaches its maturity
            date.
 
 **Loans**
 
 Loans
            receivable, excluding loans held-for-sale, declined approximately $4
            million for
            the quarter and $27 million in the first six months of the year, to less
            than
            $867 million at June 30, 2007. The drop in the loan portfolio is partly
            attributable to a decrease in loan originations which fell to $128 million
            and
            $223 million compared to $158 million and $280 million in the second
            quarter and
            first half of last year.  In addition to the decline in originations,
            the loan portfolio was impacted by a combination of continued high prepayment
            speeds and significant volumes of loan sales.
 
 **Portfolio
                      Composition**
                  
                  **June
                      30, 2007**
                  
                  
                  **March
                      31, 2007**
                  
                  
                  **December
                      31, 2006**(Dollars
                      in thousands)Single
                      Family Residential
                  
                  $
                  261,699
                  
                  
                  $
                  256,583
                  
                  
                  $
                  254,374Income
                      Property
                  
                  
                  220,056
                  
                  
                  
                  234,527
                  
                  
                  
                  248,100Business
                      Banking
                  
                  
                  164,151
                  
                  
                  
                  153,552
                  
                  
                  
                  144,771Commercial
                      Construction
                  
                  
                  47,864
                  
                  
                  
                  40,944
                  
                  
                  
                  47,153Single
                      Family ConstructionSpec
                      Construction
                  
                  
                  29,146
                  
                  
                  
                  29,043
                  
                  
                  
                  31,315Custom
                      Construction
                  
                  
                  49,129
                  
                  
                  
                  62,482
                  
                  
                  
                  70,541Consumer
                  
                  
                  94,813
                  
                  
                  
                  93,576
                  
                  
                  
                  97,177**Total**
                  
                  **$**
                  **866,858**
                  
                  
                  **$**
                  **870,707**
                  
                  
                  **$**
                  **893,431**
 
 The
            decrease observed in the loan portfolio during the first and second quarters
            was
            disappointing and contrary to our expectation for flat to modest growth
            for each
            quarter. In each
  -
                34
                -
 of
            the
            last two quarters we have experienced significant declines in our income
            property and custom construction loan portfolios.
 
 While
            our
            total loan portfolio experienced a decline over the last two quarters,
            respectable growth occurred in our business banking loan
            portfolio.  This segment has been very successful in building earning
            assets in recent years, and is looked to as a key contributor to asset
            growth
            going forward.  More modest loan growth was also observed in our
            residential lending permanent loan portfolio.  The single family
            residential loans held in our portfolio are typically non-conforming
            loans that
            do not meet the requirements for resale in the secondary market, but
            generally
            offer higher yields than conforming residential mortgages and are still
            considered eligible collateral for borrowing from the FHLB. Additionally,
            while
            consumer loan balances declined relative to the year-end, they did so
            largely as
            a result of loan sales totaling more than $14 million in the second quarter
            and
            $30 million in the first half of the year.  Were it not for these
            sales, growth would likely have been observed in this portfolio segment
            as
            well.
 
 Income
            property loans, which consist of mortgages on investor-owned commercial
            real
            estate and multifamily properties, have demonstrated a gradual downward
            trend in
            recent years.  This decline has been largely the result of lower
            originations of loans, along with a high level of prepayments, which
            we
            attribute to a combination of increased competition from other lenders,
            including conduit programs, and a flat-to-inverted yield curve.  The
            flattening of the yield curve reduced the rate differential between short-
            and
            long-term financing costs and provided a financial incentive for borrowers
            to
            select longer-term, fixed-rate loans as opposed to short-term or adjustable-rate
            financing.  As we have historically been an originator of short-term
            and adjustable-rate loans, this has impacted us in two ways.  First,
            as prospective buyers sought loans with terms that fell outside of our
            typical
            underwriting structures, our originations of permanent multifamily and
            commercial real estate loans declined.  Second, with the yield curve
            providing borrowers with a financial incentive to refinance adjustable-rate
            loans, which make up the majority of our loan portfolio, with longer-term,
            fixed-rate debt, the prepayment rates on our income property portfolio
            remained
            at relatively high levels.  Increased competition among lenders in our
            local market accelerated both the decline in new loans as well as portfolio
            payoffs, as the competition frequently resulted in lenders offering prospective
            borrowers new loan commitments or existing borrowers the opportunity
            to
            refinance at lower margins than we would consider appropriate for the
            risks
            presented by the credits.
 
 **Servicing
            Assets**
 
 Servicing
            assets represent the deferred servicing rights generated from sales of
            loans
            that are sold servicing retained, reduced by the amortization and prepayments
            of
            those loans, as well as any impairment charges that may occur. While
            our
            servicing assets have not and do not represent a significant percentage
            of our
            total assets, this area has grown with high volumes of loan sales.
 
 **Servicing
                      Assets**
                  
                  **June
                      30, 2007**
                  
                  
                  **March
                      31, 2007**
                  
                  
                  **December
                      31, 2006**Commercial
                  
                  $
                  114,000
                  
                  
                  $
                  165,000
                  
                  
                  $
                  224,000Residential
                  
                  
                  72,000
                  
                  
                  
                  57,000
                  
                  
                  
                  63,000Consumer
                  
                  
                  4,798,000
                  
                  
                  
                  4,386,000
                  
                  
                  
                  3,724,000**Total**
                  
                  **$**
                  **4,984,000**
                  
                  
                  **$**
                  **4,608,000**
                  
                  
                  **$**
                  **4,011,000**Loan
                      Balances Serviced for Others
                  
                  $
                  154,199,000
                  
                  
                  $
                  150,437,000
                  
                  
                  $
                  155,025,000
 
 -
                35
                -
 As
            a
            result of the more than $14 million in consumer loan sales during the
            quarter,
            and $30 million in the first half of the year, our servicing assets related
            to
            consumer loans increased $412,000, or approximately 9% during the second
            quarter, and $1.1 million, or 29% over the first six months of
            2007.
 
 Servicing
            assets related to commercial loans continued to decline as some existing
            commercial loan pools were paid off in the second quarter of
            2007.  These payoffs required us to immediately write off the
            remaining servicing assets associated with these credits.
 
 Residential
            loans are generally sold servicing released.  Consequently, no
            servicing assets are recognized following the vast majority of residential
            loan
            sales.
 
 **Deposits
            and Borrowings**
 
 Through
            the first half of the year, our total deposit balances fell $46 million,
            or
            approximately 6% from their year-end level, including $12 million in
            the second
            quarter. Non-maturity deposit balances, however, rose nearly $17 million,
            with
            $5 million occurring in the second quarter. Time deposits, including
            certificates issued through brokerage services, declined nearly $63 million,
            with a $17 million decrease occurring in the most recent
            quarter.  Brokered and other institutional certificates of deposit
            accounted for approximately $34 million of the year-to-date
            reduction.
 
 The
            growth of checking and money market accounts typically helps us reduce
            our
            overall cost of funds. Consequently, we consider the growth of these
            types of
            account types to be an important part of our funding strategy. To encourage
            this
            growth, we actively monitor the products and rates offered by our competition
            in
            the local market and develop new products and/or offer aggressive rates
            to
            attract new balances in the most cost-effective manner possible.
 
 The
            decrease in retail certificate balances occurred as we attempted to move
            away
            from offering rates competitive with the higher rates in the local market.
            While
            this has resulted in some of the more rate-sensitive depositors exiting
            the Bank
            for higher rates elsewhere, most of those deposits have remained on our
            books at
            significantly lower costs to the Bank.
 
 Our
            preferred supplemental funding mechanism is borrowing funds from the
            Federal
            Home Loan Bank of Seattle (FHLB).  With the reduction in assets
            exceeding the decline in deposit balances, we experienced a modest decrease
            in
            our FHLB advances to $163 million at the end of the second quarter, compared
            to
            $178 million at the end of the first quarter of 2007 and $172 million
            at the
            2006 year-end.  As of June 30, 2007, we had the authority to borrow up
            to approximately $412 million from the FHLB, subject to maintaining a
            sufficient
            level of eligible collateral.
 
 **ASSET
            QUALITY**
 
 **Provision
            and Reserve for Loan Loss and Loan Commitments Liability**
 
 The
            provision for loan losses reflects the amount deemed appropriate to produce
            an
            adequate reserve for probable loan losses inherent in the risk characteristics
            of the loan portfolio.  In determining the appropriate reserve
            balance, we consider the current and historical performance of the loan
            portfolio, the amount and type of new loans added to the portfolio, our
            level of
            non-performing loans, the amount of loans charged off, and the economic
            conditions in which we currently operate.
 
 -
                36
                -
 The
            provisions for the second quarter and first six months of 2007 totaled
            $86,000
            and $238,000 compared to provisions of $135,000 and $206,000 in the same
            periods
            last year.  The reduction in the second quarter provision was prompted
            by the decline in our loan portfolio over the course of the quarter and
            continued high sales volumes of our sales finance loans, which typically
            account
            for the majority of charged-off loan balances.
 
 Nonperforming
            assets, both in terms of balances and as a percentage of total assets,
            were
            little changed from the $3.5 million and 0.32% observed at the 2006 year-end,
            totaling $3.5 million and 0.34% at the end of the second
            quarter.  While this level of nonperforming assets remains at the high
            end of our historical experience, it remains below industry
            standards.  Noted below are the ratios from 1998 and the comparative
            industry ratios.
 
 Year
                  First
                      Mutual Bank
                  FDIC
                      Insured Commercial Banks1998
                  0.07%
                  0.65%1999
                  0.06%
                  0.63%2000
                  0.38%
                  0.74%2001
                  0.08%
                  0.92%2002
                  0.28%
                  0.94%2003
                  0.06%
                  0.77%2004
                  0.10%
                  0.55%2005
                  0.08%
                  0.48%2006
                  0.32%
                  0.51%Second
                      Quarter 2007
                  0.34%
                  N/A
 
 Including
            a $205,000 liability for unfunded commitments, our reserve for loan losses
            totaled approximately $10.0 million at June 30, 2007, down from $10.1
            million at
            the 2006 year-end.  At this level, the allowance for loan losses
            represented 1.12% of gross loans at June 30, 2007, compared to 1.11%
            at the 2006
            year-end.
 
 **Non-Performing
            Assets**
  Our
            exposure to non-performing assets as of June 30, 2007 was:
 
 Two
                      single-family residential loans in the Oregon market.  No
                      anticipatedloss.
                  
                  $
                  1,451,000One
                      mobile-home park loan in Oregon.  No anticipated
                      loss.
                    Two
                      single-family residential loans in Washington. No anticipated
                      loss.
                    Two
                      custom construction loans in Oregon market.  Impairment
                      chargestaken
                      in 2006.  No further losses anticipated.
                  
                  
                  732,000
                    574,000
                    240,000One
                      single-family residential loan in the Puget Sound
                      market.  Noanticipated
                      loss.
                  
                  
                  166,000One
                      land loan in Western Wa.  No anticipated loss.
                  
                  
                  86,000Nineteen
                      consumer loans.  Full recovery expected from insurance
                      claims.
                    One
                      lease pool.  No anticipated loss.
                    Five
                      consumer loans.  Possible loss of $38,000.
                  
                  
                  77,000
                    56,000
                    38,000Eleven
                      insured consumer loans that have exceeded the credit
                      insurancelimit.  Possible
                      loss of $35,000.
                  
                  
                  35,000Eight
                      consumer loans.  No anticipated loss.
                  
                  
                  27,000Total
                      Non-Performing Assets
                  
                  $
                  3,482,000
 
 -
                37
                -
 **BUSINESS
            SEGMENTS**
 
 Beginning
            January 1, 2007, we changed the presentation of our Business Segments
            to more
            accurately reflect the way these segments are managed within the
            Bank.  Prior to 2007, we recognized four business
            segments:  1) Consumer Lending, 2) Residential Lending, 3) Business
            Banking Lending, and 4) Income Property Lending.  All other
            departments, including our Banking Centers and investment portfolio were
            assumed
            to support these business lines.  Consequently, all income generated
            and expenses incurred at these support centers were allocated to the
            four
            business segments, resulting in no net income or loss at any department
            except
            the four lending units.
 
 To
            better
            reflect how we manage the Bank, we have changed our business segments
            as
            follows:
 
 ·
                  Established
                      a “Retail Banking” segment which includes our banking centers and direct
                      consumer lending.  The Home Equity Lines of Credit (HELOC’s) and
                      other consumer lending originated through the Banking Centers,
                      which were
                      previously included in the “Consumer Lending” segment, are included in
                      this segment.  The “Retail Banking” segment does not include
                      Sales Finance lending.  This segment also includes Community
                      Business Banking (small business lending) which had been previously
                      included in the “Business Banking”
segment.
 
 ·
                  Isolated
                      our Investment Securities activities as a separate business
                      segment so
                      that any changes in the investment portfolio’s market value or level of
                      earning assets do not distort the reported operating results
                      of our other
                      business segments.
 
 In
            moving
            the banking centers, our primary source of funds generation, from an
            allocated
            overhead category to an operating segment, it became necessary to implement
            a
            new process for transferring funds from our funds-generating operations
            to the
            users of such funds.  The objective of the funds transfer process is
            to isolate the true profit contribution of each side of the balance
            sheet.  Prior to 2007, the profitability of the funds-generating
            operations, such as the banking centers, was defined as break-even with
            the
            lending segments collectively compensating the funds-generating operations
            such
            that this result was achieved.  Under the new methodology, the rates
            at which funds are transferred between the generators and users of funds
            are
            based on market rates of interest.  The profitability of the business
            segments, including retail banking, then varies depending on the actual
            rates
            earned on assets and paid on liabilities as well as expenses incurred
            in the
            segments’ operations.  To assist in tracking and evaluating the
            profitability of such funds transfers, we now utilize four line items
            in
            determining each segment’s net interest income:
 
 ·
                  Interest
                      Income – This represents the actual interest received from the segment’s
                      loans or securities.
 
 ·
                  Interest
                      Income on Funding Sources – This represents the interest income received
                      from selling funding sources generated by the segment (i.e.
                      deposits or
                      FHLB advances) to a centralized treasury function.  The interest
                      rate paid to the segment is based on the point on the FHLB
                      rate curve for
                      advances of a duration comparable to the segment’s funding
                      source.
 
 -
                38
                -
 ·
                  Funding
                      Costs – This represents the interest paid to the centralized treasury
                      function by each business segment for the funding sources necessary
                      to
                      support earning asset balances.  Again, the interest rate
                      charged to the segment is based on the point on the FHLB rate
                      curve for
                      advances of a duration comparable to the segment’s earning
                      assets.
 
 ·
                  Interest
                      Expense – This represents the actual interest paid on the segment’s
                      liabilities (i.e. deposits or FHLB
                      advances).
 
 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:
 
 ·
                  Retail
                      Banking – Retail Banking is the segment primarily responsible for the
                      generation of funding sources, specifically our consumer and
                      small
                      business deposit accounts.  In addition to our banking centers,
                      the segment includes our direct consumer and Community Business
                      Banking
                      (small business) lending
                      departments.
 
 ·
                  Sales
                      Finance Lending – Sales Finance generates indirect unsecured consumer
                      loans in connection with home improvement projects.  A large
                      percentage of this segment’s loan volume is sold into the secondary market
                      on a servicing-retained basis, meaning we continue to process
                      payments and
                      service the loan following the
                      sale.
 
 ·
                  Residential
                      Lending - Residential Lending offers loans to borrowers to
                      purchase,
                      refinance, or build homes secured by one-to-four-unit family
                      dwellings.  This segment 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.
 
 ·
                  Business
                      Banking Lending – Business Banking offers a full range of banking services
                      to middle-market 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)
                      and
                      commercial real estate properties.  The underlying real estate
                      collateral being financed typically secures these
                      loans.
 
 ·
                  Investment
                      Securities - The investment securities segment includes the
                      investment
                      securities portfolio, FHLB stock, and interest-earning cash
                      balances.  Although management does not consider this to be an
                      operating business line, security investments represent a necessary
                      part
                      of liquidity management for the
                      Bank.
 
 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
  -
                39
                -
 primarily
            on net interest revenue in managing these segments.  No single
            customer provides more than 10% of the Bank’s revenues.
 
 **Retail
            Banking**
 
 Quarter
                      Ended
                  
                  
                  Six
                      Months EndedNet
                      Income/(Loss)
                  
                  
                  Return
                      on Equity
                  
                  
                  Net
                      Income/(Loss)
                  
                  
                  Return
                      on EquityJune
                      30, 2005
                  
                  $
                  (347,000
                  )
                  
                  
                  (9.64
                  %)
                  
                  $
                  (685,000
                  )
                  
                  
                  (9.94
                  %)June
                      30, 2006
                  
                  $
                  676,000
                  
                  
                  
                  20.27
                  %
                  
                  $
                  1,067,000
                  
                  
                  
                  15.78
                  %June
                      30, 2007
                  
                  $
                  (235,000
                  )
                  
                  
                  (5.78
                  %)
                  
                  $
                  (329,000
                  )
                  
                  
                  (4.20
                  %)
 
 Second
            quarter and year-to-date net income for our Retail Banking segment declined
            $911,000 and $1.4 million relative to the prior year based on a sharp
            reduction
            in net interest income, as rates paid on deposits continued to increase
            while
            market rates of interest, and thus the rates at which the retail operations
            are
            credited for their deposits, remained comparatively stable over the last
            four
            quarters.
 
 As
            our
            Retail Banking segment includes our banking centers, the majority of
            this
            segment’s income is received from selling funding sources, specifically deposits
            generated and serviced in the banking centers, to lending units in need
            of
            funding to support earning asset balances.  This income appears in the
            accompanying notes to our financial statements as “Treasury Income and Interest
            Income on Funding Sources” The line labeled “Funding
            Costs”  represents the expense paid by the users of these funds to
            support their earning asset balances.
 
 Relative
            to the second quarter of last year, the segment’s transferable funding sources
            (deposit balances) increased approximately $13.6 million, or 2%, totaling
            $674
            million at the quarter-end.  Combined with the movements in market
            rates of interest, at which these funds are transferred to our lending
            units,
            the Retail segment’s interest income from funding sources rose only $173,000, or
            2%, from its second quarter 2006 level.  Year-to-date results were
            slightly better, with income from funding sources rising $781,000, or
            more than
            4%, compared to the first half of 2006.  Other interest income for the
            segment, which consists of interest received on home equity, personal,
            and small
            business loans and lines, totaled $892,000 for the quarter, up $34,000
            from the
            same period last year.
 
 By
            comparison, the interest paid on deposits rose more than $1.1 million
            for the
            second quarter and $2.5 million for the first half of the year, as competition
            in the local marketplace continued to keep retail deposit rates
            high.  As a result, the segment’s net interest income declined
            $931,000 relative to the second quarter and $1.7 million compared to
            the first
            half of last year.
 
 Both
            noninterest income and noninterest expense for the segment were relatively
            little changed relative to the prior year.  Noninterest income
            declined $85,000 over the first half of the year, while noninterest expense
            increased $468,000, or approximately 7% over the first six months of
            2006.  The increase in operating expense was attributable to both
            growth among ordinary expenses, such as salary expense, which increases
            each
            year as a result of annual increases in staff salaries, as well as allocations
            of the unusual expenses incurred in the quarter, which were described
            in the
“Noninterest Expense” section.  These expenses, which were allocated
            to the various business segments, included $175,000 in legal and other
            fees
            related to the Washington Federal transaction, a $158,000 retention bonus
            to our
            CFO for remaining with the Bank past his
  -
                40
                -
 retirement
            date, $163,000 in expenditures for the payoff of a contract for an outside
            operations consultant, and a charitable contribution in the amount of
            $188,000.
 
 **Sales
            Finance**
 
 Quarter
                      Ended
                  
                  
                  Six
                      Months EndedNet
                      Income
                  
                  
                  Return
                      on Equity
                  
                  
                  Net
                      Income
                  
                  
                  Return
                      on EquityJune
                      30, 2005
                  
                  $
                  145,000
                  
                  
                  
                  10.42
                  %
                  
                  $
                  511,000
                  
                  
                  
                  20.27
                  %June
                      30, 2006
                  
                  $
                  232,000
                  
                  
                  
                  16.64
                  %
                  
                  $
                  622,000
                  
                  
                  
                  22.23
                  %June
                      30, 2007
                  
                  $
                  54,000
                  
                  
                  
                  3.88
                  %
                  
                  $
                  389,000
                  
                  
                  
                  14.25
                  %
 
 Net
            income for our Sales Finance segment declined $178,000, or approximately
            77%,
            from the level earned in the second quarter of 2006, and $233,000, or
            38%, from
            the level in the first half of last year, as significant increases in
            noninterest income, particularly gains on loan sales, were insufficient
            to
            offset a reduction in net interest income and increase in the loan loss
            provision.
 
 The
            Sales
            Finance segment’s quarter-end earning assets declined significantly relative to
            the prior year level because of a substantial increase in the level of
            loan
            sales relative to prior years.  Loan sales of more than $14 million in
            the second quarter and $30 million in the first half of this year exceeded
            the
            $10 million and $23 million sold in the same periods last year.  With
            these sales, and resulting decline in earning assets, the segment’s second
            quarter and year-to-date interest income fell 24% and 22% relative to
            the prior
            year.  While the lower level of earning assets also reduced the
            segment’s funding requirement, and consequently its interest expense, the 18%
            and 15% reductions for the second quarter and first half funding costs
            offset
            only a portion of the lost interest income.  As a result, the
            segment’s net interest income declined $288,000 and $599,000, or 30% and 31%
            from the second quarter and first half 2006 levels.  With the
            segment’s second quarter loan loss provision increasing $338,000 relative to
            the
            prior year, net interest income after the loan loss provision declined
            $626,000,
            or 62%.  On a year-to-date basis, net interest income after provision
            was down $1.1 million, or 54%.  The increase in the loan loss
            provision relative to the prior year was related to the insured loan
            pools for
            years 2002-2003 and 2003-2004 reaching their 10% coverage limits.  In
            relation to probable losses inherent in those pools, we have increased
            the
            segment’s loan loss provision.
 
 While
            the
            increased level of loan sales over the last five quarters has negatively
            impacted the segment’s net interest income, it has contributed to improvements
            in noninterest income, which rose $404,000 and $731,000 relative to the
            second
            quarter and first six months of last year.  The increase was
            attributable to additional gains on loan sales, which rose from $430,000
            and
            $1.2 million in the second quarter and first half of 2006 to $746,000
            and $1.7
            million this year, as well as service fee income, which increased from
            $298,000
            and $630,000 in 2006 to $431,000 and $892,000 this year.
 
 The
            segment’s noninterest expense remained well contained relative to the second
            quarter of last year, increasing $47,000 or approximately 3% compared
            to the
            second quarter of 2006, and only $11,000, or less than 1% on a year-to-date
            basis.  The modest rate of increase was partly attributable to a
            reduction in credit insurance premiums. As we stated in our 2006 year-end
            press
            release, after evaluating our use of credit insurance, we concluded that
            the
            benefits of the insurance no longer outweighed the costs and chose to
            forego the
            insurance and assume the credit risk on future sales finance loan
            production.  Consequently, it was our expectation that expenditures
            for credit insurance would decline in 2007.  Those loans insured prior
            to August 1,
  -
                41
                -
 2006
            remain insured under their existing policies, and some loans originated
            on or
            after August 1, 2006 were sold to institutional investors with insurance
            placed
            prior to sale and remain insured under the policy effective August 1,
            2006.
 
 **Residential
            Lending**
 
 Quarter
                      Ended
                  
                  
                  Six
                      Months EndedNet
                      Income
                  
                  
                  Return
                      on Equity
                  
                  
                  Net
                      Income
                  
                  
                  Return
                      on EquityJune
                      30, 2005
                  
                  $
                  777,000
                  
                  
                  
                  28.97
                  %
                  
                  $
                  1,423,000
                  
                  
                  
                  28.66
                  %June
                      30, 2006
                  
                  $
                  550,000
                  
                  
                  
                  19.61
                  %
                  
                  $
                  1,293,000
                  
                  
                  
                  23.27
                  %June
                      30, 2007
                  
                  $
                  661,000
                  
                  
                  
                  20.16
                  %
                  
                  $
                  1,432,000
                  
                  
                  
                  21.81
                  %
  The
            Residential Lending segment’s net income for the second quarter totaled
            $661,000, representing a 20% increase over the same period last year,
            based on a
            reduction in the segment’s provision for loan losses.  On a
            year-to-date basis, net income rose by nearly 11% as a result of a lower
            provision as well as modest improvements in net interest and noninterest
            income
            - - which were partly offset by higher noninterest expenses.
 
 While
            the
            Residential segment has been one of the largest contributors to our earning
            asset growth in recent years, the segment’s earning assets dropped relative to
            their level as of June 30, 2006, falling $11 million, or approximately
            3%, as a
            slowdown in residential lending resulted in a substantial reduction in
            both the
            number of loans originated and the portfolio balances. Based on the reduction
            in
            assets, and taking into account any repricing effects resulting from
            movements
            of interest rate indexes from which the loan rates are set, interest
            income
            earned on the portfolio declined nearly 4% relative to the second quarter
            of
            last year.  The segment’s funding costs and resulting net interest
            income also fell approximately 4% and 3% relative to the second quarter
            of
            2006.  For the year-to-date period, interest income, funding costs,
            and the resulting net interest income each rose by approximately
            1%.  The segment’s provision for loan loss declined $236,000 from the
            second quarter 2006 level based on recoveries of $198,000 in the second
            quarter
            and no new charged-off balances.
 
 For
            the
            quarter and six months ended June 30, 2007, the Residential Lending segment’s
            noninterest income rose $20,000 and $141,000, respectively, compared
            to the same
            periods last year, based largely on additional loan fee income and gains
            on loan
            sales.  Loan fee income increased relative to the prior year based on
            a higher level of fees collected in connection with loan modifications
            or
            extensions, and non-conversion of construction loans to permanent
            mortgages.  Gains on residential loan sales fluctuate from quarter to
            quarter, and typically result in modest gains or even slight losses when
            interest rates are rising quickly.  We believe the construction phase
            to be the most profitable facet of residential lending and the primary
            objective
            in a residential lending relationship.  Following the construction
            process, our practice is to retain in our portfolio those residential
            mortgages
            that we consider to be beneficial to the Bank, but to sell those that
            we
            consider less attractive assets.
 
 The
            Residential segment’s noninterest expense increased $21,000, or 2% for the
            quarter, and $131,000, or 6% through the first six months of the year,
            partially
            offsetting the quarter’s income growth over the same period last
            year.  A reduction in the amount of loan origination expenses eligible
            for deferral and amortization contributed significantly to the increase
            relative
            to last year.
 
 -
                42
                -
 In
            accordance with current accounting standards, certain loan origination
            costs,
            including some salary expenses tied to loan origination, are deferred
            and
            amortized over the life of each loan originated, rather than expensed
            in the
            current period.  Expenses are then reported in the financial
            statements net of these deferrals.  The amount of expense subject to
            deferral and amortization can vary from one period to the next based
            upon the
            number of loans originated, the mix of loan types, and year-to-year changes
            in
“standard loan costs”.   In this instance, both the number of
            loans originated by our Residential lending area in the first half of
            2007 as
            well as the deferred costs associated with each origination declined
            relative to
            the prior year.  This resulted in a higher level of expense being
            recognized in the current period.
 
 **Business
            Banking Lending**
 
 Quarter
                      Ended
                  
                  
                  Six
                      Months EndedNet
                      Income
                  
                  
                  Return
                      on Equity
                  
                  
                  Net
                      Income
                  
                  
                  Return
                      on EquityJune
                      30, 2005
                  
                  $
                  333,000
                  
                  
                  
                  17.78
                  %
                  
                  $
                  570,000
                  
                  
                  
                  16.09
                  %June
                      30, 2006
                  
                  $
                  283,000
                  
                  
                  
                  11.11
                  %
                  
                  $
                  439,000
                  
                  
                  
                  10.17
                  %June
                      30, 2007
                  
                  $
                  375,000
                  
                  
                  
                  11.14
                  %
                  
                  $
                  673,000
                  
                  
                  
                  10.77
                  %
  With
            earning assets totaling more than $162 million for the second quarter
            of 2007,
            an increase of 12% over the prior year level and the only asset growth
            among the
            lending segments, Business Banking’s interest income grew $608,000 and $1.2
            million, or 24% and 26% over the levels earned in the second quarter
            and first
            half of 2006.  Additionally, with deposit growth of nearly $26
            million, or approximately 64%, compared to June 30, 2006, income credited
            for
            funding sources rose $312,000 and $636,000 over the prior
            year.  Partially offsetting these improvements, however, were an
            additional $771,000 and $1.6 million in funding costs for the quarter
            and six
            months, respectively. Taking all of these into account, the Business
            Banking
            segment’s second quarter and six month net interest income after provision for
            loan losses rose $176,000 and $310,000, or 14% and 13%, over the same
            periods
            last year.
 
 For
            the
            quarter and six months ended June 30, 2007, the Business Banking segment’s
            noninterest income declined $171,000 and $154,000 relative to prior year
            levels.  This reduction was largely attributable to changes in the
            valuations of interest rate derivatives utilized by the segment to hedge
            interest rate risk on longer-term, fixed-rate commercial real estate
            loans.  These derivatives were structured such that a gain on any
            given derivative would be matched against a comparable loss on a second,
            corresponding derivative, resulting in minimal net impact to the Bank’s
            earnings.  Whereas changes in the values of these instruments
            contributed $50,000 to noninterest income in the first six months of
            the prior
            year, the impact through the first six months of 2007 was a reduction
            to
            noninterest income of approximately $105,000.  That loss was
            essentially matched by a $108,000 reduction in noninterest expense resulting
            from market value changes in corresponding derivatives.
 
 Taking
            into account the $158,000 reduction in noninterest expense attributable
            to the
            changes in derivative values, $50,000 in expense in 2006 versus a reduction
            of
            $108,000 in 2007, the segment’s noninterest expense declined $135,000 and
            $195,000 relative to the second quarter and first six months of
            2006.  Also worth noting is that under the new method of presenting
            our business segments, the business banking segment no longer faces significant
            increases in allocated overhead expenses as a result of deposit
            growth.  Under the previous method of segmenting our business lines,
            our banking centers were deemed to be overhead cost centers
  -
                43
                -
 rather
            than an operating segment, and consequently all income and expenses associated
            with the banking centers was allocated among the four lending
            units.  Consequently, the Business Banking segment’s deposit growth in
            prior years resulted in increasing allocations of banking center-related
            expense, which frequently negated the benefit of the additional
            deposits.  With the banking centers now included in the Retail Banking
            segment, the Business Banking and other lending segments are no longer
            subject
            to allocations of banking center expense.  Similarly, the lending
            segments no longer receive the benefit of funds generated by the banking
            centers
            at below-market rates of interest.  The segment results for 2005 and
            2006 have been restated to reflect this methodology consistently throughout
            the
            three years presented here.
 
 **Income
            Property Lending**
 
 Quarter
                      Ended
                  
                  
                  Six
                      Months EndedNet
                      Income
                  
                  
                  Return
                      on Equity
                  
                  
                  Net
                      Income
                  
                  
                  Return
                      on EquityJune
                      30, 2005
                  
                  $
                  1,346,000
                  
                  
                  
                  22.26
                  %
                  
                  $
                  2,759,000
                  
                  
                  
                  22.85
                  %June
                      30, 2006
                  
                  $
                  1,074,000
                  
                  
                  
                  19.74
                  %
                  
                  $
                  1,983,000
                  
                  
                  
                  18.40
                  %June
                      30, 2007
                  
                  $
                  990,000
                  
                  
                  
                  16.54
                  %
                  
                  $
                  2,235,000
                  
                  
                  
                  18.72
                  %
  The
            Income Property segment’s second quarter net income declined $84,000, or 8%
            relative to the same quarter last year, as growth in net interest income
            was
            more than offset by falling noninterest income and rising noninterest
            expense.  On a year-to-date basis, net income rose $252,000, or 13%,
            as the growth in net interest income was more than sufficient to offset
            the
            falling noninterest income and rising noninterest expense over that
            timeframe.
 
 Compared
            to the prior year, the segment’s net interest income after provision for loan
            loss grew $116,000 and $574,000, or 5% and 13%, for the quarter and six
            months
            ended June 30.  For the quarter, the improvement was the result of
            interest income from earning assets falling by a lesser amount than did
            interest
            expense on funding sources.  On a year-to-date basis, not only did the
            segment’s funding costs decline, but interest income actually increased by
            $100,000 relative to the first six months of last year.  The provision
            for loan loss declined $42,000 and $140,000 compared to the second quarter
            and
            first half of 2006, due in large part to a continued decline in portfolio
            balances.
 
 The
            Income Property segment’s decrease in earning assets during the first half of
            2007 continued a trend observed over the last couple of years, and is
            primarily
            a product of declining originations of permanent multifamily and commercial
            real
            estate loans, combined with a high level of prepayments on the loan portfolio,
            which we attribute to a combination of increased competition from other
            lenders
            and the flat yield curve.  Increased competition from conduit lenders
            as well as lenders in our local market accelerated both the drop in new
            volumes
            as well as portfolio payoffs, as the competition frequently resulted
            in lenders
            offering prospective borrowers new loan commitments, or existing borrowers
            the
            opportunity to refinance, at unusually low margins.  The flat yield
            curve, which has resulted from a number of increases in short-term interest
            rates, has reduced the rate differential between short- and long-term
            financing
            costs and provided a financial incentive for borrowers to select longer-term,
            fixed-rate loans as opposed to adjustable-rate financing.  As we have
            historically been an originator of short-term and adjustable-rate loans,
            this
            impacted us in two ways.  First, as prospective borrowers sought loans
            with terms that fell outside of our typical underwriting structures,
            our
            originations of permanent multifamily and commercial real estate loans
            declined.  Second, with the yield curve
  -
                44
                -
 providing
            borrowers with a financial incentive to refinance adjustable-rate loans,
            which
            make up the majority of our loan portfolio, with longer-term, fixed-rate
            debt,
            the prepayment rates on our Income Property portfolio remained at relatively
            high levels.
 
 Noninterest
            income for the Income Property segment declined $169,000 relative to
            both the
            second quarter and first half of last year, based on the combination
            of an
            unusual event last year and a negative impact from servicing asset write-offs
            this year.  In the second quarter of 2006, the segment recognized an
            unusually high level of noninterest income as a result of an allocation
            of
            insurance proceeds received from a key-man life insurance
            policy.  Additionally, the current quarter results were negatively
            impacted by the payoffs of loan participation balances sold to and serviced
            for
            other institutional investors.  As these loans were paid off, we were
            forced to immediately write-off the related servicing assets, which negatively
            impacted the quarter’s noninterest income.
 
 The
            segment’s noninterest expense increased modestly, rising $71,000 for the quarter
            and only $39,000 on a year-to-date basis compared to the same periods
            in
            2006.  As noted above, the Income Property segment has seen its
            earning asset balances decline over the last couple of years, and as
            a result,
            the segment has become a smaller component of our overall asset
            mix.  Consequently, for a number of different administrative and
            overhead expenses that we allocate out to the business segments, such
            as
            accounting and information systems related costs, the percentages allocated
            to
            other business lines has tended to increase, thus reducing the percentage
            allocated to the Income Property segment.
 
 **Investment
            and Treasury**
 
 Quarter
                      Ended
                  
                  
                  Six
                      Months EndedNet
                      Income/(Loss)
                  
                  
                  Return
                      on Equity
                  
                  
                  Net
                      Income
                  
                  
                  Return
                      on EquityJune
                      30, 2005
                  
                  $
                  264,000
                  
                  
                  
                  47.25
                  %
                  
                  $
                  524,000
                  
                  
                  
                  47.57
                  %June
                      30, 2006
                  
                  $
                  (103,000
                  )
                  
                  
                  (25.65
                  %)
                  
                  $
                  22,000
                  
                  
                  
                  2.47
                  %June
                      30, 2007
                  
                  $
                  (88,000
                  )
                  
                  
                  (25.23
                  %)
                  
                  $
                  72,000
                  
                  
                  
                  8.67
                  %
 
 The
            Investment and Treasury segment includes our investment securities portfolio
            on
            the asset side and, on the liability side, our FHLB advances and certificates
            of
            deposit issued through brokerage services.  While management does not
            consider this to be an operating business line, our security investments
            and
            wholesale borrowings represent a necessary part of liquidity management,
            and
            their impact on our operations has been recognized as its own segment
            so as not
            to distort the results of our other business lines.
 
 For
            the
            second quarter and first half of 2007, the segment posted net interest
            losses of
            $242,000 and $415,000, compared to a loss of $136,000 in the second quarter
            and
            net interest income of $74,000 for the first six months of last
            year.  In the past, the cost of funding the securities portfolio
            exceeded its yield, while the FHLB advances and brokered deposits originated
            by
            the segment were “sold” to the lending units at rates exceeding the cost of
            those funding sources.  In the second quarter of 2007, however, the
            securities portfolio moved into a profitable position, though not sufficiently
            so to achieve profitability on a year-to-date basis, while the funding
            sources
            became modestly unprofitable, resulting in the net interest loss.
 
 Noninterest
            income for the segment, which had been virtually nonexistent prior to
            this year,
            totaled $132,000 and $563,000 for the second quarter and first six months
            of
            2007, largely as a
  -
                45
                -
 result
            of
            our early adoption of SFAS 157 and 159, effective January 1, 2007. SFAS
            159,
            which was issued in February 2007, generally permits the mark-to-market
            of
            selected eligible financial instruments.  In the case of our early
            adoption, SFAS 159-related gains on affected instruments totaled $236,000
            through the first six months of the year.  Additionally, we recognized
            $116,000 in gains on securities sales during the second quarter.
 
 The
            segment’s noninterest expense is virtually immaterial, totaling $33,000 for the
            second quarter and $56,000 for the first half of 2007, both comparable
            to the
            prior year levels, and represents allocations of accounting and administrative
            overhead costs associated with the management of the portfolio.
 
 **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, and to a
            lesser
            extent, purchases of facilities and equipment.
 
 Quarter
                      Ended June 30,
                  
                  
                  Six
                      Months Ended June 30,2007
                  
                  
                  2006
                  
                  
                  2007
                  
                  
                  2006(Dollars
                      in thousands)Loan
                      Originations (disbursed)
                  
                  $
                  (128,000
                  )
                  
                  $
                  (158,000
                  )
                  
                  $
                  (223,000
                  )
                  
                  $
                  (280,000
                  )Increase/(Decrease)
                      in Undisbursed Loan Proceeds
                  
                  
                  0
                  
                  
                  
                  3,000
                  
                  
                  
                  (17,000
                  )
                  
                  
                  (2,000
                  )Security
                      Purchases
                  
                  
                  (37,000
                  )
                  
                  
                  0
                  
                  
                  
                  (42,000
                  )
                  
                  
                  (7,000
                  )Total
                      Originations and Purchases
                  
                  $
                  (165,000
                  )
                  
                  $
                  (155,000
                  )
                  
                  $
                  (282,000
                  )
                  
                  $
                  (289,000
                  )Loan
                      and Security Repayments
                  
                  $
                  101,000
                  
                  
                  $
                  105,000
                  
                  
                  $
                  206,000
                  
                  
                  $
                  217,000Sales
                      of Securities
                  
                  
                  59,000
                  
                  
                  
                  0
                  
                  
                  
                  58,000
                  
                  
                  
                  0Sales
                      of Loans
                  
                  
                  39,000
                  
                  
                  
                  28,000
                  
                  
                  
                  66,000
                  
                  
                  
                  51,000Total
                      Repayments and Sales
                  
                  $
                  199,000
                  
                  
                  $
                  133,000
                  
                  
                  $
                  330,000
                  
                  
                  $
                  268,000Net
                      Difference
                  
                  $
                  34,000
                  
                  
                  $
                  (22,000
                  )
                  
                  $
                  48,000
                  
                  
                  $
                  (21,000
                  )
 
 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 36% in
            the first half of 2007, comparable to the 38% and 39% rates observed
            for the
            first half of 2006 and fiscal year 2006, respectively.
 
 We
            believe the flat-to-inverted shape of the yield curve that has persisted
            since
            mid-2005 to the present time likely contributed to the continued high
            level of
            prepayments, as the rate differential between short- and long-term financing
            diminished and reduced the financial incentive for borrowers to use
            shorter-term, adjustable-rate financing rather than longer-term fixed
            rate
            loans.
  -
                46
                -
 This,
            in
            turn, provides borrowers holding short-term or adjustable-rate loans,
            which
            represent the majority of our loan portfolio, with an incentive to refinance
            with long-term fixed-rate loans.
 
 Our
            preferred method of funding the net difference between originations/purchases
            and repayments/sales is with deposits. To the extent that deposit growth
            is
            insufficient to fully fund the difference, we may rely on wholesale funding
            sources including, but not limited to FHLB advances, brokered certificates
            of
            deposit, and reverse repurchase agreements. During the second quarters
            and first
            halves of 2006 and 2007, changes in funds from deposits and borrowings
            were as
            follows:
 
 Quarter
                      Ended June 30,
                  
                  
                  Six
                      Months Ended June 30,2007
                  
                  
                  2006
                  
                  
                  2007
                  
                  
                  2006Deposits
                  
                  $
                  (12,000
                  )
                  
                  $
                  (23,000
                  )
                  
                  $
                  (46,000
                  )
                  
                  $
                  (37,600
                  )Borrowings
                  
                  
                  (15,000
                  )
                  
                  
                  41,000
                  
                  
                  
                  (8,000
                  )
                  
                  
                  23,000Total
                  
                  $
                  (27,000
                  )
                  
                  $
                  18,000
                  
                  
                  $
                  (54,000
                  )
                  
                  $
                  23,000
 
 Through
            the first half of the year, our total deposit balances fell $46 million,
            or
            approximately 6% from their year-end level, including $12 million in
            the second
            quarter. Non-maturity deposit balances, however, rose nearly $17 million,
            with
            $5 million occurring in the second quarter. Time deposits, including
            certificates issued through brokerage services, declined nearly $63 million,
            with a $17 million decrease occurring in the most recent
            quarter.  Brokered and other institutional certificates of deposit
            accounted for approximately $39 million of the year-to-date
            reduction.
 
 The
            inflows and outflows of deposits vary 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. The most utilized wholesale funding
            source
            is FHLB advances, which totaled $163 million at the end of the second
            quarter,
            down slightly from $172 million at the 2006 year-end. Our credit line
            with the
            FHLB is reviewed annually, and our maximum allowable borrowing level
            is
            currently set at 40% of assets, or $412 million based on assets as of
            June 30,
            2007. As a percentage of quarter-end assets, our FHLB borrowings totaled
            approximately 16% at both June 30, 2007 as well as the 2006 year-end.
            Potential
            risks associated with this funding source include the reduction or non-renewal
            of the line and insufficient collateral to utilize the line. We attempt
            to
            mitigate the risk of non-renewal by maintaining the credit quality of
            our loans
            and securities and attending to the quality and consistency of our
            earnings.
 
 The
            potential risk of not holding enough collateral to fully utilize our
            available
            FHLB advances is monitored to ensure that ample collateral is available
            to meet
            our funding needs. Our two principal sources of preferred collateral
            are
            single-family residential and multifamily loans. Because single-family
            lending
            has exhibited significant growth in recent years, we are encouraged that
            this
            business line will be able to provide sufficient collateral to meet our
            FHLB
            borrowing requirements.
 
 -
                47
                -
 Brokered
            deposits, which are included in the deposit totals, amounted to $14 million
            as
            of June 30, 2007, compared to $47 million as of the 2006
            year-end.  While the rates on these deposits are typically very
            comparable to those of FHLB advances, at various times in late 2005 and
            throughout 2006, the rates on brokered deposits fell below those of similar
            term
            FHLB advances.  At such times, and subject to our funding needs, we
            elected to increase our use of this funding source and routinely issued
            brokered
            deposits to replace maturing FHLB advances.  As of June 30, 2007,
            brokered deposits represented 1.8% of total deposits compared to 5.9%
            at the
            2006 year-end. Our internal policy limits restrict our total usage of
            brokered
            certificates to no more than 10% of total deposits.
 
 Reverse
            repurchase lines are lines of credit collateralized by securities. We
            currently
            have lines totaling $35 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
            the 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, we consider to be a consistent
            source
            based upon our earnings. On a very limited basis it can be viewed as
            cash from
            operations adjusted for items such as 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 second quarter and first half of 2007
            we
            invested $226,000 and $817,000 in these assets, down from $1.3 million
            and $2.7
            million in the same periods in 2006, as most of our major capital projects
            were
            completed by the end of last year.
  **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, 2007, we exceeded the capital levels required to
            meet the definition of a well-capitalized institution:
 
 -
                48
                -
 Actual
                  Minimum
                      for
                    Capital
                    Adequacy
                      Purposes
                  Minimum
                      to be
                    Categorized
                      as “Well
                    Capitalized”
                      Under
                    Prompt
                      Corrective
                    Action
                      ProvisionsTotal
                    capital (to risk-weighted assets):First
                    Mutual Bancshares, Inc.
                  12.65%
                  8.00%
                  N/AFirst
                    Mutual Bank
                  12.92
                  8.00
                  10.00%Tier
                    I capital (to risk-weighted assets):First
                    Mutual Bancshares, Inc.
                  11.40
                  4.00
                  N/AFirst
                    Mutual Bank
                  11.67
                  4.00
                  6.00Tier
                    I capital (to average assets):First
                    Mutual Bancshares, Inc.
                  8.76
                  4.00
                  N/AFirst
                      Mutual Bank
                  8.97
                  4.00
                  5.00
 
 **SUBSEQUENT
            EVENTS**
 
 **Merger
            with Washington Federal**
 On
            July
            2, 2007 we announced the signing of a definitive merger agreement. The
            merger
            agreement calls for the merger of First Mutual with and into the Company,
            followed by the merger of First Mutual Bank into the Company’s wholly owned
            subsidiary, Washington Federal Savings, in a stock and cash transaction
            valued
            at approximately $189.8 million. After consummation of the merger, the
            combined
            Company will have 148 offices in eight western states with total assets
            of
            approximately $11 billion and total deposits of approximately $6.8
            billion.
 
 **Securities**
 Based
            on
            our observations of the portfolio and hedge over the course of the quarter,
            we
            elected to further reduce the size of the portfolio and unwind the hedge
            position.  Consequently, in early July we sold securities with market
            values totaling approximately $41 million and unwound the hedge position.
            Our
            net losses from those activities totaled $213,000.  At the present
            time, we do not anticipate conducting any further securities
            transactions.
 
 **Trust
            Preferred
            Securities**
 In
            June
            of 2002, we issued our first Trust Preferred Security (TPS) in the amount
            of $9
            million with an interest rate adjustable on a quarterly basis.  At the
            same time, we entered into an interest rate swap with the FHLB in order
            to
            protect against potential adverse interest rate volatility from the TPS
            by
            fixing the interest rate payable for the first five years of the TPS’
life.  The swap matured in July of this year, resulting in a funding
            cost subject to adjustment on a quarterly basis at 3.65% over the current
            three-month LIBOR rate.
 
 As
            margins on current TPS issues have declined to approximately 1.35% to
            1.65% over
            three-month LIBOR, we had previously expressed an intention to call the
            outstanding $9 million TPS at the earliest contractual redemption date,
            in this
            case September 2007, and replace the issue with a new TPS at a lower
            margin.  We have since,  in consideration of the pending
            merger with Washington Federal Inc., elected instead to call the outstanding
            $9
            million TPS without replacement.  However, because we issued a
            commitment to replace the redeemed TPS we were required to pay a cancellation
            fee of $55,000.
 
 -
                49
                -
 Even
            with
            the retirement and non-replacement of the TPS, we expect to remain “well
            capitalized” in accordance with regulatory guidelines.
  ITEM
            3. Quantitative and
            Qualitative Disclosures About Market Risk
 
 Market
            risk is defined as the sensitivity of income and capital to changes in
            interest
            rates, and other relevant market rates or prices.  Our profitability
            is largely dependent on our net interest income.  Consequently, our
            primary exposure to market risk arises from the interest rate risk inherent
            in
            our lending, mortgage banking, deposit, and borrowing
            activities.  Interest rate risk is the risk to earnings and capital
            resulting from adverse movements in interest rates.  To that end, we
            actively monitor and manage our exposure to interest rate risk.
 
 A
            number
            of measures are utilized to monitor and manage interest rate risk, including
            net
            interest income and economic value of equity simulation models, as well
            as
            traditional “gap” models.  We prepare these models on a quarterly
            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.
 
 -
                50
                -
 **Hedging
            Techniques**
 
 We
            review
            interest rate trends on a monthly basis and employ hedging techniques
            where
            appropriate.  These techniques may include financial futures, options
            on financial futures, interest rate caps and floors, interest rate swaps,
            and
            extended commitments on future lending activities.
 
 Typically,
            the extent of our off-balance-sheet derivative agreements has been the
            use of
            forward loan commitments, which are used to hedge our loans
            held-for-sale.  Additionally, in 2002 we entered into an interest rate
            swap with the FHLB.  The purpose of the swap was to protect against
            potential adverse interest rate volatility that could be realized from
            the Trust
            Preferred Securities (TPS) issued in June 2002.  The swap accomplished
            this by fixing the interest rate payable for the first five years of
            the TPS’
life, and matured in June of this year.
 
 In
            the
            second quarter of 2006, we began to utilize interest rate swaps in connection
            with the underwriting of longer-term, fixed-rate commercial real estate
            loans.  This decision was the result of prospective borrowers’ demand
            for longer-term, fixed-rate loans, and the preference of depositors for
            instruments of significantly shorter terms.  Under this program, we
            originated commercial mortgage loans with amortization schedules of up
            to thirty
            years and initial ten-year fixed rates.  To hedge the interest rate
            risk exposure presented by ten-year, fixed-rate instruments, we utilized
            interest rate swaps on a loan-by-loan basis to convert each loan’s fixed rate to
            an adjustable rate subject to regular repricing relative to a market
            index rate,
            typically the one-month LIBOR rate.  Only a few of these interest rate
            swaps were originated, and we do not consider the notional principal
            of the
            swaps, which totals less than $5 million, to be material relative to
            the size of
            our commercial loan portfolio.  Additionally, the swaps originated
            under this program were used solely for the purpose of managing the interest
            rate risk associated with longer-term, fixed-rate assets, and not for
            any
            speculative purposes.
 
 Finally,
            in the first quarter of this year, we elected early adoption of SFAS
            157 and 159
            with respect to the majority of our securities portfolio, the previously
            mentioned TPS, and selected other financial
            instruments.  Consequently, these assets and liabilities would be
            reflected on our statements of condition at their fair values, with any
            changes
            in market value over the course of a period recognized as income or losses
            in
            the current period’s operating results. In the first week of May, based on the
            earnings volatility presented by the new accounting treatment, we elected
            to
            reduce the volatility of the securities portfolio by reselling some recently
            purchased securities in the secondary market and utilizing interest rate
            swaps
            with notional principal totaling $42 million to partially hedge against
            movements in the market value of the remaining trading
            portfolio.  Based on our observations of the portfolio and hedge over
            the remainder of the quarter, we elected to further reduce the size of
            the
            portfolio and unwind the hedge position.  Consequently, in early July
            we sold additional securities with market values totaling approximately
            $40
            million and unwound the hedge position.
 
 **Net
            Interest Income (NII) and Economic Value of Equity (EVE) Simulation Model
            Results**
 
 **June
                      30, 2007**
                  
                  **December
                      31, 2006****Percentage
                      Change**
                  
                  **Percentage
                      Change****Change
                      in**
                    **Interest
                      Rates**
                  
                  **Net
                      Interest**
                  **Economic
                      Value**
                  
                  **Net
                      Interest**
                  **Economic
                      Value****(in
                      basis points)**
                  
                  **Income**
                  **of
                      Equity**
                  
                  **Income**
                  **of
                      Equity**+200
                  
                  1.32%
                  1.08%
                  
                  2.40%
                  (1.07%)+100
                  
                  n/a
                  1.31%
                  
                  n/a
                  0.06%-100
                  
                  n/a
                  (1.69%)
                  
                  n/a
                  (0.88%)-200
                  
                  0.60%
                  (5.46%)
                  
                  0.23%
                  (3.76%)
 
 -
                51
                -
 **Net
            Interest Income Simulation**
 
 Our
            income simulation model based on information as of June 30, 2007 indicated
            that
            our net interest income over the following twelve months was projected
            to
            increase from its “base case” level in scenarios in which interest rates were
            assumed to either gradually increase or decline by 200 bps over a twelve-month
            period.  The magnitudes of the changes, however, suggest that there is
            little sensitivity in net interest income from the “base case” level over a
            twelve-month horizon in either scenario, as an increase in net interest
            income
            of 1.32% was observed in the rising rate environment and an improvement
            of 0.60%
            was indicated in the falling rate scenario.
 
 The
            changes indicated by the simulation model represent variances from a
“base case”
scenario, which is a projection of net interest income assuming interest
            rates
            remain unchanged from their current levels over the life of the forecast,
            and
            that the size of the balance sheet remains stable over the forecast timeframe,
            with no growth or contraction regardless of interest rate
            movements.  The base model will, however, illustrate the future
            effects of rate changes that have already occurred but have not yet flowed
            through to all the assets and liabilities on our balance sheet.  These
            changes can either increase or decrease net interest income, depending
            on the
            timing and magnitudes of those changes.  Additionally, the tendencies
            for loan and investment prepayments to accelerate in falling interest
            rate
            scenarios and slow when interest rates rise have been incorporated into
            the
            model assumptions.  Implicit in these assumptions are additional
            assumptions for increased securities purchases and loan originations
            at lower
            interest rate levels to offset accelerated prepayments, and conversely,
            reduced
            securities purchases and loan production when rates increase and prepayments
            slow.
 
 The
            rising and falling rate ramp scenarios then indicate that if the slope
            of the
            yield curve remains the same, and customer loan and deposit preferences
            do not
            change in response to further movements of the yield curve, then a parallel
            200
            basis point increase or decrease in rates will not significantly change
            net
            interest income from what is presently expected in the “base
            case.”  In the event the simulation model indicated that the increase
            or decrease in interest rates over the following twelve months would
            adversely
            affect our net interest income over the same period by more than 10%
            relative to
            the “base case” scenario, we would consider the indicated risk to have exceeded
            our internal policy limit.
 
 **Economic
            Value of Equity (EVE) Simulation**
 
 The
            EVE
            analysis goes beyond simulating net interest income for a specified period
            to
            estimating the present value of all financial instruments in our portfolio
            and
            then analyzing how the economic value of the portfolio would be affected
            by
            various alternative interest rate scenarios.  The portfolio’s economic
            value is calculated by generating principal and interest cash flows for
            the
            entire life of all assets and liabilities, then discounting these cash
            flows
            back to their present values.  The assumed discount rate used for each
            projected cash flow is based on a current market rate, such as a LIBOR,
            FHLB, or
            swap curve rate, and from alternative instruments of comparable risk
            and
            duration.  In the event the simulation model demonstrates that a 200
            basis point increase or decrease in rates would adversely affect our
            EVE by more
            than 25%, we consider the indicated risk to have exceeded our internal
            policy
            limit.  Again, as illustrated in the above results, we are operating
            within the 25% internal policy limit in all scenarios.
 
 -
                52
                -
 In
            the
            simulated 200 bps upward shift of the yield curve, the discount rates
            used to
            calculate the present values of assets and liabilities will increase,
            causing
            the present values of both assets and liabilities to fall, with more
            prominent
            effects on longer-term, fixed-rate instruments.  Additionally, when
            interest rates rise, the cash flows on our assets are typically expected
            to
            decelerate as borrowers are assumed to become less likely to prepay their
            loans.  As the cash flows on these assets are shifted further into the
            future, their present values are further reduced.  Our EVE simulation
            model results as of June 30, 2007 indicated that our liabilities would
            be
            expected to exhibit a greater level of sensitivity to rising rates than
            assets,
            with the economic value of assets declining by 2.36%, compared to a decline
            of
            2.83% for our liabilities.  Given the greater sensitivity of
            liabilities, the reduction in the economic value of liabilities exceeded
            the
            impact on assets.  Consequently, the economic value of our equity was
            positively impacted in this scenario, rising 1.08%.
 
 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 on assets, however, is the tendency for cash flows from assets
            to
            accelerate in a falling rate scenario, as borrowers refinance their existing
            loans at lower interest rates.  These loan prepayments prevent the
            economic values of these assets from increasing in a declining rate scenario,
            illustrating an effect referred to as negative convexity.  Taking this
            negative convexity into account, the simulation results indicated a negative
            impact to EVE in the falling rate scenario.  In this case, the
            economic values of both assets and liabilities were positively impacted
            when
            rates were assumed to fall by 200 bps, assets by 1.84% and liabilities
            by
            2.84%.  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 5.46%.
 
 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.
 
 **One-Year
            Interest Rate Sensitivity Gap**
 
 **June
                      30, 2007**
                  
                  
                  **December
                      31, 2006**(Dollars
                      in thousands)One-Year
                      Repricing/Maturing Assets
                  
                  $
                  623,534
                  
                  
                  $
                  673,514One-Year
                      Repricing/Maturing Liabilities
                  
                  
                  664,410
                  
                  
                  
                  725,636One-Year
                      Gap
                  
                  $
                  (40,876
                  )
                  
                  $
                  (52,122
                  )Total
                      Assets
                  
                  $
                  1,029,030
                  
                  
                  $
                  1,079,272One-Year
                      Interest Rate Gap as a Percentage of Assets
                  
                  
                  (4.0
                  %)
                  
                  
                  (4.8
                  %)
  -
                53
                -
 At
            a
            negative, or liability sensitive, 4.0% of assets, our twelve-month interest
            rate
            sensitivity gap as of June 30, 2007 indicated a modest degree of liability
            sensitivity comparable to the 4.8% observed at the 2006
            year-end.  Certain shortcomings are inherent in gap analysis,
            including the failure to recognize differences in the frequencies and
            magnitudes
            of repricing for different balance sheet instruments.  Additionally,
            some assets and liabilities may have similar maturities or repricing
            characteristics, but they may react differently to changes in interest
            rates.  This illustrates a facet of interest rate exposure referred to
            as “basis risk.”  Assets, such as adjustable-rate mortgage loans, may
            also have features that limit the effect that changes in interest rates
            have on
            the asset in the short-term and/or over the life of the loan, for example
            a
            limit on the amount by which the interest rate on the loan is allowed
            to adjust
            each year.  This illustrates another area of interest rate exposure
            referred to as “option risk.”  Due to the limitations of the gap
            analysis, these features are not taken into
            consideration.  Additionally, in the event of a change in interest
            rates, prepayment and early withdrawal penalties could deviate significantly
            from those assumed in the gap calculation.   As a result, we
            utilize the gap report as a complement to our income simulation and economic
            value of equity models.
 
 **Securities**
 
 **ITEM
                3**
  The
                following table sets forth certain information regarding carrying
                values and
                percentage of total carrying values of the Bank’s consolidated portfolio
                of securities classified as available-for-sale and
                held-to-maturity.
 June
                          30,2007
                      
                      
                      2006**Available-for-Sale:**
                      
                      Carrying
                          Value
                      
                      
                      Percent
                          of Total
                      
                      
                      Carrying
                          Value
                      
                      
                      Percent
                          of Total(Dollars
                          in thousands)US
                          Government treasury and agency obligations
                      
                      $
                      —
                      
                      
                      
                      0
                      %
                      
                      $
                      10,611
                      
                      
                      
                      11
                      %Mortgage-backed
                          securities:Freddie
                          Mac
                      
                      
                      472
                      
                      
                      
                      11
                      %
                      
                      
                      14,847
                      
                      
                      
                      15
                      %Ginnie
                          Mae
                      
                      
                      2,588
                      
                      
                      
                      62
                      %
                      
                      
                      37,871
                      
                      
                      
                      39
                      %Fannie
                          Mae
                      
                      
                      1,121
                      
                      
                      
                      27
                      %
                      
                      
                      33,810
                      
                      
                      
                      35
                      %Total
                          mortgage-backed securities
                      
                      
                      4,181
                      
                      
                      
                      100
                      %
                      
                      
                      86,528
                      
                      
                      
                      89
                      %**Total
                          securities available-for-sale**
                      
                      **$**
                      **4,181**
                      
                      
                      ****
                      **100**
                      **%**
                      
                      **$**
                      **97,139**
                      
                      
                      ****
                      **100**
                      **%**
   June
                          30,2007
                      
                      
                      2006**Held-to-Maturity:**
                      
                      Carrying
                          Value
                      
                      
                      Percent
                          of Total
                      
                      
                      Carrying
                          Value
                      
                      
                      Percent
                          of Total(Dollars
                          in thousands)Municipal
                          bonds
                      
                      $
                      4,136
                      
                      
                      
                      53
                      %
                      
                      $
                      1,166
                      
                      
                      
                      19
                      %Mortgage-backed
                          securities:Freddie
                          Mac
                      
                      
                      96
                      
                      
                      
                      1
                      %
                      
                      
                      325
                      
                      
                      
                      5
                      %Fannie
                          Mae
                      
                      
                      3,660
                      
                      
                      
                      46
                      %
                      
                      
                      4,662
                      
                      
                      
                      76
                      %Total
                          mortgage-backed securities
                      
                      
                      3,756
                      
                      
                      
                      47
                      %
                      
                      
                      4,987
                      
                      
                      
                      81
                      %**Total
                          securities held-to-maturity**
                      
                      **$**
                      **7,892**
                      
                      
                      ****
                      **100**
                      **%**
                      
                      **$**
                      **6,153**
                      
                      
                      ****
                      **100**
                      **%****Estimated
                          market value**
                      
                      **$**
                      **7,819**
                      
                      
                      
                      
                      
                      
                      **$**
                      **6,032**
  -
                  54
                  -
 **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:
 
 Available-for-sale
                          at June 30, 2007One
                          Year
                        or
                          Less
                      
                      
                      Over
                          One to
                        ThreeYears
                      
                      
                      Over
                          Three to
                        FiveYears
                      
                      
                      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:**
                      
                      (Dollars
                          in thousands)Mortgage-backed
                          securities:Ginnie
                          Mae
                      
                      $
                      2,588
                      
                      
                      
                      3.87
                      %
                      
                      $
                      —
                      
                      
                      
                      0.00
                      %
                      
                      $
                      —
                      
                      
                      
                      0.00
                      %
                      
                      $
                      —
                      
                      
                      
                      0.00
                      %
                      
                      $
                      —
                      
                      
                      
                      0.00
                      %
                      
                      $
                      —
                      
                      
                      
                      0.00
                      %
                      
                      $
                      2,588
                      
                      
                      
                      3.87
                      %Freddie
                          Mac
                      
                      
                      216
                      
                      
                      
                      7.13
                      %
                      
                      
                      256
                      
                      
                      
                      5.50
                      %
                      
                      
                      —
                      
                      
                      
                      0.00
                      %
                      
                      
                      —
                      
                      
                      
                      0.00
                      %
                      
                      
                      —
                      
                      
                      
                      0.00
                      %
                      
                      
                      —
                      
                      
                      
                      0.00
                      %
                      
                      
                      472
                      
                      
                      
                      6.24
                      %Fannie
                          Mae
                      
                      
                      197
                      
                      
                      
                      7.20
                      %
                      
                      
                      239
                      
                      
                      
                      5.50
                      %
                      
                      
                      —
                      
                      
                      
                      0.00
                      %
                      
                      
                      —
                      
                      
                      
                      0.00
                      %
                      
                      
                      685
                      
                      
                      
                      4.50
                      %
                      
                      
                      —
                      
                      
                      
                      0.00
                      %
                      
                      
                      1,121
                      
                      
                      
                      5.19
                      %Total
                          mortgage-backed securities
                      
                      
                      3,001
                      
                      
                      
                      4.32
                      %
                      
                      
                      495
                      
                      
                      
                      5.50
                      %
                      
                      
                      —
                      
                      
                      
                      0.00
                      %
                      
                      
                      —
                      
                      
                      
                      0.00
                      %
                      
                      
                      685
                      
                      
                      
                      4.50
                      %
                      
                      
                      —
                      
                      
                      
                      0.00
                      %
                      
                      
                      4,181
                      
                      
                      
                      4.49
                      %Total
                          securities available-for-sale -- Carrying Value
                      
                      $
                      3,001
                      
                      
                      
                      4.32
                      %
                      
                      $
                      495
                      
                      
                      
                      5.50
                      %
                      
                      $
                      —
                      
                      
                      
                      0.00
                      %
                      
                      $
                      —
                      
                      
                      
                      0.00
                      %
                      
                      $
                      685
                      
                      
                      
                      4.50
                      %
                      
                      $
                      —
                      
                      
                      
                      0.00
                      %
                      
                      $
                      4,181
                      
                      
                      
                      4.49
                      %Total
                          securities available-for-sale -- Amortized Cost
                      
                      $
                      2,996
                      
                      
                      
                      4.32
                      %
                      
                      $
                      489
                      
                      
                      
                      5.50
                      %
                      
                      $
                      —
                      
                      
                      
                      0.00
                      %
                      
                      $
                      —
                      
                      
                      
                      0.00
                      %
                      
                      $
                      717
                      
                      
                      
                      4.50
                      %
                      
                      $
                      —
                      
                      
                      
                      0.00
                      %
                      
                      $
                      4,202
                      
                      
                      
                      4.49
                      %
  Held-to-Maturity
                          at June 30, 2007One
                          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:**
                      
                      (Dollars
                          in thousands)Municipal
                          bonds
                      
                      $
                      —
                      
                      
                      
                      0.00
                      %
                      
                      $
                      —
                      
                      
                      
                      0.00
                      %
                      
                      $
                      —
                      
                      
                      
                      0.00
                      %
                      
                      $
                      —
                      
                      
                      
                      0.00
                      %
                      
                      $
                      3,220
                      
                      
                      
                      5.14
                      %
                      
                      $
                      916
                      
                      
                      
                      6.31
                      %
                      
                      $
                      4,136
                      
                      
                      
                      5.40
                      %Mortgage-backed
                          securities:Freddie
                          Mac
                      
                      
                      96
                      
                      
                      
                      7.38
                      %
                      
                      
                      —
                      
                      
                      
                      0.00
                      %
                      
                      
                      —
                      
                      
                      
                      0.00
                      %
                      
                      
                      —
                      
                      
                      
                      0.00
                      %
                      
                      
                      —
                      
                      
                      
                      0.00
                      %
                      
                      
                      —
                      
                      
                      
                      0.00
                      %
                      
                      
                      96
                      
                      
                      
                      7.38
                      %Fannie
                          Mae
                      
                      
                      1,053
                      
                      
                      
                      7.53
                      %
                      
                      
                      1,260
                      
                      
                      
                      4.75
                      %
                      
                      
                      —
                      
                      
                      
                      0.00
                      %
                      
                      
                      —
                      
                      
                      
                      0.00
                      %
                      
                      
                      1,347
                      
                      
                      
                      4.77
                      %
                      
                      
                      —
                      
                      
                      
                      0.00
                      %
                      
                      
                      3,660
                      
                      
                      
                      5.55
                      %Total
                          mortgage-backed securities
                      
                      
                      1,149
                      
                      
                      
                      7.52
                      %
                      
                      
                      1,260
                      
                      
                      
                      4.75
                      %
                      
                      
                      —
                      
                      
                      
                      0.00
                      %
                      
                      
                      —
                      
                      
                      
                      0.00
                      %
                      
                      
                      1,347
                      
                      
                      
                      4.77
                      %
                      
                      
                      —
                      
                      
                      
                      0.00
                      %
                      
                      
                      3,756
                      
                      
                      
                      5.60
                      %Total
                          securities held-to-maturity -- Carrying Value
                      
                      $
                      1,149
                      
                      
                      
                      7.52
                      %
                      
                      $
                      1,260
                      
                      
                      
                      4.75
                      %
                      
                      $
                      —
                      
                      
                      
                      0.00
                      %
                      
                      $
                      —
                      
                      
                      
                      0.00
                      %
                      
                      $
                      4,567
                      
                      
                      
                      5.03
                      %
                      
                      $
                      916
                      
                      
                      
                      6.31
                      %
                      
                      $
                      7,892
                      
                      
                      
                      5.50
                      %Total
                          securities held-to-maturity -- Fair Market Value
                      
                      $
                      1,162
                      
                      
                      
                      7.52
                      %
                      
                      $
                      1,248
                      
                      
                      
                      4.78
                      %
                      
                      $
                      —
                      
                      
                      
                      0.00
                      %
                      
                      $
                      —
                      
                      
                      
                      0.00
                      %
                      
                      $
                      4,500
                      
                      
                      
                      5.04
                      %
                      
                      $
                      909
                      
                      
                      
                      6.32
                      %
                      
                      $
                      7,819
                      
                      
                      
                      5.51
                      %
 
 -
                55
                -
 ITEM
            4. Controls and
            Procedures
 
 An
            evaluation of the Company’s disclosure controls and procedures (as defined in
            Rules 13a-15(e) of the Securities Exchange Act of 1934 (the “Act”)) was carried
            out under the supervision and with the participation of the Company’s Chief
            Executive Officer, Chief Financial Officer, and other members of the
            Company’s
            senior management, as of the end of the period covered by this report
            (the
“Evaluation Date”).  Based upon this evaluation, the Company’s Chief
            Executive Officer and Chief Financial Officer concluded that, as of the
            Evaluation Date, the Company’s disclosure controls and procedures are effective
            in providing reasonable assurance that the material information required
            to be
            disclosed by the Company in the reports it files or submits under the
            Act is (i)
            accumulated and communicated to the Company’s management (including the
            Company’s Chief Executive Officer and Chief Financial Officer) in a timely
            manner, and (ii) recorded, processed, summarized, and reported within
            the time
            periods specified in the SEC’s rules and forms.
 
 
 **PART
            II: OTHER
            INFORMATION**
 
 ITEM
            1. Legal
            Proceedings
 
 At
            June
            30, 2007, the Company was not engaged in any litigation, which in the
            opinion of
            management, after consultation with its legal counsel, would be material
            to the
            Company.
  ITEM
            1A. Risk
            Factors
 
 For
            information regarding certain Risk Factors, please refer to Part I, Item
            1A, in
            the Company’s Annual Report on Form 10-K for the year ended December 31,
            2006.
 
 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 26, 2007.  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  III
                        DIRECTORS**
                    **VOTES
                        FOR**
                    **VOTES
                        WITHHELD**
                    **TERM**Mary
                        Case Dunnam
                    6,471,614
                    79,444
                    3
                        YearsGeorge
                        W. Rowley, Jr.
                    6,471,618
                    79,440
                    3
                        YearsJohn
                        R. Valaas
                    6,446,628
                    104,430
                    3
                        Years
 The
            terms
            of the Class I and II directors expire at the Annual Meeting of Shareholders
            for
            2008 and 2009, respectively.
 
 CLASS
            I DIRECTORS, term expires in 2008
 
 Janine
            Florence
 F.
            Kemper
            Freeman, Jr.
 Robert
            J.
            Herbold
 Victor
            E.
            Parker
 
 CLASS
            II DIRECTORS, term expires in 2009
 
 James
            J.
            Doud Jr.
 Richard
            S. Sprague
 Robert
            C.
            Wallace
 
 ITEM
            5. Other
            Information
 
 None.
 
 -
                56
                -
 ITEM
            6. Exhibits
 
 (2.0)
                  Agreement
                      and Plan of Merger Between Washington Federal, Inc. and First
                      MutualBancshares,
                      Inc., incorporated by reference on Form 8-K filed with the
                      SEC on July 3,2007.
 
 (3.1)
                  Amended
                      and Restated Articles of Incorporation, incorporated by reference
                      onForm
                      10-Q filed with the SEC on August 8,
                      2005.
 
 (3.3)
                  Bylaws
                      (as amended and restated), incorporated by reference on Form
                      8-K filed
                      withthe
                      SEC on July 5, 2006.
 
 (11)
                  Statement
                      regarding computation of per share earnings.  Reference is made
                      to theCompany’s
                      Consolidated Statements of Income attached hereto as part of
                      Item
                      IFinancial
                      Statements, which are incorporated herein by
                      reference.
 
 (31.1)
                  Certification
                      by President and Chief Executive Officer pursuant to Section
                      302 of
                      theSarbanes-Oxley
                      Act of 2002.
 
 (31.2)
                  Certification
                      by Executive Vice President and Chief Financial Officer pursuant
                      to
                      Section302
                      of the Sarbanes-Oxley Act of 2002.
 
 (32)
                  Certification
                      by Chief Executive Officer and Chief Financial Officer pursuant
                      toSection
                      906 of the Sarbanes-Oxley Act of
                      2002.
 
 
   
 -
                57
                -
 **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 9,
                      2007
                  By:
                  /s/ John
                    R. ValaasJohn
                    R. ValaasPresident
                    and Chief Executive
                    Officer  By:
                    /s/ Roger
                      A. ManderyRoger
                        A. ManderyExecutive
                        Vice President
                      (Principal
                        Financial Officer)
   -
                  58
                  -