**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................................................September
                      30,
                      2006
  **OR**
 o
                  **Transition
                      Report Pursuant to Section 13 or 15(d) of****The
                      Securities Exchange Act of 1934**
 For
                          the transition period from ________________ to ________________
 Commission
        File Number 005-57091
   **FIRST
        MUTUAL BANCSHARES, INC.**
 (Exact
        name of registrant as specified in its charter)
   WASHINGTON
              
              91-2005970(State
                  or other jurisdiction of
              
              (I.R.S.
                  Employer Identification Number)incorporationor
                  organization)
  
 400
        108th Avenue N.E., Bellevue, WA 98004
 (Address
        of principal executive offices) (Zip code)
   Registrant’s
        telephone
        number, including area code:   (425)
        455-7300
   Indicate
        by check mark whether the registrant (1) has filed all reports
        required  to
        be
        filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
        the preceding
        12 months (or for such shorter period that the registrant was  required
        to file such reports), and (2) has been subject to such filing
        requirements  for
        the
        past 90 days.
  Yes
x     No
o
  Indicate
        by check mark whether the registrant is a large accelerated filer, an
        accelerated  filer,
        or
        a non-accelerated filer. See definition of “accelerated
        filer
        and large accelerated filer”
        in Rule 12b-2 of
        the Exchange Act).
  Large accelerated filer o
              Accelerated filer x
              Non-accelerated filer o
  Indicate
        by check mark whether the registrant is a shell company (as defined in Rule 12b-2
        of
        the Exchange Act).
  Yes
oNo
x
  Indicate
        the number of shares outstanding of each of the issuer’s classes of common
        stock, as
        of the
        latest practicable
        date. November 1,
        2006  6,671,511


FIRST
        MUTUAL BANCSHARES, INC.
 
 QUARTERLY
        REPORT ON FORM 10-Q
 September
        30, 2006
 
 TABLE
        OF
        CONTENTS
  PagePART
                  I:  FINANCIAL INFORMATION
              1Forward-Looking
                  Statements Disclaimer
              1ITEM
                  1. Financial Statements
              2ITEM
                  2. Management’s Discussion and Analysis of Financial Condition
                  andResults
                  of Operations
              19General
              19Overview
              19Results
                  of Operations
              21Net
                  Income
              21Net
                  Interest Income
              21Noninterest
                  Income
              24Noninterest
                  Expense
              28Financial
                  Condition
              33Asset
                  Quality
              37Portfolio
                  Information
              38Deposit
                  Information
              42Business
                  Segments
              42Consumer
                  Lending
              43Residential
                  Lending
              44Business
                  Banking Lending
              46Income
                  Property Lending
              47Liquidity
              48Capital
              51Subsequent
                  Events
              52ITEM
                  3. Quantitative and Qualitative Disclosures About Market
                  Risk
              53ITEM
                  4. Controls and Procedures
              60PART
                  II:  OTHER INFORMATION
              60ITEM
                  1. Legal Proceedings
              60ITEM
                  1A. Risk Factors
              60ITEM
                  2. Unregistered Sales of Equity Securities and Use of
                  Proceeds
              60ITEM
                  3. Defaults Upon Senior Securities
              60ITEM
                  4. Submission of Matters to a Vote of Security Holders
              61ITEM
                  5. Other Information
              61ITEM
                  6. Exhibits
              61SIGNATURES
              62CERTIFICATIONS
  -i-


**PART
          I :**  **FINANCIAL
          INFORMATION**
 
 **FORWARD-LOOKING
          STATEMENTS DISCLAIMER**
 
 Our
          Form
          10-Q for the quarter ended September 30, 2006, contains statements concerning
          forecasts of our financial results and condition, expectations of our operations
          and business and our assumptions for those forecasts and expectations that
          are
          forward-looking statements for the purposes of the safe harbor provisions
          under
          the Private Securities Litigation Reform Act of 1995. Such forward-looking
          statements include statements regarding our forecasts and expectations
          with
          respect to our target net income and return on equity; as well as references
          to
          potential changes in interest rate margins, anticipated changes in our
          loan
          portfolio and growth or reductions in sales of loans and securities,
          expectations regarding our Business Banking segment and other segments,
          observations regarding our loan collections and provision for loan losses,
          expectations regarding our stock option, marketing and public relations
          expenses
          and our gain on sale of consumer loans and information based on our market
          risk
          models and analysis. Although we believe that the expectations expressed
          in
          these forward-looking statements are based on reasonable assumptions within
          the
          bounds of our knowledge of our business, operations, and prospects, these
          forward-looking statements are subject to numerous uncertainties and risks,
          and
          actual events, results, and developments will ultimately differ from the
          expectations and may differ materially from those expressed or implied
          in such
          forward-looking statements. Factors which could affect actual results include
          economic conditions in our market area and the nation as a whole, interest
          rate
          fluctuations, the impact of competitive products, services, and pricing,
          our
          credit risk management, our ability to control our costs and expenses,
          loan
          delinquency rates, and the legislative and regulatory changes affecting
          the
          banking industry. There are other risks and uncertainties that could affect
          us
          which are discussed from time to time in our filings with the Securities
          and
          Exchange Commission. These risks and uncertainties should be considered
          in
          evaluating the forward-looking statements, and undue reliance should not
          be
          placed on such statements. We are not responsible for updating any such
          forward-looking statements.
  ITEM
                  1.
                Financial
                    Statements
 
 In
          the
          opinion of management, the accompanying consolidated statements of financial
          condition and related interim consolidated statements of income, comprehensive
          income, stockholders’ equity and cash flows reflect all adjustments (which
          include reclassifications and normal recurring adjustments) that are necessary
          for a fair presentation in conformity with accounting principles generally
          accepted in the United States of America (“GAAP”). The preparation of financial
          statements in conformity with GAAP requires management to make estimates
          and
          assumptions that affect amounts reported in the financial statements. Changes
          in
          these estimates and assumptions are considered reasonably possible and
          may have
          a material impact on the financial statements.
 
 Certain
          reclassifications have been made to the 2005 financial statements to conform
          to
          the 2006 presentation. There is no effect on net income, earnings per share,
          or
          equity. All significant intercompany transactions and balances have been
          eliminated.
 The
            information included in this Form 10-Q should be read in conjunction
            with the
            First Mutual Bancshares, Inc. Year 2005 Annual Report on Form 10-K to
            the
            Securities and Exchange Commission. Interim results are not necessarily
            indicative of results for a full year.
 
 Consolidated
            Financial Statements of the Company begin on page 2.
 1




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




September
                30,
            
            December
                31,2006
            
            2005**Assets**
            
            (Unaudited)Cash
                and cash equivalents:Interest-earning
                deposits
            
            $
            1,964,047
            
            $
            1,229,176Noninterest-earning
                demand deposits and cash on hand
            
            
            12,417,206
            
            
            24,551,436Total
                cash and cash equivalents
            
            
            14,381,253
            
            
            25,780,612Mortgage-backed
                and other securities available-for-sale
            
            
            93,675,270
            
            
            114,450,342Mortgage-backed
                and other securities held-to-maturityfair
                value of $5,688,890 and $6,970,890
            
            
            5,733,277
            
            
            6,966,295Loans
                held for sale
            
            
            11,411,335
            
            
            14,683,507Loans
                receivable
            
            
            918,453,400
            
            
            878,066,241Reserve
                for loan and lease losses
            
            
            (10,027,767
            )
            
            (10,069,020
            )Loans
                receivable, net
            
            
            908,425,633
            
            
            867,997,221Accrued
                interest receivable
            
            
            5,730,670
            
            
            5,350,493Land,
                buildings and equipment, net
            
            
            35,317,706
            
            
            33,483,998Federal
                Home Loan Bank (FHLB) stock, at cost
            
            
            13,122,300
            
            
            13,122,300Servicing
                assets
            
            
            3,294,649
            
            
            1,865,698Other
                assets
            
            
            2,844,857
            
            
            2,464,369**Total
                Assets**
            
            $
            1,093,936,950
            
            $
            1,086,164,835


See
        Notes
        to the Financial Statements




2




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


September
                30,
            
            December
                31,2006
            
            2005(Unaudited)**Liabilities**Deposits:Money
                market deposit and checking accounts
            
            $
            277,995,695
            
            $
            263,444,641Savings
            
            
            6,971,783
            
            
            8,053,510Time
                deposits
            
            
            489,946,525
            
            
            489,222,486Total
                deposits
            
            
            774,914,003
            
            
            760,720,637Drafts
                payable
            
            
            988,487
            
            
            733,773Accounts
                payable and other liabilities
            
            
            8,171,411
            
            
            15,706,624Advance
                payments by borrowers for taxes and insurance
            
            
            3,017,677
            
            
            1,671,496FHLB
                advances
            
            
            217,698,265
            
            
            225,705,005Other
                advances
            
            
            4,600,000
            
            
            4,600,000Junior
                subordinated long-term debentures
            
            
            17,000,000
            
            
            17,000,000Total
                liabilities
            
            
            1,026,389,843
            
            
            1,026,137,535**Stockholders’
                Equity**Common
                stock (1), $1 par value, 30,000,000 shares authorized,6,670,269
                and 6,621,013 shares issued and outstanding
            
            $
            6,670,269
            
            $
            6,621,013Additional
                paid-in capital (1)
            
            
            44,880,131
            
            
            43,964,588Retained
                earnings
            
            
            17,641,805
            
            
            10,877,529Accumulated
                other comprehensive income(loss):Unrealized
                (loss) on securities available-for-saleand
                interest rate swap, net of federal income tax
            
            
            (1,645,098
            )
            
            (1,435,830
            )Total
                stockholders’ equity
            
            
            67,547,107
            
            
            60,027,300**Total
                Liabilities and Stockholders’ Equity**
            
            $
            1,093,936,950
            
            $
            1,086,164,835




(1)
              The
                  number and amount of common shares outstanding at December 31,
                  2005 has
                  been adjusted to show the effect of
                  the five-for-four stock split paid October 4,
                  2006.




See
        Notes
        to the Financial Statements


3




**FIRST
        MUTUAL BANCSHARES, INC.**
 **CONSOLIDATED
        STATEMENTS OF INCOME**


Quarter
                ended September 30,
            
            Nine
                  months endedSeptember
                  30,2006
            
            2005
            
            2006
            
            2005(Unaudited)**Interest
                Income**Loans
                receivable
            
            $
            19,680,961
            
            $
            15,759,340
            
            $
            55,745,902
            
            $
            44,514,943Interest
                on available-for-sale securities
            
            
            1,031,712
            
            
            1,209,921
            
            
            3,313,251
            
            
            3,747,565Interest
                on held-to-maturity securities
            
            
            84,677
            
            
            97,635
            
            
            261,784
            
            
            294,294Interest
                other
            
            
            160,884
            
            
            97,020
            
            
            410,645
            
            
            292,757Total
                interest income
            
            
            20,958,234
            
            
            17,163,916
            
            
            59,731,582
            
            
            48,849,559**Interest
                Expense**Deposits
            
            
            6,909,960
            
            
            4,913,080
            
            
            19,273,338
            
            
            12,738,459FHLB
                and other advances
            
            
            3,866,238
            
            
            2,234,239
            
            
            10,020,244
            
            
            6,467,518Total
                interest expense
            
            
            10,776,198
            
            
            7,147,319
            
            
            29,293,582
            
            
            19,205,977Net
                interest income
            
            
            10,182,036
            
            
            10,016,597
            
            
            30,438,000
            
            
            29,643,582Provision
                for loan and lease losses
            
            
            267,250
            
            
            325,000
            
            
            473,087
            
            
            1,175,000Net
                interest income, after provisionfor
                loan and lease losses
            
            
            9,914,786
            
            
            9,691,597
            
            
            29,964,913
            
            
            28,468,582**Noninterest
                Income**Gain
                on sales of loans
            
            
            914,845
            
            
            173,394
            
            
            2,225,495
            
            
            1,117,887Servicing
                fees, net of amortization
            
            
            297,561
            
            
            317,988
            
            
            932,329
            
            
            1,013,541Fees
                on deposits
            
            
            181,827
            
            
            166,343
            
            
            557,433
            
            
            472,232Other
            
            
            915,867
            
            
            454,135
            
            
            2,367,306
            
            
            1,449,866Total
                noninterest income
            
            
            2,310,100
            
            
            1,111,860
            
            
            6,082,563
            
            
            4,053,526


See
        Notes
        to the Financial Statements




4
 **FIRST
          MUTUAL BANCSHARES, INC.**
 **CONSOLIDATED
            STATEMENTS OF INCOME**
 (Continued)
 Quarter
                        ended September 30,
                    
                    Nine
                          months endedSeptember
                          30,2006
                    
                    2005
                    
                    2006
                    
                    2005(Unaudited)**Noninterest
                        Expense**Salaries
                        and employee benefits
                    
                    $
                    4,351,391
                    
                    $
                    3,738,866
                    
                    $
                    13,274,632
                    
                    $
                    12,017,046Occupancy
                    
                    
                    1,038,005
                    
                    
                    851,397
                    
                    
                    3,090,835
                    
                    
                    2,483,684Other
                    
                    
                    2,310,122
                    
                    
                    2,043,631
                    
                    
                    6,857,266
                    
                    
                    6,138,971Total
                        noninterest expense
                    
                    
                    7,699,518
                    
                    
                    6,633,894
                    
                    
                    23,222,733
                    
                    
                    20,639,701Income
                        before provision for federal income tax
                    
                    
                    4,525,368
                    
                    
                    4,169,563
                    
                    
                    12,824,743
                    
                    
                    11,882,407Provision
                        for federal income tax
                    
                    
                    1,524,630
                    
                    
                    1,440,202
                    
                    
                    4,398,196
                    
                    
                    4,051,441**Net
                        Income**
                    
                    $
                    3,000,738
                    
                    $
                    2,729,361
                    
                    $
                    8,426,547
                    
                    $
                    7,830,966**Per
                        Share Data(2):**Basic
                        earnings per common share
                    
                    $
                    0.45
                    
                    $
                    0.41
                    
                    $
                    1.27
                    
                    $
                    1.18Diluted
                        earnings per common share
                    
                    $
                    0.43
                    
                    $
                    0.39
                    
                    $
                    1.23
                    
                    $
                    1.13**Weighted
                        Average Number of Shares Outstanding**
                    
                    
                    6,655,307
                    
                    
                    6,688,416
                    
                    
                    6,642,156
                    
                    
                    6,654,804**Weighted
                        Average Number of Shares Outstanding****Including
                        Dilutive Stock Options**
                    
                    
                    6,850,441
                    
                    
                    6,967,296
                    
                    
                    6,825,598
                    
                    
                    6,950,374
  (2)
                      Per
                          share and weighted average shares outstanding for all periods
                          presented
                          has 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**
 AccumulatedAdditional
                  
                  
                  
                  ComprehensiveCommon
                      Stock (3)
                  
                  Paid-in
                  
                  Retained
                  
                  IncomeShares
                  
                  Amount
                  
                  Capital
                      (3)
                  
                  Earnings
                  
                  (Loss)
                  
                  TotalBALANCE,
                      December 31, 2003
                  
                  
                  5,912,116
                  
                  $
                  5,912,116
                  
                  $
                  32,495,758
                  
                  $
                  12,832,652
                  
                  $
                  (413,770
                  )
                  $
                  50,826,756Comprehensive
                      income:Net
                      income
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  9,287,813
                  
                  
                  
                  
                  
                  9,287,813Other
                      comprehensive income (loss), net of tax:Unrealized
                      (loss) on securities available-for-sale
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (414,879
                  )
                  
                  (414,879
                  )Unrealized
                      gain on interest rate swap
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  171,664
                  
                  
                  171,664Total
                      comprehensive income
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  9,044,598Options
                      exercised, including tax benefit of $337,052
                  
                  
                  100,871
                  
                  
                  100,871
                  
                  
                  1,118,129
                  
                  
                  
                  
                  
                  
                  
                  
                  1,219,000Issuance
                      of stock through employees’ stock plans
                  
                  
                  2,524
                  
                  
                  2,524
                  
                  
                  47,487
                  
                  
                  
                  
                  
                  
                  
                  
                  50,01110%
                      stock dividend
                  
                  
                  595,100
                  
                  
                  595,100
                  
                  
                  10,611,823
                  
                  
                  (11,206,923
                  )
                  
                  
                  
                  
                  —Cash
                      dividend declared ($0.32 per share)
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (1,693,092
                  )
                  
                  
                  
                  
                  (1,693,092
                  )BALANCE,
                      December 31, 2004
                  
                  
                  6,610,611
                  
                  $
                  6,610,611
                  
                  $
                  44,273,197
                  
                  $
                  9,220,450
                  
                  $
                  (656,985
                  )
                  $
                  59,447,273Comprehensive
                      income:Net
                      income
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  10,318,649
                  
                  
                  
                  
                  
                  10,318,649Other
                      comprehensive income (loss), net of tax:Unrealized
                      (loss) on securities available-for-sale
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (945,014
                  )
                  
                  (945,014
                  )Unrealized
                      gain on interest rate swap
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  166,169
                  
                  
                  166,169Total
                      comprehensive income
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  9,539,804Options
                      exercised, including tax benefit of $478,492
                  
                  
                  185,639
                  
                  
                  185,639
                  
                  
                  1,726,469
                  
                  
                  
                  
                  
                  
                  
                  
                  1,912,108Retirement
                      of shares repurchased
                  
                  
                  (180,045
                  )
                  
                  (180,045
                  )
                  
                  (2,130,266
                  )
                  
                  (1,343,882
                  )
                  
                  
                  
                  
                  (3,654,193
                  )Issuance
                      of stock through employees’ stock plans
                  
                  
                  4,808
                  
                  
                  4,808
                  
                  
                  95,188
                  
                  
                  
                  
                  
                  
                  
                  
                  99,996Cash
                      dividend declared ($1.38 per share)
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (7,317,688
                  )
                  
                  
                  
                  
                  (7,317,688
                  )BALANCE,
                      December 31, 2005
                  
                  
                  6,621,013
                  
                  $
                  6,621,013
                  
                  $
                  43,964,588
                  
                  $
                  10,877,529
                  
                  $
                  (1,435,830
                  )
                  $
                  60,027,300Comprehensive
                      income:Net
                      income
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  8,426,547
                  
                  
                  
                  
                  
                  8,426,547Other
                      comprehensive income (loss), net of tax:Unrealized
                      (loss) on securities available-for-sale
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (209,268
                  )
                  
                  (209,268
                  )Total
                      comprehensive income
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  8,217,279Compensation
                      related to stock options
                  
                  
                  
                  
                  
                  
                  
                  
                  435,227
                  
                  
                  
                  
                  
                  
                  
                  
                  435,227Options
                      exercised, including tax benefit of $102,290
                  
                  
                  44,436
                  
                  
                  44,436
                  
                  
                  385,150
                  
                  
                  
                  
                  
                  
                  
                  
                  429,586Issuance
                      of stock through employees’ stock plans
                  
                  
                  4,820
                  
                  
                  4,820
                  
                  
                  95,166
                  
                  
                  
                  
                  
                  
                  
                  
                  99,986Cash
                      dividend declared ($0.29 per share)
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (1,662,271
                  )
                  
                  
                  
                  
                  (1,662,271
                  )BALANCE,
                      September 30, 2006
                  
                  
                  6,670,269
                  
                  $
                  6,670,269
                  
                  $
                  44,880,131
                  
                  $
                  17,641,805
                  
                  $
                  (1,645,098
                  )
                  $
                  67,547,107
  (3)
                    The
                        number and amount of common shares issued and outstanding
                        for 2003, 2004,
                        2005 and 2006 has been
                        adjusted to show the effect of the five-for-four stock split
                        paid October
                        4, 2006.
  See
              Notes
              to the Financial Statements
 6
  **FIRST
              MUTUAL BANCSHARES, INC.**
 **CONSOLIDATED
              STATEMENTS OF CASH FLOWS**
 Nine
                      months ended September 30,2006
                  
                  2005(Unaudited)**Cash
                      Flows from Operating Activities**Net
                      income
                  
                  $
                  8,426,547
                  
                  $
                  7,830,966Adjustments
                      to reconcile net income to net cash from operating
                      activities:Provision
                      for loan and lease losses
                  
                  
                  473,087
                  
                  
                  1,175,000Depreciation
                      and amortization
                  
                  
                  1,483,129
                  
                  
                  1,202,468Deferred
                      loan origination fees, net of accretion
                  
                  
                  719,620
                  
                  
                  (123,477
                  )Amortization
                      of servicing assets
                  
                  
                  974,804
                  
                  
                  701,935Gain
                      on sales of loans
                  
                  
                  (2,225,495
                  )
                  
                  (1,117,887
                  )Loss
                      on sale of repossessed real estate and other assets
                  
                  
                  329
                  
                  
                  —FHLB
                      stock dividends
                  
                  
                  —
                  
                  
                  (52,900
                  )Stock
                      based compensation
                  
                  
                  435,227
                  
                  
                  —Excess
                      tax benefit from stock-based compensation
                  
                  
                  (102,290
                  )
                  
                  —Changes
                      in operating assets and liabilities:Loans
                      held-for-sale
                  
                  
                  3,272,172
                  
                  
                  (11,265,365
                  )Accrued
                      interest receivable
                  
                  
                  (380,177
                  )
                  
                  (762,348
                  )Other
                      assets
                  
                  
                  (912,207
                  )
                  
                  (228,485
                  )Drafts
                      payable
                  
                  
                  254,714
                  
                  
                  603,726Federal
                      and state income tax refunds
                  
                  
                  497,372
                  
                  
                  —Accounts
                      payable and other liabilities
                  
                  
                  (2,276,950
                  )
                  
                  (3,675,720
                  )Advance
                      payments by borrowers for taxes and insurance
                  
                  
                  1,346,181
                  
                  
                  1,572,897Net
                      cash provided (used)  by operating activities
                  
                  
                  11,986,063
                  
                  
                  (4,139,190
                  )**Cash
                      Flows from Investing Activities**Loan
                      originations
                  
                  
                  (314,543,865
                  )
                  
                  (349,582,133
                  )Loan
                      principal repayments
                  
                  
                  287,904,359
                  
                  
                  273,768,006Increase
                      (decrease) in undisbursed loan proceeds
                  
                  
                  (15,311,091
                  )
                  
                  32,592,214Principal
                      repayments and redemptions on mortgage-backedand
                      other securities
                  
                  
                  29,001,887
                  
                  
                  15,351,545Purchase
                      of securities held-to-maturity
                  
                  
                  —
                  
                  
                  (1,015,435
                  )Purchase
                      of securities available-for-sale
                  
                  
                  (7,170,095
                  )
                  
                  (5,188,637
                  )Purchases
                      of premises and equipment
                  
                  
                  (3,436,630
                  )
                  
                  (5,893,796
                  )Purchase
                      of FHLB stock
                  
                  
                  —
                  
                  
                  (150,700
                  )Proceeds
                      from sale of impaired loan
                  
                  
                  340,000
                  
                  
                  —Net
                      cash (used) by investing activities
                  
                  
                  (23,215,435
                  )
                  
                  (40,118,936
                  )
 See
              Notes
              to the Financial Statements
  7
  **FIRST
              MUTUAL BANCSHARES, INC.**
 **CONSOLIDATED
              STATEMENTS OF CASH FLOWS**
 (Continued)
 Nine
                      months ended September 30,2006
                  
                  2005*(Unaudited)***Cash
                      Flows from Financing Activities**Net
                      increase (decrease) in deposit accounts
                  
                  $
                  (3,410,142
                  )
                  $
                  40,166,530Interest
                      credited to deposit accounts
                  
                  
                  17,603,508
                  
                  
                  11,967,856Issuance
                      of stock through employees’ stock plans
                  
                  
                  99,986
                  
                  
                  99,996Proceeds
                      from advances
                  
                  
                  704,244,000
                  
                  
                  825,760,500Repayment
                      of advances
                  
                  
                  (712,250,740
                  )
                  
                  (824,211,263
                  )Dividends
                      paid
                  
                  
                  (6,886,185
                  )
                  
                  (1,434,025
                  )Proceeds
                      from exercise of stock options and excess taxbenefit
                      of $102,290 from stock-based compensation
                  
                  
                  429,586
                  
                  
                  640,687Net
                      cash provided (used) by financing activities
                  
                  
                  (169,987
                  )
                  
                  52,990,281**Increase/(decrease)
                      in cash and cash equivalents**
                  
                  $
                  (11,399,359
                  )
                  $
                  8,732,155Cash
                      and cash equivalents, beginning of the year
                  
                  
                  25,780,612
                  
                  
                  13,845,441Cash
                      and cash equivalents, September 30, 2006
                  
                  $
                  14,381,253
                  
                  $
                  22,577,596**Supplemental
                      Disclosures of Cash Flow Information**Loans
                      originated for sale in the secondary market
                  
                  $
                  85,145,559
                  
                  $
                  56,578,281Loans
                      originated for investment activities
                  
                  
                  314,543,865
                  
                  
                  349,582,133Proceeds
                      from sale of loans held-for-sale
                  
                  
                  88,417,731
                  
                  
                  45,312,916Cash
                      paid during the year for:Interest
                  
                  
                  28,541,940
                  
                  
                  19,182,790Income
                      taxes
                  
                  
                  3,860,000
                  
                  
                  2,987,000
  See
              Notes
              to the Financial Statements
  8
 **NOTES
              TO CONSOLIDATED FINANCIAL STATEMENTS**
 **(Unaudited)**
  **Note
              1.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**
 
 The
              results of operations for the interim periods shown in this report
              are not
              necessarily indicative of results to be expected for the fiscal year.  In
              the opinion of management, the information contained herein reflects
              all
              adjustments necessary to make the results of operations for the interim
              periods
              a fair statement of such operations. Accordingly, these statements
              should be
              read in conjunction with the Bank’s
              December 31,
              2005 Annual Report on Form 10-K.
  **Note
              2.  STOCK-BASED COMPENSATION**
  We
              adopted Statement of Financial Accounting Standards (SFAS) Number 123(R),
              Share-Based Payment (SFAS No.123 (R)), on January 1, 2006 using the
              modified prospective method. Under this method, awards that are granted,
              modified, or settled after December 31, 2005, are measured and accounted
              for in
              accordance with SFAS No.123(R). Also under this method, expense is
              recognized
              for unvested awards that were granted prior to January 1, 2006, based
              upon the
              fair value determined at the grant date under SFAS No. 123, Accounting for
              Stock-Based Compensation (SFAS No. 123). Prior to adoption of SFAS No.
              123(R), we accounted for stock compensation under the intrinsic value
              method
              permitted by Accounting Principles Board Opinion No. 25, Accounting for Stock
              Issued to Employees (APB No. 25) and related interpretations. Accordingly,
              we previously recognized no compensation cost to employee stock options
              that
              were granted with an exercise price equal to the market value of the
              underlying
              common stock on the date of grant.
  The
              following table illustrates the effect on net income and earnings per
              share if
              we had applied the fair value recognition provisions of SFAS No. 123(R)
              in
              2005.
 Three
                      Months
                      Ended
                        September
                      30,
                        2005
                    
                    Nine
                      Months
                      Ended
                        September
                      30,
                        2005Net
                        Income, as reported
                    
                    $
                    2,729,361
                    
                    $
                    7,830,966Deduct:
                        Total stock-based employee compensationdetermination
                        under fair value based method for all
                      awards,
                        net of related tax effects (1)
                    
                    
                    (101,963
                    )
                    
                    (314,211
                    )Pro
                        forma net income
                    
                    $
                    2,627,398
                    
                    $
                    7,516,755Earnings
                        per share:Basic
                        - as reported
                    
                    $
                    0.41
                    
                    $
                    1.18Basic
                        - pro forma
                    
                    $
                    0.39
                    
                    $
                    1.13Diluted
                        - as reported
                    
                    $
                    0.39
                    
                    $
                    1.13Diluted
                        - pro forma
                    
                    $
                    0.38
                    
                    $
                    1.09
  (1)
                      A
                          Black- Scholes option pricing model was used to determine
                          the fair value
                          of the options granted.
 As
              a
              result of adopting SFAS 123(R) on January 1, 2006, income before taxes
              and net
              income for the quarter ended September 30, 2006 are $175,000 and $116,000
              lower,
              respectively, than if we had continued to account for share-based compensation
              under APB No. 25. The impact on income before tax and net income for the
              first nine months of 2006 were $435,000 and $286,000 lower, respectively. 
Basic and diluted earnings per share for the quarter ended September
              30, 2006
              would have been $0.47 and $0.45, respectively, if we had not adopted
              SFAS
              123(R), compared to reported basic and diluted earnings per share of
              $0.45 and
              $0.43, respectively.  Year-to-date basic and diluted earnings per share for
              the first nine months of 2006 would have been $1.31 and $1.27, respectively
              had
              we not adopted SFAS 123(R).  Prior to adopting SFAS 123(R), we presented
              all tax benefits of deductions resulting from the exercise of stock
              options as
              operating cash flows in the Consolidated Statements of Cash Flows. SFAS
              123(R) requires the cash flows resulting from the tax benefits resulting
              from
              tax deductions in excess of the compensation cost recognized for those
              options
              (excess tax benefits) to be classified as financing cash flows. The
              $102,290
              excess tax benefit classified as a financing cash flow would have been
              classified as an operating cash inflow if we had not adopted SFAS
              123(R).
  Compensation
              cost is recorded as if each vesting portion of the award is a separate
              award. Share-based compensation expense recognized for stock options was
              $175,000 for the three months ended September 30, 2006 and $435,000
              for the
              first three quarters of 2006. The total related income tax benefit
              recognized
              was $27,000 for the third quarter of 2006 and $64,000 for the nine
              months ended
              September 30, 2006.
  Stock
              Option Plans
  9
 We
              have
              stock option plans for directors and employees. Options have a term
              of six,
              seven or ten years and are granted at fair market value on the grant
              date. The
              Compensation and Stock Option Committee determine vesting during their
              term, and
              the right to exercise may be cumulative. At September 30, 2006, 649,541
              shares
              of common stock, adjusted for stock dividends, were available for grant
              under
              the plan. A total of 400,158 shares are currently exercisable at September
              30,
              2006.
  The
              following table presents the activity related to options under all
              plans for the
              nine months ended September 30, 2006:
  Options
                    
                    Weighted-
                      Average
                      Exercise
                      Price
                    
                    Weighted-
                      Average
                      Remaining
                      Term
                        (in years)
                    
                    Aggregate
                      Intrinsic
                      ValueOptions
                        Outstanding at January 1, 2006
                    
                    
                    698,255
                    
                    $
                    13.78Granted
                    
                    
                    150,317
                    
                    
                    21.39Exercised
                    
                    
                    (45,066
                    )
                    
                    7.26Forfeited
                    
                    
                    (31,864
                    )
                    
                    19.75Outstanding
                        at September 30, 2006
                    
                    
                    771,642
                    
                    
                    15.39
                    
                    
                    5.5
                    
                    $
                    5,035,769Exercisable
                        at September 30, 2006
                    
                    
                    400,158
                    
                    $
                    11.30
                    
                    
                    4.6
                    
                    $
                    4,249,037
  One
              hundred twenty-eight thousand options were granted during the three
              months ended
              September 30, 2006. For the first nine months of the year 150,000 options
              were
              granted. There were no options granted during the third quarter of
              2005 and
              147,000 options granted in the first nine months of 2005. The total
              intrinsic
              value (amount by which fair value of the underlying stock exceeds the
              exercise
              price of an option on exercise date) of options exercised during the
              three and
              nine months ended September 30, 2006 were $300,000 and $626,000, respecively.
              The like amounts for both periods in 2005 were $209,000 and
              $958,000.
  We
              have
              estimated the fair value of all stock option awards as of the date
              of the grant
              by applying a Black-Scholes pricing valuation model. The weighted-average
              assumptions for options issued during the three months ended September
              30, 2006
              are as follows:
  Non-Qualified
                        Plans
                    
                    Incentive
                        PlansExpected
                        Price Volatility
                    
                    
                    18.1
                    %
                    
                    19.3
                    %Risk-Free
                        Interest Rate
                    
                    
                    4.8
                    %
                    
                    4.8
                    %Dividend
                        Yield
                    
                    
                    1.4
                    %
                    
                    1.4
                    %Expected
                        Life in Years
                    
                    
                    4.8
                    
                    
                    4.9
  The
              expected price volatility was based on the historical volatility of
              the stock
              price, the risk-free interest rate was based on US Treasury Constant
              Maturity
              yields for periods similar to the expected life of the options, the
              dividend
              yield was based on current cash dividend yields and the expected life
              was based
              on historical data.
  Cash
              received from options exercised for the three and nine months ended
              September
              30, 2006 totaled $187,000 and $327,000, respectively. Cash received
              from options
              exercised for the three and nine months ended September 30, 2005 totaled
              $138,000 and $641,000, respectively.  We issue new shares to satisfy option
              exercises.
  A
              summary
              of the status of unvested shares and changes during the nine months
              ended
              September 30, 2006 is presented below:
  Shares
                    
                    Weighted-Average
                        Grant-
                      Date
                        Fair ValueUnvested
                        Shares at January 1, 2006
                    
                    
                    373,676
                    
                    $
                    6.14Granted
                    
                    
                    150,317
                    
                    $
                    4.84Vested
                    
                    
                    (120,645
                    )
                    $
                    6.51Forfeited
                    
                    
                    (31,864
                    )
                    $
                    5.81Unvested
                        Shares at September 30, 2006
                    
                    
                    371,484
                    
                    $
                    5.60
  At
              September 30, 2006, there was $1.4 million of total unrecognized compensation
              cost related to unvested share-based compensation arrangements granted
              under the
              Plan. That cost is expected to be recognized over a weighted-average
              period of
              1.7 years. The total fair value of shares vested during both the three
              and nine
              month periods ended September 30, 2006 was $786,000. The total fair
              value of
              shares vested during during both the three and nine month periods ended
              September 30, 2005 was $507,000.
 10
 Note
              3.
  Mortgage-Backed
              and Other Securities Available-for-Sale
  The
              amortized cost and estimated fair value of securities available-for-sale
              at
              September 30, 2006 and December 31, 2005 are summarized as follows:
  Gross
                    
                    GrossGross
                    
                    Unrealized
                    
                    Unrealized
                    
                    EstimatedAmortized
                    
                    Unrealized
                    
                    Losses
                    
                    Losses
                    
                    FairCost
                    
                    Gains
                    
                    <1
                        Year
                    
                    >1
                        Year
                    
                    Value**September
                        30, 2006**Freddie
                        Mac securities
                    
                    $
                    15,116,922
                    
                    $
                    6,955
                    
                    $
                    —
                    
                    $
                    619,313
                    
                    $
                    14,504,564Fannie
                        Mae securities
                    
                    
                    33,813,019
                    
                    
                    13,800
                    
                    
                    20,426
                    
                    
                    1,123,703
                    
                    
                    32,682,690Ginnie
                        Mae securities
                    
                    
                    36,242,057
                    
                    
                    —
                    
                    
                    166,759
                    
                    
                    387,542
                    
                    
                    35,687,756US
                        agency securities
                    
                    
                    10,989,817
                    
                    
                    —
                    
                    
                    —
                    
                    
                    189,557
                    
                    
                    10,800,260$
                    96,161,815
                    
                    $
                    20,755
                    
                    $
                    187,185
                    
                    $
                    2,320,115
                    
                    $
                    93,675,270**December
                        31, 2005**Freddie
                        Mac securities
                    
                    $
                    16,639,949
                    
                    $
                    15,285
                    
                    $
                    60,164
                    
                    $
                    485,345
                    
                    $
                    16,109,725Fannie
                        Mae securities
                    
                    
                    38,209,406
                    
                    
                    28,119
                    
                    
                    334,933
                    
                    
                    672,624
                    
                    
                    37,229,968Ginnie
                        Mae securities
                    
                    
                    43,632,279
                    
                    
                    2,673
                    
                    
                    340,680
                    
                    
                    172,152
                    
                    
                    43,122,120US
                        agency securities
                    
                    
                    18,207,150
                    
                    
                    —
                    
                    
                    123,328
                    
                    
                    95,293
                    
                    
                    17,988,529$
                    116,688,784
                    
                    $
                    46,077
                    
                    $
                    859,105
                    
                    $
                    1,425,414
                    
                    $
                    114,450,342
  Certain
              investment securities shown above currently have fair values less than
              amortized
              cost and therefore contain unrealized losses. The Bank has evaluated
              these
              securities and has determined that the decline in value is temporary
              and is
              related to the change in market interest rates since purchase.  The decline
              in value is not related to any company or industry specific event.  At
              September 30, 2006 and December 31, 2005 there were 33 and 34 investment
              securities with unrealized losses, respectively.  The Bank anticipates full
              recovery of amortized cost with respect to these securities at maturity
              or
              sooner in the event of a more favorable market interest rate
              environment.
  **Note
                  4.**
  **Mortgage-Backed
                  and Other Securities Held-to-Maturity**
  The
                  amortized cost and estimated fair value of securities held-to-maturity
                  at
                  September 30, 2006 and December 31, 2005 are summarized as
                  follows:
  Gross
                    
                    GrossGross
                    
                    Unrealized
                    
                    Unrealized
                    
                    EstimatedAmortized
                    
                    Unrealized
                    
                    Losses
                    
                    Losses
                    
                    FairCost
                    
                    Gains
                    
                    <1
                        Year
                    
                    >1
                        Year
                    
                    Value**September
                        30, 2006**Fannie
                        Mae securities
                    
                    $
                    4,264,678
                    
                    $
                    35,740
                    
                    $
                    —
                    
                    $
                    83,140
                    
                    $
                    4,217,278Freddie
                        Mac securities
                    
                    
                    321,206
                    
                    
                    5,164
                    
                    
                    —
                    
                    
                    —
                    
                    
                    326,370Municipal
                        bonds
                    
                    
                    1,147,393
                    
                    
                    1,492
                    
                    
                    3,643
                    
                    
                    —
                    
                    
                    1,145,242$
                    5,733,277
                    
                    $
                    42,396
                    
                    $
                    3,643
                    
                    $
                    83,140
                    
                    $
                    5,688,890**December
                        31, 2005**Fannie
                        Mae securities
                    
                    $
                    5,345,378
                    
                    $
                    68,712
                    
                    $
                    56,460
                    
                    $
                    17,175
                    
                    $
                    5,340,455Freddie
                        Mac securities
                    
                    
                    432,808
                    
                    
                    9,659
                    
                    
                    —
                    
                    
                    —
                    
                    
                    442,467Municipal
                        bonds
                    
                    
                    1,188,109
                    
                    
                    649
                    
                    
                    —
                    
                    
                    790
                    
                    
                    1,187,968$
                    6,966,295
                    
                    $
                    79,020
                    
                    $
                    56,460
                    
                    $
                    17,965
                    
                    $
                    6,970,890
  Certain
              investment securities shown above currently have fair values less than
              amortized
              cost and therefore contain unrealized losses. The Bank has evaluated
              these
              securities and has determined that the decline in value is temporary
              and is
              related to the change in market interest rates since purchase.  The decline
              in value is not related to any company or industry specific event.  At
              September 30, 2006 and December 31, 2005 there were 4 investment securities
              with
              unrealized losses for both years. The Bank anticipates full recovery
              of
              amortized cost with respect to these securities at maturity or sooner
              in the
              event of a more favorable market interest rate environment.
  11
 **Note
              5.**
  **Nonperforming
              Assets**
 Nonperforming
                loans are summarized as follows:
  September
                        30,
                      2006
                    
                    December
                        31,
                      2005Impaired
                        loans with a valuation allowance
                    
                    $
                    12,140
                    
                    $
                    308,645Valuation
                        allowance related to impaired loans
                    
                    
                    (1,025
                    )
                    
                    (172,475
                    )Net
                        impaired loans
                    
                    
                    11,115
                    
                    
                    136,170Non
                        accrual loans
                    
                    
                    1,520,719
                    
                    
                    761,020Total
                        nonperforming or non-accrual loans
                    
                    
                    1,531,834
                    
                    
                    897,190Real
                        estate owned
                    
                    
                    —
                    
                    
                    —Nonperforming
                        Assets
                    
                    $
                    1,531,834
                    
                    $
                    897,190Total
                        loans past due 90-days or more and still accruing interest
                    
                    $
                    —
                    
                    $
                    —Average
                        balance of impaired loans
                    
                    $
                    73,643
                    
                    $
                    138,002Interest
                        income recognized on impaired loans
                    
                    $
                    424
                    
                    $
                    793
  **Note
              6.**
  **Earnings
              Per Share**
  Basic
              Earnings Per Share is computed by dividing net income by the weighted-average
              number of shares outstanding during the year.  Diluted EPS reflects the
              potential dilutive effect of stock options and is computed by dividing
              net
              income by the weighted-average number of shares outstanding during
              the year,
              plus the dilutive common shares that would have been outstanding had
              the stock
              options been exercised.
  The
              following is a reconciliation of the numerators and denominators of
              the basic
              and diluted earnings per share computations for quarters ending September
              30,
              2006 and September 30, 2005:
  Income
                    
                    Shares
                    
                    Per
                        share(numerator)
                    
                    (denominator)
                    
                    amountQuarter
                        ended September 30, 2006 (4)Basic
                        EPS:Income
                        available to common shareholders
                    
                    $
                    3,000,738
                    
                    
                    6,655,307
                    
                    $
                    0.45Effect
                        of dilutive stock options
                    
                    
                    —
                    
                    
                    195,134Diluted
                        EPS:Income
                        available to common shareholdersplus
                        assumed stock options exercised
                    
                    $
                    3,000,738
                    
                    
                    6,850,441
                    
                    $
                    0.43Nine
                        months ended September 30, 2006 (4)Basic
                        EPS:Income
                        available to common shareholders
                    
                    $
                    8,426,547
                    
                    
                    6,642,156
                    
                    $
                    1.27Effect
                        of dilutive stock options
                    
                    
                    —
                    
                    
                    183,442Diluted
                        EPS:Income
                        available to common shareholdersplus
                        assumed stock options exercised
                    
                    $
                    8,426,547
                    
                    
                    6,825,598
                    
                    $
                    1.23Quarter
                        ended September 30, 2005 (4)Basic
                        EPS:Income
                        available to common shareholders
                    
                    $
                    2,729,361
                    
                    
                    6,688,416
                    
                    $
                    0.41Effect
                        of dilutive stock options
                    
                    
                    —
                    
                    
                    278,880Diluted
                        EPS:Income
                        available to common shareholdersplus
                        assumed stock options exercised
                    
                    $
                    2,729,361
                    
                    
                    6,967,296
                    
                    $
                    0.39Nine
                        months ended September 30, 2005 (4)Basic
                        EPS:Income
                        available to common shareholders
                    
                    $
                    7,830,966
                    
                    
                    6,654,804
                    
                    $
                    1.18Effect
                        of dilutive stock options
                    
                    
                    —
                    
                    
                    295,570Diluted
                        EPS:Income
                        available to common shareholdersplus
                        assumed stock options exercised
                    
                    $
                    7,830,966
                    
                    
                    6,950,374
                    
                    $
                    1.13
  (4)
                      Per
                          share and weighted average shares outstanding for all periods
                          presented
                          has been adjusted to reflect the five-for-four stock split
                          paid on
                          October 4, 2006.
  12
 **Note
                      7.**
                    
                    Rate
                      Volume Analysis
                    (Dollars
                      in thousands)THIRD
                          QUARTER 2006VSTHIRD
                      QUARTER 2005
                    INCREASE
                      (DECREASE) DUE TO
                  
                  NINE
                      MONTHS ENDED 2006
                      VS
                        NINE
                          MONTHS ENDED 2005INCREASE
                      (DECREASE) DUE TOTOTAL
                  
                  
                  
                  
                  
                  TOTALVOLUME
                  
                  RATE
                  
                  CHANGE
                  
                  VOLUME
                  
                  RATE
                  
                  CHANGEINTEREST
                      INCOMEInvestments:Available-for-sale
                      securities
                  
                  $
                  (232
                  )
                  $
                  54
                  
                  $
                  (178
                  )
                  $
                  (554
                  )
                  $
                  119
                  
                  $
                  (435
                  )Held-to-maturity
                      securities
                  
                  
                  (20
                  )
                  
                  7
                  
                  
                  (13
                  )
                  
                  (58
                  )
                  
                  25
                  
                  
                  (33
                  )Other
                      equity investments
                  
                  
                  (22
                  )
                  
                  86
                  
                  
                  64
                  
                  
                  67
                  
                  
                  51
                  
                  
                  118Total
                      investments
                  
                  
                  (274
                  )
                  
                  147
                  
                  
                  (127
                  )
                  
                  (545
                  )
                  
                  195
                  
                  
                  (350
                  )Loans:Residential
                  
                  $
                  565
                  
                  $
                  841
                  
                  $
                  1,406
                  
                  $
                  1,777
                  
                  $
                  1,819
                  
                  $
                  3,596Residential
                      construction
                  
                  
                  538
                  
                  
                  348
                  
                  
                  886
                  
                  
                  1,777
                  
                  
                  1,268
                  
                  
                  3,045Multifamily
                  
                  
                  (614
                  )
                  
                  443
                  
                  
                  (171
                  )
                  
                  (1,599
                  )
                  
                  1,100
                  
                  
                  (499
                  )Multifamily
                      construction
                  
                  
                  367
                  
                  
                  (5
                  )
                  
                  362
                  
                  
                  830
                  
                  
                  217
                  
                  
                  1,047Commercial
                      real estate and business
                  
                  
                  294
                  
                  
                  568
                  
                  
                  862
                  
                  
                  343
                  
                  
                  1,650
                  
                  
                  1,993Commercial
                      real estate construction
                  
                  
                  227
                  
                  
                  153
                  
                  
                  380
                  
                  
                  397
                  
                  
                  493
                  
                  
                  890Consumer
                      and other
                  
                  
                  112
                  
                  
                  84
                  
                  
                  196
                  
                  
                  787
                  
                  
                  372
                  
                  
                  1,159Total
                      loans
                  
                  
                  1,489
                  
                  
                  2,432
                  
                  
                  3,921
                  
                  
                  4,312
                  
                  
                  6,919
                  
                  
                  11,231Total
                      interest income
                  
                  $
                  1,215
                  
                  $
                  2,579
                  
                  $
                  3,794
                  
                  $
                  3,767
                  
                  $
                  7,114
                  
                  $
                  10,881INTEREST
                      EXPENSEDeposits:Money
                      market deposit and checking
                  
                  $
                  102
                  
                  $
                  556
                  
                  $
                  658
                  
                  $
                  302
                  
                  $
                  1,665
                  
                  $
                  1,967Savings
                  
                  
                  (3
                  )
                  
                  4
                  
                  
                  1
                  
                  
                  (6
                  )
                  
                  12
                  
                  
                  6Time
                      deposits
                  
                  
                  39
                  
                  
                  1,299
                  
                  
                  1,338
                  
                  
                  637
                  
                  
                  3,925
                  
                  
                  4,562Total
                      deposits
                  
                  
                  138
                  
                  
                  1,859
                  
                  
                  1,997
                  
                  
                  933
                  
                  
                  5,602
                  
                  
                  6,535FHLB
                      advances and other
                  
                  
                  285
                  
                  
                  1,347
                  
                  
                  1,632
                  
                  
                  -
                  
                  
                  3,552
                  
                  
                  3,552Total
                      interest expense
                  
                  
                  423
                  
                  
                  3,206
                  
                  
                  3,629
                  
                  
                  933
                  
                  
                  9,154
                  
                  
                  10,087Net
                      interest income
                  
                  $
                  792
                  
                  $
                  (627
                  )
                  $
                  165
                  
                  $
                  2,834
                  
                  $
                  (2,040
                  )
                  $
                  794
  13
 **Note
              8.**
  **Business
              Segments**
  The
              management reporting process measures the performance of the operating
              segments
              based on the management structure of the Bank and is not necessarily
              comparable
              with similar information for any other financial institution.
  The
              reportable segments include the following:
  Consumer
              Lending - Consumer lending includes home equity lending, direct consumer
              loans,
              and indirect home improvement loans (sales finance).
 These
              loans include lines of credit and loans for primarily consumer purposes.
  Residential
              Lending - Residential lending offers loans to borrowers to purchase,
              refinance,
              or build homes secured by one-to-four-unit family dwellings.
 They
              also
              finance the purchase or refinance of buildable residential lots.
  Business
              Banking Lending- Business banking lending offers a full range of banking
              services to small and medium size businesses including deposit and
              cash
              management products, loans for financing receivables, inventory, equipment
              as
              well as permanent and interim construction loans for commercial real
              estate. The
              underlying real estate collateral or business asset being financed
              typically
              secures these loans.
  Income
              Property Lending - Income property lending offers permanent and interim
              construction loans for multifamily housing (over four units), manufactured
              housing communities, commercial real estate properties, and spec single-family
              construction.  The underlying real estate collateral being financed
              typically secures these loans.
  Each
              of
              these business segments also sells loans into the secondary market.
              We may
              choose to retain or sell the right to service the loans sold (i.e.,
              collection
              of principal and interest payments) depending upon market
              conditions.
  These
              segments are managed separately because each business unit requires
              different
              processes and different marketing strategies to reach the customer
              base that
              purchases the products and services. The segments derive a majority
              of their
              revenue from interest income, and we rely primarily on net interest
              revenue in
              managing these segments. No single customer provides more than 10%
              of the Bank’s
              revenues.
  Financial
              information for the Bank’s segments is shown below for September 30, 2006, 2005,
              and 2004:
  **Consumer**
                    
                    **Residential**
                    
                    **Business
                        Banking**
                    
                    **Income
                        Property****Quarter
                        ended September 30:**
                    
                    
                    
                    **Lending**
                    
                    **Lending**
                    
                    **Lending**
                    
                    **Lending**
                    
                    **Totals**Interest
                        income
                    
                    
                    2004
                    
                    $
                    2,368,071
                    
                    $
                    4,057,970
                    
                    $
                    1,478,372
                    
                    $
                    6,281,125
                    
                    $
                    14,185,5382005
                    
                    
                    2,654,621
                    
                    
                    5,641,118
                    
                    
                    2,151,781
                    
                    
                    6,716,396
                    
                    
                    17,163,9162006
                    
                    
                    2,774,071
                    
                    
                    6,991,629
                    
                    
                    3,542,030
                    
                    
                    7,650,504
                    
                    
                    20,958,234Interest
                        expense
                    
                    
                    2004
                    
                    
                    655,417
                    
                    
                    1,609,897
                    
                    
                    384,618
                    
                    
                    2,276,290
                    
                    
                    4,926,2222005
                    
                    
                    717,063
                    
                    
                    2,757,251
                    
                    
                    631,081
                    
                    
                    3,041,924
                    
                    
                    7,147,3192006
                    
                    
                    1,281,703
                    
                    
                    3,922,022
                    
                    
                    1,572,494
                    
                    
                    3,999,979
                    
                    
                    10,776,198Net
                        interest income
                    
                    
                    2004
                    
                    
                    1,712,654
                    
                    
                    2,448,073
                    
                    
                    1,093,754
                    
                    
                    4,004,835
                    
                    
                    9,259,3162005
                    
                    
                    1,937,558
                    
                    
                    2,883,867
                    
                    
                    1,520,700
                    
                    
                    3,674,472
                    
                    
                    10,016,5972006
                    
                    
                    1,492,368
                    
                    
                    3,069,607
                    
                    
                    1,969,536
                    
                    
                    3,650,525
                    
                    
                    10,182,036Provision
                        for loan and lease losses
                    
                    
                    2004
                    
                    
                    132,290
                    
                    
                    208,765
                    
                    
                    45,310
                    
                    
                    138,635
                    
                    
                    525,0002005
                    
                    
                    123,600
                    
                    
                    38,675
                    
                    
                    45,355
                    
                    
                    117,370
                    
                    
                    325,0002006
                    
                    
                    75,420
                    
                    
                    (55,415
                    )
                    
                    147,220
                    
                    
                    100,025
                    
                    
                    267,250Net
                        interest income, after provision for loan and lease
                    
                    
                    2004
                    
                    
                    1,580,364
                    
                    
                    2,239,308
                    
                    
                    1,048,444
                    
                    
                    3,866,200
                    
                    
                    8,734,316losses
                    
                    
                    2005
                    
                    
                    1,813,958
                    
                    
                    2,845,192
                    
                    
                    1,475,345
                    
                    
                    3,557,102
                    
                    
                    9,691,5972006
                    
                    
                    1,416,948
                    
                    
                    3,125,022
                    
                    
                    1,822,316
                    
                    
                    3,550,500
                    
                    
                    9,914,786Noninterest
                        income
                    
                    
                    2004
                    
                    
                    575,549
                    
                    
                    289,897
                    
                    
                    108,352
                    
                    
                    215,249
                    
                    
                    1,189,0472005
                    
                    
                    511,948
                    
                    
                    301,905
                    
                    
                    109,963
                    
                    
                    188,044
                    
                    
                    1,111,8602006
                    
                    
                    1,175,790
                    
                    
                    498,049
                    
                    
                    320,723
                    
                    
                    315,538
                    
                    
                    2,310,100Noninterest
                        expense
                    
                    
                    2004
                    
                    
                    1,524,205
                    
                    
                    1,512,514
                    
                    
                    1,269,703
                    
                    
                    1,782,583
                    
                    
                    6,089,0052005
                    
                    
                    1,694,304
                    
                    
                    1,740,708
                    
                    
                    1,461,466
                    
                    
                    1,737,416
                    
                    
                    6,633,8942006
                    
                    
                    1,855,777
                    
                    
                    1,992,294
                    
                    
                    2,073,248
                    
                    
                    1,778,199
                    
                    
                    7,699,518Income
                        before provision for federal income taxes
                    
                    
                    2004
                    
                    
                    631,708
                    
                    
                    1,016,691
                    
                    
                    (112,907
                    )
                    
                    2,298,866
                    
                    
                    3,834,3582005
                    
                    
                    631,602
                    
                    
                    1,406,389
                    
                    
                    123,842
                    
                    
                    2,007,730
                    
                    
                    4,169,5632006
                    
                    
                    736,961
                    
                    
                    1,630,777
                    
                    
                    69,791
                    
                    
                    2,087,839
                    
                    
                    4,525,368Provision
                        for federal income taxes
                    
                    
                    2004
                    
                    
                    215,409
                    
                    
                    347,100
                    
                    
                    (39,513
                    )
                    
                    785,557
                    
                    
                    1,308,5532005
                    
                    
                    217,324
                    
                    
                    485,230
                    
                    
                    41,703
                    
                    
                    695,945
                    
                    
                    1,440,2022006
                    
                    
                    248,758
                    
                    
                    549,480
                    
                    
                    23,477
                    
                    
                    702,915
                    
                    
                    1,524,630**Net
                        Income**
                    
                    
                    2004
                    
                    
                    416,299
                    
                    
                    669,591
                    
                    
                    (73,394
                    )
                    
                    1,513,309
                    
                    
                    2,525,8052005
                    
                    
                    414,278
                    
                    
                    921,159
                    
                    
                    82,139
                    
                    
                    1,311,785
                    
                    
                    2,729,3612006
                    
                    
                    488,203
                    
                    
                    1,081,297
                    
                    
                    46,314
                    
                    
                    1,384,924
                    
                    
                    3,000,738Total
                        interest earning assets
                    
                    
                    2004
                    
                    
                    112,932,675
                    
                    
                    279,687,177
                    
                    
                    107,201,051
                    
                    
                    444,847,887
                    
                    
                    944,668,790(ending
                        period balances)
                    
                    
                    2005
                    
                    
                    123,903,285
                    
                    
                    344,195,402
                    
                    
                    130,046,461
                    
                    
                    407,784,711
                    
                    
                    1,005,929,8592006
                    
                    
                    117,265,604
                    
                    
                    370,793,893
                    
                    
                    175,353,692
                    
                    
                    377,767,617
                    
                    
                    1,041,180,806
  14
 **Note
            8.**
  **Segments
            (continued)**
 **Consumer**
                  
                  **Residential**
                  
                  **Business
                      Banking**
                  
                  **Income
                      Property****Year-to-date
                      ended September 30:**
                  
                  
                  
                  **Lending**
                  
                  **Lending**
                  
                  **Lending**
                  
                  **Lending**
                  
                  **Totals**Interest
                      income
                  
                  
                  2004
                  
                  $
                  6,453,804
                  
                  $
                  11,592,479
                  
                  $
                  4,085,381
                  
                  $
                  18,419,538
                  
                  $
                  40,551,2022005
                  
                  
                  7,224,772
                  
                  
                  15,323,644
                  
                  
                  6,227,199
                  
                  
                  20,073,944
                  
                  
                  48,849,5592006
                  
                  
                  8,223,669
                  
                  
                  20,060,163
                  
                  
                  9,472,243
                  
                  
                  21,975,507
                  
                  
                  59,731,582Interest
                      expense
                  
                  
                  2004
                  
                  
                  1,752,923
                  
                  
                  4,522,289
                  
                  
                  1,016,769
                  
                  
                  6,653,053
                  
                  
                  13,945,0342005
                  
                  
                  2,316,597
                  
                  
                  6,841,796
                  
                  
                  1,772,267
                  
                  
                  8,275,317
                  
                  
                  19,205,9772006
                  
                  
                  3,576,976
                  
                  
                  10,691,741
                  
                  
                  4,049,545
                  
                  
                  10,975,320
                  
                  
                  29,293,582Net
                      interest income
                  
                  
                  2004
                  
                  
                  4,700,881
                  
                  
                  7,070,190
                  
                  
                  3,068,612
                  
                  
                  11,766,485
                  
                  
                  26,606,1682005
                  
                  
                  4,908,175
                  
                  
                  8,481,848
                  
                  
                  4,454,932
                  
                  
                  11,798,627
                  
                  
                  29,643,5822006
                  
                  
                  4,646,693
                  
                  
                  9,368,422
                  
                  
                  5,422,698
                  
                  
                  11,000,187
                  
                  
                  30,438,000Provision
                      for loan and lease losses
                  
                  
                  2004
                  
                  
                  381,924
                  
                  
                  278,169
                  
                  
                  126,704
                  
                  
                  428,203
                  
                  
                  1,215,0002005
                  
                  
                  413,815
                  
                  
                  144,450
                  
                  
                  177,595
                  
                  
                  439,140
                  
                  
                  1,175,0002006
                  
                  
                  45,113
                  
                  
                  (68,301
                  )
                  
                  245,317
                  
                  
                  250,958
                  
                  
                  473,087Net
                      interest income, after provision for loan and lease
                  
                  
                  2004
                  
                  
                  4,318,957
                  
                  
                  6,792,021
                  
                  
                  2,941,908
                  
                  
                  11,338,282
                  
                  
                  25,391,168losses
                  
                  
                  2005
                  
                  
                  4,494,360
                  
                  
                  8,337,398
                  
                  
                  4,277,337
                  
                  
                  11,359,487
                  
                  
                  28,468,5822006
                  
                  
                  4,601,580
                  
                  
                  9,436,723
                  
                  
                  5,177,381
                  
                  
                  10,749,229
                  
                  
                  29,964,913Noninterest
                      income
                  
                  
                  2004
                  
                  
                  1,322,551
                  
                  
                  652,410
                  
                  
                  281,940
                  
                  
                  758,185
                  
                  
                  3,015,0862005
                  
                  
                  1,985,025
                  
                  
                  826,339
                  
                  
                  490,741
                  
                  
                  751,421
                  
                  
                  4,053,5262006
                  
                  
                  3,185,436
                  
                  
                  1,132,560
                  
                  
                  748,834
                  
                  
                  1,015,733
                  
                  
                  6,082,563Noninterest
                      expense
                  
                  
                  2004
                  
                  
                  4,149,611
                  
                  
                  4,335,059
                  
                  
                  3,655,838
                  
                  
                  5,628,797
                  
                  
                  17,769,3052005
                  
                  
                  5,071,239
                  
                  
                  5,312,799
                  
                  
                  4,641,700
                  
                  
                  5,613,963
                  
                  
                  20,639,7012006
                  
                  
                  5,741,103
                  
                  
                  5,986,439
                  
                  
                  5,955,392
                  
                  
                  5,539,799
                  
                  
                  23,222,733Income
                      before provision for federal income taxes
                  
                  
                  2004
                  
                  
                  1,491,897
                  
                  
                  3,109,372
                  
                  
                  (431,990
                  )
                  
                  6,467,670
                  
                  
                  10,636,9492005
                  
                  
                  1,408,146
                  
                  
                  3,850,938
                  
                  
                  126,378
                  
                  
                  6,496,945
                  
                  
                  11,882,4072006
                  
                  
                  2,045,913
                  
                  
                  4,582,844
                  
                  
                  (29,177
                  )
                  
                  6,225,163
                  
                  
                  12,824,743Provision
                      for federal income taxes
                  
                  
                  2004
                  
                  
                  506,567
                  
                  
                  1,055,311
                  
                  
                  (149,181
                  )
                  
                  2,197,456
                  
                  
                  3,610,1532005
                  
                  
                  480,044
                  
                  
                  1,312,716
                  
                  
                  41,093
                  
                  
                  2,217,588
                  
                  
                  4,051,4412006
                  
                  
                  702,419
                  
                  
                  1,571,689
                  
                  
                  (12,851
                  )
                  
                  2,136,939
                  
                  
                  4,398,196**Net
                      Income**
                  
                  
                  2004
                  
                  
                  985,330
                  
                  
                  2,054,061
                  
                  
                  (282,809
                  )
                  
                  4,270,214
                  
                  
                  7,026,7962005
                  
                  
                  928,102
                  
                  
                  2,538,222
                  
                  
                  85,285
                  
                  
                  4,279,357
                  
                  
                  7,830,9662006
                  
                  
                  1,343,494
                  
                  
                  3,011,155
                  
                  
                  (16,326
                  )
                  
                  4,088,224
                  
                  
                  8,426,547Total
                      interest earning assets
                  
                  
                  2004
                  
                  
                  105,868,685
                  
                  
                  266,403,325
                  
                  
                  100,951,018
                  
                  
                  441,549,203
                  
                  
                  914,772,231(average
                      balances)
                  
                  
                  2005
                  
                  
                  116,869,334
                  
                  
                  325,552,575
                  
                  
                  128,386,695
                  
                  
                  422,055,517
                  
                  
                  992,864,1212006
                  
                  
                  120,761,228
                  
                  
                  366,085,682
                  
                  
                  169,631,155
                  
                  
                  381,539,480
                  
                  
                  1,038,017,545
  15
 **Note
            9.  Derivative Financial Instruments**
 We
                enter
                into derivative contracts to manage the various risks associated
                with certain
                assets and liabilities. These derivatives are not designated in “hedge
                accounting
                relationships”
                as defined by
                Statement of Financial Accounting Standards No. 133, as amended, *Accounting
                for Derivative Instruments and Hedging Activities* ,
                but
                instead are held for other risk management purposes. Derivatives
                utilized for
                risk management purposes are used as economic hedges in which we
                have either not
                attempted to achieve, or have attempted but did not achieve, the
                highly
                effective hedge accounting standard under SFAS 133, as amended. Generally,
                derivatives are financial instruments with little or no initial net
                investment
                in comparison to their notional amount and whose value is based upon
                an
                underlying asset, index, reference rate or other variable. They may
                be privately
                negotiated contractual agreements that can be customized to meet
                specific needs
                or they may be standardized contracts executed through organized
                exchanges. All
                derivatives are recorded at fair value as either assets or liabilities
                on the
                Consolidated Balance Sheet. Changes in fair value of derivatives
                that are not in
                hedge accounting relationships are recorded within the Consolidated
                Statement of
                Income in the period in which the change in value occurs.
 
 We
                enter
                into derivative contracts to facilitate customer transactions as
                well as for
                risk management purposes. We use a variety of derivative financial
                instruments
                to include interest rate swaps and prepayment agreements. Interest
                rate swaps
                are contracts in which two parties exchange a series of interest
                rate cash flows
                of different types based on specific notional amounts. Certain prepayment
                agreements also constitute derivatives. These agreements fulfill
                the definition
                of a derivative under SFAS No. 133. They have a notional amount,
                an underlying,
                a net settlement, and no initial net investment.
 
 During
                the second quarter of 2006 we entered into two swap agreements with
                one of our
                correspondent banks to facilitate two customer transactions totaling
                $3.0
                million. The customers required fixed-rate loan products. The swap
                arrangements
                were utilized to facilitate this request. We also have two prepayment
                agreements
                that are separate from the loan agreements that we have also entered
                into with
                our two borrowers. The notional amount of the prepayment agreements
                totaled $3
                million. Each quarter the derivatives are marked-to-market and included in
                noninterest income and noninterest expense. For the third quarter
                and nine
                months ended September 30, 2006, noninterest expense related to the
                two swap
                transactions totaled $138,000 and $188,000, respectively. Noninterest
                income
                related to the prepayment agreements, totaled $138,000 and $188,000
                for the
                third quarter and nine months ended September 30, 2006.
 
 Derivative
                instruments expose the Bank to credit and market risk. If the counterparty
                fails
                to perform, the credit risk is equal to the fair value of the derivative.
                When
                the fair value of a derivative contract is positive, this indicates
                the
                counterparty owes the Bank, and therefore, creates a repayment risk
                for the
                Bank. When the fair value of a derivative contract is negative, the
                Bank owes
                the counterparty and has no repayment risk. We minimize the credit
                or repayment
                risk in derivative instruments by entering into transactions with
                high quality
                counterparties.
  16
 
 In
                2002
                we entered into an interest rate swap agreement with the FHLB to convert
                our $9.0 million floating-rate trust preferred securities (TPS) funding
                to a
                fixed-rate. Prior to the third quarter of 2006 the swap was accounted
                for as a
                cash flow hedge. The hedge, under current accounting literature at
                the time, was
                a qualifying cash flow hedge under the “shortcut”
                method as
                prescribed by SFAS 133 with changes in the fair value recorded in
                other
                comprehensive income. The Bank pays the FHLB a fixed-rate of 4.53%
                and receives
                the equivalent of 3-month LIBOR.
 
 During
                the third quarter of 2006, it was noted through a series of recent
                technical
                interpretations, hedges on TPSs were no longer eligible for the short-cut
                method
                of accounting that we had been applying. Accordingly, we determined
                the
                derivative no longer qualified for the short-cut method and therefore
                hedge
                accounting was discontinued. The derivative will continue to be recorded
                on the
                balance sheet at its fair value with changes in the fair value previously
                recorded in other comprehensive income reclassified and included
                in current
                earnings. During the 3rd quarter, the cumulative change in the fair
                value of the
                swap since inception, which totaled $52,000, was recorded on a prospective
                basis
                in noninterest income.
 
 For
                the
                third quarter and the first nine months of 2006 we recognized expense
                in the net
                interest margin of $142,000 and $357,000, respectively, related to
                cash payments
                accrued for the interest rate swap.
 
 Following
                are the amounts and related percentages, by year, that would have
                increased or
                decreased net income had the swap not been accounted for under the
                short-cut
                method:
 PercentageYear
                        
                        Amount
                        
                        of
                            Net Income2002
                        
                        
                        ($405,900
                        )
                        
                        (5.21
                        %)2003
                        
                        $
                        87,200
                        
                        
                        1.04
                        %2004
                        
                        $
                        171,700
                        
                        
                        1.85
                        %2005
                        
                        $
                        166,200
                        
                        
                        1.61
                        %YTD 2006
                        
                        $
                        52,000
                        
                        
                        n/a
 In
                accordance with Staff Accounting Bulletin No. 108 - Quantifying Financial
                Statement Misstatements and SEC Staff Accounting Bulletin No. 99
                - Materiality,
                Management and the Audit Committee have determined that the effect
                of the
                accounting error is immaterial after considering the factors above
                and the
                following qualitative factors:
  The
                first
                year’s loss was 5.21% of net income; however, gains in subsequent years
                resulted
                in a net gain of $19,200 by year 2005, which was less than two basis
                point of
                year 2005’s net income.
  The
                hedge
                was entered into with the accounting treatment that was appropriate
                at the
                time.
  17
  The
                misstatement did not obscure a change or trend in earnings, in that,
                the trend
                in earnings would have been the same without hedge accounting.
  The
                misstatement did not change a loss into a gain, or vice versa. The
                changes in
                fair value were correctly measured and reported in comprehensive
                income.
  The
                misstatement did not involve the concealment of an unlawful transaction.
                The
                change in fair values were openly reported and disclosed at each
                financial
                reporting period.
                     18
 ITEM
                        2.
                      Management’s
                          Discussion and Analysis of Financial Condition andResults
                          of Operations
 
 **GENERAL**
 
 First
                Mutual Bancshares, Inc. (the "Company"), a Washington corporation,
                is a bank
                holding company owning all of the equity of its wholly owned subsidiary,
                First
                Mutual Bank. The Company is subject to regulation by the Federal
                Reserve Bank of
                San Francisco. This discussion refers to the consolidated statements
                of the
                Company and the Bank, and therefore the references to “Bank” in this discussion
                refer to both entities.
 
 First
                Mutual Bank is a Washington-chartered savings bank subject to regulation
                by the
                State of Washington Department of Financial Institutions and the
                Federal Deposit
                Insurance Corporation ("FDIC"). The Bank conducts business from its
                headquarters
                in Bellevue, Washington, and has 12 full-service retail banking centers
                located
                in Bellevue (3), Issaquah, Kirkland (2), Monroe, Redmond, Sammamish,
                Seattle
                (2), and Woodinville. We also have consumer loan offices located
                in
                Jacksonville, Florida and Mt. Clemens, Michigan. The Bank's business
                consists
                mainly of attracting deposits from the general public as well as
                wholesale
                funding sources, and investing those funds primarily in real estate
                loans, small
                and mid-sized business loans, and consumer loans.
  **OVERVIEW**
 
 The
                third
                quarter marked our fifty-sixth consecutive quarter of year-over-year
                earnings
                growth, as net income increased 10% over the same quarter of 2005,
                to $3.0
                million, or $0.43 per diluted share, compared to $2.7 million, or
                $0.39 per
                diluted share last year. Through the first three quarters of 2006,
                net income
                totaled $8.4 million, up from $7.8 million in the first nine months
                of 2005,
                with diluted earnings per share totaling $1.23, compared to $1.13
                in the same
                period last year, for an increase of 10%. Our return on average equity
                (ROE)
                totaled 18.3% for the quarter and 17.7% for the nine months ended
                September 30,
                compared to 16.7% and 16.6% in the same periods last year. As a result,
                we were
                able to exceed one of our general corporate goals, obtaining an ROE
                of at least
                15%, for both the quarter and year-to-date periods. Though we managed to achieve
                our second corporate goal, year-over-year net income growth in the
                range of 10%
                to 12%, in the third quarter, we fell short of this objective on
                a year-to-date
                basis. Note that we consider these targets to be our corporate goals,
                and not
                indicative of current forecasts or expected future operating
                results.
 
 The
                primary source of revenue for each of our business lines is net interest
                income,
                which is commonly measured with the net interest margin ratio. Contrary
                to the
                forecast in the second quarter press release, our net interest margin
                for the
                third quarter remained comparable to that of the second quarter,
                actually
                improving three basis points to 3.94%. We had indicated in our forecast
                that we
                expected to see continued compression in our net interest margin
                as
                we
  19
 increased
                sales of Sales Finance loans, which are generally among our highest-yielding
                assets. While the sale of these loans negatively impacts our net
                interest
                margin, it results in substantial noninterest income, including the
                gains on
                loan sales recognized at the times of the transactions, as well as
                servicing fee
                income earned on an ongoing basis following the sale. We had also
                expected the
                margin to be impacted by maturities of large Federal Home Loan Bank
                of Seattle
                (FHLB) advance and time deposit balances in the first and second
                quarters of
                2006, respectively, as well as the increased use of time deposits,
                including
                those issued through brokerage services, and FHLB advances to offset
                the runoff
                of non-maturity deposit balances observed in the second quarter.
                Between these
                factors, we expected our net interest margin to decline to between
                3.85% and
                3.90% in the third quarter. A key factor in avoiding the additional
                margin
                compression predicted in our second quarter press release was a higher
                than
                predicted level of interest income resulting from commercial loan
                prepayments.
                Loan fees that are capitalized when loans are originated are then
                recognized as
                interest income in the event those loans are prepaid.
 
 The
                other
                key driver of net interest income is the growth of the business lines’ earning
                assets, which totaled $1.03 billion as of the September 2006 quarter-end,
                comparable to the $1.02 billion level at the year ended December
                31, 2005 and
                $1.04 billion as of the June 2006 quarter-end. Impeding asset growth
                in the
                third quarter were sales of consumer loans totaling $18 million,
                as well as a $4
                million reduction in the size of our securities portfolio relative
                to the
                previous quarter-end. Partially offsetting these factors was the
                continued
                growth of our Residential loan portfolio. Please see the “Net Interest Income,”
“Business Segments,” and “Asset and Liability Management” sections for further
                discussions of net interest income, earning assets, and the processes
                by which
                we manage that source of revenue.
 
 Our
                noninterest income increased $1.2 million relative to the third quarter
                of last
                year, representing growth of 108%, based primarily on significant
                increases in
                loan sales and resulting gains thereon. An increase in loan fees,
                particularly
                prepayment penalties on residential loans, as well as gains on instruments
                used
                to hedge interest rate risk on long-term, fixed-rate commercial real-estate
                loans also contributed to the fee income as compared to last year.
                It should be
                noted, however, that the income earned from this source was negated
                by
                mark-to-market losses on offsetting instruments reflected in our
                noninterest
                expense. On a year-to-date basis, noninterest income increased $2.0
                million, or
                50% relative to the prior year level, with the higher level of gains
                on loan
                sales again making the most significant contribution to the additional
                income.
                Proceeds received from a key-man life insurance policy in the second
                quarter of
                this year also contributed to the increase, as did gains on hedging
                instruments.
                Please see the “Noninterest Income” section for additional
                discussion.
 
 Noninterest
                expense increased nearly $1.1 million, or 16% in the third quarter
                relative to
                the third quarter of 2005, but declined 2% on a sequential quarter
                basis against
                the second quarter of this year. For the first nine months of 2006,
                noninterest
                expense grew $2.6 million, or 13% over the same period in 2005. While
                personnel
                related expenses represented the most significant contribution to
                operating
                costs, occupancy and other noninterest expenses also increased substantially
                on
                both a quarterly and year-to-date basis. Please see the “Noninterest Expense”
section for additional information.
 
 Another
                critical factor in achieving our goal of consistent earnings is the
                credit
                quality of our loan portfolio, which has exceeded the national average
                for many
                years. For the quarter ended September 30, 2006, our credit quality
                remained
                strong, with non-performing assets (NPAs) totaling $1.5 million,
                or 0.14% of
                total assets. By comparison, NPAs totaled $635,000, or 0.06% at the
                end of the
                third quarter of last year, and $897,000, or 0.08%, at the 2005 year-end.
                For
                the
  20
 quarter,
                we reserved $267,000 in provisions for loan losses while net charge-offs
                totaled
                only $56,000. With this provision, our reserve for loan losses totaled
                approximately $10.4 million, up from $9.9 million at September 30,
                2005 and
                $10.1 million at the 2005 year-end. Note that the $10.4 million figure
                includes
                a $345,000 liability, which is included in “Accounts Payable and Other
                Liabilities” on the balance sheet, representing a reserve for losses for
                unfunded commitments. The allowance for loan losses represented 1.12%
                of gross
                loans at the end of the quarter, far exceeding our non-performing
                loans, and
                comparable to the 1.13% level observed at both the 2005 year-end
                and quarter
                ended September 30, 2005. For additional information regarding our
                credit
                quality please refer to the “Asset Quality” section.
  **RESULTS
                OF OPERATIONS**
 
 **Net
                Income**
 
 Net
                income increased 10%, from $2.7 million in the third quarter of 2005
                to $3.0
                million in the same period of 2006. Net interest income, after provision
                for
                loan losses, rose $223,000, and noninterest income increased $1.2
                million on a
                third quarter comparison. Partially offsetting the growth in revenue
                was a rise
                of $1.1 million in noninterest expense.
 
 **Net
                Interest Income**
  For
                the
                quarter and year-to-date period ended September 30, 2006, our net
                interest
                income increased $165,000 and $794,000 relative to the same periods
                last year.
                This improvement resulted from growth in our earning assets, as the
                net effects
                of asset and liability repricing negatively impacted net interest
                income for
                both periods. The following table illustrates the impacts to our
                net interest
                income from balance sheet growth and rate changes on our assets and
                liabilities,
                with the results attributable to the level of earning assets classified
                as
“volume” and the effect of asset and liability repricing labeled
“rate.”
  Rate/Volume
                          Analysis
                      
                      Quarter
                          Ended
                      
                      Nine
                          Months EndedSeptember
                          30, 2006 vs.
                        September
                          30, 2005
                      
                      September
                          30, 2006 vs.
                        September
                          30, 2005Increase/(Decrease)
                          due to
                      
                      Increase/(Decrease)
                          due toVolume
                      
                      Rate
                      
                      Total
                      
                      Volume
                      
                      Rate
                      
                      TotalInterest
                          Income
                      
                      (Dollars
                          in thousands)Total
                          Investments
                      
                      $
                      (274
                      )
                      $
                      147
                      
                      $
                      (127
                      )
                      $
                      (545
                      )
                      $
                      195
                      
                      $
                      (350
                      )Total
                          Loans
                      
                      
                      1,489
                      
                      
                      2,432
                      
                      
                      3,921
                      
                      
                      4,312
                      
                      
                      6,919
                      
                      
                      11,231Total
                          Interest Income
                      
                      $
                      1,215
                      
                      $
                      2,579
                      
                      $
                      3,794
                      
                      $
                      3,767
                      
                      $
                      7,114
                      
                      $
                      10,881Interest
                          ExpenseTotal
                          Deposits
                      
                      $
                      138
                      
                      $
                      1,859
                      
                      $
                      1,997
                      
                      $
                      933
                      
                      $
                      5,602
                      
                      $
                      6,535FHLB
                          and Other
                      
                      
                      285
                      
                      
                      1,347
                      
                      
                      1,632
                      
                      
                      —
                      
                      
                      3,552
                      
                      
                      3,552Total
                          Interest Expense
                      
                      $
                      423
                      
                      $
                      3,206
                      
                      $
                      3,629
                      
                      $
                      933
                      
                      $
                      9,154
                      
                      $
                      10,087Net
                          Interest Income
                      
                      $
                      792
                      
                      $
                      (627
                      )
                      $
                      165
                      
                      $
                      2,834
                      
                      $
                      (2,040
                      )
                      $
                      794
 
  21
 **Earning
                Asset Growth (Volume)**
  For
                the
                third quarter and first nine months of 2006, the growth in our earning
                assets
                contributed an additional $1.2 million and $3.8 million in interest
                income
                compared to the same periods last year. Partially offsetting this
                improvement
                was additional interest expense of $423,000 for the quarter and $933,000
                for the
                year-to-date period, incurred from the funding sources used to accommodate
                the
                asset growth. Consequently, the net impacts of asset growth were
                improvements in
                net interest income of $792,000 and $2.8 million compared to the
                quarter and
                nine months ended September 30, 2005.
 
 Quarter
                          Ending
                      Earning
                          Assets
                      Net
                          Loans (including
                        loans
                          held for sale)
                      Deposits(Dollars
                          in thousands)September
                          30, 2005
                      $
                          1,001,005
                      $
                          863,404
                      $
                          727,503December
                          31, 2005
                      $
                          1,018,449
                      $
                          882,681
                      $
                          760,721March
                          31, 2006
                      $
                          1,018,058
                      $
                          885,295
                      $
                          783,614June
                          30, 2006
                      $
                          1,036,750
                      $
                          919,418
                      $
                          760,344September
                          30, 2006
                      $
                          1,034,332
                      $
                          919,837
                      $
                          774,914
  As
                can be
                seen in the table above, earning asset growth has been minimal through
                the first
                three quarters of 2006, with sequential quarter growth occurring
                only in the
                second quarter of this year. A substantially higher level of loan
                sales than in
                prior years and the continued runoff of our securities portfolio
                have been
                significant factors in the lack of growth this year.
  The
                modest increase that has occurred in earning assets over the course
                of this year
                has been attributable to growth in our loan portfolio. Business Banking
                and
                Residential Lending segments made the most significant contributions,
                despite
                the Business Banking portfolio contracting slightly in the third
                quarter
                following strong growth in the first half of the year. Additionally,
                our
                consumer lending segment would likely have shown significant growth
                this year,
                if not for the previously mentioned loan sales. Our sales of consumer
                loans have
                exceeded $41 million so far this year, including $18 million in the
                third
                quarter. The lack of any significant growth in the loan portfolio
                for the most
                recent quarter was in line with expectations, as we indicated in
                our second
                quarter press release that based on our forecasts for production
                volumes,
                payoffs, and loan sales, we did not expect to see any growth, and
                possibly even
                a modest decline in the size of our loan portfolio in the third
                quarter.
  Further
                reducing our earning asset growth this year, our securities portfolio continued
                to contract, falling nearly $23 million compared to the September
                2005 level,
                $22 million from the year end level, and $4 million from the June
                30, 2006
                quarter-end. Over the past several quarters, we have typically found
                the yields
                available on investment securities to be significantly less attractive
                than
                those on loans, particularly when the funding costs to support the
                additional
                assets were taken into account. Consequently, as the securities in
                our portfolio
                have been called or matured, we have generally not replaced the paid-off
                securities balances, but instead redirected those cash flows to support
                loan
                growth. In the event that yields on securities and/or the cost of
                funding
                purchases should become more conducive to holding investment securities,
                we
                would consider increasing the size of our securities portfolio at
                that
                time.
  22
 Historically,
                we have generally relied upon growth in our deposit balances, including
                certificates issued in institutional markets through deposit brokerage
                services,
                to support our asset growth. When our deposit growth has been insufficient
                to
                fully support our asset growth, we have utilized advances from the
                FHLB as an
                alternative funding source.
  For
                the
                third quarter and year-to-date periods, our total deposit balances
                increased
                $14.6 million and $14.2 million, respectively, with non-maturity
                deposit
                balances rising in the first quarter, and then losing ground over
                the subsequent
                quarters. In contrast, time deposit balances declined modestly in
                the first
                quarter, and significantly in the second, before increasing substantially
                in the
                most recent quarter.
  Following
                the first quarter of this year, we noted that a substantial increase
                in
                non-maturity deposit balances had allowed us to take steps to improve
                our
                funding mix by reducing FHLB borrowings and the rates offered on
                retail
                certificates of deposit. Unfortunately, this trend did not continue
                in the
                second and third quarters. Following impressive growth in the first
                quarter, our
                non-maturity deposit balances peaked in mid-April, then steadily
                declined for
                the next month as a result of outflows for federal income tax and
                state property
                tax payments, as well as a substantial reduction in balances maintained
                by a
                large commercial customer. The decline continued in the third quarter,
                as our
                non-maturity balances fell in July, then recovered modestly over
                the remainder
                of the quarter. Despite this recovery, our non-maturity balances
                ended the
                quarter at a level lower than that at which the quarter began. However,
                our
                non-maturity deposit balances remained approximately $13.5 million
                above the
                2005 year-end level.
  Offsetting
                the decline in non-maturity deposit balances in the third quarter
                were increased
                time deposit balances, including an increase in certificates issued
                through
                deposit brokerage services. Time deposit balances fell modestly in
                the first
                quarter and significantly in the second as we priced our time deposits
                less
                aggressively, resulting in a lower retention of maturing certificate
                balances.
                Also contributing to the higher time deposit balances as of September
                30, 2006,
                was an $8.1 million net increase in certificates issued through deposit
                brokerage services relative to the June 30 quarter-end. At the end
                of the third
                quarter, our brokered certificate balances had increased $15.1 million
                from the
                first of the year.
  **Asset
                Yields and Funding Costs (Rate)**
  Adjustable-rate
                loans accounted for approximately 81% of our loan portfolio as of
                September 30,
                2006. Since new loans are generally being originated at higher interest
                rates
                than existing portfolio loans, the effects of interest rate movements
                and
                repricing accounted for $2.4 million and $6.9 million in additional
                interest
                income relative to the third quarter and first nine months of last
                year. On the
                liability side of the balance sheet, the effects of interest rate
                movements and
                repricing increased our interest expense on deposits and wholesale
                funding by
                $3.2 million for the quarter and nearly $9.2 million on a year-to-date
                basis. As
                a result, for the third quarter and first nine months of 2006, the
                net effects
                of rate movements and repricing negatively impacted our net interest
                income by
                $627,000 and $2.0 million relative to the same periods in 2005.
  23
 
 Quarter
                          Ended
                      Net
                          Interest MarginSeptember
                          30, 2005
                      4.03%December
                          31, 2005
                      4.18%March
                          31, 2006
                      4.02%June
                          30, 2006
                      3.91%September
                          30, 2006
                      3.94%
  Contrary
                to the forecast in the second quarter press release, our net interest
                margin for
                the third quarter remained comparable to that of the second quarter,
                actually
                improving three basis points to 3.94%. We had indicated in our forecast
                that we
                expected to see continued compression in our net interest margin
                as we increased
                sales of Sales Finance loans, which are generally among our highest-yielding
                assets. While the sale of these loans negatively impacts our net
                interest
                margin, it results in substantial noninterest income, including the
                gains on
                loan sales recognized at the times of the transactions, as well as
                servicing fee
                income earned on an ongoing basis following the sales. We had also
                expected the
                margin to be impacted by maturities of large FHLB advance and time
                deposit
                balances in the first and second quarters of 2006, respectively.
                Between these
                factors, we expected our net interest margin to decline to between
                3.85% and
                3.90% in the third quarter and 3.80% to 3.85% in the fourth quarter.
                A key
                factor in avoiding the additional margin compression predicted in
                our second
                quarter press release was a higher than predicted level of interest
                income
                resulting from commercial loan prepayments.  Loan fees that are capitalized
                when loans are originated are then recognized as interest income
                in the event
                those loans are prepaid.
  **Noninterest
                Income**
  Our
                noninterest income increased $1.2 million, or 108% relative to the
                third quarter
                of last year, based primarily on significant increases in loan sales
                and
                resulting gains thereon. An increase in loan fees, particularly prepayment
                penalties on residential loans, as well as gains on derivative instruments
                related to long-term, fixed-rate commercial real-estate loans, also
                contributed
                to the fee income growth. It should be noted, however, that the income
                earned
                from this source was negated by mark-to-market losses on interest
                rate swaps
                reflected in our noninterest expense.
  On
                a
                year-to-date basis, noninterest income increased $2.0 million, or
                50% relative
                to the prior year level, with the higher level of gains on loan sales
                again
                making the most significant contribution to the additional income.
                Proceeds
                received from an insurance policy in the second quarter of this year
                also
                contributed to the increase, as did the previously mentioned gains
                on derivative
                instruments.
 
 Quarter
                          Ended
                      
                      Nine
                          Months EndedSeptember
                          30,
                        2006
                      
                      September
                          30,
                        2005
                      
                      September
                          30,
                        2006
                      
                      September
                          30,
                        2005Gains/(Losses)
                          on Loan Sales:Consumer
                      
                      $
                      784,000
                      
                      $
                      117,000
                      
                      $
                      1,962,000
                      
                      $
                      820,000Residential
                      
                      
                      69,000
                      
                      
                      59,000
                      
                      
                      68,000
                      
                      
                      120,000Commercial
                      
                      
                      62,000
                      
                      
                      (3,000
                      )
                      
                      195,000
                      
                      
                      178,000Total
                          Gains on Loan
                        Sales
                      
                      $
                      915,000
                      
                      $
                      173,000
                      
                      $
                      2,225,000
                      
                      $
                      1,118,000
  24
 Loans
                          Sold:Consumer
                      
                      $
                      17,987,000
                      
                      $
                      2,207,000
                      
                      $
                      41,030,000
                      
                      $
                      17,883,000Residential
                      
                      
                      12,701,000
                      
                      
                      9,440,000
                      
                      
                      35,813,000
                      
                      
                      21,530,000Commercial
                      
                      
                      6,382,000
                      
                      
                      3,330,000
                      
                      
                      11,575,000
                      
                      
                      5,900,000Total
                          Loans Sold
                      
                      $
                      37,070,000
                      
                      $
                      14,977,000
                      
                      $
                      88,418,000
                      
                      $
                      45,313,000
  Continuing
                the trend from the first half of this year, our third quarter gains
                on loan
                sales, primarily consumer loans, significantly exceeded those of
                the prior year.
                For the quarter, gains on loan sales increased $742,000, or 428%
                over the third
                quarter of last year. On a year-to-date basis, gains were up $1.1
                million,
                nearly double over last year’s level.
  In
                recent
                quarters we have noted an increased level of interest in our consumer
                loans in
                the secondary market, and that we expected sales of these loans to
                increase
                relative to the levels experienced in 2005. Although consumer loan
                sales for the
                third quarter of 2006 were at the low end of our expectations, sales
                still far
                exceeded those of the same period last year, partially because of
                a very low
                level of sales in 2005. Based on our current levels of loan production
                and
                market demand, our expectation is for our fourth quarter consumer
                loan sales to
                total in the $14 - $18 million range, which would once again significantly
                exceed the prior year’s sales levels. Note that these expectations may be
                subject to change based on changes in loan production, market conditions,
                and
                other factors.
                25
 Because
                of a high sales level in September, the volume of residential loans
                sold during
                the quarter exceeded the amount sold in the same periods last year,
                as did gains
                thereon. As 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 for competitive reasons. Additionally, as residential loans
                are typically
                sold servicing released, sales do not result in future servicing
                income.
  After
                selling participations in several commercial real-estate loans during
                the second
                quarter, additional participations were transacted in the third quarter.
                Based
                on the absence of gains in the third quarter of last year, gains
                in the third
                quarter of 2006 were well above their year ago levels, and gains
                on a
                year-to-date basis were slightly ahead of last year’s pace. While our current
                expectation is that we will continue our commercial real-estate loan
                sales, we
                would reiterate our comment made in previous quarters that commercial
                real-estate loan transactions, particularly those that are candidates
                for sales
                of participations to other institutions, tend to be larger-dollar
                credits and
                unpredictable in their timing and frequency of occurrence. As a result,
                the
                volumes of commercial real-estate loans sold, and gains thereon,
                will vary
                considerably from one quarter to the next depending on the timing
                of the loan
                and sales transactions.
  **Service
                Fee Income/(Expense)**
  Quarter
                          Ended
                      
                      Nine
                          Months EndedSeptember
                          30, 2006
                      
                      September
                          30, 2005
                      
                      September
                          30, 2006
                      
                      September
                          30, 2005Consumer
                          Loans
                      
                      $
                      300,000
                      
                      $
                      314,000
                      
                      $
                      930,000
                      
                      $
                      955,000Commercial
                          Loans
                      
                      
                      —
                      
                      
                      9,000
                      
                      
                      9,000
                      
                      
                      59,000Residential
                          Loans
                      
                      
                      (3,000
                      )
                      
                      (5,000
                      )
                      
                      (7,000
                      )
                      
                      (1,000
                      )Service
                          Fee Income
                      
                      $
                      297,000
                      
                      $
                      318,000
                      
                      $
                      932,000
                      
                      $
                      1,013,000
  As
                was
                the case in the second quarter of this year, our third quarter servicing
                fee
                income declined relative to the level earned in the same period last
                year, with
                significant reductions observed in servicing income from both consumer
                and
                commercial loans serviced for other institutions. Servicing fee income
                represents the net of actual servicing income received less the amortization
                of
                servicing assets, which is 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 at allocated cost based
                on fair
                value. The servicing rights are then amortized in proportion to,
                and over the
                period of, the estimated future servicing income.
  The
                primary reason for the decline in net service fee income was an increase
                in
                servicing asset amortization expense, relative to the level of gross
                service fee
                income received. The amortization of servicing assets is reviewed
                on a quarterly
                basis, taking into account market
  26
 discount
                rates, anticipated prepayment speeds, estimated servicing cost per
                loan, and
                other relevant factors. These factors are subject to significant
                fluctuations,
                and any projection of servicing asset amortization in future periods
                is limited
                by the conditions that existed at the time the calculations were
                performed, and
                may not be indicative of actual amortization expense that will be
                recorded in
                future periods.
  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 our deposit accounts increased $15,000, or 9%, compared
                to the
                third quarter of 2005, and $85,000, or 18% on a year-to-date basis
                relative to
                last year. The improvement over the prior year level is attributable
                to
                increased fees and checking account service charges, which have grown
                as we have
                continued our efforts to expand our base of business and consumer
                checking
                accounts.
  **Other
                Noninterest Income**
 
 Quarter
                          Ended
                      
                      Nine
                          Months EndedSeptember
                          30,
                        2006
                      
                      September
                          30,
                        2005
                      
                      September
                          30,
                        2006
                      
                      September
                          30,
                        2005ATM/Wire/Safe
                          Deposit Fees
                      
                      $
                      87,000
                      
                      $
                      69,000
                      
                      $
                      241,000
                      
                      $
                      188,000Late
                          Charges
                      
                      
                      73,000
                      
                      
                      53,000
                      
                      
                      189,000
                      
                      
                      147,000Loan
                          Fee Income
                      
                      
                      294,000
                      
                      
                      111,000
                      
                      
                      545,000
                      
                      
                      469,000Rental
                          Income
                      
                      
                      192,000
                      
                      
                      160,000
                      
                      
                      535,000
                      
                      
                      470,000Miscellaneous
                      
                      
                      270,000
                      
                      
                      61,000
                      
                      
                      857,000
                      
                      
                      176,000Other
                          Noninterest Income
                      
                      $
                      916,000
                      
                      $
                      454,000
                      
                      $
                      2,367,000
                      
                      $
                      1,450,000
  Our
                noninterest income from sources other than those described earlier
                rose by
                $462,000, or 102% for the quarter and $917,000, or 63% on a year-to-date
                basis
                relative to the same periods last year. As previously noted, gains
                on derivative
                instruments contributed to the increase for both the quarter and
                the
                year-to-date period, while insurance proceeds received from a key-man
                insurance
                policy in the second quarter of this year also factored significantly
                in the
                year-to-date result.
  The
                marking-to-market of two interest-rate derivatives that we entered
                into during
                the second quarter, contributed $138,000 in income for the third
                quarter and
                $188,000 for the nine months ended September 30, 2006. While these
                were, in
                fact, unrealized gains on the positions, accounting rules require
                any change in
                the market value of such instruments to be reflected in the current
                period
                income. As previously noted, mark-to-market losses on interest rate
                swaps
                counteracted the income earned from this source. The unrealized mark-to-market
                losses on these additional instruments are reflected in our noninterest
                expense.
                These derivatives are associated with two commercial loans totaling
                approximately $3 million and are marked-to-market each quarter. The
                derivatives
                were utilized to hedge interest rate risk associated with extending
  27
 longer-term,
                fixed-rate periods on commercial real-estate loans, and structured
                such that a
                gain on any given derivative is matched against a nearly identical
                loss on an
                offsetting derivative, resulting in essentially no net impact to
                the Bank’s
                earnings. To the extent that we continue to offer similar longer-term,
                fixed-rate periods on commercial real-estate loans in the future,
                and use
                similar derivative structures to manage interest rate risk, this
                income, as well
                as the offsetting expense, would be expected to increase in future
                periods.
  A
                change
                in the accounting treatment for a cash flow hedge on a Trust Preferred
                Security
                (TPS) resulted in a mark-to-market gain of $52,000 in the third quarter.
                Change
                in valuations for the cash flow hedge had previously been recorded
                in
                comprehensive income and reflected in shareholder equity. A recent
                change in SEC
                guidelines directed that any change in value for the interest rate
                swap used to
                hedge the TPS needed to be reflected in earnings. The cumulative
                effect of the
                change in valuation for the hedge since its inception in 2002 was
                $52,000.
                Because the amount of the change in accounting treatment was insignificant
                compared to the current and past quarters, we have accounted for
                the change on a
                prospective basis. The interest rate swap matures in July 2007.
  Following
                a reduction in the second quarter, loan fee income recovered strongly,
                exceeding
                the third quarter 2005 level by $183,000, or 165%. This, in turn,
                resulted in a
                year-to-date total of approximately $76,000 over that earned through
                the first
                nine months of last year. Prepayment penalties have typically accounted
                for the
                majority of this fee income, and this remained the case in the third
                quarter.
                While higher prepayment fees were received from our commercial real
                estate and
                consumer loan portfolios relative to the third quarter of 2005, residential
                loans accounted for the majority of both total fees and the increase
                over the
                prior year. Prepayment fees on residential loans totaled $179,000
                for the
                quarter, including one on a custom construction loan that exceeded
                $70,000.
  We
                continued to observe significant growth in our ATM/Wire/Safe Deposit
                Fees, which
                totaled $87,000 for the quarter and $241,000 on a year-to-date basis,
                representing increases of 26% and 28% over the same periods in 2005.
                Most of
                this growth is attributable to Visa fee income, which we expect to
                continue
                rising as checking accounts become a greater piece of our overall
                deposit
                mix.
  Rental
                income also increased significantly relative to the prior year, as
                the second
                quarter of 2006 brought the arrival of a new tenant in the First
                Mutual Center
                building, as well as a recovery of some 2005 operating expenses from
                other
                tenants in the building.
  **Noninterest
                Expense**
  Noninterest
                expense increased nearly $1.1 million, or 16% in the third quarter
                and $2.6
                million, or 13% in the first nine months of 2006 over the same periods
                in 2005.
                While personnel related expenses represented the most significant
                increase in
                operating costs, occupancy and other noninterest expenses also increased
                substantially on both a quarterly and year-to-date basis.
  28
 **Salaries
                and Employee Benefits Expense**
  In
                the
                third quarter of 2006, salary and employee benefit expense increased
                $613,000,
                or 16% over the same quarter last year, after growing only $145,000,
                or 3% in
                the second quarter of 2006 relative to the same period in 2005. On
                a
                year-to-date basis, salary and employee benefit expense increased
                $1.3 million,
                10% over the prior year’s level.
  Quarter
                          Ended
                      
                      Nine
                          Months EndedSeptember
                          30,
                        2006
                      
                      September
                          30,
                        2005
                      
                      September
                          30,
                        2006
                      
                      September
                          30,
                        2005Salaries
                      
                      $
                      3,480,000
                      
                      $
                      3,107,000
                      
                      $
                      10,308,000
                      
                      $
                      9,293,000Less
                          Amount Deferred with Loan Origination Fees (FAS 91)
                      
                      
                      (403,000
                      )
                      
                      (580,000
                      )
                      
                      (1,264,000
                      )
                      
                      (1,619,000
                      )Net
                          Salaries
                      
                      $
                      3,077,000
                      
                      $
                      2,527,000
                      
                      $
                      9,044,000
                      
                      $
                      7,674,000Commissions
                          and Incentive Bonuses
                      
                      
                      506,000
                      
                      
                      434,000
                      
                      
                      1,680,000
                      
                      
                      1,873,000Employment
                          Taxes and Insurance
                      
                      
                      225,000
                      
                      
                      189,000
                      
                      
                      793,000
                      
                      
                      751,000Temporary
                          Office Help
                      
                      
                      24,000
                      
                      
                      95,000
                      
                      
                      178,000
                      
                      
                      206,000Benefits
                      
                      
                      520,000
                      
                      
                      494,000
                      
                      
                      1,580,000
                      
                      
                      1,513,000Total
                      
                      $
                      4,352,000
                      
                      $
                      3,739,000
                      
                      $
                      13,275,000
                      
                      $
                      12,017,000
  Relative
                to the prior year, net salaries expense grew 22%, or $550,000, for
                the third
                quarter, and 18%, or $1.4 million on a year-to-date basis. A large
                part of the
                increase in salary expense this year has been a result of expensing
                stock option
                compensation in accordance with Statement of Financial Accounting
                Standard
                (SFAS) 123-R, which we adopted effective January 1, 2006. Expense
                related to
                stock option compensation totaled $175,000 in the third quarter,
                up from
                $135,000 and $125,000 in the first and second quarters of 2006, respectively.
                As
                SFAS 123-R had not been adopted in 2005, no expense was recognized
                last year. We
                noted in our second quarter press release that an increase in stock
                option
                expense was anticipated for the third quarter based on the timing
                of options
                granted. We currently anticipate an additional increase of 12% in
                the fourth
                quarter.
  Further
                contributing to the growth in salary expense was a significant reduction
                in the
                deferral of salary costs related to loan originations. In accordance
                with
                current accounting standards, certain loan origination costs, including
                some
                salary expenses tied to loan origination, are deferred and amortized
                over the
                life of each loan originated, rather than expensed in the current
                period.
                Operating costs 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.”
  Through
                the first three quarters of this year, the amount of salary expense
                deferred by
                our Income Property and Residential Lending areas has run below the
                levels
                deferred in 2005, resulting in higher current period expenses. In
                the case of
                our Residential lending area, both the number of loans originated
                in 2006, as
                well as the deferred costs associated with each origination, declined
                relative
                to last year. In contrast, while our Income Property department’s originations
                through the first nine months of this year were comparable to last
                year, the mix
                of
  29
 loans
                changed substantially, with a greater volume of construction loans,
                which
                resulted in a much lower level of expense deferral.
  Additionally,
                part of the increase can be attributed to growth in staffing levels,
                as we
                employed 235 full-time equivalent employees (FTE) as of September
                30, 2006,
                versus 221 FTE employees a year earlier, representing growth of approximately
                6%. Also contributing to the escalation in regular compensation expense
                were the
                annual increases in staff salaries, which took effect in April 2006
                and
                generally fell within the 2% to 4% range.
  While
                commission and incentive compensation grew relative to the third
                quarter of last
                year, the increase was attributable to an unusual occurrence last
                year, as
                opposed to anything pertaining to our 2006 operations. For those
                personnel not
                participating in a specified commission or incentive compensation
                plan, we
                maintain a separate bonus pool, with accruals made to the pool at
                the end of
                each quarter based on our year-to-date performance. Based on our
                results through
                June 30, 2005, and the assumption that our results for the remainder
                of the year
                would meet or exceed the outlook presented in our second quarter
                2005 press
                release, we accrued a total of $426,000 in the first two quarters
                of last year.
                These results did not materialize, and at the end of the third quarter
                of last
                year our year-to-date performance did not support the bonus that
                had been
                accrued. Consequently, for the third quarter of 2005, we made a reversal
                of
                $165,000, leaving a year-to-date balance of $261,000. For the third
                quarter of
                2006, we made no accrual or reversal to this bonus pool, implying
                a $165,000
                increase in quarterly bonus expense relative to last year’s
                reversal.
  Partially
                offsetting this implied increase in the staff bonus pool was a $73,000,
                or 16%
                reduction in loan officer commissions in the third quarter relative
                to the prior
                year, as residential loan production and thus commissions paid to
                our lending
                officers fell significantly from last year. The incentive compensation
                plans for
                loan production staff tend to vary directly with the production of
                the business
                lines.
  Expenditures
                on temporary office help during the quarter declined significantly
                relative to
                the third quarter of last year, largely because of reductions in
                usage in our
                accounting, consumer loan administration, and customer service areas.
                Temporary
                office help is frequently used to staff positions left vacant as
                a result of
                employee turnover. As permanent employees were placed in these positions
                following the third quarter of last year, reliance upon temporary
                staff was
                reduced. On a year-to-date basis, expenditures for temporary office
                help were
                down $28,000, or approximately 14%.
  **Occupancy
                Expense**
  Occupancy
                expense increased $187,000, or 22% compared to the third quarter
                of 2005, and
                $607,000, or 24% relative to the first three quarters of last year.
                Factoring
                heavily in the increases for both the quarter and year-to-date period
                was a
                substantial increase in depreciation expense. We remodeled several
                of our
                banking centers and sections of our First Mutual Center building,
                most of which
                was completed in the second half of 2005, and relocated the West
                Seattle Banking
                Center in 2006.
  30
 
 Quarter
                          Ended
                      
                      Nine
                          Months EndedSeptember
                          30,
                        2006
                      
                      September
                          30,
                        2005
                      
                      September
                          30,
                        2006
                      
                      September
                          30,
                        2005Rent
                          Expense
                      
                      $
                      64,000
                      
                      $
                      82,000
                      
                      $
                      222,000
                      
                      $
                      241,000Utilities
                          and Maintenance
                      
                      
                      180,000
                      
                      
                      154,000
                      
                      
                      582,000
                      
                      
                      483,000Depreciation
                          Expense
                      
                      
                      528,000
                      
                      
                      410,000
                      
                      
                      1,555,000
                      
                      
                      1,144,000Other
                          Occupancy Expenses
                      
                      
                      266,000
                      
                      
                      205,000
                      
                      
                      732,000
                      
                      
                      616,000Total
                          Occupancy Expense
                      
                      $
                      1,038,000
                      
                      
                      851,000
                      
                      $
                      3,091,000
                      
                      $
                      2,484,000
  Depreciation
                expense rose nearly $118,000, or 29% compared to the third quarter
                of last year
                and $411,000, or 36% relative to the first nine months of 2005, as
                a result of
                the previously noted new buildings and improvements. In addition,
                depreciation
                related to items such as furniture, fixtures, and computer networking
                equipment
                also increased relative to 2005 levels, as the construction and renovation
                projects were typically accompanied by new furnishings and equipment.
                On a
                sequential quarter basis, depreciation expense has remained relatively
                stable
                this year, showing only modest increases between the first, second,
                and third
                quarters.
  Utilities
                and maintenance expenses increased $26,000, or 17% for the third
                quarter, and
                $99,000, or 21% through the first three quarters of the year, relative
                to the
                same periods in 2005. In addition to higher utilities rates this
                year, several
                projects completed in the banking centers and at First Mutual Center
                contributed
                to the increased costs. These projects included, among other things,
                new
                signage, removing old signage at the previous West Seattle Banking
                Center
                location, landscaping, and HVAC and window film repairs at First
                Mutual
                Center.
  Rent
                expense was lower on both a quarterly and year-to-date basis this
                year, due to
                the closings of Income Property lending offices as well as the relocation
                of the
                West Seattle Banking Center from a rented space to a new building
                that we
                own.
  Within
                the other occupancy costs category, small fixed asset purchases,
                which are
                expensed rather than capitalized, represented the most significant
                component of
                the overall increase for both the quarter and year-to-date periods,
                increasing
                $47,000 for the quarter and $45,000 through the first nine months
                of the year.
                This increase over the prior year was largely attributable to a nonrecurring
                purchase of furniture and equipment for our Redmond training center
                in July
                2006. Maintenance costs for computers and equipment rose by $31,000
                on a
                year-to-date basis, based on a change in the management of, and contract
                for,
                office equipment such as printers and copy machines. Additionally,
                real estate
                taxes rose $27,000 compared to the first three quarters of 2005 as
                a result of
                annual increases in taxes paid on Bank properties, as well as property
                taxes on
                the land purchased for our new Canyon Park banking center, which
                is scheduled to
                open in the second or third quarter of 2007.
  **Other
                Noninterest Expense**
  For
                the
                quarter, other noninterest expense increased $266,000, or 13% relative
                to the
                third quarter of last year. The most significant contributors to
                the growth were
                losses on instruments used to hedge interest rate risk on long-term,
                fixed-rate
                commercial real-estate loans, as well as taxes, and legal fees. As
                previously
                discussed, the losses incurred from the hedging instruments were
                offset by
                mark-to-market gains on offsetting instruments that were reflected
                in our
  31
 noninterest
                income. Through the first three quarters of 2006, other noninterest
                expense
                increased $718,000, or 12% compared to the prior year. In addition
                to the losses
                on hedging instruments, taxes, legal fees, and increased expenditures
                for credit
                insurance also contributed significantly to the higher level of year-to-date
                expense.
  Quarter
                          Ended
                      
                      Nine
                          Months EndedSeptember
                          30,
                        2006
                      
                      September
                          30,
                        2005
                      
                      September
                          30,
                        2006
                      
                      September
                          30,
                        2005Marketing
                          and Public Relations
                      
                      $
                      210,000
                      
                      $
                      353,000
                      
                      $
                      730,000
                      
                      $
                      1,056,000Credit
                          Insurance
                      
                      
                      394,000
                      
                      
                      365,000
                      
                      
                      1,336,000
                      
                      
                      1,043,000Outside
                          Services
                      
                      
                      194,000
                      
                      
                      162,000
                      
                      
                      616,000
                      
                      
                      514,000Information
                          Systems
                      
                      
                      244,000
                      
                      
                      232,000
                      
                      
                      674,000
                      
                      
                      705,000Taxes
                      
                      
                      205,000
                      
                      
                      137,000
                      
                      
                      509,000
                      
                      
                      363,000Legal
                          Fees
                      
                      
                      115,000
                      
                      
                      58,000
                      
                      
                      420,000
                      
                      
                      265,000Other
                      
                      
                      948,000
                      
                      
                      737,000
                      
                      
                      2,572,000
                      
                      
                      2,193,000Total
                          Other Noninterest Expense
                      
                      $
                      2,310,000
                      
                      $
                      2,044,000
                      
                      $
                      6,857,000
                      
                      $
                      6,139,000
  The
                hedging instruments, which represent the marking to market of two
                interest-rate
                swaps into which we entered during the second quarter, resulted in
                $138,000 in
                noninterest expense for the third quarter and $188,000 for the nine
                months ended
                September 30, 2006. While the losses on these instruments were, in
                fact,
                unrealized, accounting rules require any change in the market value
                of such
                instruments to be reflected in the current period income. Additionally,
                as
                previously noted in the “noninterest income” section, the losses incurred on
                these swaps were offset by mark-to-market gains on offsetting instruments.
                These
                derivatives are associated with two longer-term, fixed-rate commercial
                real-estate loans totaling approximately $3 million, and are marked-to-market
                each quarter. The derivatives were utilized to hedge interest rate
                risk
                associated with these loans and structured such that a gain on any
                given
                derivative is matched against a nearly identical loss on an offsetting
                derivative, resulting in essentially no net impact to the Bank’s earnings. To
                the extent that we continue to offer similar longer-term, fixed-rate
                maturities
                on commercial real estate loans in the future and use similar derivative
                structures to manage interest rate risk, this income, as well as
                the offsetting
                expense, would be expected to increase in future periods.
  Relative
                to prior year levels, our tax expense rose 88% in the second quarter
                and 49% in
                the third quarter of 2006 due to increased business and occupation
                taxes. In
                addition to an increase in taxes resulting from income received from
                sales of
                consumer loans, the third quarter taxes include a $35,000 settlement
                with the WA
                State Department of Revenue on our B&O tax audit.
  Compared
                to the same periods last year, legal fees rose $57,000, or 98% for
                the quarter,
                and $155,000, or 59% on a year-to-date basis, principally from our
                Sales Finance
                operations. The growth in that department’s legal expense was associated with a
                biennial compliance review of our lending practices in the numerous
                states in
                which the Sales Finance area conducts business. In addition to our
                Sales Finance
                operations, the first quarter of 2006 saw legal expenses increase
                as a result of
                fees associated with several non-performing loans. We recovered a
                portion of
                these expenses early in the second quarter.
  32
 After
                rising 39% over prior year levels in the first half of the year,
                our credit
                insurance premium costs rose only 8% in the third quarter, based
                on a refund of
                $70,000 in premiums on one of our insured sales finance pools. The
                majority of
                the credit insurance premiums is attributable to sales finance loans
                and, to a
                much lesser extent, residential land loans. A small share of the
                consumer and
                income property loan portfolios is also insured. As the portfolios
                and the
                percentage of the portfolios insured have grown, credit insurance
                premium
                expenses have increased. Including the third quarter refund, our
                credit
                insurance expense was up $293,000, or 28% over the prior year, through
                the first
                three quarters of 2006.
  Partially
                offsetting the growth in operating costs was a decline in our marketing
                and
                public relations expenses of $143,000, or 40% in the third quarter
                of 2006
                compared to the same period last year, and $326,000, or 31% for the
                nine months
                ended September 30, 2006. We reduced marketing expenditures across
                all
                departments during the first three quarters of this year, and anticipate
                that
                marketing and public relations costs will be maintained at a similar
                level for
                the remainder of the year.
  **FINANCIAL
                CONDITION**
 
 **Assets**
 
 As
                of the
                September 30, 2006 quarter-end, our assets totaled $1.094 billion,
                representing
                an increase of less than 1% over the $1.086 billion 2005 year-end
                level, and a
                reduction of a similar magnitude from the June 2006 quarter-end level
                of $1.103
                billion. Asset growth has been minimal through the first three quarters
                of 2006,
                with sequential quarter growth occurring only in the second quarter
                of this
                year. A substantially higher level of loan sales than in prior years
                and the
                continued runoff of our securities portfolio have been significant
                factors in
                the lack of growth this year.
 
 **Cash
                and Equivalents**
 
 Our
                balances of cash and equivalents, specifically our noninterest earning
                balances,
                declined significantly as of the September 30, 2006 quarter-end,
                totaling $14
                million after exceeding $20 million at both the previous quarter
                and December
                2005 year-end. Contributing to the reduction were the introduction
                of a new
                program which decreased our reserve requirement at the Federal Reserve,
                as well
                as a change in our correspondent banking relationship which reduced
                balances in
                transit.
 
 We
                view
                the decline in cash balances as a positive event, as reducing a noninterest
                earning asset balance does not result in the loss of any interest
                income, but
                does allow us to retire a corresponding level of funding sources
                and avoid the
                related interest expense.
 
 **Securities**
 
 Our
                securities portfolio (available-for-sale and held-to-maturity) fell
                $23 million
                from its level as of September 2005, $22 million from the year end
                level, and $4
                million from the June 30, 2006 quarter-end, to $99 million as of
                September 30,
                2006. Our expectation for the remainder of 2006 is that while we
                may consider
                executing a purchase of securities to replace part of the run-off
                in the
                portfolio, we do not anticipate a material increase in the size of
                our
                securities portfolio.
 
 33
 Over
                the
                past several quarters, we have typically found the yields available
                on
                investment securities to be significantly less attractive than those
                on loans,
                particularly when the funding costs to support the additional assets
                were taken
                into account. Consequently, as the securities in our portfolio have
                amortized or
                matured, we have generally not replaced the paid off balances, but
                instead
                redirected those cash flows to support loan growth. In the event
                that yields on
                securities and/or the cost of funding purchases should become more
                conducive to
                holding investment securities, we would consider increasing the size
                of our
                securities portfolio at that time.
 
 Based
                on
                current accounting literature, any investment security purchased
                is classified
                in one of the following categories: 1) trading, 2) available-for-sale,
                or 3)
                held-to-maturity. The majority of the securities in our present portfolio
                are of
                the second type, available-for-sale. None of the securities in our
                portfolio are
                classified in the trading category. Available-for-sale securities
                are reviewed
                regularly, and any unrealized gains or losses are recorded in comprehensive
                income in the shareholders’ equity account. As of September 30, 2006, the
                balance of the unrealized loss in comprehensive income, net of federal
                income
                taxes, totaled $1.6 million, indicating a decline relative to the
                $2.7 million
                and $2.0 million levels as of the quarters ended June 30 and March
                31, 2006, and
                nearly returned to the $1.5 million balance as of the December 31,
                2005
                year-end. Generally, falling interest rates will enhance the amount
                recorded as
                unrealized gain, and rising rates will erode unrealized gains, as
                the market
                value of securities inversely adjusts to the change in interest rates.
                The
                passage of time partially counteracts these interest rate effects,
                as the
                unrealized gain or loss on a given security will gradually decline
                to zero as
                the security approaches its maturity date. As we do not anticipate
                liquidating
                any of our securities that are currently in an unrealized loss position,
                we do
                not expect that any of the unrealized loss will directly impact the
                gain or loss
                from security sales in future periods.
 
 **Servicing
                Assets**
 
 Servicing
                assets represent the deferred servicing rights generated from sales
                of loans
                that are sold servicing retained, reduced by the amortization and
                prepayments of
                those loans, as well as any impairment charges that may occur. While
                the
                increases in servicing assets have not and do not represent a significant
                percentage of our total assets, this area has grown and is expected
                to continue
                growing with future loan sales. Our servicing assets increased more
                than $1.4
                million, or 77% through the first three quarters of 2006, including
                growth of
                $593,000 or 22% in the third quarter.
   3Q
                          2006
                      
                      2Q
                          2006
                      
                      1Q
                          2006
                      
                      4Q
                          2005Commercial
                      
                      $
                      281,000
                      
                      $
                      287,000
                      
                      $
                      275,000
                      
                      $
                      292,000Residential
                      
                      
                      71,000
                      
                      
                      82,000
                      
                      
                      92,000
                      
                      
                      114,000Consumer
                      
                      
                      2,943,000
                      
                      
                      2,333,000
                      
                      
                      2,107,000
                      
                      
                      1,460,000Total
                      
                      $
                      3,295,000
                      
                      $
                      2,702,000
                      
                      $
                      2,474,000
                      
                      $
                      1,866,000Loan
                          Balances Serviced for Others
                      
                      $
                      135,708,000
                      
                      $
                      117,789,000
                      
                      $
                      107,479,000
                      
                      $
                      105,850,000
 
 Continuing
                the trend from the first half of this year, our third quarter consumer
                loan
                sales significantly exceeded those of the prior year. In recent quarters,
                we
                have noted an increased level of interest in, and favorable opportunities
                to
                market our consumer loans to other
  34
 institutional
                investors, as well as our expectation that sales of these loans would
                likely
                increase relative to the levels observed in 2005. As we have taken
                advantage of
                these opportunities, our servicing asset balance for consumer loans
                has grown.
                Although consumer loan sales of $18 million for the third quarter
                of 2006 were
                at the low end of our expectations, sales still far exceeded those
                of the same
                period last year, as well as our first and second quarter 2006 sales
                volumes of
                $13 million and $10 million, respectively. Based on our current levels
                of loan
                production and market demand, our expectation is for our fourth quarter
                consumer
                loan sales to total in the $14 million to $18 million range, which
                would once
                again significantly exceed the prior year’s sales levels. Note that these
                expectations may be subject to change based on changes in loan production,
                market conditions, and other factors.
 
 Servicing
                assets related to commercial loans decreased slightly from the 2005
                year-end and
                second quarter of this year, as servicing assets on participations
                sold during
                the quarter and first nine months of the year have roughly replaced
                the
                amortization of existing assets. While we continue to investigate
                opportunities
                to sell participations in our commercial real estate loans, the volumes
                of loan
                sales and gains thereon can vary significantly from quarter to quarter
                based the
                unique natures of these loans and sales.
 
 Residential
                loans are generally sold servicing released and consequently, no
                servicing
                assets are recognized. In the fourth quarter of 2005, however, we
                executed a
                transaction that retained servicing rights for a pool of residential
                loans.
 
 **Loans**
 
 Loans
                receivable, excluding loans held-for-sale, increased $40 million
                from $878
                million at the close of 2005 to $918 million at September 30, 2006,
                with the
                majority of this growth, or approximately $27 million, occurring
                in the second
                quarter, and nearly $10 million in the third quarter. While loan
                originations
                rose 15% in the second quarter relative to the same quarter last
                year,
                production was down 21% in the third quarter and nearly 2% on a year-to-date
                basis compared to the same periods last year.
 
 Portfolio
                          Distribution
                      
                      3Q
                          2006
                      
                      2Q
                          2006
                      
                      1Q
                          2006
                      
                      Q4
                          2005Single
                          Family (includes held-for-sale)
                      
                      
                      28%
                      
                      
                      26%
                      
                      
                      26%
                      
                      
                      25%Income
                          Property
                      
                      
                      28%
                      
                      
                      28%
                      
                      
                      31%
                      
                      
                      34%Business
                          Banking
                      
                      
                      16%
                      
                      
                      16%
                      
                      
                      14%
                      
                      
                      13%Commercial
                          Construction
                      
                      
                      5%
                      
                      
                      5%
                      
                      
                      4%
                      
                      
                      3%Single
                          Family Construction:Spec
                          Construction
                      
                      
                      3%
                      
                      
                      3%
                      
                      
                      3%
                      
                      
                      2%Custom
                          Construction
                      
                      
                      9%
                      
                      
                      10%
                      
                      
                      10%
                      
                      
                      10%Consumer
                      
                      
                      11%
                      
                      
                      12%
                      
                      
                      12%
                      
                      
                      13%Total
                      
                      
                      100%
                      
                      
                      100%
                      
                      
                      100%
                      
                      
                      100%
 
 The
                modest increase that has occurred in earning assets over the course
                of this year
                has been attributable to growth in our loan portfolio, with our Business
                Banking
                and Residential Lending segments making the most significant contributions,
                though the Business Banking segment’s portfolio experienced a slight contraction
                in the third quarter following strong growth in the first half of
                the year.
                Additionally, our consumer lending segment would likely have shown
                significant
                growth this year, if not for the previously mentioned loan sales.
                Our sales of
                consumer loans have exceeded $41 million so far this year, including
                $18 million
                in the third
  35
 quarter.
                The lack of any significant growth in the loan portfolio for the
                most recent
                quarter was in line with expectations, as we indicated in our second
                quarter
                press release that based on our forecasts for production volumes,
                payoffs, and
                loan sales, we did not expect to see any growth, and possibly even
                a modest
                decline in the size of our loan portfolio in the third quarter.
 
 Income
                property loans, which consist of mortgages on investor-owned commercial
                real
                estate and multifamily properties, held steady as a percentage of
                the total
                portfolio between the second and third quarters, but have demonstrated
                a gradual
                declining trend over the longer term. This gradual decline has been
                largely the
                result of lower originations of permanent multifamily and commercial
                real estate
                loans, along with a high level of prepayments on the loan portfolio,
                which we
                attribute to a combination of a flat-to-inverted yield curve and
                increased
                competition from other lenders. 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 as 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. Secondly,
                with the yield
                curve providing borrowers with a financial incentive to refinance
                adjustable-rate loans, which make up the majority of our loan portfolio,
                with
                longer-term, fixed-rate debt, the prepayment rates on our income
                property
                portfolio remained at relatively high levels. Increased competition
                among
                lenders in our local market accelerated both the decline in new volumes
                as well
                as portfolio payoffs, as the competition frequently resulted in lenders
                offering
                prospective borrowers new loan commitments or existing borrowers
                the opportunity
                to refinance at unusually low margins.
 
 We
                have
                undertaken several initiatives to reduce the high prepayment rates
                in the income
                property loan portfolio and to address borrowers’ requests for fixed-rate loans.
                In an effort to prevent prepayments of certain loans this year, we
                offered rate
                modifications to some of our borrowers. While these modifications
                effectively
                reduced asset yields and negatively impacted our net interest margin,
                we believe
                that retaining these loans outweighed the costs of losing the borrowing
                relationships altogether. The impact to net interest income, and
                ultimately
                earnings, as a result of these modifications is less than what the
                reduction in
                net interest income would have been had these loans paid off and
                refinanced
                elsewhere, effectively compressing our income property portfolio.
                Additionally,
                in the second quarter of this year, we began to utilize interest-rate
                swaps to
                hedge interest rate risk associated with extending longer-term, fixed-rate
                loans
                to certain commercial real estate borrowers. The use of these swaps
                allows us to
                provide loans with the longer terms sought by certain borrowers,
                and then
                convert the loan’s fixed rate to a floating rate through an institutional
                counterparty, thus offsetting any potential interest rate risk to
                the Bank as a
                consequence of offering loans with longer, fixed-rate terms.
 
 Consumer
                loans, as a percentage of our overall loan portfolio, gradually declined
                from
                13% at the 2005 year-end to 11% at the end of the third quarter.
                This decline is
                a direct result of the high level of loan sales this year. Consumer
                loan sales
                totaled $13 million, $10 million, and $18 million for the first,
                second, and
                third quarters of 2006, respectively.
 
 **Deposits
                and Borrowings**
 
 For
                the
                third quarter and year-to-date periods, our total deposit balances
                increased $15
                million and $14 million, respectively, with non-maturity deposit
                balances rising
                in the first quarter, and
  36
 then
                losing ground over the subsequent quarters. In contrast, time deposit
                balances
                declined modestly in the first quarter, significantly in the second,
                and then
                increased substantially in the most recent quarter.
 
 In
                the
                first quarter of this year a substantial increase in non-maturity
                deposit
                balances allowed us to take steps to improve our funding mix by reducing
                balances borrowed from the FHLB, as well as rates offered on retail
                certificates
                of deposit. Unfortunately, this trend did not continue in the second
                and third
                quarters. Following impressive growth in the first quarter, our non-maturity
                deposit balances peaked in mid-April, then steadily declined for
                the next month
                as a result of outflows for federal income tax and state property
                tax payments,
                as well as a substantial reduction in balances maintained by a large
                commercial
                customer. The decline continued in the third quarter, as our non-maturity
                balances fell in July, then recovered modestly over the remainder
                of the
                quarter. Despite this recovery, our non-maturity balances ended the
                quarter at a
                level lower than that at which the quarter began. On a year-to-date
                basis,
                however, our non-maturity deposit balances remain approximately $13
                million
                above the 2005 year-end level.
 
 Offsetting
                the decline in non-maturity deposit balances in the third quarter
                were increased
                time deposit balances, including an increase in certificates issued
                through
                deposit brokerage services. Time deposit balances fell modestly in
                the first
                quarter and significantly in the second as we priced our time deposits
                less
                aggressively, resulting in a lower retention of maturing certificate
                balances.
                In the third quarter, however, time deposit balances increased significantly,
                rising nearly $23 million from their level as of the June 30, 2006
                quarter end,
                restoring balances to approximately $1 million over the 2005 year
                end level.
                Contributing to the higher time deposit balances as of September
                30, 2006 was an
                $8 million net increase in certificates issued through deposit brokerage
                services relative to the June 30, 2006 quarter-end. On a year-to-date
                basis, our
                brokered certificate balances increased $15 million on a net basis.
 
 Our
                preferred supplemental funding mechanism is borrowing funds from
                the FHLB.
                During the first quarter of this year, modest asset growth and substantial
                increases in non-maturity deposit balances allowed us to reduce the
                amount
                borrowed from the FHLB and improve our funding mix. This trend did
                not continue
                into the second quarter, however, as the combination of deposit runoff
                and
                increased asset growth resulted in an increased use of FHLB funding.
                After
                declining from $226 million as of December 31, 2005 to $207 million
                at the end
                of the first quarter, advances from the FHLB rose to $248 million
                at the end of
                the second quarter. Similar to the first quarter, however, the third
                quarter saw
                an absence of asset growth as well as an increase in deposit balances.
                The
                combination of these two factors resulted in our balance of outstanding
                FHLB
                advances declining to $218 million as of the most recent quarter-end.
                As of
                September 30, 2006, we had the authority to borrow up to approximately
                $438
                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**
  For
                the
                quarter, we reserved $267,000 in provisions for loan losses and unfunded
                commitments, down from the $325,000 provision in the third quarter
                of last year.
                Similarly, through the first three quarters 2006, the $473,000 reserved
                was a
                significant reduction relative to the $1.2 million provision for
                the same period
                in 2005. The reductions in this year’s provision were based in large part on
                very low net charge-off levels relative to historical norms, as well
                as this
                year’s
  37
 high
                sales levels of consumer loans, which typically constitute the majority
                of our
                charged-off balances. Our charged-off loan balances, net of recoveries,
                totaled
                only $56,000 in the third quarter of 2006 and $170,000 for the first
                nine months
                of the year. In contrast, net charge-offs totaled $173,000 and $615,000
                for the
                same periods last year. Also contributing to the reduction in this
                year’s
                provision was a significant slowdown in the rate of loan portfolio
                growth, and
                the fact that the loan growth we have experienced this year has been
                largely
                attributable to our residential lending segment, which is generally
                considered
                lower risk than other lending segments.
  Prior
                to
                the second quarter of 2006, the reserve for loan loss included the
                estimated
                loss from unfunded loan commitments. The preferred accounting method
                is to
                separate the loan commitments from the disbursed loan amounts and
                record the
                loan commitment portion as a liability. At September 30, 2006, we
                determined
                that the reserve for loan commitments was $345,000, which we have
                included in
“Accounts Payable and Other Liabilities.”
  We
                consider the liability account for unfunded commitments to be part
                of the
                reserve for loan loss. Although the accounting treatment that we
                now use is a
                preferred method, the substance of the reserve is the same as it
                has been in
                prior quarters. When we calculate the reserve for loan loss ratio
                to total loans
                we include the liability account in that calculation.
 
 Including
                the $345,000 liability for unfunded commitments, our reserve for
                loan losses
                totaled approximately $10.4 million at September 30, 2006, up from
                $9.9 million
                at September 30, 2005 and $10.1 million at the 2005 year-end. At
                this level, the
                allowance for loan losses represented 1.12% of gross loans at September
                30,
                2006, compared to 1.13% at both the 2005 year-end and September 30,
                2005.
 
 **Non-Performing
                Assets**
  Our
                exposure to non-performing assets as of September 30, 2006 was:
 One
                          multi-family loan in OR. Possible loss of $90,000.
                      
                      $
                      484,000One
                          multi-family loan in OR. No anticipated loss.
                      
                      
                      381,000Sixty-seven
                          consumer loans. Full recovery anticipated from insuranceclaims.
                      
                      
                      381,000Fourteen
                          insured consumer loans (insurance limits have beenexceeded).
                          Possible loss of $99,000
                      
                      
                      99,000Twelve
                          consumer loans. Possible loss of $84,000.
                      
                      
                      84,000One
                          single-family residential loan in Western WA. No anticipated
                          loss.
                      
                      
                      83,000Two
                          consumer loans. No anticipated loss.
                      
                      
                      20,000Total
                          Non-Performing Assets
                      
                      $
                      1,532,000
  **PORTFOLIO
                INFORMATION**
 
 **Commercial
                Real Estate Loans**
  The
                average loan size (excluding construction loans) in the Commercial
                Real Estate
                portfolio was $719,000 as of September 30, 2006, with an average
                loan-to-value
                ratio of 63%. At quarter-
  38
 end,
                two
                of these commercial loans were delinquent for 60 days. Small individual
                investors or their limited liability companies and business owners
                typically own
                the properties securing these loans. At quarter-end, the portfolio
                was 41%
                residential (multi-family or mobile home parks) and 59% commercial.
  The
                loans
                in our commercial real estate portfolio are well diversified, secured
                by small
                retail shopping centers, office buildings, warehouses, mini-storage
                facilities,
                restaurants and gas stations, as well as other properties classified
                as general
                commercial use. To diversify our risk and to continue serving our
                customers, we
                sell participation interests in some loans to other financial institutions.
                About 14% of commercial real estate loan balances originated by the
                Bank have
                been sold in this manner. We continue to service the customer’s loan and are
                paid a servicing fee by the participant. Likewise, we occasionally
                buy an
                interest in loans originated by other lenders. About $8 million of
                the
                portfolio, or 2%, has been purchased in this manner.
  **Sales
                Finance (Home Improvement) Loans**
  The
                Sales
                Finance loan portfolio balance decreased $4 million to $78 million,
                based on $21
                million in new loan production, $18 million in loan sales, and loan
                prepayments
                that ranged from 30%-40% (annualized).
  We
                manage
                the portfolio by segregating it into its uninsured and insured balances.
                The
                uninsured balance totaled $48 million at the end of the third quarter
                2006,
                while the insured balance was $30 million. A decision to insure a
                loan is
                principally determined by the borrower’s credit score. Uninsured loans have an
                average credit score of 732 while the insured loans have an average
                score of
                670. We are responsible for loan losses with uninsured loans and,
                as illustrated
                in the following table, the charge-offs for that portion of the portfolio
                have
                ranged from a low of $55,000 in net recoveries in second quarter
                2006 to a high
                of $223,000 in charge-offs in the first quarter 2006. The charge-offs
                in the
                first quarter 2006 were largely attributable to bankruptcy filings
                that occurred
                as a consequence of the change in bankruptcy laws in October 2005.
  UNINSURED
                          PORTFOLIO - BANK BALANCESBank
                        Balance
                      Net
                        Charge-Offs
                      Charge-offs
                        (%
                          of Bank
                        Portfolio)
                      Delinquent
                          Loans
                        (%
                          of Bank
                        Portfolio)September
                          30, 2005
                      $48
                          million
                      $  
                          98,000
                      0.21%
                      1.20%December
                          31, 2005
                      $52
                          million
                      $  
                          93,000
                      0.18%
                      1.18%March
                          31, 2006
                      $47
                          million
                      $
                          223,000
                      0.47%
                      0.92%June
                          30, 2006
                      $50
                          million
                      ($  
                          55,000)
                      (0.11%)
                      0.58%September
                          30, 2006
                      $48
                          million
                      $  
                          63,000
                      0.13%
                      1.33%
  Losses
                that we sustain in the insured portfolio are reimbursed by an insurance
                carrier
                up to the loss limit defined in the insurance policy. As shown in
                the following
                table, the claims to the insurance carrier have varied in the last
                five quarters
                from a low of $483,000 to as much as $1.0 million in the fourth quarter
                of 2005.
                The substantial increases in claims paid during the fourth quarter
                2005 and
                first quarter 2006 again were largely related to bankruptcy filings
                immediately
                before the change in bankruptcy laws. The standard limitation on
                loss coverage
                for this portion of the portfolio is 10% of the original pool of
                loans.
  39
 
 INSURED
                          PORTFOLIO - BANK AND INVESTOR LOANSClaims
                          Paid
                      Claims
                        (%
                          of Insured Balance)
                      Delinquent
                          Loans
                        (%
                          of Bank Portfolio)September
                          30, 2005
                      $  
                          493,000
                      0.91%
                      3.64%December
                          31, 2005
                      $1,023,000
                      1.87%
                      3.60%March
                          31, 2006
                      $  
                          985,000
                      1.81%
                      3.60%June
                          30, 2006
                      $  
                          483,000
                      0.86%
                      3.25%September
                          30, 2006
                      $  
                          555,000
                      0.97%
                      5.99%
  Through
                the third quarter of 2005, we maintained a relationship with a single
                credit
                insurance company (Insurer #1) that provided credit insurance on
                Sales Finance
                loans as well as on a small number of home equity products. In August
                2005, we
                entered into an agreement with another credit insurance company (Insurer
                #2) to
                provide similar insurance products with very similar underwriting
                and pricing
                terms.
  In
                October of 2005, we were unable to reach an agreement on the pricing
                of
                insurance for Sales Finance loans with Insurer #1, and have since
                placed newly
                insured loans with Insurer #2. This decision does not affect the
                pricing or
                coverage in place on loans currently insured with Insurer #1.
  In
                March
                2006, the pool for the policy year 2002/2003 reached the 10% cap
                from Insurer
                #1. Earlier, in October 2005, we acquired back-up insurance through
                Insurer #2
                to address this circumstance. The policy through Insurer #2 added
                $1.07 million
                in additional coverage to that pool year, an amount equal to 10%
                of the
                outstanding balances at the policy date. The cost of this policy
                was competitive
                with the premiums that we were paying to Insurer #1. However, beginning
                July 1,
                2006, Insurer #2 raised premiums by nearly 60% and we chose to discontinue
                the
                additional coverage. Upon cancellation, the insurer refunded approximately
                $70,000 in premiums paid on that policy, which lowered our insurance
                premiums in
                the third quarter.
  We
                are
                negotiating a new policy with Insurer #2 for the policy year beginning
                August 1,
                2006. As part of that negotiation, we are evaluating whether to continue
                insuring future loan production. Any decision about the continuation
                of credit
                default insurance on Sales Finance loans will likely be made in the
                fourth
                quarter.
  Insurer
                #1
 RemainingCurrent
                      Original
                      
                      Remaining*
                      Limit
                          as %
                      CurrentPolicy
                      Loans
                      Loan
                      Loss
                      Claims*
                      Loss
                      of
                          Current
                      DelinquencyYear*
                      Insured
                      Balance
                      Limit
                      Paid
                      Limit
                      Balance
                      Rate2002/2003
                      $21,442,000
                      $ 
                          7,587,000
                      $2,144,000
                      $2,153,000
                      $   
                          67,000
                      0.88%
                      8.63%2003/2004
                      $35,242,000
                      $15,681,000
                      $3,524,000
                      $2,853,000
                      $ 
                          671,000
                      4.28%
                      6.75%2004/2005
                      $23,964,000
                      $14,667,000
                      $2,396,000
                      $1,034,000
                      $1,359,000
                      9.27%
                      5.36%
  Policy
                years close on 9/30 of each year.
  *Claims
                Paid and Remaining Loss Limit include credit for recoveries.
  40
 Insurer
                #2
 RemainingCurrent
                      Original
                      
                      Remaining
                      Limit
                          as %
                      CurrentPolicy
                      Loans
                      Loan
                      Loss
                      Claims
                      Loss
                      of
                          Current
                      DelinquencyYear
                      Insured
                      Balance
                      Limit
                      Paid
                      Limit
                      Balance
                      Rate2002/2003*
                      $0
                      $0
                      $1,077,000
                      $134,000
                      $0
                      0%
                      8.63%2005/2006
                      $19,992,000
                      $15,570,000
                      $1,999,000
                      $157,000
                      $1,842,000
                      11.83%
                      2.96%2006/2007
                      $ 
                          3,911,000
                      $ 
                          3,870,000
                      N/A**
                      $0
                      N/A
                      N/A
                      0%
  *Loans
                in
                this policy year were the same loans insured with Insurer #1 during
                the same
                time period. This policy is no longer active and there are no claims
                pending.
  **Not
                Applicable. Policy year closes on 7/31 of each year.
  The
                prepayment speeds for the entire portfolio continue to remain in
                a range of 30%
                to 40%. During the third quarter of 2006, the average new loan amount
                was
                $11,000. The average loan balance in the entire portfolio is $9,200,
                and the
                yield on this portfolio is 10.54%. Loans with credit insurance in
                place
                represent 40% of our portfolio balance, and 27% (by balance) of the
                loans
                originated in the third quarter were insured.
  **Residential
                Lending**
  The
                residential lending portfolio (including loans held for sale) totaled
                $331
                million on September 30, 2006. This represents an increase of $6
                million from
                the end of the second quarter, 2006. The breakdown of that portfolio
                at
                September 30, 2006 was:
  Bank
                          Balance
                      
                      %
                          of PortfolioAdjustable
                          rate permanent loans
                      $183
                          million
                      
                      55%Fixed
                          rate permanent loans
                      $ 
                          18 million
                      
                      5%Residential
                          building lots
                      $
                           47 million
                      
                      14%Disbursed
                          balances on custom construction loans
                      $ 
                          82 million
                      
                      25%Loans
                          held-for-sale
                      $   
                          1 million
                      
                      1%Total
                      $331
                          million
                      
                      100%
  The
                average loan balance in the permanent-loan portfolio is $202,000,
                and the
                average balance in the building-lot portfolio is $116,000. Owner-occupied
                properties, excluding building lots, constitute 75% of the portfolio.
                Our
                underwriting is typically described as non-conforming, and largely
                consists of
                loans that, for a variety of reasons, are not readily salable in
                the secondary
                market at the time of origination. The yield earned on the portfolio
                is
                generally much higher than the yield on a more typical “conforming underwriting”
portfolio. We underwrite the permanent loans by focusing primarily
                on the
                borrower’s good or excellent credit and our overall exposure on the loan.
                We
                manually underwrite all loans and review the loans for compensating
                factors to
                offset the non-conforming elements of those loans. We do not currently
                originate
                portfolio loans with interest-only payment plans nor do we originate
                an “Option
                ARM” product, where borrowers are given a variety of monthly payment options
                that allow for the possibility of negative amortization.
  41
 **DEPOSIT
                INFORMATION**
  The
                number of business checking accounts increased by 14%, from 2,182
                at September
                30, 2005, to 2,484 as of September 30, 2006, a gain of 302 accounts.
                The deposit
                balances for those accounts grew 11%. Consumer checking accounts
                also increased,
                from 7,350 in the third quarter of 2005 to 7,728 this year, an increase
                of 378
                accounts, or 5%. Our total balances for consumer checking accounts
                declined 5%.
  The
                following table shows the distribution of our deposits.
  Time
                        Deposits
                      
                      Checking
                      
                      MoneyMarket
                        Accounts
                      
                      SavingsSeptember
                          30, 2005
                      
                      65%
                      
                      14%
                      
                      20%
                      
                      1%December
                          31, 2005
                      
                      64%
                      
                      14%
                      
                      21%
                      
                      1%March
                          31, 2006
                      
                      62%
                      
                      13%
                      
                      24%
                      
                      1%June
                          30, 2006
                      
                      62%
                      
                      13%
                      
                      24%
                      
                      1%September
                          30, 2006
                      
                      63%
                      
                      13%
                      
                      23%
                      
                      1%
  **BUSINESS
                SEGMENTS**
 
 The
                management reporting process measures the performance of the operating
                segments
                based on the management structure of the Bank and is not necessarily
                comparable
                with similar information for any other financial institution.
 
 The
                reportable segments include the following:
 
 ·
                      *Consumer
                          Lending -*Consumer
                          lending includes home equity lending, direct consumer loans,
                          and indirect
                          home improvement loans (sales finance). These loans include
                          lines of
                          credit and loans for primarily consumer purposes.
 
 ·
                      *Residential
                          Lending -*Residential
                          lending offers loans to borrowers to purchase, refinance,
                          or build homes
                          secured by one-to-four-unit family dwellings. They also
                          finance the
                          purchase or refinance of buildable residential lots.
 
 ·
                      *Business
                          Banking Lending -*Business
                          Banking lending offers a full range of banking services
                          to small and
                          medium size businesses including deposit and cash management
                          products,
                          loans for financing receivables, inventory, equipment as
                          well as permanent
                          and interim construction loans for commercial real estate.
                          The underlying
                          real estate collateral or business asset being financed
                          typically secures
                          these loans.
 
 ·
                      *Income
                          Property Lending -*Income
                          Property lending offers permanent and interim construction
                          loans for
                          multifamily housing (over four units), manufactured housing
                          communities,
                          commercial real estate properties, and spec single-family
                          construction.
                          The underlying real estate collateral being financed typically
                          secures
                          these loans.
 
 Each
                of
                these business segments also sells loans into the secondary market.
                We may
                choose to retain or sell the right to service the loans sold (i.e.,
                collection
                of principal and interest payments) depending upon market
                conditions.
 
 42
 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, with the exception
                of the
                Consumer Lending Segment, derive a majority of their revenue from interest
                income, and we rely primarily on net interest revenue in managing
                these
                segments. No single customer provides more than 10% of the Bank’s
                revenues.
 
 **Consumer
                Lending**
 
 Quarter
                          Ended
                      
                      Nine
                          Months EndedNet
                          Income
                      
                      Return
                          on Equity
                      
                      Net
                          Income
                      
                      Return
                          on EquitySeptember
                          30, 2004
                      $
                          416,000
                      
                      18.34%
                      
                      $   
                          985,000
                      
                      15.83%September
                          30, 2005
                      $
                          414,000
                      
                      16.24%
                      
                      $   
                          928,000
                      
                      13.19%September
                          30, 2006
                      $
                          488,000
                      
                      21.25%
                      
                      $
                          1,343,000
                      
                      19.47%
 
 The
                Consumer Lending segment’s net income rose relative to the third quarter of 2005
                and increased significantly compared to the first nine months of
                last year based
                on substantially higher noninterest income, particularly gains on
                loan sales,
                compared to the prior year. These additional gains were, however,
                partially
                offset by a reduction in net interest income and higher noninterest
                expense.
 
 As
                of the
                September 30, 2006 quarter end, the Consumer segment’s earning assets totaled
                $117 million, a 5% reduction relative to the level one year prior,
                based on
                consumer loan sales of $41 million in the first nine months of this
                year,
                including $18 million in the third quarter. The lower level of earning
                assets
                was partially offset by new loans with higher rates resulting in
                interest income
                that was approximately flat with third quarter of last year. On a
                year-to-date
                basis, the segment’s average earning assets were only 3% higher than the
                previous year; however, increases in the prime rate earlier this
                year in the
                HELOC portion of the segment’s portfolio resulted in a 14% year-to-date increase
                in interest income.
 
 Interest
                expense rose 79% on a quarterly and 54% on a year-to-date basis relative
                to the
                same periods last year. A significant factor in our increasing cost
                of funds
                this year has been the decline in non-maturity deposit balances over
                the last
                two quarters. Following the first quarter of this year, we noted
                that a
                substantial growth in non-maturity deposit balances had allowed us
                to take steps
                to improve our funding mix by reducing FHLB borrowings and the rates
                offered on
                retail certificates of deposit. Unfortunately, this trend did not
                continue in
                the second and third quarters. Our non-maturity deposit balances
                peaked in
                mid-April, then declined as a result of outflows for federal income
                tax and
                state property tax payments, as well as a substantial reduction in
                balances
                maintained by a large commercial customer. The decline continued
                in the third
                quarter, as our non-maturity balances fell in July, then recovered
                modestly over
                the remainder of the quarter. This runoff in non-maturity balances
                was replaced
                by higher cost funding sources, specifically growth in time deposits,
                including
                those issued through brokerage services, and at various times, higher
                levels of
                FHLB advances. Also contributing to the increase over the prior year
                were FHLB
                advance balances that matured over the first quarter of this year
                and
                substantial time deposit balances maturing in the second quarter.
                Based on the
                rise in interest rates since these advances and time deposits were
                originated,
                these liabilities were subject to renewal at rates much higher than
                their
                original rates, resulting in a significant increase in interest expense
                compared
                to the prior year.
 
 Combined,
                these factors resulted in a 23% reduction in the Consumer segment’s net interest
                income relative to its third quarter 2005 level and a 5% decline
                from its level
                for the first three
  43
 quarters
                of last year.  Even with a $48,000 reduction in the third quarter provision
                for loan loss relative to the prior year, the segment’s net interest income
                after provision declined $397,000, or approximately 22% relative
                to the third
                quarter of 2005. Through three quarters, a $369,000 reduction in
                the segment’s
                provision for loan losses resulted in a $107,000, or 2% increase
                in the
                segment’s net interest income after provision relative to the prior year.
                Significant recoveries on previously charged-off loans during the
                second quarter
                and a low level of charge-offs in the third quarter, combined with
                this year’s
                high level of loan sales and resulting slowdown in loan portfolio
                growth, led to
                the significant reduction in the segment’s provision for loan losses. While we
                expect our improved collection efforts will contribute to a reduced
                level of
                loan losses relative to prior years, we believe that the provision
                for loan
                losses so far this year represent an unusual situation and expect
                our provision
                for loan losses to return to a level more consistent with historical
                norms in
                future quarters.
 
 The
                Consumer segment’s noninterest income exceeded the prior year levels by $664,000
                for the third quarter and $1.2 million on a year-to-date basis based
                on
                significantly higher volumes of loan sales and gains thereon. For
                the quarter,
                gains on consumer loan sales totaled $784,000 on sales of $18 million,
                up from
                $117,000 on sales of $2 million in the third quarter of 2005. Similarly,
                gains
                on sales through the first three quarters of this year totaled nearly
                $2.0
                million on sales of $41 million, compared to $820,000 on sales of
                $18 million
                last year. Based on our current levels of loan production and market
                demand, our
                expectation is for fourth quarter consumer loan sales to total in
                the $14
                million to $18 million range, significantly exceeding the prior year’s sales
                levels. Note that these expectations may be subject to change based
                on changes
                in loan production, market conditions, and other factors.
 
 Partially
                offsetting the additional net interest and noninterest income, however,
                was
                growth in the Consumer segment’s noninterest expenses, which increased $161,000
                and $670,000, or 10% and 13% compared to the third quarter and first
                nine months
                of last year. The largest contributors to the increased costs were
                compensation,
                credit insurance premiums, legal fees, and taxes. Compensation expense
                rose as a
                result of annual salary increases, additional expenditures for temporary
                office
                help, and the arrival of new personnel including a new manager for
                our Sales
                Finance lending area. The additional insurance cost was attributable
                to growth
                in insured sales finance loan balances, including both the loans
                in our
                portfolio and those serviced for other institutions, as well as a
                supplemental
                insurance policy taken out in late 2005 on a seasoned pool of previously
                insured
                loans. Also contributing to the additional expense were higher legal
                expenses
                for our Sales Finance operations attributable to the biennial compliance
                review
                process that evaluates our practices in the states in which we do
                business, as
                well as increased tax expense, which resulted from this year’s higher gains on
                loan sales and resulting profitability.
 
 **Residential
                Lending**
 
 Quarter
                          Ended
                      
                      Nine
                          Months EndedNet
                          Income
                      
                      Return
                          on Equity
                      
                      Net
                          Income
                      
                      Return
                          on EquitySeptember
                          30, 2004
                      $   
                          670,000
                      
                      24.21%
                      
                      $
                          2,054,000
                      
                      26.24%September
                          30, 2005
                      $   
                          921,000
                      
                      24.79%
                      
                      $
                          2,538,000
                      
                      24.65%September
                          30, 2006
                      $
                          1,081,000
                      
                      27.61%
                      
                      $
                          3,011,000
                      
                      27.23%
  For
                the
                most recent quarter and year-to-date period, the Residential Lending
                segment’s
                net income totaled $1.1 million and $3.0 million, representing improvements
                of
                17% and 19% over
  44
 the
                comparable 2005 results, based on higher levels of net interest and
                noninterest
                income as well as reductions in the provisions for loan losses. The
                additional
                revenues were, however, partly offset by rising operating expenses.
 
 The
                Residential segment has established a track record for consistent
                earning asset
                growth, with the segment’s September 30, 2006 balance indicating asset growth of
                approximately $27 million relative to the level one year prior. With
                the
                additional assets and the repricing effects resulting from increases
                in interest
                rate indexes from which the loan rates are set, interest income earned
                on the
                portfolio increased $1.4 million and $4.7 million, or 24% and 31%
                relative to
                the third quarter and first nine months of last year.
 
 As
                with
                the Consumer Lending segment, the rates of increase for the Residential
                segment’s interest expense exceeded the rates of interest income growth,
                totaling 42% and 56% relative to the quarter and nine months ended
                September 30,
                2005 due to the factors previously described in the Consumer Lending
                section; as
                well as the cost of the additional funds required to support the
                earning asset
                growth. Taking into account the increase in funding costs and the
                benefit of a
                $94,000 reduction in the segment’s provision for loan loss, the segment’s net
                interest income after provision increased approximately 10%, or $280,000
                compared to the third quarter of last year. Through the first three
                quarters of
                the year, net interest income after provision exceeded the prior
                year by $1.1
                million, or 13%, with $887,000 attributable to additional net interest
                income
                and $213,000 from reductions in the segment’s provision for loan
                loss.
 
 For
                the
                quarter, the Residential Lending segment’s noninterest income rose $196,000, or
                65%, based in large part on a higher level of loan fees, particularly
                prepayment
                fees. Prepayment fees on residential loans totaled $179,000 for the
                quarter, and
                included one fee received on a custom construction loan that exceeded
                $70,000.
                For the year-to-date period, the Residential Lending segment’s noninterest
                income increased $306,000, or 37%. In addition to the higher level
                of loan fee
                income, an allocation of insurance proceeds received from a key-man
                life
                insurance policy in the second quarter also contributed to the
                increase.
 
 The
                Residential segment’s noninterest expense increased $252,000, or 15% for the
                quarter. Similarly, for the nine months ended September 30, 2006,
                noninterest
                expense totaled $674,000 more in 2006, an increase of 13%. In both
                cases, a
                reduction in the amount of loan origination expenses eligible for
                deferral and
                amortization contributed significantly to the increase relative to
                last year.
 
 In
                accordance with current accounting standards, certain loan origination
                costs are
                deferred and amortized over the life of each loan originated, rather
                than
                expensed in the current period. Expenses are then reported in the
                financial
                statements net of these deferrals. The amount of expense subject
                to deferral and
                amortization can vary from one period to the next based upon the
                number of loans
                originated, the mix of loan types, and year-to-year changes in “standard loan
                costs”. In this instance, both the number of loans originated by our Residential
                lending area as well as the deferred costs associated with each origination
                declined relative to the prior year. This resulted in a lower level
                of expense
                being deferred and a higher level of expense being recognized in
                the current
                period.
 
 Also
                contributing to the additional expense in the third quarter and first
                nine
                months of 2006 were rising allocations of administrative and other
                costs,
                including expenses incurred at the banking centers. These allocations
                have
                increased with the growth of the Residential segment.
 
 45
 **Business
                Banking Lending**
 
 Quarter
                          Ended
                      
                      Nine
                          Months EndedNet
                          Income
                      
                      Return
                          on Equity
                      
                      Net
                          Income
                      
                      Return
                          on EquitySeptember
                          30, 2004
                      ($
                          73,000)
                      
                      (3.63%)
                      
                      ($
                          283,000)
                      
                      (4.92%)September
                          30, 2005
                      $
                          82,000
                      
                      3.02%
                      
                      $  
                          85,000
                      
                      1.09%September
                          30, 2006
                      $
                          46,000
                      
                      1.28%
                      
                      ($  
                          16,000)
                      
                      (0.16%)
 
 Our
                Business Banking segment is one of the newer business lines in which
                we have
                invested, and will continue to invest our resources with the eventual
                goal of
                achieving our targeted 15% return on equity and consistent year-over-year
                earnings growth. While these results have not yet been achieved,
                we continue to
                invest in this segment, based upon its ability to attract low-cost
                core
                deposits, which help reduce our overall cost of funds, the diversification
                it
                brings to our portfolio of earning assets, and the potential it offers
                for
                generating longer-term relationship-banking opportunities and additional
                sources
                of noninterest income.
 
 The
                Business Banking segment’s third quarter net interest income after provision for
                loan losses rose $347,000, or 24% over the same period last year,
                the largest
                increase among our business segments. Similarly, on a year-to-date
                basis, the
                segment’s net interest income after provision for loan losses exceeded the
                prior
                year level by $900,000, or 21%, the highest percentage increase among
                the four
                segments and second largest dollar increase behind the Residential
                segment. Like
                the Residential segment, the Business Banking segment succeeded in
                building
                incremental assets over the prior year, with earning assets totaling
                $175
                million as of September 30, 2006, an increase of nearly 35% over
                the prior year
                level and the highest rate of growth for any of our business
                segments.
 
 In
                addition to the earning asset growth, the prevalence of prime-based
                loans in the
                business banking portfolio also contributed to the improvement in
                interest
                income. While the majority of adjustable-rate loans in our portfolio
                reprice
                according to contractually defined schedules, most commonly on an
                annual basis,
                the rates on prime-based loans typically adjust in response to any
                change in the
                prime rate. Consequently, these loans repriced on several occasions
                over the
                course of 2005 and the first half of 2006.
 
 For
                the
                quarter and nine months ended September 30, 2006, the Business Banking
                segment’s
                noninterest income rose $211,000 and $258,000, or 192% and 53% over
                the levels
                earned in the prior year. Contributing to the increase in miscellaneous
                fee
                income this year were the mark-to-market entries for two interest-rate
                derivatives into which we entered during the second quarter. The
                income on these
                instruments, which totaled $138,000 in the third quarter and $188,000
                on a
                year-to-date basis, was essentially matched by comparable mark-to-market
                losses
                on offsetting derivatives recorded in our other noninterest expense.
                These
                derivatives are associated with two commercial loans totaling approximately
                $3
                million and are marked-to-market each quarter. The derivatives were
                utilized to
                hedge interest rate risk associated with extending longer-term, fixed-rate
                periods on commercial real estate loans, and structured such that
                a gain on any
                given derivative would be matched against a nearly identical loss
                on a
                corresponding instrument, resulting in essentially no net impact
                to earnings. To
                the extent that we continue to offer similar longer-term, fixed-rate
                maturities
                on commercial real estate loans in the future and use similar derivative
                structures to manage interest rate risk, this income, as well as
                the offsetting
                expense, would be expected to increase in future periods.
 
 46
 Offsetting
                the growth in net interest and noninterest income was additional
                noninterest
                expense of $612,000 and $1.3 million relative the third quarter and
                first nine
                months of last year. Increases in expenses from our retail banking
                centers and
                other administrative departments allocated to the Business Banking
                segment made
                the most significant contributions to the growth in noninterest expense.
                The
                expenses from our retail banking centers allocated to the Business
                Banking
                segment have increased largely as a result of the strong growth of
                our business
                checking and other commercial deposit accounts. An increase was also
                observed in
                the segment’s compensation expense due to higher loan officer commissions in
                response to this year’s production of earning asset and deposit balances as well
                as the addition of a new business banking officer. Additionally,
                the
                mark-to-market losses on derivatives of $138,000 for the quarter
                and $188,000
                for the nine-month period previously mentioned in the discussion
                of the
                segment’s noninterest income were included in the segment’s noninterest
                expense.
 
 **Income
                Property Lending**
 
 Quarter
                          Ended
                      
                      Nine
                          Months EndedNet
                          Income
                      
                      Return
                          on Equity
                      
                      Net
                          Income
                      
                      Return
                          on EquitySeptember
                          30, 2004
                      $
                          1,513,000
                      
                      20.34%
                      
                      $
                          4,270,000
                      
                      19.49%September
                          30, 2005
                      $
                          1,312,000
                      
                      17.21%
                      
                      $
                          4,279,000
                      
                      18.75%September
                          30, 2006
                      $
                          1,385,000
                      
                      19.59%
                      
                      $
                          4,088,000
                      
                      20.05%
 
 The
                Income Property segment’s net income for the third quarter remained comparable
                with that of the third quarter of last year, rising $73,000, or approximately
                6%. Through the first three quarters of 2006, however, the segment’s net income
                declined $191,000, or nearly 5% from last year’s level, as a reduction in
                earning assets negatively impacted net interest income. Additionally,
                the
                segment saw improvement in its noninterest income and a reduction
                in its
                provision for loan loss relative to the prior year, while noninterest
                expense
                remained little changed relative to the prior year.
 
 For
                the
                most recent quarter, the segment’s net interest income after provision for loan
                loss declined $7,000, or a fraction of 1%, from the prior year level,
                based on
                interest income growth of 14% and a more than offsetting 32% increase
                in
                interest expense. The year-to-date results were about the same, as
                a 33%
                increase in interest expense exceeded the 10% growth in interest
                income. Unlike
                our other business segments, the Income Property segment’s portfolio of earning
                assets declined in the third quarter of 2006, continuing a trend
                observed in
                recent quarters.
 
 The
                contraction of the segment’s earning assets has been largely attributable to
                declining originations of permanent multifamily and commercial real
                estate
                loans, combined with a high level of prepayments on the loan portfolio,
                which we
                attribute to a combination of a flat to inverted yield curve and
                increased
                competition from other lenders. The flat yield curve has reduced
                the rate
                differential between short- and long-term financing costs and provided
                a
                financial incentive for borrowers to select longer-term, fixed-rate
                loans as
                opposed to adjustable-rate financing. As we have historically been
                an originator
                of short-term and adjustable-rate loans, this impacted us in two
                ways. First, as
                prospective borrowers sought loans with terms that fell outside of
                our typical
                underwriting structures, our originations of permanent multifamily
                and
                commercial real estate loans declined. Second, with the yield curve
                providing
                borrowers with a financial incentive to refinance adjustable-rate
                loans, which
                make up the majority of our loan portfolio, with longer-term, fixed-rate
                debt,
                the prepayment rates on our Income Property portfolio remained at
                relatively
                high levels. Increased competition among lenders in our local market
                accelerated
                both the decline in new volumes as well as portfolio payoffs, as
                the
  47
 competition
                frequently resulted in lenders offering prospective borrowers new
                loan
                commitments, or existing borrowers the opportunity to refinance,
                at unusually
                low margins.
 
 The
                segment’s noninterest income rose $127,000, or 68%, relative to the third
                quarter of last year, based on increases in gains on loan sales as
                well as
                prepayment penalties received from paid off loans. After selling
                participations
                in several commercial real-estate loans during the second quarter,
                additional
                participations were transacted in the third quarter. Based on a virtual
                absence
                of gains in the third quarter of last year, gains in the third quarter
                of 2006
                were well above their year ago levels, and gains on a year-to-date
                basis
                substantially ahead of last year’s pace. Through the first three quarters of
                2006, the segment’s noninterest income was up $264,000, or 35%. In addition to
                the higher level of loan sale gains, the allocation to the business
                segments of
                insurance proceeds received from a key-man life insurance policy
                factored
                significantly into the increase over 2005.
 
 In
                contrast to the other business segments, noninterest expense for
                the Income
                Property segment remained little changed relative to the prior year,
                increasing
                2% for the quarter and declining 1% relative to the first nine months
                of last
                year. As previously noted, the asset growth exhibited by the Residential
                and
                Business Banking segments was not observed with the Income Property
                segment,
                which instead saw its balances decline as the other business lines
                grew their
                operations and became larger components of our overall asset mix.
                Consequently,
                for a number of different expenses that we allocate out to the business
                segments, such as banking center and administrative costs, the percentages
                allocated to other business lines increased over the prior year with
                their
                growing activity and asset balances, thus reducing the percentage
                allocated to
                the Income Property segment.
  **LIQUIDITY**
 
 We
                consider the repayment and/or sales of loans and securities, deposit
                growth, and
                the borrowing of wholesale funds to be our primary sources of liquidity.
                A
                secondary source of liquidity is cash from operations, which, though
                not
                significant, 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 the purchase of facilities and
                equipment.
 
 3Q
                          2006
                      
                      3Q
                          2005
                      
                      YTD
                          2006
                      
                      YTD
                          2005(Dollars
                          in thousands)Loan
                          Originations (Disbursed)
                      
                      $
                      (120,000
                      )
                      $
                      (151,000
                      )
                      $
                      (400,000
                      )
                      $
                      (406,000
                      )Increase/(Decrease)
                          in Undisbursed Loan Proceeds
                      
                      
                      (13,000
                      )
                      
                      21,000
                      
                      
                      (15,000
                      )
                      
                      33,000Securities
                          Purchases
                      
                      
                      0
                      
                      
                      0
                      
                      
                      (7,000
                      )
                      
                      (6,000
                      )Total
                          Originations and Purchases
                      
                      $
                      (133,000
                      )
                      $
                      (130,000
                      )
                      $
                      (422,000
                      )
                      $
                      (379,000
                      )Loan
                          and Security Repayments
                      
                      $
                      100,000
                      
                      $
                      103,000
                      
                      $
                      317,000
                      
                      $
                      289,000Sales
                          of Loans
                      
                      
                      37,000
                      
                      
                      15,000
                      
                      
                      88,000
                      
                      
                      45,000Total
                          Repayments and Sales
                      
                      $
                      137,000
                      
                      $
                      118,000
                      
                      $
                      405,000
                      
                      $
                      334,000Net
                          Difference
                      
                      $
                      4,000
                      
                      $
                      (12,000
                      )
                      $
                      (17,000
                      )
                      $
                      (45,000
                      )
 
 48
 Loan
                and
                security sales and repayments, our most significant sources of funding,
                are
                heavily influenced by trends in mortgage rates. When rates trend
                downward our
                prepayment speeds typically increase as borrowers refinance their
                loans at lower
                interest rates. Conversely, as rates rise we expect prepayments to
                slow, as
                fewer borrowers will have a financial incentive to refinance their
                loans.
                Through the first three quarters of 2006 our loan portfolio, excluding
                loans
                sold into the secondary market and spec construction loans, experienced
                an
                annualized prepayment rate of 37%, similar to the 35% observed in
                2005.
 
 We
                believe the flat to inverted shape of the yield curve in the first
                three
                quarters of 2006 likely contributed to the continued high level of
                prepayments,
                as the rate differential between short- and long-term financing diminished
                and
                reduced the financial incentive for borrowers to use shorter-term,
                adjustable-rate financing rather than longer-term fixed rate loans.
                This, in
                turn, provides borrowers holding short-term or adjustable-rate loans
                with an
                incentive to refinance with long-term fixed-rate loans.
 
 Our
                preferred method of funding the net different 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 third quarter
                and first
                nine months of 2005 and 2006, changes in funds from deposits and
                borrowings were
                as follows:
 
 3Q
                          2006
                      
                      3Q
                          2005
                      
                      YTD
                          2006
                      
                      YTD
                          2005(Dollars
                          in thousands)Deposits
                      
                      $
                      15,000
                      
                      $
                      8,000
                      
                      $
                      14,000
                      
                      $
                      52,000Borrowings
                      
                      
                      (31,000
                      )
                      
                      8,000
                      
                      
                      (8,000
                      )
                      
                      2,000Total
                      
                      $
                      (16,000
                      )
                      $
                      16,000
                      
                      $
                      6,000
                      
                      $
                      54,000
 
 For
                the
                third quarter and year-to-date periods our total deposit balances
                increased $15
                million and $14 million, respectively, with non-maturity deposit
                balances rising
                in the first quarter, and then losing ground over the subsequent
                quarters. In
                contrast time deposit balances declined modestly in the first quarter,
                significantly in the second, and then increased substantially in
                the most recent
                quarter.
 
 Following
                the first quarter of this year, we noted that a substantial increase
                in
                non-maturity deposit balances had allowed us to take steps to improve
                our
                funding mix by reducing balances borrowed from the FHLB as well as
                rates offered
                on retail certificates of deposit. Unfortunately, this trend did
                not continue in
                the second and third quarters. Following impressive growth in the
                first quarter,
                our non-maturity deposit balances peaked in mid-April, then steadily
                declined
                for the next month as a result of outflows for federal income tax
                and state
                property tax payments, as well as a substantial reduction in balances
                maintained
                by a large commercial customer. The decline continued in the third
                quarter as
                our non-maturity balances fell in July, then recovered modestly over
                the
                remainder of the quarter. Despite this recovery, our non-maturity
                balances ended
                the quarter at a lower level. On a year-to-date basis, however, our
                non-maturity
                deposit balances remained approximately $13 million above the 2005
                year-end
                level.
 
 Offsetting
                the decline in non-maturity deposit balances in the third quarter
                were increased
                time deposit balances, including an increase in certificates issued
                through
                deposit brokerage services. Time deposit balances fell modestly in
                the first
                quarter and significantly in the second as we
  49
 priced
                our time deposits less aggressively, resulting in a lower retention
                of maturing
                certificate balances. In the third quarter, however, time deposit
                balances
                increased significantly, rising nearly $23 million from their level
                as of the
                June 30, 2006 quarter end, restoring balances to approximately $1
                million over
                the 2005 year end level. Contributing to the higher time deposit
                balances as of
                September 30 was an $8 million net increase in certificates issued
                through
                deposit brokerage services relative to the June 30, 2006 quarter-end.
                On a
                year-to-date basis, our brokered certificate balances increased $15
                million in
                net balances.
 
 The
                inflow of deposits varies from period to period, and our ability
                to raise
                liquidity from this source is dependent on our effectiveness in competing
                with
                other financial institutions in our local market. That competition
                tends to
                focus on rate and service. Although we control the quality of service
                that we
                provide, we have no control over the rates offered by our
                competitors.
 
 Our
                other
                major source of liquidity is wholesale funds, which includes our
                preferred
                supplemental funding mechanism, borrowings from the FHLB, as well
                as brokered
                deposits, reverse repurchase agreements, and a revolving line of
                credit at the
                Holding Company level. During the first quarter of this year, modest
                asset
                growth and substantial increases in non-maturity deposit balances
                allowed us to
                reduce the amount of funding borrowed from the FHLB and improve our
                funding mix.
                This trend did not continue into the second quarter, however, as
                the combination
                of deposit runoff and asset growth resulted in an increased use of
                FHLB funding.
                After declining from $226 million as of December 31, 2005 to $207
                million at the
                end of the first quarter, advances from the FHLB rose to $248 million
                at the end
                of the second quarter. Similar to the first quarter, however, the
                third quarter
                saw an absence of asset growth as well as an increase in deposit
                balances. The
                combination of these two factors resulted in our balance of outstanding
                FHLB
                advances declining to $218 million as of the most recent
                quarter-end.
 
 Our
                credit line with the FHLB is reviewed annually, and our maximum allowable
                level
                of borrowing is currently set at 40% of assets, implying the ability
                to borrow
                up to $438 million as of September 30, 2006, subject to a sufficient
                level of
                eligible collateral. As a percentage of quarter-end assets, our FHLB
                borrowings
                totaled 20%, compared to 23% at June 30, 2006, and 21% at the 2005
                year-end.
                Potential risks associated with this funding source include the reduction
                or
                non-renewal of the line and insufficient collateral to utilize the
                line. We try
                to mitigate the risk of non-renewal by maintaining the credit quality
                of our
                loans and securities and attending to the quality and consistency
                of our
                earnings.
 
 The
                potential risk of not holding sufficient collateral to utilize our
                available
                FHLB line as needed is monitored to ensure that ample collateral
                is available to
                meet our funding needs. Eligible collateral to secure our FHLB line
                totaled $291
                million as of September 30, 2006, representing nearly 27% of total
                quarter-end
                assets. Our two principal sources of preferred collateral are single-family
                residential and multifamily loans. Over the last three years, we
                have seen an
                increase in single-family loans, while the level of multifamily loans
                has
                declined. Because single-family lending is a very profitable business
                segment
                and has exhibited steady growth in the last few years, we are encouraged
                that
                the business line will be able to provide sufficient collateral to
                meet our FHLB
                borrowing requirements.
 
 Brokered
                deposits, which are included in the deposit totals, amounted to $57
                million at
                the September 30, 2006 quarter-end, compared to $49 million as of
                June 30, 2006,
                $51 million at March 31, 2006, and $42 million at the December 2005
                year-end.
                The decision to maintain a higher level of institutional deposits
                in 2006 has
                typically been attributable to rate differentials
  50
 between
                these deposits and FHLB advances. Historically, rates on the two
                funding sources
                have been very comparable. However, at various points over the last
                four
                quarters, interest rates on brokered deposits fell below those of
                similar term
                FHLB advances. During these times, we increased our use of this funding
                source
                and issued brokered deposits to replace maturing FHLB advances. As
                of September
                30, 2006, brokered deposits represented approximately 7.4% of total
                deposits. We
                may continue to increase our use in the future, depending on the
                costs of
                various wholesale funding sources and subject to internal policy
                limits. Our
                policy limit dictates that brokered deposits may represent no more
                than 20% of
                our total deposits. A risk associated with this type of funding is
                that the
                market would be unable to accept a high enough volume of brokered
                deposits from
                our Bank to reach the 20% policy limit. Additionally, any perceived
                or factual
                reputation risk associated with the Bank could endanger our ability
                to collect
                deposits from brokered or institutional sources. Again, the Bank
                works to
                mitigate such risk by actively managing the credit quality of our
                loans and
                securities, and the quality and consistency of our earnings.
 
 Reverse
                repurchase lines are lines of credit, typically collateralized by
                securities. At
                the present time, we maintain two reverse repurchase lines, the first
                of which
                has a borrowing limit of $10 million. While securities are the preferred
                source
                of collateral on this line, loans may be used as collateral as well,
                including
                loans that are not considered eligible collateral to secure FHLB
                advances. Our
                other reverse repurchase line has a limit of $25 million with securities
                being
                the collateral source. 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. Risk mitigation techniques
                include
                attending to the quality and reliability of our earnings, as well
                as to the
                quality of our credit.
 
 An
                additional source of liquidity has been our cash from operations,
                which, though
                not significant, is a consistent source based upon the quality of
                our earnings.
                On a very limited basis it can be viewed as cash from operations,
                adjusted for
                items such as provision for loan losses and depreciation. See the
“Consolidated
                Statements of Cash Flows” in the financial statements section of this filing for
                a calculation of net cash provided by operating activities.
 
 In
                addition to using liquidity to fund loans and securities, we routinely
                invest in
                facilities and equipment. In the first three quarters of 2006, we
                spent $3.4
                million in this area, of which $772,000 was invested in the third
                quarter. By
                comparison, we invested $5.9 million in these assets in the first
                three quarters
                of last year. Planned projects over the remainder of this year include
                further
                renovation of First Mutual Center and the continued construction
                of our new
                banking center at Canyon Park.
  **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
                September 30,
                2006, we exceeded the capital levels required to meet the definition
                of a
                well-capitalized institution:
 
 51
 Actual
                      Minimum
                          for
                        Capital
                        Adequacy
                          Purposes
                      Minimum
                          to be
                        Categorized
                          as “Well
                        Capitalized”
                          Under
                        Prompt
                          Corrective
                        Action
                          ProvisionsTotal
                        capital (to
                        risk-weighted assets):First
                          Mutual Bancshares, Inc.
                      11.64%
                      8.00%
                      N/AFirst
                          Mutual Bank
                      11.54
                      8.00
                      10.00%Tier
                          I capital (to risk-weighted assets):First
                          Mutual Bancshares, Inc.
                      10.39
                      4.00
                      N/AFirst
                          Mutual Bank
                      10.29
                      4.00
                      6.00Tier
                          I capital (to average assets):First
                          Mutual Bancshares, Inc.
                      7.61
                      4.00
                      N/AFirst
                            Mutual Bank
                      7.67
                      4.00
                      5.00
  **SUBSEQUENT
                EVENTS**
 
 We
                currently insure many of the sales finance loans with a FICO score
                of 720 or
                less. In the third quarter, insured loans represented 27% of the
                new loans
                originated. The insurance contract is negotiated annually, and loans
                originated
                in the ensuing 12 months are placed in a separate pool. For the forthcoming
                pool
                year beginning August 1, 2006, the insurer has informed us that the
                general
                terms and conditions that we have negotiated in prior years will
                not be
                available to us. Insurance coverage will still be offered but with
                a premium
                structure that effectively results in a lifetime premium obligation
                equal to, or
                greater than, the amount of claims paid by the insurance company.
 
 We
                are
                considering three options to address this issue:
 
 1)
                      Sell
                          loans to investors without any credit enhancement. The
                          pass-through
                          interest rate to the investor would be appropriately higher
                          to compensate
                          for the greater credit risk the investor has
                          assumed.
 2)
                      Continue
                          to insure only those loans sold with lower credit scores.
                          The credit
                          enhancement would be passed through to the investor and
                          may result in a
                          lower pass-through rate to the
                          investor.
 3)
                      Sell
                          loans to investors with the Bank accepting limited recourse
                          of
                          approximately 2.5%-3.0% of the loans sold. Again, this
                          structure would
                          presumably result in a lower pass-through rate to the
                          investor.
 
 In
                options two and three, we incur the obligation of limited recourse
                that will be
                expensed at the time of sale as an offset to the gain on loan sale.
                We estimate
                that the expensing of the limited recourse will reduce our gains
                by about 25%.
                Our current gain on loan sale is approximately 4%-5% of the loans
                sold. With the
                limited recourse obligation we would anticipate that gain dropping
                to about
                3.00%-3.75%.
 
 52
 The
                option selected will largely depend on investor preference. Our sales
                for the
                last few years have been structured such that the investor assumes
                the entire
                risk on loans with FICO scores above 720 (about 70% of the loans
                sold). For the
                insured loans with scores below 720, the investor receives insurance
                protection
                for up to 10% of those loan balances. Option #2 has the same structure
                as past
                loan sales and we are confident that if necessary we could continue
                to offer
                that program. Our preference would be Option #1, which is to increase
                the
                pass-through rate with the investor assuming the risk of any loans
                in default.
                Option #3 is a hybrid of the two basic options. The number of loans
                subject to
                limited recourse in either option #2 or #3 may also change by lowering
                the FICO
                cutoff score, for example from 720 to 700.
 
 The
                lead
                time in introducing a new program is two to three months so we do
                not believe
                that we will know the nature of investor preference until the end
                of fourth
                quarter. It is entirely possible that all three options will be employed
                with
                individual investors having varied preferences. Although we favor
                not having to
                expense limited recourse at the time of sale, all three options will
                be priced
                to be attractive to the investor while maximizing the profitability
                of the loan
                sales to the Bank.
 
 **Update
                to the Outlook section of the Press Release**
 
 In
                the
“Outlook for Fourth Quarter 2006” section of our press release, dated October
                24, 2006, we indicated that we expected our loan portfolio to increase
                by
                $10-$15 million in the fourth quarter. Subsequent to that press release
                we have
                completed an analysis of our loan portfolio as of October 31st, and
                our business
                lines have reassessed the probable net portfolio gain or loss for
                the remaining
                two months. Because of an unexpected increase in loan prepayments
                we now believe
                that our loan portfolio will decline in the fourth quarter within
                a range of
                $5-$15 million.
 
 As
                we
                have noted in prior quarters estimating loan growth is very difficult.
                Loan
                prepayments can vary widely, and loan originations often exceed or
                fail to meet
                expectations. In addition, loan sales will vary considerably from
                one quarter to
                another depending on the opportunities presented by investors.
  ITEM
                        3.
                      Quantitative
                          and Qualitative Disclosures About Market
                          Risk
 
 Market
                risk is defined as the sensitivity of income and capital to changes
                in interest
                rates, and other relevant market rates or prices. Our profitability
                is largely
                dependent on our net interest income. Consequently, our primary exposure
                to
                market risk arises from the interest rate risk inherent in our lending,
                mortgage
                banking, deposit, and borrowing activities. Interest rate risk is
                the risk to
                earnings and capital resulting from adverse movements in interest
                rates. To that
                end, we actively monitor and manage our exposure to interest rate
                risk.
 
 A
                number
                of measures are utilized to monitor and manage interest rate risk,
                including net
                interest income and economic value of equity simulation models, as
                well as
                traditional “gap” models. We prepare these models on a monthly basis for review
                by our Asset Liability Committee (ALCO), senior management, and Board
                of
                Directors. The use of these models requires us to formulate and apply
                assumptions to various balance sheet items. Assumptions regarding
                interest rate
                risk are inherent in all financial institutions, and may include,
                but are not
                limited to, prepayment speeds on loans and mortgage-backed securities,
                cash
                flows and maturities of financial instruments held for purposes other
                than
                trading, changes in market conditions, loan
  53
 volumes
                and pricing, deposit sensitivities, consumer preferences, and management’s
                capital leverage plans. We believe that the data and assumptions
                used for our
                models are reasonable representations of our portfolio and possible
                outcomes
                under the various interest rate scenarios. Nonetheless, these assumptions
                are
                inherently uncertain; therefore, the models cannot precisely estimate
                net
                interest income or predict the impact of higher or lower interest
                rates on net
                interest income. Actual results may differ significantly from simulated
                results
                due to timing, magnitude, and frequency of interest rate changes,
                and changes in
                market conditions and specific strategies, among other factors.
 
 **Asset
                and Liability Management**
 
 Our
                primary objective in managing interest rate risk is to minimize the
                adverse
                impact of changes in interest rates on our net interest income and
                capital,
                while structuring the asset and liability components to maximize
                net interest
                margin, utilize capital effectively, and provide adequate liquidity.
                We rely
                primarily on our asset and liability structure to control interest
                rate
                risk.
 
 Asset
                and
                liability management is the responsibility of the Asset Liability
                Committee,
                which acts within policy directives established by the Board of Directors.
                This
                committee meets regularly to monitor the composition of the balance
                sheet, to
                assess projected earnings trends, and to formulate strategies consistent
                with
                the objectives for liquidity, interest rate risk, and capital adequacy.
                The
                objective of asset/liability management is to maximize long-term
                shareholder
                returns by optimizing net interest income within the constraints
                of credit
                quality, interest rate risk policies, levels of capital leverage,
                and adequate
                liquidity. Assets and liabilities are managed by matching maturities
                and
                repricing characteristics in a systematic manner.
 
 **Hedging
                Techniques**
 
 We
                review
                interest rate trends on a monthly basis and employ hedging techniques
                where we
                believe they are appropriate. These techniques may include financial
                futures,
                options on financial futures, interest rate caps and floors, interest
                rate
                swaps, and extended commitments on future lending activities.
 
 Typically,
                the extent of our off-balance-sheet derivative agreements has been
                the use of
                forward loan commitments, which are used to hedge our loans held-for-sale.
                Additionally, in 2002 we entered into an interest rate swap with
                the FHLB. The
                purpose of the swap is to protect against potential adverse interest
                rate
                volatility that could be realized from the Trust Preferred Securities
                (TPS)
                issued in June 2002. The swap accomplished this by fixing the interest
                rate
                payable for the first five years of the TPS’ life.
 
 In
                the
                second quarter of 2006, we began to utilize interest rate swaps in
                connection
                with the underwriting of longer-term, fixed-rate commercial real
                estate loans.
                This decision was the result of prospective borrowers’ demand for longer-term,
                fixed-rate loans, and the preference of depositors for instruments
                of
                significantly shorter terms. Under this program, we originate commercial
                mortgage loans with amortization schedules of up to thirty-years,
                with an
                initial ten-year fixed rate. To hedge the interest rate risk exposure
                presented
                by ten-year, fixed-rate instruments, we utilize interest rate swaps
                on a
                loan-by-loan basis to convert each loan’s fixed rate to an adjustable rate
                subject to regular repricing relative to a market index rate, typically
                the
                one-month LIBOR rate. As this is a new program, with the first two
                such credits
                just originated in the second quarter, we do not yet have an expectation
                of the
                number of loans that will likely
  54
 be
                originated and hedged in such a manner. These interest rate swaps
                will be used
                solely for the purpose of managing the interest rate risk associated
                with
                longer-term, fixed-rate assets, and will not be used for any speculative
                purposes.
 
 In
                addition to the interest rate swaps associated with these loans,
                the borrowers
                entered into prepayment agreements that have been determined to be
                derivatives.
                Although the interest rate swap derivative and prepayment agreement
                derivative
                are not constructed as a hedge, their valuations tend to move in
                opposite
                directions constituting an offset to each other.
 
 **Net
                Interest Income (NII) and Economic Value of Equity (EVE) Simulation
                Model
                Results**
 
 **September
                          30, 2006**
                      
                      **December
                          31, 2005****Percentage
                          Change**
                      
                      **Percentage
                          Change****Change
                          in**
                        **Interest
                          Rates**
                      
                      **Net
                          Interest**
                      **Economic**
                        **Value**
                      
                      **Net
                          Interest**
                      **Economic**
                        **Value****(in
                          basis points)**
                      
                      **Income**
                      **of
                          Equity**
                      
                      **Income**
                      **of
                          Equity**+200
                      
                      1.61%
                      (2.90%)
                      
                      0.06%
                      (2.72%)+100
                      
                      n/a
                      (0.90%)
                      
                      n/a
                      (0.55%)-100
                      
                      n/a
                      0.04%
                      
                      n/a
                      (1.94%)-200
                      
                      0.79%
                      (2.41%)
                      
                      (1.32%)
                      (6.54%)
 
 **Net
                Interest Income Simulation**
 
 Our
                income simulation model, based on information as of September 30,
                2006,
                indicated that our net interest income over the following twelve
                months was
                projected to increase from its “base case” level in scenarios in which interest
                rates are assumed to gradually increase or decline by 200 bps over
                a
                twelve-month period. The magnitudes of the changes, however, suggest
                that there
                is little sensitivity in net interest income from the “base case” level over a
                twelve-month horizon in either scenario, as an increase in net interest
                income
                of 1.61% was observed in the rising rate environment, and a change
                of only 0.79%
                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
  55
 case.”
In
                the event the simulation model indicated that the increase or decrease
                in
                interest rates over the following twelve months would adversely affect
                our net
                interest income over the same period by more than 10% relative to
                the “base
                case” scenario, we would consider the indicated risk to have exceeded our
                internal policy limit.
 
 **Economic
                Value of Equity (EVE) Simulation**
 
 The
                EVE
                analysis goes beyond simulating net interest income for a specified
                period to
                estimating the present value of all financial instruments in our
                portfolio and
                then analyzing how the economic value of the portfolio would be affected
                by
                various alternative interest rate scenarios. The portfolio’s economic value is
                calculated by generating principal and interest cash flows for the
                entire life
                of all assets and liabilities, then discounting these cash flows
                back to their
                present values. The assumed discount rate used for each projected
                cash flow is
                based on a current market rate, such as a LIBOR, FHLB, or swap curve
                rate, and
                from alternative instruments of comparable risk and duration. In
                the event the
                simulation model demonstrates that a 200 basis point increase or
                decrease in
                rates would adversely affect our EVE by more than 25%, we consider
                the indicated
                risk to have exceeded our internal policy limit. Again, as illustrated
                in the
                above results, we are operating within the 25% internal policy limit
                in all
                scenarios.
 
 In
                the
                simulated 200 bps upward shift of the yield curve, the discount rates
                used to
                calculate the present values of assets and liabilities will increase,
                causing
                the present values of both assets and liabilities to fall, with more
                prominent
                effects on longer-term, fixed-rate instruments. Additionally, when
                interest
                rates rise, the cash flows on our assets are typically expected to
                decelerate as
                borrowers are assumed to become less likely to prepay their loans.
                As the cash
                flows on these assets are shifted further into the future, their
                present values
                are further reduced. Our EVE simulation model results as of September
                30, 2006
                indicated that our assets and liabilities would be expected to exhibit
                similar
                levels of sensitivity to rising rates, with the economic value of
                assets
                declining by 2.54%, compared to a decline of 2.50% for our liabilities.
                Given
                the higher asset sensitivity and greater asset balance than liabilities,
                the
                reduction in the economic value of assets exceeded the impact on
                liabilities.
                Consequently, the economic value of our equity was negatively impacted
                in this
                scenario, declining 2.90%.
 
 The
                opposite occurs when rates decline, as the discount rates used to
                calculate the
                present values of assets and liabilities will decrease, causing the
                present
                values of both assets and liabilities to rise. Counteracting this
                effect for
                assets, however, is the tendency for cash flows from assets to accelerate
                in a
                falling rate scenario, as borrowers refinance their existing loans
                at lower
                interest rates. These loan prepayments prevent the economic values
                of these
                assets from increasing in a declining rate scenario, illustrating
                an effect
                referred to as negative convexity. Taking this negative convexity
                into account,
                the simulation results indicated a negative impact to EVE in the
                falling rate
                scenario. In this case, the economic values of both assets and liabilities
                were
                positively impacted when rates were assumed to fall by 200 bps, assets
                by 1.89%
                and liabilities by 2.37%. As a result, with the value of liabilities
                rising more
                than asset values, our economic value of equity was negatively impacted
                in this
                scenario, declining 2.41%.
 
 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,
  56
 deposit
                decay rates, pricing decisions on loans and deposits, reinvestment/replacement
                of asset and liability cash flows, customer preferences, and competitor
                and
                economic influences.
 
 **Gap
                Model**
 
 In
                addition to the above simulation models, an interest “gap” analysis is used to
                measure the matching of our assets and liabilities and exposure to
                changes in
                interest rates. This model, which represents a traditional view of
                interest rate
                sensitivity, quantifies the mismatch between assets maturing, repricing,
                or
                prepaying within a period, and liabilities maturing or repricing
                within the same
                period. A gap is considered positive when the amount of interest-rate-sensitive
                assets exceeds the amount of interest-rate-sensitive liabilities
                within a given
                period. A gap is considered negative in the reverse situation.
 
 Certain
                shortcomings are inherent in gap analysis, including the failure
                to recognize
                differences in the frequencies and magnitudes of repricing for different
                balance
                sheet instruments. Additionally, some assets and liabilities may
                have similar
                maturities or repricing characteristics, but they may react differently
                to
                changes in interest rates. This illustrates a facet of interest rate
                exposure
                referred to as “basis risk.” Assets, such as adjustable-rate mortgage loans, may
                also have features that limit the effect that changes in interest
                rates have on
                the asset in the short-term and/or over the life of the loan, for
                example a
                limit on the amount by which the interest rate on the loan is allowed
                to adjust
                each year. This illustrates another area of interest rate exposure
                referred to
                as “option risk.” Due to the limitations of the gap analysis, these features are
                not taken into consideration. Additionally, in the event of a change
                in interest
                rates, prepayment and early withdrawal penalties could deviate significantly
                from those assumed in the gap calculation. As a result, we utilize
                the gap
                report as a complement to our income simulation and economic value
                of equity
                models.
 
 **One-Year
                Interest Rate Sensitivity Gap**
 
 **September
                          30,**
                        **2006**
                      
                      **December
                          31,**
                        **2005**(Dollars
                          in thousands)One-Year
                          Repricing/Maturing Assets
                      
                      $
                      691,833
                      
                      $
                      715,543One-Year
                          Repricing/Maturing Liabilities
                      
                      
                      756,504
                      
                      
                      773,093One-Year
                          Gap
                      
                      $
                      (64,671
                      )
                      $
                      (57,550
                      )Total
                          Assets
                      
                      $
                      1,093,937
                      
                      $
                      1,086,165One-Year
                          Interest Rate Gap as a Percentage of Assets
                      
                      
                      (5.9%
                      )
                      
                      (5.3%
                      )
 
 At
                a
                negative, or liability sensitive, 5.9% of assets, our twelve-month
                interest rate
                sensitivity gap as of September 30, 2006 indicated a degree of liability
                sensitivity similar to the 5.3% observed at the 2005 year-end, and
                a decrease
                from 8.9% at June 30, 2006. Impacting the gap ratio as of June 30
                was a timing
                difference between hybrid ARM securities held in our investment portfolio
                and
                the FHLB advances utilized to fund their purchase.
 
 57
 The
                hybrid securities were purchased in the second quarter of 2004 with
                a first rate
                reset date of July 2007. Given the velocity at which market interest
                rates were
                moving at that time, the funding sources for these securities, and
                thus our
                margins on the trades, were locked in at the times of the trades.
                Consequently,
                the funding sources are scheduled to mature in the second quarter
                of 2007, and
                were thus included in the “One-Year Repricing/Maturing Liabilities” in the June
                2006 ratio, while the corresponding assets are not subject to reprice
                until July
                2007, and were thus just beyond the one-year time horizon. The impact
                of this
                timing difference on our one-year gap ratio reversed in July 2006,
                as the
                securities moved to the “One-Year Repricing/Maturing Assets” category, with a
                corresponding decrease in our liability sensitivity.
 
 **Securities**
  **ITEM
                3**
 The
                  following table sets forth certain information regarding carrying
                  values and
                  percentage of total carrying values of the Bank’s consolidated portfolio
                  of securities classified as available-for-sale and held-to-maturity
                  (dollars in
                  thousands).
 September
                          30,2006
                      
                      2005**Available-for-Sale:**
                      
                      Carrying
                          Value
                      
                      Percent
                          of Total
                      
                      Carrying
                          Value
                      
                      Percent
                          of TotalUS
                          Government treasury and agency obligations
                      
                      $
                      10,800
                      
                      
                      12
                      %
                      $
                      18,031
                      
                      
                      16
                      %Mortgage
                          backed securities:Freddie
                          Mac
                      
                      
                      14,504
                      
                      
                      15
                      %
                      
                      16,893
                      
                      
                      15
                      %Ginnie
                          Mae
                      
                      
                      35,688
                      
                      
                      38
                      %
                      
                      46,131
                      
                      
                      40
                      %Fannie
                          Mae
                      
                      
                      32,683
                      
                      
                      35
                      %
                      
                      33,683
                      
                      
                      29
                      %Total
                          mortgage-backed securities
                      
                      
                      82,875
                      
                      
                      88
                      %
                      
                      96,707
                      
                      
                      84
                      %**Total
                          securities available-for-sale**
                      
                      **$**
                      **93,675**
                      
                      
                      **100**
                      **%**
                      **$**
                      **114,738**
                      
                      
                      **100**
                      **%**September
                          30,2006
                      
                      
                      2005**Held-to-Maturity:**
                      
                      
                      Carrying
                          Value
                      
                      
                      Percent
                          of Total
                      
                      
                      Carrying
                          Value
                      
                      
                      Percent
                          of TotalMunicipal
                          bonds
                      
                      $
                      1,147
                      
                      
                      20
                      %
                      $
                      1,192
                      
                      
                      16
                      %Mortgage
                          backed securities:Freddie
                          Mac
                      
                      
                      321
                      
                      
                      6
                      %
                      
                      476
                      
                      
                      6
                      %Fannie
                          Mae
                      
                      
                      4,265
                      
                      
                      74
                      %
                      
                      5,679
                      
                      
                      78
                      %Total
                          mortgage-backed securities
                      
                      
                      4,586
                      
                      
                      80
                      %
                      
                      6,155
                      
                      
                      84
                      %**Total
                          securities held-to-maturity**
                      
                      **$**
                      **5,733**
                      
                      
                      **100**
                      **%**
                      **$**
                      **7,347**
                      
                      
                      **100**
                      **%****Estimated
                          market value**
                      
                      **$**
                      **5,689**
                      
                      
                      
                      
                      **$**
                      **7,399**
   58
  **ITEM
                  3A**
  The
                  following table shows the maturity or period to repricing of the
                  Bank’s
                  consolidated portfolio of securities available-for-sale and held-to-maturity
                  (dollars in thousands):
  Available-for-Sale
                            at September 30, 2006One
                            Year
                          or
                            Less
                        
                        Over
                            One to
                          Three
                            Years
                        
                        Over
                            Three to
                          Five
                            Years
                        
                        Over
                            Five to
                          Ten
                            Years
                        
                        Over
                            Ten to
                          Twenty
                            Years
                        
                        Over
                          Twenty
                            Years
                        
                        TotalCarrying
                            Value
                        
                        Weighted
                            Average Yield
                        
                        Carrying
                            Value
                        
                        Weighted
                            Average Yield
                        
                        Carrying
                            Value
                        
                        Weighted
                            Average Yield
                        
                        Carrying
                            Value
                        
                        Weighted
                            Average Yield
                        
                        Carrying
                            Value
                        
                        Weighted
                            Average Yield
                        
                        Carrying
                            Value
                        
                        Weighted
                            Average Yield
                        
                        Carrying
                            Value
                        
                        Weighted
                            Average Yield**Available-for-Sale:**US
                            Government treasury and agency obligations
                        
                        $
                        —
                        
                        
                        
                        
                        $
                        —
                        
                        
                        
                        
                        $
                        5,852
                        
                        
                        4.08
                        %
                        $
                        —
                        
                        
                        
                        
                        $
                        4,948
                        
                        
                        4.00
                        %
                        $
                        —
                        
                        
                        
                        
                        $
                        10,800
                        
                        
                        4.05
                        %Mortgage
                            backed securities:Ginnie
                            Mae
                        
                        
                        26,028
                        
                        
                        4.06
                        %
                        
                        9,660
                        
                        
                        4.04
                        %
                        
                        —
                        
                        
                        
                        
                        
                        —
                        
                        
                        
                        
                        
                        —
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        35,688
                        
                        
                        4.06
                        %Freddie
                            Mac
                        
                        
                        275
                        
                        
                        7.13
                        %
                        
                        1,729
                        
                        
                        4.05
                        %
                        
                        2,846
                        
                        
                        3.50
                        %
                        
                        2,992
                        
                        
                        4.63
                        %
                        
                        6,662
                        
                        
                        4.50
                        %
                        
                        —
                        
                        
                        
                        
                        
                        14,504
                        
                        
                        4.33
                        %Fannie
                            Mae
                        
                        
                        203
                        
                        
                        6.95
                        %
                        
                        4,284
                        
                        
                        4.77
                        %
                        
                        3,187
                        
                        
                        4.12
                        %
                        
                        —
                        
                        
                        
                        
                        
                        25,009
                        
                        
                        4.29
                        %
                        
                        —
                        
                        
                        
                        
                        
                        32,683
                        
                        
                        4.35
                        %Total
                            mortgage-backed securities
                        
                        
                        26,506
                        
                        
                        4.11
                        %
                        
                        15,673
                        
                        
                        4.24
                        %
                        
                        6,033
                        
                        
                        3.83
                        %
                        
                        2,992
                        
                        
                        4.63
                        %
                        
                        31,671
                        
                        
                        4.33
                        %
                        
                        —
                        
                        
                        
                        
                        
                        82,875
                        
                        
                        4.22
                        %Total
                            securities available-for-sale -- Carrying Value
                        
                        $
                        26,506
                        
                        
                        4.11
                        %
                        $
                        15,673
                        
                        
                        4.24
                        %
                        $
                        11,885
                        
                        
                        3.95
                        %
                        $
                        2,992
                        
                        
                        4.63
                        %
                        $
                        36,619
                        
                        
                        4.29
                        %
                        $
                        —
                        
                        
                        0.00
                        %
                        $
                        93,675
                        
                        
                        4.20
                        %Total
                            securities available-for-sale -- Amortized Cost
                        
                        $
                        26,831
                        
                        
                        4.11
                        %
                        $
                        15,937
                        
                        
                        4.24
                        %
                        $
                        12,280
                        
                        
                        3.95
                        %
                        $
                        3,134
                        
                        
                        4.63
                        %
                        $
                        37,980
                        
                        
                        4.29
                        %
                        
                        
                        
                        
                        
                        
                        $
                        96,162
                        
                        
                        4.20
                        %Held-to-Maturity
                            at September 30, 2006One
                            Year
                          or
                            Less
                        
                        
                        Over
                            One to
                          Three
                            Years
                        
                        
                        Over
                            Three to
                          Five
                            Years
                        
                        
                        Over
                            Five to
                          Ten
                            Years
                        
                        
                        Over
                            Ten to
                          Twenty
                            Years
                        
                        
                        Over
                          Twenty
                            Years
                        
                        
                        TotalCarrying
                            Value
                        
                        
                        Weighted
                            Average Yield
                        
                        
                        Carrying
                            Value
                        
                        
                        Weighted
                            Average Yield
                        
                        
                        Carrying
                            Value
                        
                        
                        Weighted
                            Average Yield
                        
                        
                        Carrying
                            Value
                        
                        
                        Weighted
                            Average Yield
                        
                        
                        Carrying
                            Value
                        
                        
                        Weighted
                            Average Yield
                        
                        
                        Carrying
                            Value
                        
                        
                        Weighted
                            Average Yield
                        
                        
                        Carrying
                            Value
                        
                        
                        Weighted
                            Average Yield**Held-to-Maturity:**Municipal
                            bonds
                        
                        $
                        —
                        
                        
                        
                        
                        $
                        —
                        
                        
                        
                        
                        $
                        —
                        
                        
                        
                        
                        $
                        —
                        
                        
                        
                        
                        $
                        220
                        
                        
                        5.38
                        %
                        $
                        927
                        
                        
                        6.31
                        %
                        $
                        1,147
                        
                        
                        6.13
                        %Mortgage
                            backed securities:Freddie
                            Mac
                        
                        
                        321
                        
                        
                        6.86
                        %
                        
                        —
                        
                        
                        
                        
                        
                        —
                        
                        
                        
                        
                        
                        —
                        
                        
                        
                        
                        
                        —
                        
                        
                        
                        
                        
                        —
                        
                        
                        
                        
                        
                        321
                        
                        
                        6.86
                        %Fannie
                            Mae
                        
                        
                        1,344
                        
                        
                        6.83
                        %
                        
                        1,338
                        
                        
                        4.29
                        %
                        
                        —
                        
                        
                        
                        
                        
                        —
                        
                        
                        
                        
                        
                        1,583
                        
                        
                        4.78
                        %
                        
                        —
                        
                        
                        
                        
                        
                        4,265
                        
                        
                        5.27
                        %Total
                            mortgage-backed securities
                        
                        
                        1,665
                        
                        
                        6.83
                        %
                        
                        1,338
                        
                        
                        4.29
                        %
                        
                        —
                        
                        
                        
                        
                        
                        —
                        
                        
                        
                        
                        
                        1,583
                        
                        
                        4.78
                        %
                        
                        —
                        
                        
                        
                        
                        
                        4,586
                        
                        
                        5.38
                        %Total
                            securities held-to-maturity -- Carrying Value
                        
                        $
                        1,665
                        
                        
                        6.84
                        %
                        $
                        1,338
                        
                        
                        4.29
                        %
                        $
                        —
                        
                        
                        
                        
                        $
                        —
                        
                        
                        
                        
                        $
                        1,803
                        
                        
                        4.85
                        %
                        $
                        927
                        
                        
                        6.30
                        %
                        $
                        5,733
                        
                        
                        5.53
                        %Total
                            securities held-to-maturity -- Fair Market Value
                        
                        $
                        1,704
                        
                        
                        6.83
                        %
                        $
                        1,304
                        
                        
                        4.30
                        %
                        $
                        —
                        
                        
                        
                        
                        $
                        —
                        
                        
                        
                        
                        $
                        1,757
                        
                        
                        4.86
                        %
                        $
                        924
                        
                        
                        6.32
                        %
                        $
                        5,689
                        
                        
                        5.56
                        %






59





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
      September 30, 2006, the Company was not engaged in any litigation, which in
      the
      opinion of management, after consultation with its legal counsel, would be
      material to the Company.





**ITEM
              1A.**
            **Risk
                Factors**





For
      information regarding certain Risk Factors, please refer to Part I, Item 1A,
      in
      the Company’s Annual Report on Form 10-K for the year ended December 31,
      2005.








**ITEM
              2.**
            **Unregistered
                Sales of Equity Securities and Use of
                Proceeds**





None.





**ITEM
              3.**
            **Defaults
                Upon Senior Securities**





None.





60


**ITEM
              4.**
            **Submission
                of Matters to a Vote of Security
                Holders**





None.





**ITEM
              5.**
            **Other
                Information**





None.





**ITEM
              6.**
            **Exhibits**





(3.1)
            Amended
                and Restated Articles of Incorporation, incorporated by reference
                onForm
                10-Q filed with the SEC on August 8,
                2005.





(3.3)
            Bylaws
                (as amended and restated), incorporated by reference on Form 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.


61


**SIGNATURES**





Pursuant
      to the requirements of the Securities Exchange Act of 1934, the registrant
      has
      duly caused this report to be signed on its behalf by the undersigned thereunto
      duly authorized.




Date:
              November 7, 2006
            FIRST
              MUTUAL BANCSHARES, INC.By:
            /s/ John
              R.
              ValaasJohn
              R. ValaasPresident
              and
              Chief Executive Officer By:
            /s/ Roger
              A.
              ManderyRoger
              A. ManderyExecutive
                Vice President
              (Principal
                Financial Officer)




62