**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,
                  2007**OR**o
              **Transition
                  Report Pursuant to Section 13 or 15(d) of****The
                  Securities Exchange Act of 1934**For
                  the transition period from __________ to
                  ___________


Commission
      File Number 005-57091







**FIRST
      MUTUAL BANCSHARES, INC.**





(Exact
      name of registrant as specified in its charter)







**WASHINGTON**
              (State
                or other jurisdiction of incorporation
                or
                organization)
            **91-2005970**
              (I.R.S.
                Employer Identification
                Number)**400
                108th Avenue N.E., Bellevue, WA**
              (Address
                of principal executive
                offices)
            **98004**
              (Zip
                code)






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






Indicate
      by check mark whether the registrant (1) has filed all reports required to
      be
      filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
      the preceding
      12 months (or for such shorter period that the registrant was required
      to file such reports), and (2) has been subject to such filing requirements for
      the
      past 90 days. Yes   x   
      No   o




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





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




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




Indicate
      the number of shares outstanding of each of the issuer’s classes of common
      stock, as
      of the
      latest practicable date.      November
      1, 2007  6,697,628



















FIRST
              MUTUAL BANCSHARES, INC.
 
 QUARTERLY
              REPORT ON FORM 10-Q
 September 30,
              2007
 
 TABLE
              OF
              CONTENTS
 PagePART
                          I: FINANCIAL INFORMATION
                      1Forward-Looking
                          Statements Disclaimer
                      1ITEM
                          1. Financial Statements
                      1ITEM
                          2. Management’s Discussion and Analysis of Financial Condition and Results
                          of Operations
                      22General
                      22Overview
                      22Results
                          of Operations
                      23Net
                          Income
                      23Net
                          Interest Income
                      23Noninterest
                          Income
                      26Noninterest
                          Expense
                      29Financial
                          Condition
                      33Asset
                          Quality
                      36Business
                          Segments
                      37Retail
                          Banking
                      39Sales
                          Finance
                      40Residential
                          Lending
                      41Business
                          Banking Lending
                      42Income
                          Property Lending
                      43Investments
                          and Treasury
                      44Liquidity
                      45Capital
                      47Subsequent
                          Events
                      47ITEM
                          3. Quantitative and Qualitative Disclosures About Market
                          Risk
                      54ITEM
                          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
                      60ITEM
                          5. Other Information
                      61ITEM
                          6. Exhibits
                      62SIGNATURES
                      63CERTIFICATIONS
 
 **PART I:**
                      **FINANCIAL
                          INFORMATION**
  **FORWARD-LOOKING
                STATEMENTS DISCLAIMER**
 
 Our
                Form
                10-Q for the quarter ended September 30, 2007, contains statements
                concerning
                forecasts of our financial results and condition, expectations of
                our operations
                and business and our assumptions for those forecasts and expectations
                that are
                forward-looking statements for the purposes of the safe harbor provisions
                under
                the Private Securities Litigation Reform Act of 1995.  Such
                forward-looking statements include statements regarding anticipated
                securities
                transactions, our observations regarding our provisions for loan
                losses,
                information regarding the possible effects of hedging our trading
                portfolio,
                information based upon our market risk models and analysis and information
                regarding our merger transaction with Washington Federal,
                Inc.  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.  Obviously, the closing of our merger
                transaction with Washington Federal, Inc. could have material effects
                on our
                subsequent operations and results of operations.  Other factors which
                could affect actual results include economic conditions in our market
                area and
                the nation as a whole, interest rate fluctuations, the impact of
                competitive
                products, services, and pricing, our credit risk management, our
                ability to
                control our costs and expenses, and the legislative and regulatory
                changes
                affecting the banking industry.  There are other risks and
                uncertainties that could affect us which are discussed from time
                to time in our
                filings with the Securities and Exchange Commission.  These risks and
                uncertainties should be considered in evaluating the forward-looking
                statements,
                and undue reliance should not be placed on such statements.  We are
                not responsible for updating any such forward-looking statements.
  ITEM
                          1.
                      Financial
                          Statements
 
 In
                the
                opinion of management, the accompanying consolidated statements of
                financial
                condition and related interim consolidated statements of income,
                stockholders’
equity and comprehensive income and cash flows reflect all adjustments
                (which
                include reclassifications and normal recurring adjustments) that
                are necessary
                for a fair presentation in conformity with accounting principles
                generally
                accepted in the United States of America (“GAAP”).  The preparation of
                financial statements in conformity with GAAP requires management
                to make
                estimates and assumptions that affect amounts reported in the financial
                statements.  Changes in these estimates and assumptions are considered
                reasonably possible and may have a material impact on the financial
                statements.
 
 Certain
                reclassifications have been made to the 2006 financial statements
                to conform to
                the 2007 presentation.  There is no effect on net income, earnings per
                share, or equity.  All significant intercompany transactions and
                balances have been eliminated.
 
 The
                information included in this Form 10-Q should be read in conjunction
                with the
                First Mutual Bancshares, Inc. Year 2006 Annual Report on Form 10-K
                to the
                Securities and Exchange Commission.  Interim results are not
                necessarily indicative of results for a full year.
 
 Consolidated
                Financial Statements of the Company begin on page 2.
 
 -
                    1
                    -
 
 Item
                    1.  Financial Statements
  **FIRST
                      MUTUAL BANCSHARES, INC.**
 **CONSOLIDATED
                        STATEMENTS OF FINANCIAL CONDITION**
 **(Dollars
                          in
                          thousands)**




September
                30,
            
            
            December
                31,2007
            
            
            2006**Assets**
            
            *(Unaudited)*Cash
                and Cash Equivalents:Interest-earning
                deposits
            
            $
            3,777
            
            
            $
            6,990Noninterest-earning
                demand deposits and cash on hand
            
            
            24,913
            
            
            
            18,372Total
                cash and cash equivalents
            
            
            28,690
            
            
            
            25,362Mortgage-backed
                and other securities available-for-sale (at fair value)
            
            
            3,697
            
            
            
            89,728Mortgage-backed
                and other securities held for trading (at fair value)
            
            
            13,582
            
            
            
            —Mortgage-backed
                and other securities held-to-maturity(fair
                value of $7,553 and $5,585, respectively)
            
            
            7,587
            
            
            
            5,620Loans
                held for sale
            
            
            33,053
            
            
            
            13,733Loans
                receivable
            
            
            879,665
            
            
            
            893,431Reserve
                for loan and lease losses
            
            
            (10,049
            )
            
            
            (9,728
            )Loans
                receivable, net
            
            
            869,616
            
            
            
            883,703Accrued
                interest receivable
            
            
            5,484
            
            
            
            5,534Land,
                buildings and equipment, net
            
            
            35,357
            
            
            
            35,566Federal
                Home Loan Bank (FHLB) stock, at cost
            
            
            13,122
            
            
            
            13,122Servicing
                assets
            
            
            4,726
            
            
            
            4,011Other
                assets
            
            
            2,407
            
            
            
            2,884**Total
                Assets**
            
            $
            1,017,321
            
            
            $
            1,079,263




See
      Notes
      to the Financial Statements


-
          2
          -


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


September
                30,
            
            
            December
                31,2007
            
            
            2006*(Unaudited)***Liabilities**Deposits:Non-interest-bearing
            
            $
            62,888
            
            
            $
            56,566Interest-bearing
                transactions and savings accounts
            
            
            278,817
            
            
            
            263,830Interest-bearing
                time deposits
            
            
            408,970
            
            
            
            485,399Total
                deposits
            
            
            750,675
            
            
            
            805,795Drafts
                payable
            
            
            10,473
            
            
            
            1,314Accounts
                payable and other liabilities
            
            
            6,452
            
            
            
            7,018Advance
                payments by borrowers for taxes and insurance
            
            
            2,711
            
            
            
            1,583FHLB
                advances
            
            
            159,090
            
            
            
            171,932Other
                advances
            
            
            4,600
            
            
            
            4,600Junior
                subordinated long-term debentures
            
            
            8,000
            
            
            
            17,000Total
                liabilities
            
            
            942,001
            
            
            
            1,009,242**Stockholders’
                Equity**Common
                stock, $1 par value, 30,000,000 shares authorized,6,697,628
                and 6,673,528 shares issued and outstanding
            
            $
            6,698
            
            
            $
            6,674Additional
                paid-in capital
            
            
            45,975
            
            
            
            45,119Retained
                earnings
            
            
            22,642
            
            
            
            19,589Accumulated
                other comprehensive income(loss):Unrealized
                gain/(loss) on securities available-for-sale,net
                of federal income tax
            
            
            5
            
            
            
            (1,361
            )Total
                stockholders’ equity
            
            
            75,320
            
            
            
            70,021**Total
                Liabilities and Stockholders’ Equity**
            
            $
            1,017,321
            
            
            $
            1,079,263




See
      Notes
      to the Financial Statements


-
          3
          -


**FIRST
      MUTUAL BANCSHARES, INC.**


**CONSOLIDATED
      STATEMENTS OF INCOME**


**(Dollars
      in thousands)**


Quarter
                ended September 30,
            
            
            Nine
                months ended September 30,2007
            
            
            2006
            
            
            2007
            
            
            2006*(Unaudited)***Interest
                Income**Loans
                receivable
            
            $
            18,747
            
            
            $
            19,681
            
            
            $
            55,339
            
            
            $
            55,746Interest
                on available-for-sale securities
            
            
            45
            
            
            
            1,032
            
            
            
            150
            
            
            
            3,313Interest
                on held-to-maturity securities
            
            
            108
            
            
            
            84
            
            
            
            260
            
            
            
            261Interest
                on held-for-trading securities
            
            
            219
            
            
            
            —
            
            
            
            1,974
            
            
            
            —Interest
                other
            
            
            219
            
            
            
            161
            
            
            
            968
            
            
            
            411Total
                interest income
            
            
            19,338
            
            
            
            20,958
            
            
            
            58,691
            
            
            
            59,731**Interest
                Expense**Deposits
            
            
            7,543
            
            
            
            6,910
            
            
            
            22,740
            
            
            
            19,273FHLB
                and other advances
            
            
            2,515
            
            
            
            3,866
            
            
            
            8,459
            
            
            
            10,020Total
                interest expense
            
            
            10,058
            
            
            
            10,776
            
            
            
            31,199
            
            
            
            29,293Net
                interest income
            
            
            9,280
            
            
            
            10,182
            
            
            
            27,492
            
            
            
            30,438Provision
                for loan and lease losses
            
            
            (449
            )
            
            
            (267
            )
            
            
            (687
            )
            
            
            (473
            )Net
                interest income, after provisionfor
                loan and lease losses
            
            
            8,831
            
            
            
            9,915
            
            
            
            26,805
            
            
            
            29,965**Noninterest
                Income**Gain
                on sales of loans
            
            
            241
            
            
            
            915
            
            
            
            2,087
            
            
            
            2,225Gain
                (loss) from mark to market (SFAS 159)
            
            
            (119
            )
            
            
            —
            
            
            
            117
            
            
            
            —Servicing
                fees, net of amortization
            
            
            432
            
            
            
            297
            
            
            
            1,268
            
            
            
            932Gain
                on sales of investments
            
            
            69
            
            
            
            —
            
            
            
            185
            
            
            
            —Fees
                on deposits
            
            
            193
            
            
            
            182
            
            
            
            589
            
            
            
            558Other
            
            
            838
            
            
            
            916
            
            
            
            2,202
            
            
            
            2,367Total
                noninterest income
            
            
            1,654
            
            
            
            2,310
            
            
            
            6,448
            
            
            
            6,082




See
      Notes
      to the Financial Statements


-
          4
          -


**FIRST
      MUTUAL BANCSHARES, INC.**


**CONSOLIDATED
      STATEMENTS OF INCOME**


**(Dollars
      in thousands except per share amounts)**


**(Continued)**


Quarter
                ended September 30,
            
            
            Nine
                months ended September 30,2007
            
            
            2006
            
            
            2007
            
            
            2006*(Unaudited)***Noninterest
                Expense**Salaries
                and employee benefits
            
            
            $
            4,351
            
            
            $
            4,352
            
            
            $
            13,477
            
            
            $
            13,275Occupancy
            
            
            
            937
            
            
            
            1,038
            
            
            
            2,887
            
            
            
            3,091Credit
                insurance premiums
            
            
            
            352
            
            
            
            394
            
            
            
            1,158
            
            
            
            1,336Other
            
            
            
            1,920
            
            
            
            1,916
            
            
            
            6,015
            
            
            
            5,521Total
                noninterest expense
            
            
            
            7,560
            
            
            
            7,700
            
            
            
            23,537
            
            
            
            23,223Income
                before provision for federal income tax
            
            
            2,925
            
            
            
            4,525
            
            
            
            9,716
            
            
            
            12,824Provision
                for federal income tax
            
            
            
            983
            
            
            
            1,524
            
            
            
            3,302
            
            
            
            4,397**Net
                Income**
            
            
            
            $
            1,942
            
            
            $
            3,001
            
            
            $
            6,414
            
            
            $
            8,427**Per
                Share Data(1):**Basic
                earnings per common share
            
            
            $
            0.29
            
            
            $
            0.45
            
            
            $
            0.96
            
            
            $
            1.27Diluted
                earnings per common share
            
            
            $
            0.28
            
            
            $
            0.43
            
            
            $
            0.92
            
            
            $
            1.23**Weighted
                Average Number of Shares Outstanding**
            
            
            6,697,175
            
            
            
            6,655,307
            
            
            
            6,690,051
            
            
            
            6,642,156**Weighted
                Average Number of Shares Outstanding****Including
                Dilutive Stock Options**
            
            
            
            6,957,414
            
            
            
            6,850,441
            
            
            
            6,943,422
            
            
            
            6,825,598


(1)
        Shares and EPS have been adjusted to reflect the five-for-four stock split
        paid
        on October 4, 2006.




See
        Notes
        to the Financial Statements


-
          5
          -


**First
      Mutual Bancshares, Inc. and Subsidiaries**


**Consolidated
      Statements of Stockholders’ Equity and Comprehensive
      Income**


**(Dollars
      in thousands except per share amounts)**


AccumulatedAdditional
            
            
            
            
            
            ComprehensiveCommon
                Stock (1)
            
            
            Paid-in
            
            
            Retained
            
            
            IncomeShares
            
            
            Amount
            
            
            Capital
                (1)
            
            
            Earnings
            
            
            (Loss)
            
            
            TotalBALANCE,
                December 31, 2004
            
            
            6,611
            
            
            $
            6,611
            
            
            $
            44,273
            
            
            $
            9,220
            
            
            $
            (657
            )
            
            $
            59,447Comprehensive
                income:Net
                income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            10,319
            
            
            
            
            
            
            
            10,319Other
                comprehensive income (loss), net of tax:Unrealized
                (loss) on securities available-for-sale
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (945
            )
            
            
            (945
            )Unrealized
                gain on interest rate swap
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            166
            
            
            
            166Total
                comprehensive income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            9,540Options
                exercised, including tax benefit of $479
            
            
            185
            
            
            
            185
            
            
            
            1,727
            
            
            
            
            
            
            
            
            
            
            
            1,912Retirement
                of shares repurchased
            
            
            (180
            )
            
            
            (180
            )
            
            
            (2,130
            )
            
            
            (1,344
            )
            
            
            
            
            
            
            (3,654
            )Issuance
                of stock through employees’ stock plans
            
            
            5
            
            
            
            5
            
            
            
            95
            
            
            
            
            
            
            
            
            
            
            
            100Cash
                dividend declared ($1.11 per share)
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (7,318
            )
            
            
            
            
            
            
            (7,318
            )—BALANCE,
                December 31, 2005
            
            
            6,621
            
            
            $
            6,621
            
            
            $
            43,965
            
            
            $
            10,877
            
            
            $
            (1,436
            )
            
            $
            60,027Comprehensive
                income:Net
                income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            10,980
            
            
            
            
            
            
            
            10,980Other
                comprehensive income, net of tax:Unrealized
                gain on securities available-for-sale
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            75
            
            
            
            75Total
                comprehensive income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            11,055Compensation
                related to stock options
            
            
            
            
            
            
            
            
            
            
            632
            
            
            
            
            
            
            
            
            
            
            
            632Options
                exercised, including tax benefit of $110
            
            
            48
            
            
            
            48
            
            
            
            427
            
            
            
            
            
            
            
            
            
            
            
            475Issuance
                of stock through employees’ stock plans
            
            
            5
            
            
            
            5
            
            
            
            95
            
            
            
            
            
            
            
            
            
            
            
            100Cash
                dividend declared ($0.32 per share)
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (2,268
            )
            
            
            
            
            
            
            (2,268
            )—BALANCE,
                December 31, 2006
            
            
            6,674
            
            
            $
            6,674
            
            
            $
            45,119
            
            
            $
            19,589
            
            
            $
            (1,361
            )
            
            $
            70,021Cumulative-effect
                adjustment for the initial adoption of SFAS No. 159
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (1,554
            )
            
            
            
            
            
            
            (1,554
            )Comprehensive
                income:Net
                income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            6,414
            
            
            
            
            
            
            
            6,414Other
                comprehensive income, net of tax:Unrealized
                gain on securities available-for-sale
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            1,366
            
            
            
            1,366Total
                comprehensive income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            7,780Compensation
                related to stock options
            
            
            
            
            
            
            
            
            
            
            486
            
            
            
            
            
            
            
            
            
            
            
            486Options
                exercised, including tax benefit of $55
            
            
            19
            
            
            
            19
            
            
            
            255
            
            
            
            
            
            
            
            
            
            
            
            274Issuance
                of stock through employees’ stock plans
            
            
            5
            
            
            
            5
            
            
            
            115
            
            
            
            
            
            
            
            
            
            
            
            120Cash
                dividend declared ($0.27 per share)
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (1,807
            )
            
            
            
            
            
            
            (1,807
            )—BALANCE,
                September 30, 2007
            
            
            6,698
            
            
            $
            6,698
            
            
            $
            45,975
            
            
            $
            22,642
            
            
            $
            5
            
            
            $
            75,320




(1)
      The
      number and amount of common shares issued and outstanding have been adjusted
      to
      reflect the five-for-four stock split paid on October 4, 2006.


-
          6
          -


**FIRST
        MUTUAL BANCSHARES, INC.**
 **CONSOLIDATED
          STATEMENTS OF CASH FLOWS**
 **(Dollars
            in thousands)**


Nine
                months ended September 30,2007
            
            
            2006*(Unaudited)***Cash
                Flows from Operating Activities**Net
                income
            
            
            
            $
            6,414
            
            
            $
            8,427Adjustments
                to reconcile net income to net cash from operating
                activities:Provision
                for loan and lease losses
            
            
            
            687
            
            
            
            473Depreciation
                and amortization
            
            
            
            1,434
            
            
            
            1,483Deferred
                loan origination fees, net of accretion
            
            
            69
            
            
            
            719Amortization
                of servicing assets
            
            
            
            1,795
            
            
            
            975Gain
                on sales of loans
            
            
            
            (2,087
            )
            
            
            (2,225
            )Gain
                on sale of securities held for trading
            
            
            
            (185
            )
            
            
            —Gain
                on mark to market (FAS 159)
            
            
            
            (117
            )
            
            
            —Stock-based
                compensation
            
            
            
            
            486
            
            
            
            435Excess
                tax benefit from stock-based compensation
            
            
            (55
            )
            
            
            (102
            )Changes
                in operating assets and liabilities:Loans
                held-for-sale
            
            
            
            
            (19,320
            )
            
            
            3,272Accrued
                interest receivable
            
            
            
            50
            
            
            
            (380
            )Other
                assets
            
            
            
            261
            
            
            
            (912
            )Drafts
                payable
            
            
            
            9,159
            
            
            
            254Accounts
                payable and other liabilities
            
            
            
            (490
            )
            
            
            (1,780
            )Advance
                payments by borrowers for taxes and insurance
            
            
            1,128
            
            
            
            1,346Net
                cash provided/(used) by operating activities
            
            
            
            (771
            )
            
            
            11,985**Cash
                Flows from Investing Activities**Loan
                originations
            
            
            
            
            (240,902
            )
            
            
            (314,544
            )Loan
                principal repayments
            
            
            
            274,635
            
            
            
            287,904Decrease
                in undisbursed loan proceeds
            
            
            
            (20,042
            )
            
            
            (15,311
            )Principal
                repayments and redemptions on mortgage-backedand
                other securities
            
            
            
            13,800
            
            
            
            29,002Purchase
                of securities held-to-maturity
            
            
            
            (3,000
            )
            
            
            —Purchase
                of securities held-for-trading
            
            
            (39,303
            )
            
            
            (7,170
            )Purchases
                of premises and equipment
            
            
            
            (1,255
            )
            
            
            (3,436
            )Proceeds
                from sale of securities held-for-trading
            
            
            
            98,037
            
            
            
            —Proceeds
                from sale of impaired loans
            
            
            
            502
            
            
            
            340Net
                cash provided/(used) by investing activities
            
            
            
            82,472
            
            
            
            (23,215
            )




See
      Notes
      to the Financial Statements


-
          7
          -


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


Nine
                months ended September 30,2007
            
            
            2006*(Unaudited)***Cash
                Flows from Financing Activities**Net
                decrease in deposit accounts
            
            
            
            $
            (76,902
            )
            
            $
            (3,410
            )Interest
                credited to deposit accounts
            
            
            
            21,782
            
            
            
            17,604Redemption
                of long-term debentures (trust preferred securities)
            
            
            (9,000
            )
            
            
            —Issuance
                of stock through employees’ stock plans
            
            
            120
            
            
            
            100Proceeds
                from advances
            
            
            
            
            422,307
            
            
            
            704,244Repayment
                of advances
            
            
            
            
            (435,149
            )
            
            
            (712,251
            )Dividends
                paid
            
            
            
            
            (1,805
            )
            
            
            (6,887
            )Proceeds
                from exercise of stock options and excess tax benefitof
                $55 and $102 from stock-based compensation
            
            
            274
            
            
            
            430Net
                cash used by financing activities
            
            
            
            
            (78,373
            )
            
            
            (170
            )**Increase/(decrease)
                in cash and cash equivalents**
            
            $
            3,328
            
            
            $
            (11,400
            )Cash
                and cash equivalents, beginning of the year
            
            
            25,362
            
            
            
            25,781Cash
                and cash equivalents, end of quarter
            
            
            $
            28,690
            
            
            $
            14,381**Supplemental
                Disclosures of Cash Flow Information**Loans
                originated for sale in the secondary market
            
            $
            111,726
            
            
            $
            85,146Loans
                originated for investment activities
            
            
            
            240,902
            
            
            
            314,544Proceeds
                from sale of loans held-for-sale
            
            
            
            92,406
            
            
            
            88,418Additions
                to servicing assets
            
            
            
            
            2,510
            
            
            
            2,453Cash
                paid during the year for:Interest
            
            
            
            
            31,613
            
            
            
            28,542Income
                taxes
            
            
            
            
            2,910
            
            
            
            3,860




See
        Notes
        to the Financial Statements


-
          8
          -


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**(Unaudited)**





**Note
      1.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**





The
      results of operations for the interim periods shown in this report are not
      necessarily indicative of results to be expected for the fiscal
      year.  In the opinion of management, the information contained herein
      reflects all adjustments necessary to make the results of operations for the
      interim periods a fair statement of such operations.





**Note
      2.  ADOPTION OF NEW ACCOUNTING STANDARDS**





**Financial
      Accounting Standards Board Interpretation No. 48,*Accounting for
      Uncertainty in Income Taxes*(FIN No. 48)**





In
      June
      2006, the Financial Accounting Standards Board (FASB) issued FIN No. 48 - an
      interpretation of FASB Statement No. 109, *Accounting for Income Taxes*.
      FIN No. 48 establishes a single model to address accounting for uncertain tax
      positions. FIN No. 48 clarifies the accounting for income taxes by prescribing
      a
      minimum recognition threshold a tax position is required to meet before being
      recognized in the financial statements.  FIN No. 48 also provides
      guidance on derecognition, measurement classification, interest and penalties,
      accounting in interim periods, disclosure and transition.  We adopted
      FIN No. 48 on January 1, 2007; no adjustments have been made to our financial
      statements as a result of this adoption. We do not believe that we have any
      uncertain tax positions that would rise to the level of having a material impact
      on our financial statements.





Our
      continuing practice is to recognize interest and/or penalties related to income
      tax matters in income tax expense.





**Statement
      of Financial Accounting Standards No. 156,*Accounting for Servicing
      of Financial Assets (SFAS 156)***





In
      March
      of 2006, the FASB published SFAS No. 156, which amends SFAS No. 140,
*Accounting for Transfers and Servicing of Financial Assets and
      Extinguishments of Liabilities*, with respect to the accounting for
      servicing of financial assets. SFAS No. 156 requires that all separately
      recognized servicing rights be initially measured at fair value, if practicable.
      For each class of seperately recognized servicing assets and liabilities, SFAS
      No. 156 permits an entity to choose either of the following subsequent
      measurement methods:  (1) the amortization of servicing assets or
      liabilities in proportion to and over the period of estimated net servicing
      income or net servicing loss or (2) the reporting of servicing assets or
      liabilities at fair value at each reporting date and reporting changes in fair
      value in earnings in the period in which the changes occur. SFAS No. 156 also
      requires additional disclosures for all separately recognized servicing
      rights.  We adopted SFAS No. 156 on January 1, 2007 and have elected
      to continue to amortize our servicing assets or liabilities in proportion to
      and
      over the period of estimated net servicing income or net servicing
      loss.





Originated
      servicing assets are recorded when loans are originated and subsequently sold
      or
      securitized (and held as available-for-sale securities) with the servicing
      rights retained. Servicing assets are initially recognized at fair value on
      the
      balance sheet. Fair value is based on market prices for comparable servicing
      contracts when available, or alternatively, is based on a valuation model that
      calculates the present value of the estimated future cash flows. Assumptions
      used in the valuation model include market discount rates and anticipated
      prepayment speeds. The prepayment speeds of the servicing portfolio are based
      on
      our prepayment experience for those strata for which market data are not readily
      available. These servicing assets include sales finance loans, construction
      loan
      participations, lot loans, and other commercial loans for which where are no
      readily available online quotation data.  In addition, estimates of
      the cost of servicing per loan, an inflation rate, ancillary income per loan,
      and default rates are used. The cost relating to the servicing rights is
      capitalized and amortized into noninterest income in proportion to, and over
      the
      period of, estimated future net servicing income. Amounts capitalized are
      recorded at cost, net of accumulated amortization and valuation
      allowance.





We
      assess
      impairment of the capitalized servicing assets based on recalculations of the
      present value of the remaining future cash flows using updated market discount
      rates and prepayment speeds.  Subsequent loan prepayments and changes
      in prepayment assumptions in excess of those forecasted can adversely impact
      the
      carrying value of the servicing assets. Impairment is assessed on a
      stratum-by-stratum basis with any impairment recognized through a valuation
      allowance for each impaired stratum. The servicing assets are stratified based
      on the types of loans and the underlying collateral. We have three strata or
      classes of servicing assets:  consumer (sales finance), commercial,
      and residential.





The
      effect of changes in market interest rates on estimated rates of loan
      prepayments is the predominant risk characteristic for mortgage servicing
      rights. For those loans that do not have quoted prepayment rates we utilize
      our
      own prepayment experience over the previous three months to reflect the actual
      prepayment environment in our underlying assumptions of the estimated fair
      value
      of the servicing rights upon recognition. The significant assumption used in
      the
      valuation model is the discount rate. This is generally the weighted average
      note rate of the underlying loans.





Changes
      in the servicing asset balances, the fair values, discount and prepayment
      assumptions by strata are as follows:


-
          9
          -


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**(Unaudited)**





**Note
      2.  ADOPTION OF NEW ACCOUNTING STANDARDS
      (Continued)**


Third
                Quarter 2007Consumer
            
            
            Commercial
            
            
            Residential
            
            
            Total(Dollars
                in thousands)Balance,
                beginning of quarter
            
            $
            4,798
            
            
            $
            114
            
            
            $
            72
            
            
            $
            4,984Additions
            
            
            337
            
            
            
            32
            
            
            
            —
            
            
            
            369Amortization
            
            
            (586
            )
            
            
            (23
            )
            
            
            (6
            )
            
            
            (615
            )Impairment
            
            
            (12
            )
            
            
            —
            
            
            
            —
            
            
            
            (12
            )Balance
                at September 30, 2007
            
            $
            4,537
            
            
            $
            123
            
            
            $
            66
            
            
            $
            4,726Fair
                values atJuly
                1, 2007
            
            $
            4,786
            
            
            $
            127
            
            
            $
            96Fair
                values atSeptember
                30, 2007
            
            $
            4,828
            
            
            $
            155
            
            
            $
            80Discount
                rate
            
            
            11.6
            %
            
            
            8.9
            %
            
            
            7.8
            %Prepayment
                speed
            
            
            33.2
            %
            
            
            21.6
            %
            
            
            38.0
            %Third
                Quarter 2006Consumer
            
            
            Commercial
            
            
            Residential
            
            
            Total(Dollars
                in thousands)Balance,
                beginning of quarter
            
            $
            2,333
            
            
            $
            287
            
            
            $
            82
            
            
            $
            2,702Additions
            
            
            975
            
            
            
            42
            
            
            
            —
            
            
            
            1,017Amortization
            
            
            (365
            )
            
            
            (48
            )
            
            
            (11
            )
            
            
            (424
            )Impairment
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —Balance
                at September 30, 2006
            
            $
            2,943
            
            
            $
            281
            
            
            $
            71
            
            
            $
            3,295Fair
                values atJuly
                1, 2006
            
            $
            2,697
            
            
            $
            472
            
            
            $
            88Fair
                values atSeptember
                30, 2006
            
            $
            3,198
            
            
            $
            527
            
            
            $
            101Discount
                rate
            
            
            11.1
            %
            
            
            11.2
            %
            
            
            8.6
            %Prepayment
                speed
            
            
            39.8
            %
            
            
            24.4
            %
            
            
            36.7
            %




Servicing
        fee income, net of amortization, consisted of the following for the quarters
        ended September 30, 2007 and 2006:





Third
                Quarter 2007Consumer
            
            
            Commercial
            
            
            Residential
            
            
            Total(Dollars
                in thousands)Servicing
                fees
            
            $
            1,026
            
            
            $
            25
            
            
            $
            8
            
            
            $
            1,059Amortization
            
            
            (598
            )
            
            
            (23
            )
            
            
            (6
            )
            
            
            (627
            )Loan
                servicing fees, net
            
            $
            428
            
            
            $
            2
            
            
            $
            2
            
            
            $
            432Third
                Quarter 2006Consumer
            
            
            Commercial
            
            
            Residential
            
            
            Total(Dollars
                in thousands)Servicing
                fees
            
            $
            665
            
            
            $
            48
            
            
            $
            8
            
            
            $
            721Amortization
            
            
            (365
            )
            
            
            (48
            )
            
            
            (11
            )
            
            
            (424
            )Loan
                servicing fees, net
            
            $
            300
            
            
            $
            —
            
            
            $
            (3
            )
            
            $
            297


-
          10
          -


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**(Unaudited)**





**Note
      2.  ADOPTION OF NEW ACCOUNTING STANDARDS
      (Continued)**





**Statement
      of Financial Accounting Standards No. 157,*Fair Value
      Measurements*and No 159,*The Fair Value Option for
      Financial Assets and Financial Liabilities*, (SFAS No. 157 and SFAS
      No. 159)**





We
      elected early adoption of SFAS No. 157 and SFAS No. 159 effective January 1,
      2007.





In
      September 2006, the FASB issued SFAS No. 157 which defines fair value,
      establishes a framework for measuring fair value in Generally Accepted
      Accounting Principles, and expands disclosure requirements about fair value
      measurements. SFAS No. 157, among other things, requires us to maximize the
      use
      of observable inputs and minimize the use of unobservable inputs when measuring
      fair values.





Valuation
      techniques are based upon observable and unobservable inputs. Observable inputs
      reflect market data obtained from independent sources, while unobservable inputs
      reflect our market assumptions. These two types of inputs create the following
      fair value hierarchy.





Level
      1 -
      Quoted prices for identical instruments in active markets.





Level
      2 -
      Quoted prices for similar instruments in active markets; quoted prices for
      identical or similar instruments in markets that are not active; and
      model-derived valuations whose inputs are observable.





Level
      3 -
      Instruments whose significant value drivers are unobservable.





In
      February 2007, the FASB issued SFAS No. 159.  SFAS 159 allows entities
      to voluntarily choose, at specified election dates, to measure many financial
      assets and financial liabilities at fair value. The election is made on an
      instrument-by-instrument basis and is irrevocable. If the fair value option
      is
      elected for an instrument, all subsequent changes in fair value for that
      instrument shall be reported in earnings.





The
      following is a breakdown of the cumulative effect adjustment that was made
      to
      retained earnings upon adoption of SFAS 159:




**Description**
              
              **Balance
                  Sheet**
                **at
                  January 1,**
                **2007
                  prior to**
                **Adoption**
              
              
              **Net**
                **Gain/(Loss)**
                **upon
                  Adoption**
              
              
              **Balance
                  Sheet**
                **at
                  January 1,**
                **2007
                  after**
                **Adoption
                  of the**
                **Fair
                  Value**
                **Option**(Dollars
                  in thousands)Mortgage-backed
                  and agency securities - gross
              
              $
              87,148
              
              
              $
              (2,149
              )
              
              $
              84,999(excluding
                  premiums and discounts)Premiums
                  and discounts related to securities
              
              
              (97
              )
              
              
              97
              
              
              
              —Long-term
                  debentures payable (trust preferred securities)
              
              
              9,000
              
              
              
              (89
              )
              
              
              8,911Issuance
                  costs related to long-term debentures
              
              
              249
              
              
              
              (249
              )
              
              
              —Pretax
                  cumulative effect of adoption ofthe
                  fair value option
              
              
              
              
              
              
              (2,390
              )Increase
                  in deferred tax asset
              
              
              
              
              
              
              836Cumulative
                  effect of adoption of the fair valueoption
                  (charge to retained earnings)
              
              
              
              
              
              $
              (1,554
              )
  -
            11
            -


**NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **(Unaudited)**
  **Note
        2.  ADOPTION OF NEW ACCOUNTING STANDARDS
        (Continued)**


Mortgage-Backed
      and Agency Securities





Upon
      adoption, the mortgage-backed and agency securities selected for treatment
      under
      SFAS No. 159 consisted of $87.1 million or 89% of the securities portfolio.
      Securities with a remaining balance less than one million dollars and
      instruments held for Community Reinvestment Act (CRA) investments were not
      included in the adoption of SFAS No. 159. Securites with small balances are
      much
      less attractive to potential purchasers and the CRA investments were purchased
      to facilitate compliance with the Community Reinvestment Act. The initial fair
      value of the securities selected for SFAS No. 159 adoption resulted in a
      $1,334,000 cumulative-effect adjustment, net of tax, recorded as a reduction
      in
      retained earnings as of January 1, 2007. Under SFAS No. 159, this one-time
      charge was not recognized in earnings. As a result of the fair value measurement
      election for these securities, we recorded gains in the first quarter 2007
      earnings of $402,000, a loss of $211,000 in the second quarter, and a loss
      of
      $119,000 in the third quarter.  The standard was adopted early as we
      believed that it would enable us to more effectively manage interest rate risk.
      However, because of the volatility observed in the second quarter we have
      reduced, through security sales, most of the securities originally selected
      for
      treatment under SFAS No. 159. Our current balance for securities held in the
      “held for
      trading”
      account as of September 30, 2007 is $13.6 million.





The
      securities selected to be accounted for under SFAS No. 159 are presented
      separately from the securities that are accounted for at cost and titled “Held
      for Trading (at fair value)”.





Junior
      Subordinated Long-Term Debentures Payable (Trust Preferred
      Securities)





The
      junior subordinated long-term debentures selected for treatment under SFAS
      No.
      159 totaled $9 million. The initial fair value measurement resulted in a
      $220,000, net of tax, charge to retained earnings for unamortized issuance
      costs
      and excess interest.  In the first quarter of 2007, we recorded
      $45,000 in pre-tax mark-to-market gains, a loss of $4,000 in the second quarter
      and a loss of $48,000 in the third quarter. We elected to account for our first
      $9 million junior subordinated long-term debenture issuance and not the other
      two issuances of $4 million each under SFAS No. 159 because this particular
      security is hedged with an interest-rate swap that is carried at fair value
      with
      changes in value reflected in our earnings (the other two debentures are not
      hedged). The election to fair value the debentures matches the change in value
      of the interest-rate swap with the change in value of the debentures -
      effectively reducing the volitility in earnings. This security was redeemed
      on
      September 28, 2007.





The
      long-term debentures payable selected to be accounted for under SFAS No. 159
      are
      presented seperately from the long-term debentures payable that are accounted
      for at cost and titled “long-term debentures payable (at fair
      value)”.





Interest-Rate
      Swaps





The
      interest-rate swaps and related commercial loans were included in the early
      adoption of SFAS 159 for administrative reasons. We have two fair value swaps
      that are hedged with commercial loans and are evaluated quarterly in accordance
      with SFAS 133, the hedge accounting statement. The inclusion of these two swaps
      and loans in the adoption of SFAS 159 did not impact retained earnings or net
      income, however, the administrative burden associated with accounting for these
      instruments will be greatly reduced under the new accounting statement. These
      two swaps were the only swaps that were accounted for in accordance with the
      “long-haul accounting method”, under SFAS No. 133, as amended.





-
          12
          -


**NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **(Unaudited)**
  **Note
        2.  ADOPTION OF NEW ACCOUNTING STANDARDS
        (Continued)**




The
      fair
      value of the swaps is included in “Accounts Payable and Other” and the fair
      value of the commercial loans that are being hedged is included in “Loans
      Receivable” on the balance sheet. On January 1, 2007, the fair value of the two
      swaps was $23,517 and the fair value of the loans totaled $22,742.  On
      September 30, 2007, the fair value of the swaps included in “Accounts Payable
      and Other” totaled $25,451 and the fair value of the loans amounted to
      $25,447.






Fair
                Value Measurements at September 30, 2007
            
            
            Changes
                in Fair Values for the 3-Month Period Ended September 30, 2007, for
                Items
                Measured at Fair Value Pursuant to Election of the Fair Value
                OptionDescription
            
            Fair
                Value Measurements 9/30/07
            
            
            Quoted
                Prices in Active Markets for Identical Assets (Level 1)
            
            
            Significant
                Other Observable Inputs (Level 2)
            
            
            Significant
                Unobservable Inputs (Level 3)
            
            
            Interest
                Expense - FHLB and Other Advances
            
            
            Interest
                Income on Loans
            
            
            Loss
                from Mark to Market (SFAS 159) - Noninterest Income
            
            
            Total
                Changes in Fair Values Included in Current-Period Earnings(Dollars
                in thousands)Trading
                securities
            
            $
            13,582
            
            
            $
            13,582
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            $
            (167
            )
            
            $
            (167
            )Long-term
                debentures payable
            
            
            —
            
            
            
            
            
            
            
            —
            
            
            
            
            
            
            203
            
            
            
            
            
            
            
            
            
            
            203Loans
                receivable
            
            
            25
            
            
            
            
            
            
            
            
            
            
            
            25
            
            
            
            
            
            
            
            27
            
            
            
            
            
            
            
            27




The
      contractual long-term debentures payable totaling $9.0 million were redeemed
      on
      September 28, 2007.  The unpaid principal balance on the two
      loans
      that were selected to be carried at fair value totaled $1.4 million at September
      30, 2007.





-
            13
            -


**NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **(Unaudited)**




**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, 2007 and December 31, 2006 are summarized as follows:


Gross
            
            
            GrossGross
            
            
            Unrealized
            
            
            Unrealized
            
            
            EstimatedAmortized
            
            
            Unrealized
            
            
            Losses
            
            
            Losses
            
            
            FairCost
            
            
            Gains
            
            
            <1
                Year
            
            
            >1
                Year
            
            
            Value**September
                30, 2007**
            
            (Dollars
                in thousands)Freddie
                Mac securities
            
            $
            451
            
            
            $
            5
            
            
            $
            —
            
            
            $
            —
            
            
            $
            456Fannie
                Mae securities
            
            
            910
            
            
            
            4
            
            
            
            —
            
            
            
            19
            
            
            
            895Ginnie
                Mae securities
            
            
            2,328
            
            
            
            18
            
            
            
            —
            
            
            
            —
            
            
            
            2,346$
            3,689
            
            
            $
            27
            
            
            $
            —
            
            
            $
            19
            
            
            $
            3,697**December
                31, 2006**Freddie
                Mac securities
            
            $
            14,657
            
            
            $
            9
            
            
            $
            —
            
            
            $
            565
            
            
            $
            14,101Fannie
                Mae securities
            
            
            32,222
            
            
            
            8
            
            
            
            —
            
            
            
            1,090
            
            
            
            31,140Ginnie
                Mae securities
            
            
            34,053
            
            
            
            2
            
            
            
            —
            
            
            
            397
            
            
            
            33,658US
                agency securities
            
            
            10,990
            
            
            
            —
            
            
            
            —
            
            
            
            161
            
            
            
            10,829$
            91,922
            
            
            $
            19
            
            
            $
            —
            
            
            $
            2,213
            
            
            $
            89,728





Certain
      investment securities shown above currently have fair values less than amortized
      cost and therefore contain unrealized losses. The Bank has evaluated these
      securities and has determined that the decline in value is temporary and is
      related to the change in market interest rates since purchase. The decline
      in value is not related to any company or industry specific event.  At
      September 30, 2007 and December 31, 2006, there were 2 and 32 investment
      securities with unrealized losses, respectively. The Bank anticipates full
      recovery of amortized cost with respect to these securities at maturity or
      sooner in the event of a more favorable market interest rate
      environment.




**Note
      4.**





**Mortgage-Backed
      and Other Securities Held-to-Maturity**





The
      amortized cost and estimated fair value of securities held-to-maturity at
      September 30, 2007 and December 31, 2006 are summarized as follows:





Gross
            
            
            GrossGross
            
            
            Unrealized
            
            
            Unrealized
            
            
            EstimatedAmortized
            
            
            Unrealized
            
            
            Losses
            
            
            Losses
            
            
            FairCost
            
            
            Gains
            
            
            <1
                Year
            
            
            >1
                Year
            
            
            Value**September
                30, 2007**
            
            (Dollars
                in thousands)Fannie
                Mae securities
            
            $
            3,371
            
            
            $
            18
            
            
            $
            —
            
            
            $
            50
            
            
            $
            3,339Freddie
                Mac securities
            
            
            94
            
            
            
            1
            
            
            
            —
            
            
            
            —
            
            
            
            95Municipal
                bonds
            
            
            4,122
            
            
            
            1
            
            
            
            —
            
            
            
            4
            
            
            
            4,119$
            7,587
            
            
            $
            20
            
            
            $
            —
            
            
            $
            54
            
            
            $
            7,553**December
                31, 2006**Fannie
                Mae securities
            
            $
            4,176
            
            
            $
            35
            
            
            $
            —
            
            
            $
            74
            
            
            $
            4,137Freddie
                Mac securities
            
            
            300
            
            
            
            7
            
            
            
            —
            
            
            
            —
            
            
            
            307Municipal
                bonds
            
            
            1,144
            
            
            
            1
            
            
            
            —
            
            
            
            4
            
            
            
            1,141$
            5,620
            
            
            $
            43
            
            
            $
            —
            
            
            $
            78
            
            
            $
            5,585




Certain
        investment securities shown above currently have fair values less than amortized
        cost and therefore contain unrealized losses. The Bank has evaluated these
        securities and has determined that the decline in value is temporary and
        is
        related to the change in market interest rates since purchase. The decline
        in value is not related to any company or industry specific event. At September
        30, 2007 and December 31, 2006, there were 4 investment securities with
        unrealized losses. The Bank anticipates full recovery of amortized cost
        with respect to these securities at maturity or sooner in the event of a
        more favorable market interest rate environment.





-
            14
            -


**NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **(Unaudited)**


**Note
      5.**


**Nonperforming
        Assets**
 
 Nonperforming
        loans are summarized as follows:
  September
                  30, 2007
              
              
              December
                  31, 2006(Dollars
                  in thousands)Impaired
                  loans with a valuation allowance
              
              $
              390
              
              
              $
              1,283Valuation
                  allowance related to impaired loans
              
              
              (139
              )
              
              
              (236
              )Net
                  impaired loans
              
              
              251
              
              
              
              1,047Non
                  accrual loans
              
              
              2,918
              
              
              
              2,415Total
                  nonperforming or non-accrual loans
              
              
              3,169
              
              
              
              3,462Real
                  estate owned
              
              
              0
              
              
              
              —Nonperforming
                  assets
              
              $
              3,169
              
              
              $
              3,462Total
                  loans past due 90-days or more and still accruing interest
              
              $
              —
              
              
              $
              —Average
                  balance of impaired loans
              
              $
              555
              
              
              $
              592Interest
                  income recognized on impaired loans
              
              $
              —
              
              
              $
              1




**Note
        6.**
 
 **Earnings
        Per Share**
 
 Basic
        Earnings Per Share is computed by dividing net income by the weighted-average
        number of shares outstanding during the period. Diluted EPS reflects the
        potential dilutive effect of stock options and is computed by dividing net
        income by the weighted-average number of shares outstanding during the period,
        plus the dilutive common shares that would have been outstanding had the
        stock
        options been exercised.
 
 The
        following is a reconciliation of the numerators and denominators of the basic
        and diluted earnings per share computations for the quarters and nine months
        ending September 30, 2007 and September 30, 2006:
  Income
              
              
              Shares
              
              
              Per
                  share(numerator)
              
              
              (denominator)
              
              
              amount(Dollars
                  and shares in thousands except per share amounts)Quarter
                  ended September 30, 2007Basic
                  EPS:Income
                  available to common shareholders
              
              $
              1,942
              
              
              
              6,697
              
              
              $
              0.29Effect
                  of dilutive stock options
              
              
              —
              
              
              
              260Diluted
                  EPS:Income
                  available to common shareholdersplus
                  assumed stock options exercised
              
              $
              1,942
              
              
              
              6,957
              
              
              $
              0.28Quarter
                  ended September 30, 2006 (2)Basic
                  EPS:Income
                  available to common shareholders
              
              $
              3,001
              
              
              
              6,655
              
              
              $
              0.45Effect
                  of dilutive stock options
              
              
              —
              
              
              
              195Diluted
                  EPS:Income
                  available to common shareholdersplus
                  assumed stock options exercised
              
              $
              3,001
              
              
              
              6,850
              
              
              $
              0.43Nine
                    months ended September 30, 2007Basic
                  EPS:Income
                  available to common shareholders
              
              $
              6,414
              
              
              
              6,690
              
              
              $
              0.96Effect
                  of dilutive stock options
              
              
              —
              
              
              
              253Diluted
                  EPS:Income
                  available to common shareholdersplus
                  assumed stock options exercised
              
              $
              6,414
              
              
              
              6,943
              
              
              $
              0.92Nine
                  months ended September 30, 2006 (2)Basic
                  EPS:Income
                  available to common shareholders
              
              $
              8,427
              
              
              
              6,642
              
              
              $
              1.27Effect
                  of dilutive stock options
              
              
              —
              
              
              
              184Diluted
                  EPS:Income
                  available to common shareholdersplus
                  assumed stock options exercised
              
              $
              8,427
              
              
              
              6,826
              
              
              $
              1.23(2)
                  Shares and EPS have been adjusted to reflect the five-for-four
                  stock split
                  paid on October 4, 2006.


-
            15
            -


**NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**
 **(Unaudited)**
  **Note
        7.**


**Rate
                Volume Analysis**
            
            THIRD
                QUARTER 2007
            
            
            NINE
                MONTHS ENDED 2007VS
            
            
            VSTHIRD
                QUARTER 2006
            
            
            NINE
                MONTHS ENDED 2006INCREASE
                (DECREASE) DUE TO
            
            
            INCREASE
                (DECREASE) DUE TOTOTAL
            
            
            
            
            
            
            
            
            TOTALVOLUME
            
            
            RATE
            
            
            CHANGE
            
            
            VOLUME
            
            
            RATE
            
            
            CHANGEINTEREST
                INCOME
            
            (Dollars
                in thousands)Investments:Available-for-sale
                securities
            
            $
            (989
            )
            
            $
            2
            
            
            $
            (987
            )
            
            $
            (2,723
            )
            
            $
            (440
            )
            
            $
            (3,163
            )Held-for-trading
                securities
            
            
            219
            
            
            
            —
            
            
            
            219
            
            
            
            1,974
            
            
            
            —
            
            
            
            1,974Held-to-maturity
                securities
            
            
            26
            
            
            
            (3
            )
            
            
            23
            
            
            
            13
            
            
            
            (15
            )
            
            
            (2
            )Other
                equity investments
            
            
            29
            
            
            
            30
            
            
            
            59
            
            
            
            66
            
            
            
            492
            
            
            
            558Total
                investments
            
            
            (715
            )
            
            
            29
            
            
            
            (686
            )
            
            
            (670
            )
            
            
            37
            
            
            
            (633
            )Loans:Residential
            
            $
            516
            
            
            $
            29
            
            
            $
            545
            
            
            $
            1,907
            
            
            $
            846
            
            
            $
            2,753Residential
                construction
            
            
            (1,121
            )
            
            
            (69
            )
            
            
            (1,190
            )
            
            
            (2,467
            )
            
            
            49
            
            
            
            (2,418
            )Multifamily
            
            
            (597
            )
            
            
            129
            
            
            
            (468
            )
            
            
            (1,745
            )
            
            
            565
            
            
            
            (1,180
            )Multifamily
                construction
            
            
            189
            
            
            
            (65
            )
            
            
            124
            
            
            
            352
            
            
            
            (113
            )
            
            
            239Commercial
                real estate and business
            
            
            235
            
            
            
            (102
            )
            
            
            133
            
            
            
            793
            
            
            
            110
            
            
            
            903Commercial
                real estate construction
            
            
            (139
            )
            
            
            (10
            )
            
            
            (149
            )
            
            
            (2
            )
            
            
            55
            
            
            
            53Consumer
                and other
            
            
            (7
            )
            
            
            77
            
            
            
            70
            
            
            
            (632
            )
            
            
            (126
            )
            
            
            (758
            )Total
                loans
            
            
            (924
            )
            
            
            (11
            )
            
            
            (935
            )
            
            
            (1,794
            )
            
            
            1,386
            
            
            
            (408
            )Total
                interest income
            
            $
            (1,639
            )
            
            $
            18
            
            
            $
            (1,621
            )
            
            $
            (2,464
            )
            
            $
            1,423
            
            
            $
            (1,041
            )INTEREST
                EXPENSEDeposits:Money
                market deposit and checking
            
            $
            320
            
            
            $
            385
            
            
            $
            705
            
            
            $
            771
            
            
            $
            1,335
            
            
            $
            2,106Savings
            
            
            (2
            )
            
            
            (1
            )
            
            
            (3
            )
            
            
            (7
            )
            
            
            (1
            )
            
            
            (8
            )Time
                deposits
            
            
            (565
            )
            
            
            495
            
            
            
            (70
            )
            
            
            (1,114
            )
            
            
            2,482
            
            
            
            1,368Total
                deposits
            
            
            (247
            )
            
            
            879
            
            
            
            632
            
            
            
            (350
            )
            
            
            3,816
            
            
            
            3,466FHLB
                advances and other
            
            
            (1,620
            )
            
            
            269
            
            
            
            (1,351
            )
            
            
            (3,152
            )
            
            
            1,591
            
            
            
            (1,561
            )Total
                interest expense
            
            
            (1,867
            )
            
            
            1,148
            
            
            
            (719
            )
            
            
            (3,502
            )
            
            
            5,407
            
            
            
            1,905Net
                interest income
            
            $
            228
            
            
            $
            (1,130
            )
            
            $
            (902
            )
            
            $
            1,038
            
            
            $
            (3,984
            )
            
            $
            (2,946
            )





-
            16
            -


**NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **(Unaudited)**




**Note
      8.**


**Business
        Segments**
  Beginning
        January 1, 2007, we changed the presentation of our Business Segments to
        more
        accurately reflect the way these segments are managed within the
        Bank.  Prior to 2007, we recognized four business
        segments:  1) Consumer Lending, 2) Residential Lending, 3) Business
        Banking Lending, and 4) Income Property Lending.  All other
        departments, including our Banking Centers and investment portfolio were
        assumed
        to support these business lines.  Consequently, all income generated
        and expenses incurred at these support centers were allocated to the four
        business segments, resulting in no net income or loss at any department except
        the four lending units.
 
 To
        better
        reflect how we manage the Bank, we have changed our business segments as
        follows:
 
 ·
              Established
                  a “Retail Banking” segment which includes our banking centers and direct
                  consumer lending.  The Home Equity Lines of Credit (HELOC’s) and
                  other consumer lending originated through the Banking Centers,
                  which were
                  previously included in the “Consumer Lending” segment, are included in
                  this segment.  The “Retail Banking” segment does not include
                  Sales Finance lending.  This segment also includes Community
                  Business Banking (small business lending) which had been previously
                  included in the “Business Banking”
segment.
 
 ·
              Isolated
                  our Investment Securities activities as a separate business segment
                  so
                  that any changes in the investment portfolio’s market value or level of
                  earning assets do not distort the reported operating results of
                  our other
                  business segments.
 
 In
        moving
        the banking centers, our primary source of funds generation, from an allocated
        overhead category to an operating segment, it became necessary to implement
        a
        new process for transferring funds from our funds-generating operations to
        the
        users of such funds.  The objective of the funds transfer process is
        to isolate the true profit contribution of each side of the balance
        sheet.  Prior to 2007, the profitability of the funds-generating
        operations, such as the banking centers, was defined as break-even with the
        lending segments collectively compensating the funds-generating operations
        such
        that this result was achieved.  Under the new methodology, the rates
        at which funds are transferred between the generators and users of funds
        are
        based on market rates of interest.  The profitability of the business
        segments, including retail banking, then varies depending on the actual rates
        earned on assets and paid on liabilities as well as expenses incurred in
        the
        segments’ operations.  To assist in tracking and evaluating the
        profitability of such funds transfers, we now utilize four line items in
        determining each segment’s net interest income:
 
 ·
              Interest
                  Income – This represents the actual interest received from the segment’s
                  loans or securities.
 
 ·
              Interest
                  Income on Funding Sources – This represents the interest income received
                  from selling funding sources generated by the segment (i.e. deposits
                  or
                  FHLB advances) to a centralized treasury function.  The interest
                  rate paid to the
 -
              17
              -
 
 **NOTES
              TO CONSOLIDATED FINANCIAL STATEMENTS**
 **(Unaudited)**
  Note 8. (Continued)
 segment
                    is based on the point on the FHLB rate curve for advances of
                    a duration
                    comparable to the segment’s funding
                    source.
 ·
              Funding
                  Costs – This represents the interest paid to the centralized treasury
                  function by each business segment for the funding sources necessary
                  to
                  support earning asset balances.  Again, the interest rate
                  charged to the segment is based on the point on the FHLB rate curve
                  for
                  advances of a duration comparable to the segment’s earning
                  assets.
 
 ·
              Interest
                  Expense – This represents the actual interest paid on the segment’s
                  liabilities (i.e. deposits or FHLB
                  advances).
 
 The
        management reporting process measures the performance of the operating segments
        based on the management structure of the Bank and is not necessarily comparable
        with similar information for any other financial institution.
 
 The
        reportable segments include the following:
 
 ·
              Retail
                  Banking – Retail Banking is the segment primarily responsible for the
                  generation of funding sources, specifically our consumer and small
                  business deposit accounts.  In addition to our banking centers,
                  the segment includes our direct consumer and Community Business
                  Banking
                  (small business) lending
                  departments.
 
 ·
              Sales
                  Finance Lending – Sales Finance generates indirect unsecured consumer
                  loans in connection with home improvement projects.  A large
                  percentage of this segment’s loan volume is sold into the secondary market
                  on a servicing-retained basis, meaning we continue to process payments
                  and
                  service the loan following the
                  sale.
 
 ·
              Residential
                  Lending - Residential Lending offers loans to borrowers to purchase,
                  refinance, or build homes secured by one-to-four-unit family
                  dwellings.  This segment also sells loans into the secondary
                  market.  We may choose to retain or sell the right to service
                  the loans sold (i.e., collection of principal and interest payments)
                  depending upon market conditions.
 
 ·
              Business
                  Banking Lending – Business Banking offers a full range of banking services
                  to middle-market size businesses including deposit and cash management
                  products, loans for financing receivables, inventory, equipment
                  as well as
                  permanent and interim construction loans for commercial real
                  estate.  The underlying real estate collateral or business asset
                  being financed typically secures these
                  loans.
 
 ·
              Income
                  Property Lending – Income Property Lending offers permanent and interim
                  construction loans for multifamily housing (over four units)
                  and
  -
            18
            -
 
 **NOTES
            TO CONSOLIDATED FINANCIAL STATEMENTS**
 **(Unaudited)**
  Note 8. (Continued)
 commercial
                  real estate properties.  The underlying real estate collateral
                  being financed typically secures these
                  loans.
 ·
              Investment and
                  Treasury - The Investment and Treasury segment includes the
                  investment securities portfolio, FHLB stock, and interest-earning
                  cash
                  balances.  Although management does not consider this to be an
                  operating business line, security investments represent a necessary
                  part
                  of liquidity management for the
                  Bank.
 
 These
        segments are managed separately because each business unit requires different
        processes and different marketing strategies to reach the customer base that
        purchases the products and services.  The segments derive a majority
        of their revenue from interest income, and we rely primarily on net interest
        revenue in managing these segments.  No single customer provides more
        than 10% of the Bank’s revenues.


**Quarter
                ended September 30,**Retail
            
            
            
            Sales
            
            
            
            Residential
            
            
            
            Business
            
            
            
            Income
            
            
            
            Investment
                &
            
            
            
            ConsolidatedBanking
            
            
            
            Finance
            
            
            
            Lending
            
            
            
            Banking
            
            
            
            Property
            
            
            
            Treasury
            
            
            
            Totals(Dollars
                in thousands)


**Interest
                income**
            2005
            
            $
            716
            
            
            $
            2,025
            
            
            $
            5,133
            
            
            $
            1,679
            
            
            $
            6,207
            
            
            $
            1,404
            
            
            $
            17,1642006
            
            
            892
            
            
            
            2,092
            
            
            
            6,514
            
            
            
            3,012
            
            
            
            7,188
            
            
            
            1,260
            
            
            
            20,9582007
            
            
            928
            
            
            
            2,041
            
            
            
            5,902
            
            
            
            3,345
            
            
            
            6,591
            
            
            
            531
            
            
            
            19,338**Treasury
                and interest income**
            2005
            
            
            6,905
            
            
            
            28
            
            
            
            132
            
            
            
            369
            
            
            
            130
            
            
            
            3,197
            
            
            
            10,761**on
                funding sources**
            2006
            
            
            8,918
            
            
            
            54
            
            
            
            263
            
            
            
            621
            
            
            
            160
            
            
            
            4,300
            
            
            
            14,3162007
            
            
            8,883
            
            
            
            (19
            )
            
            
            (107
            )
            
            
            821
            
            
            
            30
            
            
            
            2,592
            
            
            
            12,200**Funding
                costs**
            2005
            
            
            387
            
            
            
            877
            
            
            
            3,267
            
            
            
            848
            
            
            
            3,741
            
            
            
            1,641
            
            
            
            10,7612006
            
            
            576
            
            
            
            1,119
            
            
            
            4,426
            
            
            
            1,948
            
            
            
            4,699
            
            
            
            1,548
            
            
            
            14,3162007
            
            
            589
            
            
            
            966
            
            
            
            3,963
            
            
            
            2,133
            
            
            
            3,954
            
            
            
            595
            
            
            
            12,200**Interest
                expense**
            2005
            
            
            4,458
            
            
            
            —
            
            
            
            —
            
            
            
            171
            
            
            
            19
            
            
            
            2,499
            
            
            
            7,1472006
            
            
            6,077
            
            
            
            —
            
            
            
            —
            
            
            
            296
            
            
            
            18
            
            
            
            4,385
            
            
            
            10,7762007
            
            
            6,901
            
            
            
            —
            
            
            
            —
            
            
            
            563
            
            
            
            45
            
            
            
            2,549
            
            
            
            10,058**Net
                interest income/(loss)**
            2005
            
            
            2,776
            
            
            
            1,176
            
            
            
            1,998
            
            
            
            1,029
            
            
            
            2,577
            
            
            
            461
            
            
            
            10,0172006
            
            
            3,157
            
            
            
            1,027
            
            
            
            2,351
            
            
            
            1,389
            
            
            
            2,631
            
            
            
            (373
            )
            
            
            10,1822007
            
            
            2,321
            
            
            
            1,056
            
            
            
            1,832
            
            
            
            1,470
            
            
            
            2,622
            
            
            
            (21
            )
            
            
            9,280**Provision(recovery)
                for loan and lease losses**
            2005
            
            
            18
            
            
            
            112
            
            
            
            38
            
            
            
            40
            
            
            
            117
            
            
            
            —
            
            
            
            3252006
            
            
            82
            
            
            
            74
            
            
            
            (55
            )
            
            
            66
            
            
            
            100
            
            
            
            —
            
            
            
            2672007
            
            
            (36
            )
            
            
            243
            
            
            
            36
            
            
            
            118
            
            
            
            88
            
            
            
            —
            
            
            
            449**Net
                interest income/(loss), after**
            2005
            
            
            2,758
            
            
            
            1,064
            
            
            
            1,960
            
            
            
            989
            
            
            
            2,460
            
            
            
            461
            
            
            
            9,692**provision
                for loan and**
            2006
            
            
            3,075
            
            
            
            953
            
            
            
            2,406
            
            
            
            1,323
            
            
            
            2,531
            
            
            
            (373
            )
            
            
            9,915**lease
                losses**
            2007
            
            
            2,357
            
            
            
            813
            
            
            
            1,796
            
            
            
            1,352
            
            
            
            2,534
            
            
            
            (21
            )
            
            
            8,831**Noninterest
                income(loss)**
            2005
            
            
            341
            
            
            
            484
            
            
            
            198
            
            
            
            27
            
            
            
            61
            
            
            
            —
            
            
            
            1,1112006
            
            
            411
            
            
            
            1,143
            
            
            
            352
            
            
            
            190
            
            
            
            161
            
            
            
            53
            
            
            
            2,3102007
            
            
            421
            
            
            
            732
            
            
            
            335
            
            
            
            98
            
            
            
            148
            
            
            
            (80
            )
            
            
            1,654**Noninterest
                expense**
            2005
            
            
            2,981
            
            
            
            1,332
            
            
            
            903
            
            
            
            615
            
            
            
            777
            
            
            
            26
            
            
            
            6,6342006
            
            
            3,296
            
            
            
            1,421
            
            
            
            1,112
            
            
            
            983
            
            
            
            862
            
            
            
            26
            
            
            
            7,7002007
            
            
            3,146
            
            
            
            1,401
            
            
            
            1,035
            
            
            
            1,066
            
            
            
            893
            
            
            
            19
            
            
            
            7,560**Income/(loss)
                before provision**
            2005
            
            
            118
            
            
            
            216
            
            
            
            1,255
            
            
            
            401
            
            
            
            1,744
            
            
            
            435
            
            
            
            4,169**for
                federal income taxes**
            2006
            
            
            190
            
            
            
            675
            
            
            
            1,646
            
            
            
            530
            
            
            
            1,830
            
            
            
            (346
            )
            
            
            4,5252007
            
            
            (368
            )
            
            
            144
            
            
            
            1,096
            
            
            
            384
            
            
            
            1,789
            
            
            
            (120
            )
            
            
            2,925**Provision(tax
                benefit) for**
            2005
            
            
            42
            
            
            
            75
            
            
            
            434
            
            
            
            139
            
            
            
            603
            
            
            
            147
            
            
            
            1,440**federal
                income taxes**
            2006
            
            
            66
            
            
            
            227
            
            
            
            557
            
            
            
            179
            
            
            
            619
            
            
            
            (124
            )
            
            
            1,5242007
            
            
            (126
            )
            
            
            50
            
            
            
            375
            
            
            
            132
            
            
            
            612
            
            
            
            (60
            )
            
            
            983**Net
                income/(loss)**
            2005
            
            
            76
            
            
            
            141
            
            
            
            821
            
            
            
            262
            
            
            
            1,141
            
            
            
            288
            
            
            
            2,7292006
            
            
            124
            
            
            
            448
            
            
            
            1,089
            
            
            
            351
            
            
            
            1,211
            
            
            
            (222
            )
            
            
            3,0012007
            
            
            (242
            )
            
            
            94
            
            
            
            721
            
            
            
            252
            
            
            
            1,177
            
            
            
            (60
            )
            
            
            1,942**Total
                interest earning assets (ending balances)**
            2005
            
            
            39,891
            
            
            
            80,498
            
            
            
            297,108
            
            
            
            98,814
            
            
            
            352,015
            
            
            
            142,554
            
            
            
            1,010,8802006
            
            
            40,792
            
            
            
            77,628
            
            
            
            330,022
            
            
            
            142,044
            
            
            
            336,217
            
            
            
            117,674
            
            
            
            1,044,3772007
            
            
            44,629
            
            
            
            80,610
            
            
            
            310,965
            
            
            
            169,355
            
            
            
            309,119
            
            
            
            39,590
            
            
            
            954,268**Total
                interest bearing liabilities (ending balances)**
            2005
            
            
            661,930
            
            
            
            —
            
            
            
            —
            
            
            
            31,624
            
            
            
            5,183
            
            
            
            283,122
            
            
            
            981,8592006
            
            
            667,276
            
            
            
            —
            
            
            
            —
            
            
            
            39,647
            
            
            
            3,822
            
            
            
            299,317
            
            
            
            1,010,0622007
            
            
            667,962
            
            
            
            —
            
            
            
            —
            
            
            
            73,701
            
            
            
            5,497
            
            
            
            175,204
            
            
            
            922,364**Allocated
                equity (ending balances)**
            2005
            
            
            14,934
            
            
            
            6,081
            
            
            
            11,409
            
            
            
            7,728
            
            
            
            24,122
            
            
            
            2,154
            
            
            
            66,4282006
            
            
            14,145
            
            
            
            5,686
            
            
            
            12,169
            
            
            
            10,732
            
            
            
            23,091
            
            
            
            1,724
            
            
            
            67,5472007
            
            
            16,363
            
            
            
            6,789
            
            
            
            13,140
            
            
            
            14,064
            
            
            
            24,298
            
            
            
            666
            
            
            
            75,320**Return
                on equity**
            2005
            
            
            2.04
            %
            
            
            9.27
            %
            
            
            28.78
            %
            
            
            13.56
            %
            
            
            18.92
            %
            
            
            53.48
            %
            
            
            16.43
            %2006
            
            
            3.51
            %
            
            
            31.52
            %
            
            
            35.80
            %
            
            
            13.08
            %
            
            
            20.98
            %
            
            
            -51.51
            %
            
            
            17.77
            %2007
            
            
            -5.92
            %
            
            
            5.54
            %
            
            
            21.95
            %
            
            
            7.17
            %
            
            
            19.38
            %
            
            
            -36.04
            %
            
            
            10.31
            %**Net
                interest margin**
            2005
            
            
            27.84
            %
            
            
            5.84
            %
            
            
            2.69
            %
            
            
            4.17
            %
            
            
            2.93
            %
            
            
            1.29
            %
            
            
            3.96
            %2006
            
            
            30.96
            %
            
            
            5.29
            %
            
            
            2.85
            %
            
            
            3.91
            %
            
            
            3.13
            %
            
            
            -1.27
            %
            
            
            3.90
            %2007
            
            
            20.80
            %
            
            
            5.24
            %
            
            
            2.36
            %
            
            
            3.47
            %
            
            
            3.39
            %
            
            
            -0.21
            %
            
            
            3.89
            %





-
            19
            -


**NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **(Unaudited)**
  Note 8. (Continued)




**Business
          Segments(continued)**
 **Nine
                    months ended September 30,**Retail
                
                
                
                Sales
                
                
                
                Residential
                
                
                
                Business
                
                
                
                Income
                
                
                
                Investment
                    &
                
                
                
                ConsolidatedBanking
                
                
                
                Finance
                
                
                
                Lending
                
                
                
                Banking
                
                
                
                Property
                
                
                
                Treasury
                
                
                
                Totals(Dollars
                    in thousands)


**Interest
                income**
            2005
            
            $
            2,009
            
            
            $
            5,444
            
            
            $
            13,875
            
            
            $
            4,827
            
            
            $
            18,360
            
            
            $
            4,335
            
            
            $
            48,8502006
            
            
            2,570
            
            
            
            6,175
            
            
            
            18,649
            
            
            
            7,831
            
            
            
            20,538
            
            
            
            3,968
            
            
            
            59,7312007
            
            
            2,674
            
            
            
            5,215
            
            
            
            18,170
            
            
            
            9,398
            
            
            
            20,041
            
            
            
            3,193
            
            
            
            58,691**Treasury
                and interest income**
            2005
            
            
            18,051
            
            
            
            112
            
            
            
            545
            
            
            
            965
            
            
            
            496
            
            
            
            8,859
            
            
            
            29,028**on
                funding sources**
            2006
            
            
            26,462
            
            
            
            116
            
            
            
            567
            
            
            
            1,796
            
            
            
            389
            
            
            
            12,214
            
            
            
            41,5442007
            
            
            27,208
            
            
            
            26
            
            
            
            184
            
            
            
            2,632
            
            
            
            345
            
            
            
            8,757
            
            
            
            39,152**Funding
                costs**
            2005
            
            
            1,008
            
            
            
            2,187
            
            
            
            8,517
            
            
            
            2,214
            
            
            
            10,314
            
            
            
            4,788
            
            
            
            29,0282006
            
            
            1,669
            
            
            
            3,302
            
            
            
            13,024
            
            
            
            4,967
            
            
            
            13,571
            
            
            
            5,011
            
            
            
            41,5442007
            
            
            1,704
            
            
            
            2,822
            
            
            
            12,631
            
            
            
            6,226
            
            
            
            12,501
            
            
            
            3,268
            
            
            
            39,152**Interest
                expense**
            2005
            
            
            11,654
            
            
            
            —
            
            
            
            —
            
            
            
            389
            
            
            
            52
            
            
            
            7,111
            
            
            
            19,2062006
            
            
            16,937
            
            
            
            —
            
            
            
            —
            
            
            
            838
            
            
            
            48
            
            
            
            11,470
            
            
            
            29,2932007
            
            
            20,265
            
            
            
            —
            
            
            
            —
            
            
            
            1,664
            
            
            
            152
            
            
            
            9,118
            
            
            
            31,199**Net
                interest income/(loss)**
            2005
            
            
            7,398
            
            
            
            3,369
            
            
            
            5,903
            
            
            
            3,189
            
            
            
            8,490
            
            
            
            1,295
            
            
            
            29,6442006
            
            
            10,426
            
            
            
            2,989
            
            
            
            6,192
            
            
            
            3,822
            
            
            
            7,308
            
            
            
            (299
            )
            
            
            30,4382007
            
            
            7,913
            
            
            
            2,419
            
            
            
            5,723
            
            
            
            4,140
            
            
            
            7,733
            
            
            
            (436
            )
            
            
            27,492**Provision(recovery)
                for loan and lease losses**
            2005
            
            
            66
            
            
            
            368
            
            
            
            144
            
            
            
            158
            
            
            
            439
            
            
            
            —
            
            
            
            1,1752006
            
            
            100
            
            
            
            42
            
            
            
            (68
            )
            
            
            148
            
            
            
            251
            
            
            
            —
            
            
            
            4732007
            
            
            (116
            )
            
            
            692
            
            
            
            (115
            )
            
            
            127
            
            
            
            99
            
            
            
            —
            
            
            
            687**Net
                interest income/(loss), after**
            2005
            
            
            7,332
            
            
            
            3,001
            
            
            
            5,759
            
            
            
            3,031
            
            
            
            8,051
            
            
            
            1,295
            
            
            
            28,469**provision
                for loan and**
            2006
            
            
            10,326
            
            
            
            2,947
            
            
            
            6,260
            
            
            
            3,674
            
            
            
            7,057
            
            
            
            (299
            )
            
            
            29,965**lease
                losses**
            2007
            
            
            8,029
            
            
            
            1,727
            
            
            
            5,838
            
            
            
            4,013
            
            
            
            7,634
            
            
            
            (436
            )
            
            
            26,805**Noninterest
                income(loss)**
            2005
            
            
            983
            
            
            
            1,913
            
            
            
            547
            
            
            
            248
            
            
            
            360
            
            
            
            2
            
            
            
            4,0532006
            
            
            1,359
            
            
            
            3,102
            
            
            
            699
            
            
            
            354
            
            
            
            510
            
            
            
            58
            
            
            
            6,0822007
            
            
            1,284
            
            
            
            3,422
            
            
            
            823
            
            
            
            108
            
            
            
            328
            
            
            
            483
            
            
            
            6,448**Noninterest
                expense**
            2005
            
            
            9,235
            
            
            
            3,924
            
            
            
            2,894
            
            
            
            2,014
            
            
            
            2,485
            
            
            
            88
            
            
            
            20,6402006
            
            
            9,864
            
            
            
            4,422
            
            
            
            3,331
            
            
            
            2,825
            
            
            
            2,699
            
            
            
            82
            
            
            
            23,2232007
            
            
            10,182
            
            
            
            4,413
            
            
            
            3,385
            
            
            
            2,713
            
            
            
            2,769
            
            
            
            75
            
            
            
            23,537**Income/(loss)
                before provision**
            2005
            
            
            (920
            )
            
            
            990
            
            
            
            3,412
            
            
            
            1,265
            
            
            
            5,926
            
            
            
            1,209
            
            
            
            11,882**for
                federal income taxes**
            2006
            
            
            1,821
            
            
            
            1,627
            
            
            
            3,628
            
            
            
            1,203
            
            
            
            4,868
            
            
            
            (323
            )
            
            
            12,8242007
            
            
            (869
            )
            
            
            736
            
            
            
            3,276
            
            
            
            1,408
            
            
            
            5,193
            
            
            
            (28
            )
            
            
            9,716**Provision(tax
                benefit) for**
            2005
            
            
            (311
            )
            
            
            338
            
            
            
            1,168
            
            
            
            433
            
            
            
            2,026
            
            
            
            397
            
            
            
            4,051**federal
                income taxes**
            2006
            
            
            630
            
            
            
            557
            
            
            
            1,246
            
            
            
            413
            
            
            
            1,674
            
            
            
            (123
            )
            
            
            4,3972007
            
            
            (298
            )
            
            
            253
            
            
            
            1,123
            
            
            
            483
            
            
            
            1,781
            
            
            
            (40
            )
            
            
            3,302**Net
                income/(loss)**
            2005
            
            
            (609
            )
            
            
            652
            
            
            
            2,244
            
            
            
            832
            
            
            
            3,900
            
            
            
            812
            
            
            
            7,8312006
            
            
            1,191
            
            
            
            1,070
            
            
            
            2,382
            
            
            
            790
            
            
            
            3,194
            
            
            
            (200
            )
            
            
            8,4272007
            
            
            (571
            )
            
            
            483
            
            
            
            2,153
            
            
            
            925
            
            
            
            3,412
            
            
            
            12
            
            
            
            6,414**Interest
                earning assets (average balances)**
            2005
            
            
            39,644
            
            
            
            72,373
            
            
            
            273,111
            
            
            
            94,781
            
            
            
            363,908
            
            
            
            148,485
            
            
            
            992,3022006
            
            
            41,374
            
            
            
            81,175
            
            
            
            322,855
            
            
            
            130,634
            
            
            
            337,690
            
            
            
            125,548
            
            
            
            1,039,2762007
            
            
            42,375
            
            
            
            70,876
            
            
            
            318,430
            
            
            
            156,716
            
            
            
            311,468
            
            
            
            81,225
            
            
            
            981,090**Interest
                bearing liabilities (average balances)**
            2005
            
            
            628,215
            
            
            
            —
            
            
            
            —
            
            
            
            28,674
            
            
            
            6,357
            
            
            
            297,066
            
            
            
            960,3122006
            
            
            661,235
            
            
            
            —
            
            
            
            —
            
            
            
            42,220
            
            
            
            4,051
            
            
            
            314,184
            
            
            
            1,021,6902007
            
            
            672,579
            
            
            
            —
            
            
            
            —
            
            
            
            66,041
            
            
            
            6,516
            
            
            
            203,843
            
            
            
            948,979**Allocated
                equity (average balances)**
            2005
            
            
            14,150
            
            
            
            5,373
            
            
            
            10,376
            
            
            
            7,147
            
            
            
            24,050
            
            
            
            2,201
            
            
            
            63,2972006
            
            
            13,581
            
            
            
            5,636
            
            
            
            11,358
            
            
            
            9,225
            
            
            
            21,921
            
            
            
            1,743
            
            
            
            63,4642007
            
            
            15,866
            
            
            
            5,814
            
            
            
            13,107
            
            
            
            13,001
            
            
            
            23,927
            
            
            
            1,322
            
            
            
            73,037**Return
                on equity**
            2005
            
            
            -5.74
            %
            
            
            16.18
            %
            
            
            28.84
            %
            
            
            15.52
            %
            
            
            21.62
            %
            
            
            49.19
            %
            
            
            16.50
            %2006
            
            
            11.69
            %
            
            
            25.31
            %
            
            
            27.96
            %
            
            
            11.42
            %
            
            
            19.43
            %
            
            
            -15.30
            %
            
            
            17.70
            %2007
            
            
            -4.80
            %
            
            
            11.08
            %
            
            
            21.90
            %
            
            
            9.49
            %
            
            
            19.01
            %
            
            
            1.21
            %
            
            
            11.71
            %**Net
                interest margin**
            2005
            
            
            24.88
            %
            
            
            6.21
            %
            
            
            2.88
            %
            
            
            4.49
            %
            
            
            3.11
            %
            
            
            1.16
            %
            
            
            3.98
            %2006
            
            
            33.60
            %
            
            
            4.91
            %
            
            
            2.56
            %
            
            
            3.90
            %
            
            
            2.89
            %
            
            
            -0.32
            %
            
            
            3.91
            %2007
            
            
            24.90
            %
            
            
            4.55
            %
            
            
            2.40
            %
            
            
            3.52
            %
            
            
            3.31
            %
            
            
            -0.72
            %
            
            
            3.74
            %





-
            20
            -


**NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **(Unaudited)**


**Trading
        Securities**
 
 The
        Company’s short-term investments in debt securities, all of which are classified
        as trading securities, are carried at their fair value based on the quoted
        prices of the securities at September 30, 2007. Net realized and unrealized
        gains and losses on trading securities are included in net earnings. For
        purpose
        of determining realized gains and losses, the cost of securities sold is
        based
        on specific identification.
 
 The
        composition of trading securities is as follows at September 30, 2007. There
        were no trading securities in 2006.
  September
                  30, 2007Cost
              
              
              Fair
                  Value(Dollars
                  in thousands)Fannie
                  Mae securities
              
              $
              2,800
              
              
              $
              2,821Freddie
                  Mac securities
              
              
              5,874
              
              
              
              5,865Ginnie
                  Mae securities
              
              
              4,879
              
              
              
              4,896Total
                  trading securities
              
              $
              13,553
              
              
              $
              13,582Investment
                  income for the quarter ended September 30, 2007 consists
                  of the following:2007Dividend
                  and interest income
              
              $
              211Net
                  unrealized holding gains
              
              
              28Net
                  investment income
              
              $
              239
  Note
        10.
 **SUBSEQUENT
        EVENTS**
  Subsequent
          to the quarter end, we received unexpected information regarding a borrowing
          relationship in our Income Property portfolio.  While this
          relationship had been subject to a downgrade during the third quarter,
          the
          information we received subsequent to the quarter end necessitated a further
          downgrade of the relationship’s risk rating.  The loans involved
          totaled $6,692,000 at September 30, 2007.  Subsequent to quarter end
          they were downgraded from “other loans especially mentioned” to
“substandard”.  The additional downgrade is expected to increase our
          reserve requirement for the fourth quarter.
 -
              21
              -
 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 Orange Park, Florida and Mt. Clemens,
          Michigan.  The Bank’s business
          consists mainly of attracting deposits from the general public as well
          as
          wholesale funding sources, and investing those funds primarily in real
          estate
          loans, small and mid-sized business loans, and consumer loans.
 
 
 **OVERVIEW**
 
 For
          the
          third quarter and first nine months of 2007, our net income declined
          significantly relative to the same periods last year, totaling $1.9 million
          and
          $6.4 million, down from $3.0 million and $8.4 million for the quarter and
          nine
          months ended September 30, 2006.  Our earnings per diluted share fell
          to $0.28 and $0.92, compared to $0.43 and $1.23 per diluted share in the
          third
          quarter and first nine months of last year, while return on average equity
          (ROE)
          totaled 10.42% for the quarter and 11.74% on a year-to-date basis, compared
          to
          18.29% and 17.74% in the prior year, respectively.
 
 On
          July
          2, 2007, we announced that we had entered into a definitive merger agreement
          with Washington Federal, Inc. (NASDAQ: WFSL) which provides, subject to
          certain
          conditions, for a merger of First Mutual with and into Washington
          Federal.  Our performance for the second and third quarters was
          negatively impacted by expenses related to this transaction, including
          third
          quarter expenditures for merger-related legal and other services, a penalty
          for
          the cancellation of a commitment to issue $9 million in new trust preferred
          securities, and retention bonuses paid to our former CFO for remaining
          with the
          Bank past his scheduled April 2007 retirement date.
 
 The
          primary source of revenue for each of our business lines is net interest
          income.  For the third quarter and first nine months of 2007, our net
          interest income totaled $9.3 million and $27.5 million, down $902,000 and
          $2.9
          million from the levels earned in the prior year.  A key driver of net
          interest income is the level of our earning assets, which declined relative
          to
          the prior year, averaging $954 million for the quarter, down from $1,036
          million
          in the third quarter of last year. The drop in earning assets was due largely
          to
          securities sales, which reduced the size of the
  -
              22
              -
 portfolio
          as of September 30, 2007 by nearly $75 million compared to the level at
          the
          September 2006 quarter-end.  Also contributing to the decline in
          earning assets was a substantial reduction in loan originations, which
          fell from
          $400 million through the first three quarters of last year to $353 million
          in
          the first nine months of 2007, combined with continued high levels of loan
          payoffs and sales.  Please see the “Net Interest Income” and “Business
          Segments” sections for further discussions of net interest income and earning
          assets.
 
 A
          secondary source of revenue is our noninterest income, which declined $656,000
          compared to the third quarter of last year, based on a substantial reduction
          in
          consumer loan sales during the quarter as market demand for these loans
          softened.  Based on the higher levels of sales in the first half of
          this year, as well as higher levels of loan servicing fee income, noninterest
          income through the first nine months of the year still outpaced the prior
          year
          by approximately $366,000.  Please see the “Noninterest Income”
section for additional discussion.
 
 Despite
          the unique expenses mentioned above, our operating expenses declined $140,000
          relative to the third quarter of last year, and increased by only $314,000
          on a
          year-to-date basis, as reductions in occupancy and credit insurance expenses
          partially offset increases in other noninterest expenses.  Please
          refer to the “Noninterest Expense” section for additional
          information.
 
 For
          the
          quarter ended September 30, 2007, our credit quality remained acceptable,
          with
          non-performing assets (NPAs) totaling $3.2 million, or 0.31% of total assets,
          little changed compared to the similar $3.5 million, or 0.32% at the 2006
          year-end.  For the quarter, we reserved $449,000 in provisions for
          loan losses and our reserve for loan losses, including unfunded commitments,
          totaled approximately $10.2 million, which was again little changed compared
          to
          $10.1 million at the year-end level.  The allowance for loan losses
          represented 1.12% of gross loans at the quarter-end, up from 1.11% at the
          2006
          year-end.  For additional information regarding our credit quality
          please refer to the “Asset Quality” section.
 
 **RESULTS
          OF OPERATIONS**
 
 **Net
          Income**
 
 Net
          income declined nearly $1.1 million or approximately 35% for the third
          quarter
          of 2007 as compared to the same quarter last year, while year-to-date net
          income
          fell $2.0 million or 24% relative to last year.  Net interest income
          declined $902,000 for the quarter and $2.9 million for the first nine months
          of
          2007, while noninterest income fell $656,000 for the quarter but improved
          $366,000 on a year-to-date basis, and noninterest expense declined $140,000
          for
          the quarter but increased $314,000 for the first nine months of the
          year.
 
 **Net
          Interest
          Income**
 
 For
          the
          quarter and nine months ended September 30, 2007, our net interest income
          declined $902,000 and $2.9 million relative to the same periods last
          year.  The net effects of asset and liability repricing negatively
          impacted net interest income for both periods, while changes in the levels
          and
          mix of earning assets and funding sources positively impacted net interest
          income for both the quarter and nine month periods.  The following
          table illustrates the impacts to our net interest income from our level
          of
          earning assets and rate changes on our assets and liabilities, with the
          results
          attributable to asset levels classified as “volume” and the effect of asset and
          liability repricing labeled “rate.”
 
 -
              23
              -
 **Rate/Volume
          Analysis**
  Quarter
                        EndedSeptember
                      30, 2007 vs. September 30, 2006Increase/(Decrease)
                    due to
                
                
                Nine
                        Months EndedSeptember
                      30, 2007 vs. September 30, 2006Increase/(Decrease)
                    due toVolume
                
                
                Rate
                
                
                Total
                
                
                Volume
                
                
                Rate
                
                
                TotalInterest
                    Income
                
                (Dollars
                    in thousands)Total
                    Investments
                
                $
                (715
                )
                
                $
                29
                
                
                $
                (686
                )
                
                $
                (670
                )
                
                $
                37
                
                
                $
                (633
                )Total
                    Loans
                
                
                (924
                )
                
                
                (11
                )
                
                
                (935
                )
                
                
                (1,794
                )
                
                
                1,386
                
                
                
                (408
                )Total
                    Interest Income
                
                $
                (1,639
                )
                
                $
                18
                
                
                $
                (1,621
                )
                
                $
                (2,464
                )
                
                $
                1,423
                
                
                $
                (1,041
                )
 Interest
                    ExpenseTotal
                    Deposits
                
                
                (247
                )
                
                
                879
                
                
                
                632
                
                
                
                (350
                )
                
                
                3,816
                
                
                
                3,466FHLB
                    and Other
                
                
                (1,620
                )
                
                
                269
                
                
                
                (1,351
                )
                
                
                (3,152
                )
                
                
                1,591
                
                
                
                (1,561
                )Total
                    Interest Expense
                
                $
                (1,867
                )
                
                $
                1,148
                
                
                $
                (719
                )
                
                $
                (3,502
                )
                
                $
                5,407
                
                
                $
                1,905
 Net
                    Interest Income
                
                $
                228
                
                
                $
                (1,130
                )
                
                $
                (902
                )
                
                $
                1,038
                
                
                $
                (3,984
                )
                
                $
                (2,946
                )
  **Earning
          Asset Growth (Volume)**
  For
          the
          third quarter and first nine months of 2007, declines in our levels of
          earning
          assets resulted in reductions of $1.6 million and $2.5 million in interest
          income relative to the same periods last year.  More than offsetting
          these reductions, however, were lower levels of interest expense resulting
          from
          the elimination of funding sources previously needed to accommodate asset
          levels.  Consequently, the net impacts of earning asset levels were an
          improvement in third-quarter net interest income of approximately $228,000
          and a
          year-to-date improvement of $1.0 million compared to the first nine months
          of
          2006.
 
 Quarter
                    Ending
                Earning
                    Assets
                Net
                    Loans (incl.LHFS)
                Deposits(Dollars
                    in thousands)September
                    30, 2006
                $
                    1,034,332
                $
                    919,837
                $
                    774,914December
                    31, 2006
                $
                    1,012,896
                $
                    897,436
                $
                    805,795March
                    31, 2007
                $    995,058
                $
                    881,849
                $
                    771,659June
                    30, 2007
                $    962,998
                $
                    878,490
                $
                    759,786September
                    30, 2007
                $    944,195
                $
                    902,669
                $
                    750,675
 
 As
          can be
          seen in the table above, our overall levels of deposits and earning assets
          have
          exhibited declining trends over the last several quarters, as had our loan
          portfolio prior to the most recent quarter.
 
 Driving
          the decline in earning assets, the balance of our securities portfolio
          (including trading, available-for-sale, and held-to-maturity securities)
          totaled
          approximately $25 million as of September 30, 2007, down from its year-end
          2006
          and second-quarter 2007 levels of $95 million and $67 million,
          respectively.  The portfolio contraction followed significant trading
          volumes and portfolio turnover resulting from our election to early adopt
          SFAS
          159.
 
 -
              24
              -
 Following
          the end of the first quarter, we sold several longer-maturity securities
          from
          the newly established trading portfolio, replaced the sold issues with
          approximately $34 million in shorter-term hybrid ARM securities, and began
          evaluating the potential risks and benefits of employing strategies to
          hedge
          against movements in the market value of the trading portfolio. In the
          first
          week of May, based on the earnings volatility presented by the new accounting
          treatment, we elected to proceed with a plan to reduce the volatility of
          the
          portfolio by reselling these recently purchased securities, leaving the
          portfolio at a smaller size than that at which it began the
          quarter.
  Based
          on
          our observations of the portfolio and hedge over the remainder of the second
          quarter, we elected to further reduce the size of the portfolio in the
          third
          quarter.  Consequently, in early July we sold securities with market
          values totaling approximately $41 million, leaving the portfolio at
          approximately its current size, and unwound the hedge position established
          in
          mid-May.  At the present time, we do not anticipate conducting any
          further securities transactions.
 
 Through
          the first three quarters of this year, we experienced declines in our income
          property and residential construction loans, while balances of business
          banking
          loans, commercial construction, consumer, and single-family permanent loans
          ended the third quarter at levels higher than those observed at the 2006
          year-end. Additionally, while consumer loan balances declined during the
          first
          half of the year, they did so largely as a result of high loan sales volumes,
          which totaled approximately $30 million for the first two quarters of the
          year.  Were it not for these sales, growth would likely have been
          observed in this portfolio segment as well, as it was in the most recent
          quarter
          with sales totaling less than $6 million.
  On
          the
          liabilities side of the balance sheet, our total deposit balances declined
          $55
          million, or approximately 7% in the first nine months of the year, including
          $9
          million in the most recent quarter.  Our non-maturity deposit balances
          grew more than $21 million through the first three quarters of the year,
          with
          more than $4 million occurring in the most recent quarter, while time deposits,
          including certificates issued through brokerage services, declined $76
          million,
          with nearly $14 million occurring in the third quarter.  Brokered
          certificates of deposit accounted for approximately $36 million of the
          year-to-date reduction, including $2 million in the third
          quarter.  The decrease in retail certificate balances occurred as we
          attempted to move away from offering rates competitive with the higher
          rates in
          the local market. While this has resulted in some of the more rate-sensitive
          depositors exiting the Bank for higher rates elsewhere, most of these funds
          have
          remained on our books at lower costs to the Bank.
  **Asset
          Yields and Funding Costs (Rate)**
 
 Quarter
                    Ended
                Net
                    Interest MarginSeptember
                    30, 2006
                3.94%December
                    31, 2006
                3.78%March
                    31, 2007
                3.73%June
                    30, 2007
                3.62%September
                    30, 2007
                3.90%
  While
          the
          effects of interest rate movements and repricing on our loan portfolio
          negatively impacted the income earned on our loan portfolio by $11,000
          for the
          third quarter, repricing accounted for an additional $1.4 million in interest
          income relative to last year on a year-to-date
  -
              25
              -
 basis.  Adjustable-rate
          loans, which reprice according to terms specified in our loan agreements
          with
          the borrowers, accounted for approximately 74% of our loan portfolio as
          of
          September 30, 2007, down from 80% at the 2006 year-end.
 
 On
          the
          liability side of the balance sheet, however, the effects of interest rate
          movements and repricing were more pronounced, increasing our interest expense
          on
          deposits and wholesale funding by more than $1.1 million for the quarter
          and
          $5.4 million on a year-to-date basis.  As a result, for the third
          quarter and first nine months of 2007, the net effects of rate movements
          and
          repricing negatively impacted our net interest income by $1.1 million and
          $4.0
          million relative to the same periods in the prior year, as the large volumes
          of
          maturing/repricing liabilities resulted in a greater increase in liability
          costs
          than was observed for asset yields.
 
 **Noninterest
          Income**
 
 Relative
          to the third quarter of last year, our noninterest income fell $656,000,
          or
          approximately 28%, as a result of a substantial reduction in consumer loan
          sales
          and resulting gains thereon.  On a year-to-date basis, noninterest
          income increased by approximately 6%, or $366,000 as compared to the prior
          year,
          based on a comparable level of loan sales and higher servicing fee
          income.
 
 **SFAS
          No. 157 and 159 Related Gains/(Losses)**
 
 Effective
          January 1, 2007, we elected early adoption of SFAS No. 157 and 159, which
          generally permit the mark-to-market of selected eligible financial
          instruments.  In our case, we elected to apply the standards to
          certain investments held in our securities portfolio and a $9 million long
          term
          debenture payable (trust preferred security).  With the early
          adoption, we recorded total pre-tax, SFAS No. 159-related, mark-to-market
          gains
          of $447,000 for the first quarter.  In the second quarter, however, we
          experienced net SFAS No. 159-related losses totaling $211,000 resulting
          primarily from adverse movements in the prices of our
          securities.  This net loss reflected the partial offset from a
          $244,000 gain on a hedge position against those securities, which had been
          established in the second week of May.
  Based
          on
          our observations of the portfolio and hedge, we elected to further reduce
          the
          size of the portfolio and unwind the hedge position.  Consequently, in
          early July we sold securities with market values totaling approximately
          $41
          million and unwound the hedge position, which resulted in gains on sale
          totaling
          $69,000 for the quarter, bringing our year-to-date gains on securities
          sales to
          $185,000. With these transactions completed in mid-July, our net SFAS No.
          159-related losses for the third quarter totaled $119,000, resulting in
          a net
          year-to-date SFAS No. 159-related gain of $117,000.  At the present
          time, we do not anticipate conducting any further securities
          transactions.
 
 -
              26
              -
 **Gains/(Losses)
          on Sales of Loans**
 
 Quarter
                    Ended September 30,
                
                
                Nine
                    Months Ended September 30,2007
                
                
                2006
                
                
                2007
                
                
                2006Gains/(Losses)
                    on Sales:Consumer
                
                $
                238,000
                
                
                $
                784,000
                
                
                $
                1,917,000
                
                
                $
                1,962,000Residential
                
                
                (34,000
                )
                
                
                69,000
                
                
                
                80,000
                
                
                
                68,000Commercial
                
                
                37,000
                
                
                
                62,000
                
                
                
                90,000
                
                
                
                195,000Total
                    Gains on Loan Sales
                
                $
                241,000
                
                
                $
                915,000
                
                
                $
                2,087,000
                
                
                $
                2,225,000Loans
                    Sold:Consumer
                
                $
                5,511,000
                
                
                $
                17,987,000
                
                
                $
                35,525,000
                
                
                $
                41,030,000Residential
                
                
                10,783,000
                
                
                
                12,701,000
                
                
                
                42,581,000
                
                
                
                35,814,000Commercial
                
                
                10,244,000
                
                
                
                6,382,000
                
                
                
                14,300,000
                
                
                
                11,574,000Total
                    Loans Sold
                
                $
                26,538,000
                
                
                $
                37,070,000
                
                
                $
                92,406,000
                
                
                $
                88,418,000
  Contrary
          to the trend observed over the last several quarters, our third quarter
          gains on
          loan sales declined significantly relative to the prior year based on a
          substantial reduction in sales of our consumer loans.  Following sales
          of $30 million in the first half of 2007, sales of consumer loan sales
          totaled
          less than $6 million for the third quarter due to a softening in market
          demand.  Based on uncertainties of the marketplace we are not offering
          a forecast for anticipated loan sales at this time.
  Following
          an absence of commercial real estate loan sales in the first quarter of
          2007, we
          sold participations in commercial real estate loans during the second and
          third
          quarters, though gains trailed their year-ago levels.  Commercial real
          estate loan transactions, particularly those that are candidates for sales
          of
          participations to other institutions, tend to be larger-dollar credits
          and
          unpredictable in their timing and frequency of occurrence. As a result,
          the
          volumes of commercial real estate loans sold, and gains thereon, can be
          expected
          to vary considerably from one quarter to the next depending on the timing
          of the
          loan and sales transactions.
 
 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 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 generally result in future servicing
          income.
  **Service
          Fee Income/(Expense)**
  Quarter
                    Ended September 30,
                
                
                Nine
                    Months Ended September 30,2007
                
                
                2006
                
                
                2007
                
                
                2006Consumer
                    Loans
                
                $
                428,000
                
                
                $
                300,000
                
                
                $
                1,320,000
                
                
                $
                930,000Commercial
                    Loans
                
                
                2,000
                
                
                
                0
                
                
                
                (59,000
                )
                
                
                9,000Residential
                    Loans
                
                
                2,000
                
                
                
                (3,000
                )
                
                
                7,000
                
                
                
                (7,000
                )Service
                    Fee Income
                
                $
                432,000
                
                
                $
                297,000
                
                
                $
                1,268,000
                
                
                $
                932,000
    Our
          servicing fee income rose 45% from the level earned in the third quarter
          of last
          year and 36% on a year-to-date basis, as income from consumer loans serviced
          for
          other institutions increased in response to higher levels of loan sales
          in late
          2006 and the first half of 2007.  Servicing fee income represents the
          net of servicing income received less the amortization of servicing assets,
          which are recorded when we sell loans from our portfolio to other investors.
  -
              27
              -
 The
          values of these servicing assets are determined at the time of the sale
          using a
          valuation model that calculates the present value of future cash flows
          for the
          loans sold, including cash flows related to the servicing of the loans.
          The
          servicing asset is recorded based on fair value. The servicing rights are
          then
          amortized in proportion to, and over the period of, the estimated future
          servicing income.
 
 For
          the
          third quarter and first nine months of 2007, service fee income earned
          on
          consumer loans serviced for other investors exceeded that earned in the
          same
          periods of the prior year by 43% and 42%. This improvement was based on
          a
          significant increase in the balances of consumer loans serviced, which
          was in
          turn a product of the increased volume of loan sales in 2006 and the first
          half
          of 2007.
 
 In
          the
          case of commercial loans, a minimal level of servicing income was earned
          during
          the third quarter, while on a year-to-date basis, payoffs during the first
          half
          of the year of balances sold to and serviced for other institutional investors
          required us to immediately write-off the related servicing assets, which
          resulted in the loss presented above.
  In
          contrast to consumer and commercial loans, residential loans are typically
          sold
          servicing released, which means we no longer service those loans once they
          are
          sold. Consequently, we do not view these loans as a significant source
          of
          servicing fee income.
  **Fees
          on Deposits**
  Fee
          income earned on deposit accounts rose by $12,000 and $32,000, both
          approximately 6%, compared to the third quarter and first nine months of
          last
          year, based primarily on a higher level of checking account service
          charges.  This source of fee income has grown as we have continued our
          efforts to expand our base of business and consumer checking
          accounts.
  **Other
          Noninterest Income**
  Quarter
                    Ended September 30,
                
                
                Nine
                    Months Ended September 30,2007
                
                
                2006
                
                
                2007
                
                
                2006ATM/Wire/Safe
                  Deposit
                    Fees
                
                $
                95,000
                
                
                $
                87,000
                
                
                $
                280,000
                
                
                $
                241,000Late
                    Charges
                
                
                92,000
                
                
                
                73,000
                
                
                
                236,000
                
                
                
                189,000Loan
                    Fee Income
                
                
                298,000
                
                
                
                294,000
                
                
                
                697,000
                
                
                
                545,000Rental
                    Income
                
                
                198,000
                
                
                
                192,000
                
                
                
                554,000
                
                
                
                535,000Miscellaneous
                
                
                155,000
                
                
                
                270,000
                
                
                
                435,000
                
                
                
                857,000Other
                    Noninterest
                  Income
                
                $
                838,000
                
                
                $
                916,000
                
                
                $
                2,202,000
                
                
                $
                2,367,000
  Our
          noninterest income from sources other than those described earlier declined
          $78,000, or 9% for the quarter and $165,000, or 7% on a year-to-date basis
          relative to the same periods last year.
 
 We
          continued to observe growth in our ATM/Wire/Safe Deposit Fees, which totaled
          $95,000 for the quarter and $280,000 on a year-to-date basis, representing
          increases of 10% and 16% over the same periods last year.  Most of
          this growth is attributable to Visa and ATM fee income, which we expect
          to
          continue rising as checking accounts become a greater piece of our overall
          deposit mix.
 
 -
              28
              -
 Late
          charges earned from our loan portfolio increased 26% and 24% relative to
          the
          third quarter and first nine months of 2006 based on higher fees collected
          from
          real estate loans.
 
 Income
          received from miscellaneous sources declined significantly relative to
          both the
          third quarter and first nine months of last year.  For the quarter,
          the decline was largely a result of changes in the market values of interest
          rate derivative contracts.  These derivatives are 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 is matched against a nearly identical loss on an offsetting
          derivative, reflected in our miscellaneous operating expense category,
          resulting
          in essentially no net earnings impact to the Bank.  In the third
          quarter and first nine months of last year, appreciation in the market
          values of
          these instruments resulted in noninterest income totaling $190,000 and
          $240,000
          compared to $77,000 and $181,000 in the same periods this year.  These
          changes in the market values of the positions were largely offset by similar
          levels of expense reflected in our miscellaneous operating expense
          category.  Accounting rules require any change in the market value of
          such instruments to be reflected in the current period income.
 
 Also
          contributing to the significant year-to-date decline in miscellaneous income
          was
          a unique item that occurred in the second quarter of 2006, specifically
          the
          receipt of $400,000 in insurance proceeds from a key-man life insurance
          policy.
 
  Partially
          offsetting these declines, loan fee income increased on a year-to-date
          basis
          compared to the prior year based on higher levels of prepayment penalties
          and
          non-deferred loan fees. These typically include fees collected in connection
          with loan modifications or extensions, non-conversion of construction loans
          to
          permanent mortgages, and letters of credit originated for commercial
          borrowers.
 
 **Noninterest
          Expense**
 
 Noninterest
          expense for the third quarter declined $140,000, or 2% relative to the
          same
          period last year, but increased $314,000, or slightly more than 1% on a
          year-to-date basis.
  **Salaries
          and Employee Benefits Expense**
 
 Our
          personnel-related expenses remained well contained in the first nine months
          of
          2007, with no change observed for the third quarter relative to the prior
          year
          and an increase of less than 2% on a year-to-date basis.
  Quarter
                    Ended September 30,
                
                
                Nine
                    Months Ended September 30,2007
                
                
                2006
                
                
                2007
                
                
                2006Salaries
                
                $
                2,982,000
                
                
                $
                3,077,000
                
                
                $
                9,381,000
                
                
                $
                9,044,000Commissions
                    and
                  Incentives
                
                
                668,000
                
                
                
                506,000
                
                
                
                1,857,000
                
                
                
                1,680,000Employment
                    Taxes
                  and
                    Insurance
                
                
                215,000
                
                
                
                225,000
                
                
                
                773,000
                
                
                
                793,000Temporary
                    Office
                  Help
                
                
                72,000
                
                
                
                24,000
                
                
                
                222,000
                
                
                
                178,000Benefits
                
                
                414,000
                
                
                
                520,000
                
                
                
                1,244,000
                
                
                
                1,580,000Total
                
                $
                4,351,000
                
                
                $
                4,352,000
                
                
                $
                13,477,000
                
                
                $
                13,275,000
 
 -
              29
              -
 While
          annual increases in staff salaries resulted in higher expense on a year-to-date
          basis, regular employee salary expense actually declined from $2,583,000
          in the
          third quarter of last year to $2,504,000 this year based primarily on employee
          attrition and non-replacement since the announcement of the Washington
          Federal
          acquisition.
 
 Also
          contributing to the year-to-date increase in salary expense were certain
          merger-related items that impacted the second quarter.  Specifically,
          Directors’ compensation increased $124,000 for the second quarter as compared to
          the prior year, primarily as a result of a $100,000 payment to one of our
          directors for consulting services regarding the upcoming Washington Federal
          acquisition.
 
 Among
          the
          categories of incentive compensation, loan officer commissions increased
          $51,000
          for the quarter but declined $147,000 on a year-to-date basis based largely
          on
          loan origination volumes exceeding the prior year for the third quarter,
          but
          lagging for the year-to-date period.  Other incentive compensation
          rose $101,000 for the quarter and $370,000 through the first nine months
          of the
          year based primarily on retention bonuses paid to our former CFO in the
          second
          and third quarters for staying on past his retirement date.
 
 Expenditures
          for temporary office help increased significantly relative to the prior
          year as
          temporary employees were frequently used to staff positions left vacant
          as a
          result of employee attrition following the announcement of the Washington
          Federal acquisition.
  Employee
          benefit expense declined significantly relative to the third quarter and
          first
          nine months of last year, falling $105,000 and $336,000, or 20% and 21%,
          respectively. The reduction was largely attributable to a decision to forego
          profit sharing contributions to our 401K and ESOP plans.  Reductions
          in Director and Officer insurance expense and employee insurance benefits
          also
          contributed to the lower level of expense.
  **Occupancy
          Expense**
 
 Occupancy
          expense declined by $101,000 and $204,000, or 10% and 7%, compared to the
          third
          quarter and first nine months of last year, based on reductions in depreciation
          and other occupancy expenses.
 
 Quarter
                    Ended September 30,
                
                
                Nine
                    Months Ended September 30,2007
                
                
                2006
                
                
                2007
                
                
                2006Rent
                
                $
                70,000
                
                
                $
                64,000
                
                
                $
                210,000
                
                
                $
                222,000Utilities
                    and
                  Maintenance
                
                
                181,000
                
                
                
                180,000
                
                
                
                587,000
                
                
                
                582,000Depreciation
                
                
                487,000
                
                
                
                528,000
                
                
                
                1,434,000
                
                
                
                1,555,000Other
                    Occupancy
                
                
                199,000
                
                
                
                266,000
                
                
                
                656,000
                
                
                
                732,000Total
                    Occupancy Expense
                
                $
                937,000
                
                
                $
                1,038,000
                
                
                $
                2,887,000
                
                
                $
                3,091,000
  For
          the
          third quarter, depreciation expense declined $41,000, or nearly 8% relative
          to
          the 2006 level, based primarily on reductions in furniture/fixture and
          network
          software depreciation expense.  On a year-to-date basis, depreciation
          expense was down $121,000, also nearly 8%, based on reductions in the same
          categories as well as other PC and network depreciation expense.
  -
              30
              -
 Additionally,
          the first quarter saw a $48,000 reduction in depreciation expense due to
          the
          correction of a booking error associated with the purchase of our Juanita
          Banking Center.  In that transaction, the value of the land had been
          included in the cost of the building and consequently depreciated based
          on the
          building’s amortization schedule.  As land is not depreciable, this
          error was corrected upon its discovery and resulted in a one-time $40,000
          credit
          to depreciation for the quarter.
  The
          decline in other occupancy expenses for both the quarter and year-to-date
          periods was attributable to a reduction in purchases of assets for less
          than
          $1,000, which are expensed rather than capitalized.  Given the pending
          Washington Federal transaction, we have largely foregone such purchases
          this
          year.  Consequently, these purchases totaled $84,000 through the first
          nine months of 2007 and only $7,000 for the most recent quarter.  By
          comparison, $177,000 in such purchases occurred in the first nine months
          of
          2006, with nearly $81,000 in the third quarter.
  **Credit
          Insurance**
  Credit
          insurance premium costs fell 11% in the third quarter, and 13% on a year-to-date
          basis compared to the same periods in 2006. As we stated in our 2006 year-end
          press release, we expected that expenditures for credit insurance would
          decline
          over the course of 2007. The majority of credit insurance premiums are
          attributable to our sales finance loans, including both those loans retained
          in
          our portfolio as well as those loans serviced for other
          institutions.  In mid-2006, after evaluating our use of credit
          insurance, we concluded that the benefits of the insurance no longer outweighed
          the costs and chose to forego the insurance and assume the credit risk
          on future
          sales finance loan production.  Those loans insured prior to August 1,
          2006 remain insured under their existing policies.  Additionally, some
          loans originated on or after August 1, 2006 were sold to institutional
          investors
          with insurance placed prior to sale and remain insured under the policy
          effective August 1, 2006.  All other loan volumes originated on or
          after August 1, 2006 have not been insured. To a much lesser extent, residential
          land loans and a small percentage of the consumer and income property loan
          portfolios are also insured. While these insured balances may continue
          to
          increase in future quarters, the premiums paid on these balances are small
          relative to those paid on sales finance loans so that total premiums are
          still
          expected to decline.
  **Other
          Noninterest Expense**
  Other
          noninterest expense remained unchanged relative to the third quarter of
          2006 as
          reductions in some categories offset increases in others.  On a
          year-to-date basis, other noninterest expense rose $494,000, or 9%, due
          to a
          number of unique and/or merger-related items in the second quarter of the
          year.
  -
              31
              -
 Quarter
                    Ended September 30,
                
                
                Nine
                    Months Ended September 30,2007
                
                
                2006
                
                
                2007
                
                
                2006Marketing
                    and
                  Investor
                    Relations
                
                $
                185,000
                
                
                $
                211,000
                
                
                $
                641,000
                
                
                $
                730,000Outside
                    Services
                
                
                220,000
                
                
                
                193,000
                
                
                
                747,000
                
                
                
                616,000Information
                    Systems
                
                
                299,000
                
                
                
                244,000
                
                
                
                798,000
                
                
                
                674,000Taxes
                
                
                169,000
                
                
                
                205,000
                
                
                
                525,000
                
                
                
                509,000Legal
                
                
                203,000
                
                
                
                115,000
                
                
                
                567,000
                
                
                
                420,000Other
                
                
                844,000
                
                
                
                948,000
                
                
                
                2,737,000
                
                
                
                2,572,000Total
                
                $
                1,920,000
                
                
                $
                1,916,000
                
                
                $
                6,015,000
                
                
                $
                5,521,000
 
 Expenditures
          on outside services increased nearly $27,000 in the third quarter, and
          more
          significantly $130,000 through the first nine months of 2007 as compared
          to the
          same periods in the prior year.  Included in the third quarter
          expenses were a $55,000 fee for the cancellation of a commitment to issue
          $9
          million in trust preferred securities and $29,000 in due diligence related
          expenses.  Both of these expenses were incurred as a result of the
          pending Washington Federal transaction.
 
 Legal
          fees grew by $88,000 for the quarter and $147,000 on a year-to-date
          basis.  Our legal expense has exceeded its historical norm over the
          last two quarters, also based largely upon expenses related to the Washington
          Federal transaction.
 
 Partially
          offsetting the overall increase in other noninterest expenses, our marketing
          and
          investor relations costs declined $26,000 for the quarter and $90,000 on
          a
          year-to-date basis relative to the same periods last year.
 
 Other
          miscellaneous operating expenses declined $104,000 for the third quarter,
          or 11%
          relative to the same quarter last year, but remained nearly $166,000, or
          6%,
          above last year’s level on a year-to-date basis.  Compared to the
          prior year, charitable contributions declined $42,000 for the quarter,
          but
          increased $139,000 for the year-to-date period as a result of a $188,000
          contribution to a local performing arts organization in the second
          quarter.  We had originally expected to make this contribution in
          several installments over time, but given the pending merger with Washington
          Federal, we elected to go ahead and lump-sum the remaining
          contribution.  Similarly, recruiting expenses declined $1,000 for the
          quarter, but increased $217,000 for the year-to-date period.  The
          unusually high level of recruiting expense in the first half of the year
          resulted from the use of employment services in connection with our search
          for a
          new CFO, as well as the hiring of a new business banking officer, income
          property lending officer and production assistant, treasury management
          officer,
          as well as various other personnel including accounting and information
          systems
          staff.
 
 Among
          other items included in this category, lower levels of expense associated
          with
          the marking-to-market of interest rate derivatives reduced our other noninterest
          expense for both the quarter and year-to-date periods.  As previously
          noted, however, these derivatives are structured such that a loss on any
          given
          derivative is matched against a nearly identical gain on an offsetting
          derivative, reflected in our miscellaneous noninterest income
          category.  Consequently, the lower level of expense was nearly matched
          by the previously mentioned lower level of noninterest income, resulting
          in
          essentially no net earnings impact to the Bank.
 
 
 -
              32
              -
 **FINANCIAL
          CONDITION**
 
 **Assets**
 
 Because
          of a decline in the securities portfolio balances, our assets totaled $1.017
          billion at September 30, 2007, down from $1.029 billion at the start of
          the
          quarter and representing a decline of approximately 6% from the $1.079
          billion
          2006 year-end level.  The reduction in the securities portfolio was an
          indirect result of our decision to elect early adoption of SFAS
          159.
 
 **Securities**
 
 The
          balance of our securities portfolio (including trading, available-for-sale,
          and
          held-to-maturity securities) totaled approximately $25 million as of September
          30, 2007, down from its year-end and second-quarter 2007 levels of $95
          million
          and nearly $67 million.
 
 Following
          the end of the first quarter, we sold several longer-maturity securities
          from
          the newly established trading portfolio, replaced the sold issues with
          approximately $34 million in shorter-term hybrid ARM securities, and began
          evaluating the potential risks and benefits of employing strategies to
          hedge
          against movements in the market value of the trading portfolio. In the
          first
          week of May, we elected to proceed with a plan to reduce the volatility
          of the
          portfolio by reselling our recently purchased securities in the secondary
          market
          and utilizing an interest rate swap to partially hedge against movements
          in the
          market value of the remaining trading portfolio.  Based on our
          observations of the portfolio and hedge over the remainder of the quarter,
          we
          elected to further reduce the size of the portfolio and unwind the hedge
          position.  Consequently, in early July we sold additional securities
          with market values totaling approximately $41 million and unwound the hedge
          position.  These securities were seasoned hybrid ARM securities and
          two FHLB agency bullet securities that had been moved from the
          available-for-sale or held-to-maturity category to the trading portfolio
          at the
          time of our SFAS 159 adoption.  At the present time, we do not
          anticipate conducting any further significant securities
          transactions.
 
 Any
          investment security purchased is classified in one of the following categories:
          1) trading, 2) available-for-sale, or 3) held-to-maturity. Prior to our
          early
          adoption of SFAS 159, the majority of the securities in our present portfolio
          had been classified as available-for-sale, while no securities were classified
          in the trading category. Available-for-sale securities are reviewed regularly,
          and any unrealized gains or losses are recorded in comprehensive income
          in the
          shareholders’ equity account. In contrast, any change in market value of trading
          securities during the period is reflected in current period income. Generally,
          falling interest rates will increase the market values of securities, thus
          enhancing the amounts recorded as gains or reducing losses, while rising
          rates
          will have the opposite effect. The passage of time partially counteracts
          these
          interest rate effects, as the unrealized gain or loss on a given security
          will
          gradually decline to zero as the security approaches its maturity
          date.
 
 **Loans**
 
 Loans
          receivable, excluding loans held-for-sale, grew by nearly $13 million for
          the
          quarter, but still ended September at a level $14 million less than at
          the start
          of the year.  While loan originations in the most recent quarter
          exceeded those of the prior year, totaling $129 million, up from $120 million
          at
          the end of the third quarter last year, originations have typically lagged
          2006
          this year, totaling $353 million through the first nine months of 2007
          compared
          to $400 million through the first three quarters of 2006.  In addition
          to the decline in originations, the loan portfolio was impacted by a combination
          of continued high prepayment speeds and significant volumes of loan
          sales.
  -
              33
              -
 
 **Portfolio
                    Composition**
                
                **September
                    30, 2007**
                
                
                **June
                    30, 2007**
                
                
                **December
                    31, 2006**(Dollars
                    in thousands)Single
                    Family Residential
                
                $
                265,705
                
                
                $
                261,699
                
                
                $
                254,374Income
                    Property
                
                
                217,488
                
                
                
                220,056
                
                
                
                248,100Business
                    Banking
                
                
                168,986
                
                
                
                164,151
                
                
                
                144,771Commercial
                    Construction
                
                
                54,291
                
                
                
                47,864
                
                
                
                47,153Single
                    Family ConstructionSpec
                    Construction
                
                
                27,469
                
                
                
                29,146
                
                
                
                31,315Custom
                    Construction
                
                
                47,683
                
                
                
                49,129
                
                
                
                70,541Consumer
                
                
                98,043
                
                
                
                94,813
                
                
                
                97,177**Total**
                
                **$**
                **879,665**
                
                
                **$**
                **866,858**
                
                
                **$**
                **893,431**
 
 While
          our
          total loan portfolio experienced a decline since the last year-end, respectable
          growth occurred in our business banking loan portfolio, which has been
          very
          successful in building earning assets in recent years.  More modest
          loan growth was also observed in our residential lending permanent loan
          portfolio.  The single family residential loans held in our portfolio
          are typically non-conforming loans that do not meet the requirements for
          resale
          in the secondary market, but generally offer higher yields than conforming
          residential mortgages and are still considered eligible collateral for
          borrowing
          from the FHLB. Additionally, while consumer loan balances rose only minimally
          relative to the year-end, they did so despite loan sales totaling nearly
          $36
          million in the first nine months of the year.  Were it not for these
          sales, substantial growth would likely have been observed in this portfolio
          segment as well.
 
 Income
          property loans, which consist of mortgages on investor-owned commercial
          real
          estate and multifamily properties, have demonstrated a gradual downward
          trend in
          recent years.  This decline has been largely the result of lower
          originations of loans, along with a high level of prepayments, which we
          attribute to a combination of increased competition from other lenders,
          including conduit programs, and a flat-to-inverted yield curve.  The
          flattening of the yield curve reduced the rate differential between short-
          and
          long-term financing costs and provided a financial incentive for borrowers
          to
          select longer-term, fixed-rate loans as opposed to short-term or adjustable-rate
          financing.  As we have historically been an originator of short-term
          and adjustable-rate loans, this has impacted us in two ways.  First,
          as prospective buyers sought loans with terms that fell outside of our
          typical
          underwriting structures, our originations of permanent multifamily and
          commercial real estate loans declined.  Second, with the yield curve
          providing borrowers with a financial incentive to refinance adjustable-rate
          loans, which make up the majority of our loan portfolio, with longer-term,
          fixed-rate debt, the prepayment rates on our income property portfolio
          remained
          at relatively high levels.  Increased competition among lenders in our
          local market accelerated both the decline in new loans as well as portfolio
          payoffs, as the competition frequently resulted in lenders offering prospective
          borrowers new loan commitments or existing borrowers the opportunity to
          refinance at lower margins than we would consider appropriate for the risks
          presented by the credits.
 
 **Servicing
          Assets**
 
 Servicing
          assets represent the deferred servicing rights generated from sales of
          loans
          that are sold servicing retained, reduced by the amortization and prepayments
          of
          those loans, as well as any impairment charges that may occur. While our
          servicing assets have not and do not represent a significant percentage
          of our
          total assets, this area has grown with high volumes of loan sales.
  -
              34
              -
 
 **Servicing
                    Assets**
                
                **September
                    30, 2007**
                
                
                **June
                    30, 2007**
                
                
                **December
                    31, 2006**Commercial
                
                $
                123,000
                
                
                $
                114,000
                
                
                $
                224,000Residential
                
                
                66,000
                
                
                
                72,000
                
                
                
                63,000Consumer
                
                
                4,537,000
                
                
                
                4,798,000
                
                
                
                3,724,000**Total**
                
                **$**
                **4,726,000**
                
                
                **$**
                **4,984,000**
                
                
                **$**
                **4,011,000**Loan
                    Balances Serviced for Others
                
                $
                161,580,000
                
                
                $
                154,199,000
                
                
                $
                155,025,000
 
 As
          a
          result of the nearly $36 million in loan sales for the first nine months
          of the
          year, our servicing assets related to consumer loans increased significantly
          relative to the year-end level.  However, due to the substantial
          reduction in loan sale volumes in the third quarter combined with high
          payoff
          rates and rapid amortization of these servicing assets, the consumer loan
          servicing asset declined relative to the previous quarter-end.
 
 Servicing
          assets related to commercial loans increased modestly during the third
          quarter
          as deferred servicing rights related to participations sold during the
          quarter
          slightly exceeded the amortization of existing servicing assets.  On a
          year-to-date basis, commercial servicing assets declined as some existing
          commercial loan pools were paid off in the first half of 2007.  These
          payoffs required us to immediately write off the remaining servicing assets
          associated with these credits.
 
 Residential
          loans are generally sold servicing released.  Consequently, no
          servicing assets are recognized following the vast majority of residential
          loan
          sales.
 
 **Deposits
          and Borrowings**
 
 Through
          the first nine months of the year, our total deposit balances declined
          $55
          million, or approximately 7%, including $9 million in the most recent
          quarter.  Our non-maturity deposit balances grew more than $21 million
          through the first three quarters of the year, with more than $4 million
          occurring in the most recent quarter, while time deposits, including
          certificates issued through brokerage services, declined $76 million, with
          nearly $14 million occurring in the third quarter.  Brokered
          certificates of deposit accounted for approximately $36 million of the
          year-to-date reduction, including $2 million in the third quarter.
 
 The
          growth of checking and money market accounts typically helps us reduce
          our
          overall cost of funds. Consequently, we consider the growth of these types
          of
          accounts to be an important part of our funding strategy. To encourage
          this
          growth, we actively monitor the products and rates offered by our competition
          in
          the local market and develop new products and/or offer aggressive rates
          to
          attract new balances in the most cost-effective manner possible.
 
 The
          decrease in retail certificate balances occurred as we attempted to move
          away
          from offering rates competitive with the higher rates in the local market.
          While
          this has resulted in some of the more rate-sensitive depositors exiting
          the Bank
          for higher rates elsewhere, most of those deposits have remained on our
          books at
          significantly lower costs to the Bank.
 
 Our
          preferred supplemental funding mechanism is borrowing funds from the Federal
          Home Loan Bank of Seattle (FHLB).  We experienced a modest decrease in
          our FHLB advances to $159 million at the end of the third quarter, compared
          to
          $163 million at the end of the second quarter of 2007 and $172 million
          at the
          2006 year-end.  As of September 30, 2007, we had the authority to
          borrow up to approximately $407 million from the FHLB, subject to maintaining
          a
          sufficient level of eligible collateral.
 
 
 -
              35
              -
 **ASSET
          QUALITY**
 
 **Provision
          and Reserve for Loan Loss and Loan Commitments Liability**
 
 The
          provision for loan losses reflects the amount deemed appropriate to produce
          an
          adequate reserve for probable loan losses inherent in the risk characteristics
          of the loan portfolio.  In determining the appropriate reserve
          balance, we consider the current and historical performance of the loan
          portfolio, the amount and type of new loans added to the portfolio, our
          level of
          non-performing loans, the amount of loans charged off, and the economic
          conditions in which we currently operate.
 
 The
          provisions for the third quarter and first nine months of 2007 totaled
          $449,000
          and $687,000 compared to provisions of $267,000 and $473,000 in the same
          periods
          last year.  The increase in the provision for the quarter was prompted
          by the growth in our loan portfolio over the course of the quarter, a reduced
          volume of consumer loan sales, and the downgrade of a borrowing relationship
          in
          our Income Property portfolio during the third quarter.  Information
          we received subsequent to the end of the third quarter has necessitated
          a
          further downgrade of this relationship’s risk rating, and is consequently
          expected to increase our reserve requirement for the fourth
          quarter.  Please see the “Subsequent Events” section for further
          information.
 
 Nonperforming
          assets, both in terms of balances and as a percentage of total assets,
          were
          little changed from the $3.5 million and 0.32% observed at the 2006 year-end,
          totaling $3.2 million and 0.31% at the end of the third
          quarter.  While this level of nonperforming assets remains at the high
          end of our historical experience, it remains below industry
          standards.  Noted below are the ratios from 1998 and the comparative
          industry ratios.
 
 Year
                First
                    Mutual Bank
                FDIC
                    Insured Commercial Banks1998
                0.07%
                0.65%1999
                0.06%
                0.63%2000
                0.38%
                0.74%2001
                0.08%
                0.92%2002
                0.28%
                0.94%2003
                0.06%
                0.77%2004
                0.10%
                0.55%2005
                0.08%
                0.48%2006
                0.32%
                0.51%Third
                    Quarter 2007
                0.31%
                N/A
 
 Including
          a $198,000 liability for unfunded commitments, our reserve for loan losses
          totaled approximately $10.2 million at September 30, 2007, little changed
          from
          $10.1 million at the 2006 year-end.  At this level, the allowance for
          loan losses represented 1.12% of gross loans at the end of the quarter,
          compared
          to 1.11% at the 2006 year-end.
 
 -
              36
              -
 **Non-Performing
          Assets**
  Our
          exposure to non-performing assets as of September 30, 2007 was:
 
 Two
                    single-family residential loans in the Oregon market.  No
                    anticipatedloss.
                
                $
                1,451,000One
                    mobile-home park loan in Oregon.  No anticipated
                    loss.
                
                
                732,000Two
                    single-family residential loans in Washington. No anticipated
                    loss.
                
                
                320,000One
                    custom construction loan in the Oregon market.  Impairment
                    chargestaken
                    in 2006.  No further losses anticipated
                
                
                240,000One
                    land loan in Western Washington.  No anticipated
                    loss.
                
                
                151,000Thirty
                    consumer loans.  Full recovery expected from insurance
                    claims.
                
                
                138,000One
                    lease pool.  Possible loss of $52,000.
                
                
                52,000Eighteen
                    consumer loans.  Possible loss of $34,000.
                
                
                34,000Six
                    consumer loans.  No anticipated loss.
                
                
                26,000One
                    multifamily loan with an impairment balance of
                    $1,000.
                
                
                11,000Six
                    insured consumer loans that have exceeded the credit
                    insurancelimit.  Possible
                    loss of $10,000.
                
                
                10,000One
                    commercial line of credit possible loss of $4,000.
                
                
                4,000Total
                    Non-Performing Assets
                
                $
                3,169,000
  **BUSINESS
          SEGMENTS**
 
 Beginning
          January 1, 2007, we changed the presentation of our Business Segments to
          more
          accurately reflect the way these segments are managed within the
          Bank.  Prior to 2007, we recognized four business
          segments:  1) Consumer Lending, 2) Residential Lending, 3) Business
          Banking Lending, and 4) Income Property Lending.  All other
          departments, including our Banking Centers and investment portfolio were
          assumed
          to support these business lines.  Consequently, all income generated
          and expenses incurred at these support centers were allocated to the four
          business segments, resulting in no net income or loss at any department
          except
          the four lending units.
 
 To
          better
          reflect how we manage the Bank, we have changed our business segments as
          follows:
 
 ·
                Established
                    a “Retail Banking” segment which includes our banking centers and direct
                    consumer lending.  The Home Equity Lines of Credit (HELOC’s) and
                    other consumer lending originated through the Banking Centers,
                    which were
                    previously included in the “Consumer Lending” segment, are included in
                    this segment.  The “Retail Banking” segment does not include
                    Sales Finance lending.  This segment also includes Community
                    Business Banking (small business lending) which had been previously
                    included in the “Business Banking”
segment.
 
 ·
                Isolated
                    our Investment Securities activities as a separate business segment
                    so
                    that any changes in the investment portfolio’s market value or level of
                    earning assets do not distort the reported operating results
                    of our other
                    business segments.
 
 In
          moving
          the banking centers, our primary source of funds generation, from an allocated
          overhead category to an operating segment, it became necessary to implement
          a
          new process for transferring funds from our funds-generating operations
          to the
          users of such funds.  The objective of the funds transfer process is
          to isolate the true profit contribution of each side of the
  -
              37
              -
 balance
          sheet.  Prior to 2007, the profitability of the funds-generating
          operations, such as the banking centers, was defined as break-even with
          the
          lending segments collectively compensating the funds-generating operations
          such
          that this result was achieved.  Under the new methodology, the rates
          at which funds are transferred between the generators and users of funds
          are
          based on market rates of interest.  The profitability of the business
          segments, including retail banking, then varies depending on the actual
          rates
          earned on assets and paid on liabilities as well as expenses incurred in
          the
          segments’ operations.  To assist in tracking and evaluating the
          profitability of such funds transfers, we now utilize four line items in
          determining each segment’s net interest income:
 
 ·
                Interest
                    Income – This represents the actual interest received from the segment’s
                    loans or securities.
 
 ·
                Interest
                    Income on Funding Sources – This represents the interest income received
                    from selling funding sources generated by the segment (i.e. deposits
                    or
                    FHLB advances) to a centralized treasury function.  The interest
                    rate paid to the segment is based on the point on the FHLB rate
                    curve for
                    advances of a duration comparable to the segment’s funding
                    source.
 
 ·
                Funding
                    Costs – This represents the interest paid to the centralized treasury
                    function by each business segment for the funding sources necessary
                    to
                    support earning asset balances.  Again, the interest rate
                    charged to the segment is based on the point on the FHLB rate
                    curve for
                    advances of a duration comparable to the segment’s earning
                    assets.
 
 ·
                Interest
                    Expense – This represents the actual interest paid on the segment’s
                    liabilities (i.e. deposits or FHLB
                    advances).
 
 The
          management reporting process measures the performance of the operating
          segments
          based on the management structure of the Bank and is not necessarily comparable
          with similar information for any other financial institution.
 
 The
          reportable segments include the following:
 
 ·
                Retail
                    Banking – Retail Banking is the segment primarily responsible for the
                    generation of funding sources, specifically our consumer and
                    small
                    business deposit accounts.  In addition to our banking centers,
                    the segment includes our direct consumer and Community Business
                    Banking
                    (small business) lending
                    departments.
 
 ·
                Sales
                    Finance Lending – Sales Finance generates indirect unsecured consumer
                    loans in connection with home improvement projects.  A large
                    percentage of this segment’s loan volume is sold into the secondary market
                    on a servicing-retained basis, meaning we continue to process
                    payments and
                    service the loan following the
                    sale.
 
 ·
                Residential
                    Lending - Residential Lending offers loans to borrowers to purchase,
                    refinance, or build homes secured by one-to-four-unit family
                    dwellings.  This segment also sells loans into the secondary
                    market.  We may choose to retain or sell the right to service
                    the loans sold (i.e., collection of principal and interest payments)
                    depending upon market conditions.
 
 -
              38
              -
 ·
                Business
                    Banking Lending – Business Banking offers a full range of banking services
                    to middle-market size businesses including deposit and cash management
                    products, loans for financing receivables, inventory, and equipment
                    as
                    well as permanent and interim construction loans for commercial
                    real
                    estate.  The underlying real estate collateral or business asset
                    being financed typically secures these
                    loans.
 
 ·
                Income
                    Property Lending – Income Property Lending offers permanent and interim
                    construction loans for multifamily housing (over four units)
                    and
                    commercial real estate properties.  The underlying real estate
                    collateral being financed typically secures these
                    loans.
 
 ·
                Investment
                    and Treasury - The Investment and Treasury segment includes the
                    investment
                    securities portfolio, FHLB stock, and interest-earning cash
                    balances.  Although management does not consider this to be an
                    operating business line, security investments represent a necessary
                    part
                    of liquidity management for the
                    Bank.
 
 These
          segments are managed separately because each business unit requires different
          processes and different marketing strategies to reach the customer base
          that
          purchases the products and services.  The segments derive a majority
          of their revenue from interest income, and we rely primarily on net interest
          revenue in managing these segments.  No single customer provides more
          than 10% of the Bank’s revenues.
 
 **Retail
          Banking**
 
 Quarter
                    Ended
                
                Nine
                    Months EndedNet
                  Income/(Loss)
                Return
                    on
                  Equity
                
                Net
                  Income/(Loss)
                Return
                    on
                  EquitySept.
                    30, 2005
                76,000
                2.04%
                
                (609,000)
                (5.74%)Sept.
                    30, 2006
                124,000
                3.51%
                
                1,191,000
                11.69%Sept.
                    30, 2007
                (242,000)
                (5.92%)
                
                (571,000)
                (4.80%)
 
 Third
          quarter and year-to-date net income for our Retail Banking segment declined
          $366,000 and $1.8 million relative to the prior year based on a sharp reduction
          in net interest income, as rates paid on deposits continued to increase
          while
          market rates of interest, and thus the rates at which the retail operations
          are
          credited for their deposits, remained comparatively stable over the last
          several
          quarters.
 
 As
          our
          Retail Banking segment includes our banking centers, the majority of this
          segment’s income is received from selling funding sources, specifically deposits
          generated and serviced in the banking centers, to lending units in need
          of
          funding to support earning asset balances.  This income appears in the
          accompanying notes to our financial statements as “Treasury Income and Interest
          Income on Funding Sources”.  The line labeled “Funding
          Costs”  represents the expense paid by the users of these funds to
          support their earning asset balances.
 
 Relative
          to the third quarter of last year, the segment’s transferable funding sources
          (deposit balances) remained virtually unchanged totaling slightly less
          than $668
          million at the quarter-end.  Combined with the movements in market
          rates of interest, at which these funds are transferred to our lending
          units,
          the Retail segment’s interest income from funding sources declined $35,000 from
          its third quarter 2006 level.  Year-to-date results were slightly
          better, with income from funding sources rising $746,000, or nearly 3%,
          compared
          to the first nine months of
  -
              39
              -
 2006.  Other
          interest income for the segment, which consists of interest received on
          home
          equity, personal, and small business loans and lines, totaled $928,000
          for the
          quarter, up 4% from the same period last year.
 
 By
          comparison, the interest paid on deposits rose more than $824,000 for the
          quarter and $3.3 million on a year-to-date basis, as competition in the
          local
          marketplace continued to keep retail deposit rates high.  As a result,
          the segment’s net interest income declined $836,000 relative to the third
          quarter and $2.5 million compared to the first nine months of last
          year.
 
 Both
          noninterest income and noninterest expense for the segment were relatively
          little changed relative to the prior year.  Noninterest income
          declined $75,000 compared to the first nine months of last year, while
          noninterest expense increased $318,000, or approximately 3% relative to
          the
          first three quarters of 2006.  The increase in operating expense was
          attributable to both growth among ordinary expenses, such as salary expense,
          which increases each year as a result of annual increases in staff salaries,
          as
          well as allocations of the unusual expenses incurred in the quarter, which
          were
          described in the “Noninterest Expense” section.  These expenses, which
          were allocated to the various business segments, included legal and other
          fees
          related to the Washington Federal transaction, as well as retention bonuses
          to
          our CFO for remaining with the Bank past his retirement date, again related
          to
          the Washington Federal transaction.
 
 **Sales
          Finance**
 
 Quarter
                    Ended
                
                Nine
                    Months EndedNet
                  Income/(Loss)
                Return
                    on
                  Equity
                
                Net
                  Income/(Loss)
                Return
                    on
                  EquitySept.
                    30, 2005
                141,000
                9.27%
                
                652,000
                16.18%Sept.
                    30, 2006
                448,000
                31.52%
                
                1,070,000
                25.31%Sept.
                    30, 2007
                94,000
                5.54%
                
                483,000
                11.08%
 
 Net
          income for our Sales Finance segment declined $354,000, or approximately
          79%,
          from the level earned in the third quarter of 2006, and $587,000, or nearly
          55%,
          compared to the first nine months of last year based primarily on a reduction
          in
          net interest income and increase in the segment’s loan loss
          provision.
 
 While
          the
          Sales Finance segment’s quarter-end earning assets showed modest growth relative
          to the prior year, up 4% to nearly $81 million, the average level through
          the
          first three quarters of the year declined significantly relative to 2006
          based
          on a substantial increase in the level of loan sales relative to prior
          years.  While less than $6 million in loans were sold in the most
          recent quarter, sales for the first half of this year totaled $30
          million.
 
 With
          these sales, the segment’s net interest income declined $570,000, or 19%
          compared to the first nine months of 2006, but showed signs of recovery
          with the
          reduced sales in the third quarter, exceeding the third quarter 2006 net
          interest income by $29,000.  With the segment’s third quarter loan
          loss provision increasing $169,000 relative to the prior year, net interest
          income after the loan loss provision declined $140,000, or 15%.  On a
          year-to-date basis, the segment’s loan loss provision increased $650,000
          relative to the prior year, with net interest income after provision down
          $1.2
          million, or 41%.  The increase in the loan loss provision relative to
          the prior year was related to the insured loan pools for years 2002-2003
          and
          2003-2004 reaching their 10% coverage limits.  In relation to probable
          losses inherent in those pools, the segment’s loan loss provision was
          increased.
 
 -
              40
              -
 While
          the
          increased loan sales prior to the most recent quarter negatively impacted
          the
          segment’s net interest income, they contributed to improvements in noninterest
          income in the first half of the year.  For the most recent quarter,
          however, the segment’s noninterest income declined $411,000 relative to the
          prior year based on the significant reduction in loan sales.  Besides
          gains on sales, loan sale transactions also result in additional service
          fee
          income on an ongoing basis after loans are sold.  The segment’s
          servicing fee income increased from $300,000 and $930,000 in the third
          quarter
          and first nine months of 2006 to $428,000 and $1.3 million this
          year.
 
 The
          segment’s noninterest expense remained well contained relative to the third
          quarter of last year, declining $20,000 compared to the third quarter of
          2006,
          and $9,000 on a year-to-date basis.  The improvement was partly
          attributable to a reduction in credit insurance premiums. As we stated
          in our
          2006 year-end press release, after evaluating our use of credit insurance,
          we
          concluded that the benefits of the insurance no longer outweighed the costs
          and
          chose to forego the insurance and assume the credit risk on future sales
          finance
          loan production.  Consequently, it was our expectation that
          expenditures for credit insurance would decline in 2007.  Those loans
          insured prior to August 1, 2006 remain insured under their existing policies,
          and some loans originated on or after August 1, 2006 were sold to institutional
          investors with insurance placed prior to sale and remain insured under
          the
          policy effective August 1, 2006.
 
 **Residential
          Lending**
 
 Quarter
                    Ended
                
                Nine
                    Months EndedNet
                  Income/(Loss)
                Return
                    on
                  Equity
                
                Net
                  Income/(Loss)
                Return
                    on
                  EquitySept.
                    30, 2005
                821,000
                28.78%
                
                2,244,000
                28.84%Sept.
                    30, 2006
                1,089,000
                35.80%
                
                2,382,000
                27.96%Sept.
                    30, 2007
                721,000
                21.95%
                
                2,153,000
                21.90%
 
 The
          Residential Lending segment’s net income for the third quarter totaled $721,000,
          representing a 34% decline relative to the same period last year, based
          primarily on a reduction in the segment’s net interest income.  On a
          year-to-date basis, net income fell nearly 10% also as a result of a reduction
          in the segment’s net interest income.
 
 While
          the
          Residential segment has been one of the largest contributors to our earning
          asset growth in recent years, the segment’s earning assets dropped substantially
          relative to their level as of September 30, 2006, falling $19 million,
          or
          approximately 6%, as a slowdown in residential lending resulted in a substantial
          reduction in both the number of loans originated and the portfolio balances.
          Based on the reduction in assets, net interest income earned on the portfolio
          declined $519,000, or approximately 22% relative to the third quarter of
          last
          year.  For the year-to-date period, interest income and funding costs
          each declined by approximately 3%, with net interest income before the
          provision
          for loan losses falling nearly 8%.  While the segment’s third quarter
          provision for loan losses rose $91,000 compared to the same quarter last
          year,
          its year-to-date provision declined by $47,000 based on recoveries of $103,000
          in the second quarter.
 
 For
          the
          quarter, the Residential Lending segment’s noninterest income fell $17,000
          compared to the prior year, as additional loan fee income largely offset
          a
          reduction in gains on loan sales.  On a year-to-date basis,
          noninterest income rose $124,000, based primarily on the additional loan
          fee
          income, which increased relative to the prior year based on a higher level
          of
          fees collected in
  -
              41
              -
 connection
          with loan modifications or extensions, and non-conversion of construction
          loans
          to permanent mortgages.  Gains on residential loan sales fluctuate
          from quarter to quarter, and typically result in modest gains or even slight
          losses when interest rates are rising quickly.  We believe the
          construction phase to be the most profitable facet of residential lending
          and
          the primary objective in a residential lending
          relationship.  Following the construction process, our practice is to
          retain in our portfolio those residential mortgages that we consider to
          be
          beneficial to the Bank, but to sell those that we consider less attractive
          assets.
 
 The
          Residential segment’s noninterest expense declined $77,000, or 7% for the
          quarter, and rose only $54,000, or less than 2% through the first nine
          months of
          the year.
 
 **Business
          Banking Lending**
 
 Quarter
                    Ended
                
                Nine
                    Months EndedNet
                  Income/(Loss)
                Return
                    on
                  Equity
                
                Net
                  Income/(Loss)
                Return
                    on
                  EquitySept.
                    30, 2005
                262,000
                13.56%
                
                832,000
                15.52%Sept.
                    30, 2006
                351,000
                13.08%
                
                790,000
                11.42%Sept.
                    30, 2007
                252,000
                7.17%
                
                925,000
                9.49%
 
 With
          earning assets totaling more than $169 million at the end of the third
          quarter,
          an increase of 19% over the prior year level, Business Banking’s interest income
          grew $333,000 and $1.6 million, or 11% and 20% over the levels earned in
          the
          third quarter and first nine months of 2006.  Additionally, with
          deposit growth of $34 million, or approximately 86%, compared to September
          30,
          2006, income credited for funding sources rose $200,000 for the quarter
          and
          $836,000 year-to-date compared to the prior year.  Partially
          offsetting these improvements, however, were an additional $185,000 and
          $1.3
          million in funding costs for the quarter and nine months, respectively.
          Taking
          all of these into account, the Business Banking segment’s third quarter and nine
          month net interest income after provision for loan losses rose $29,000
          and
          $339,000, or 2% and 9%, respectively, over the same periods last
          year.
 
 For
          the
          quarter and nine months ended September 30, 2007, the Business Banking
          segment’s
          noninterest income declined $92,000 and $246,000 relative to prior year
          levels.  This reduction was largely attributable to changes in the
          valuations of interest rate derivatives utilized by the segment to hedge
          interest rate risk on longer-term, fixed-rate commercial real estate
          loans.  These derivatives were structured such that a gain on any
          given derivative would be matched against a comparable loss on a second,
          corresponding derivative, resulting in minimal net impact to the Bank’s
          earnings.  In the third quarter and first nine months of last year,
          appreciation in the market values of these instruments resulted in additions
          to
          noninterest income of $238,000 and $188,000 compared to $108,000 and $2,000
          in
          the same periods this year.  These were largely offset by similar
          levels of expense reflected in our miscellaneous operating expense
          category.  Accounting rules require any change in the market value of
          such instruments to be reflected in the current period income.
 
 Including
          the corresponding reduction in noninterest expense attributable to the
          changes
          in derivative values, changes in the segment’s noninterest expense were rather
          modest, increasing $83,000 and declining $112,000 relative to the third
          quarter
          and first nine months of 2006.  Also worth noting is that under the
          new method of presenting our business segments, the Business Banking segment
          no
          longer faces significant increases in allocated overhead expenses as a
          result of
          deposit growth.  Under the previous method of segmenting our business
          lines, our banking
  -
              42
              -
 centers
          were deemed to be overhead cost centers rather than an operating segment,
          and
          consequently all income and expenses associated with the banking centers
          was
          allocated among the four lending units.  Consequently, the Business
          Banking segment’s deposit growth in prior years resulted in increasing
          allocations of banking center-related expense, which frequently negated
          the
          benefit of the additional deposits.  With the banking centers now
          included in the Retail Banking segment, the Business Banking and other
          lending
          segments are no longer subject to allocations of banking center
          expense.  Similarly, the lending segments no longer receive the
          benefit of funds generated by the banking centers at below-market rates
          of
          interest.  The segment results for 2005 and 2006 have been restated to
          reflect this methodology consistently throughout the three years presented
          here.
 
 **Income
          Property Lending**
 
 Quarter
                    Ended
                
                Nine
                    Months EndedNet
                  Income/(Loss)
                Return
                    on
                  Equity
                
                Net
                  Income/(Loss)
                Return
                    on
                  EquitySept.
                    30, 2005
                1,141,000
                18.92%
                
                3,900,000
                21.62%Sept.
                    30, 2006
                1,211,000
                20.98%
                
                3,194,000
                19.43%Sept.
                    30, 2007
                1,177,000
                19.38%
                
                3,412,000
                19.01%
 
 The
          Income Property segment’s third quarter net income declined $34,000, or 3%
          relative to the same quarter last year, based on flat net interest income,
          falling noninterest income, and rising noninterest expense.  On a
          year-to-date basis, net income rose $218,000, or 7%, as growth in net interest
          income was more than sufficient to offset the falling noninterest income
          and
          rising noninterest expense over that timeframe.
 
 Compared
          to the prior year, the segment’s net interest income after provision for loan
          losses grew $577,000 for nine months ended September 30 as a result of
          interest
          income from earning assets falling by a lesser amount than did interest
          expense
          on funding sources.  The provision for loan loss declined $12,000 and
          $152,000 compared to the third quarter and first nine months of 2006, due
          in
          large part to continued declines in portfolio balances.
 
 The
          Income Property segment’s decrease in earning assets during the first three
          quarters of 2007 continued a trend observed over the last couple of years,
          and
          is primarily a product of declining originations of permanent multifamily
          and
          commercial real estate loans, combined with a high level of prepayments
          on the
          loan portfolio, which we attribute to a combination of increased competition
          from other lenders and the flat yield curve.  Increased competition
          from conduit lenders as well as lenders in our local market accelerated
          both the
          drop in new volumes as well as portfolio payoffs, as the competition frequently
          resulted in lenders offering prospective borrowers new loan commitments,
          or
          existing borrowers the opportunity to refinance, at unusually low
          margins.  The flat yield curve, which has resulted from a number of
          increases in short-term interest rates, has reduced the rate differential
          between short- and long-term financing costs and provided a financial incentive
          for borrowers to select longer-term, fixed-rate loans as opposed to
          adjustable-rate financing.  As we have historically been an originator
          of short-term and adjustable-rate loans, this impacted us in two
          ways.  First, as prospective borrowers sought loans with terms that
          fell outside of our typical underwriting structures, our originations of
          permanent multifamily and commercial real estate loans
          declined.  Second, with the yield curve 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.
 
 -
              43
              -
 Noninterest
          income for the Income Property segment declined $13,000 and $182,000 relative
          to
          the third quarter and first nine months of last year, with the year-to-date
          reduction based on the combination of an unusual event last year and a
          negative
          impact from servicing asset write-offs this year.  In the second
          quarter of 2006, the segment recognized an unusually high level of noninterest
          income as a result of an allocation of insurance proceeds received from
          a
          key-man life insurance policy.  Additionally, the year-to-date results
          were negatively impacted by payoffs earlier this year of loan participation
          balances sold to and serviced for other institutional investors.  As
          these loans were paid off, we were forced to immediately write-off the
          related
          servicing assets, which negatively impacted noninterest income.
 
 The
          segment’s noninterest expense increased modestly, rising $31,000 for the quarter
          and $70,000 on a year-to-date basis compared to the same periods in
          2006.  As noted above, the Income Property segment has seen its
          earning asset balances decline over the last couple of years, and as a
          result,
          the segment has become a smaller component of our overall asset
          mix.  Consequently, for a number of different administrative and
          overhead expenses that we allocate out to the business segments, such as
          accounting and information systems related costs, the percentages allocated
          to
          other business lines has tended to increase, thus reducing the percentage
          allocated to the Income Property segment.
 
 **Investment
          and Treasury**
 
 Quarter
                    Ended
                
                Nine
                    Months EndedNet
                  Income/(Loss)
                Return
                    on
                  Equity
                
                Net
                  Income/(Loss)
                Return
                    on
                  EquitySept.
                    30, 2005
                288,000
                53.48%
                
                812,000
                49.19%Sept.
                    30, 2006
                (222,000)
                (51.51%)
                
                (200,000)
                (15.30%)Sept.
                    30, 2007
                (60,000)
                (36.04%)
                
                12,000
                1.21%
 
 The
          Investment and Treasury segment includes our investment securities portfolio
          on
          the asset side and on the liability side our FHLB advances and certificates
          of
          deposit issued through brokerage services.  While management does not
          consider this to be an operating business line, our security investments
          and
          wholesale borrowings represent a necessary part of liquidity management,
          and
          their impact on our operations has been recognized as its own segment so
          as not
          to distort the results of our other business lines.
 
 For
          the
          third quarter and first nine months of 2007, the segment posted net interest
          losses of $21,000 and $436,000, compared to losses of $373,000 and $299,000
          in
          the third quarter and first nine months of last year.  Generally, the
          cost of funding the securities portfolio exceeded its yield, while the
          FHLB
          advances and brokered deposits originated by the segment were “sold” to the
          lending units at rates exceeding the cost of those funding
          sources.  In the second and third quarters of 2007, however, the
          funding sources became modestly unprofitable, contributing to the net interest
          loss.
 
 Noninterest
          income for the segment, which had been virtually nonexistent prior to this
          year,
          totaled a loss of $80,000 and income of $483,000 for the third quarter
          and first
          nine months of 2007, largely as a result of our early adoption of SFAS
          157 and
          159, effective January 1, 2007. SFAS 159, which was issued in February
          2007,
          generally permits the mark-to-market of selected eligible financial
          instruments.  In the case of our early adoption, SFAS 159-related
          gains on affected instruments totaled $117,000 through the first nine months
          of
          the year.  Additionally, we
  -
              44
              -
 recognized
          $69,000 in gains on securities sales during the third quarter, bringing
          the
          year-to-date total to $185,000.
 
 The
          segment’s noninterest expense is virtually immaterial, totaling $19,000 for the
          third quarter and $75,000 for the first nine months of 2007, both slightly
          less
          than the prior year levels, and represents allocations of accounting and
          administrative overhead costs associated with the management of the
          portfolio.
 
 **LIQUIDITY**
 
 Our
          primary sources of liquidity are loan and security sales and repayments,
          deposits, and wholesale funds. A secondary source of liquidity is cash
          from
          operations, which, though not a significant source of liquidity, is a consistent
          source based upon the quality of our earnings. Our principal uses of liquidity
          are the origination and acquisition of loans and securities, and to a lesser
          extent, purchases of facilities and equipment.
 
 Quarter
                    Ended September 30,
                
                
                Nine
                    Months Ended September 30,2007
                
                
                2006
                
                
                2007
                
                
                2006(Dollars
                    in thousands)Loan
                    Originations (disbursed)
                
                $
                (129,000
                )
                
                $
                (120,000
                )
                
                $
                (353,000
                )
                
                $
                (400,000
                )Decrease
                    in Undisbursed LoanProceeds
                
                
                (3,000
                )
                
                
                (13,000
                )
                
                
                (20,000
                )
                
                
                (15,000
                )Security
                    Purchases
                
                
                0
                
                
                
                0
                
                
                
                (42,000
                )
                
                
                (7,000
                )Total
                    Originations and Purchases
                
                $
                (132,000
                )
                
                $
                (133,000
                )
                
                $
                (415,000
                )
                
                $
                (422,000
                )Loan
                    and Security Repayments
                
                $
                74,000
                
                
                $
                100,000
                
                
                $
                279,000
                
                
                $
                317,000Sales
                    of Securities
                
                
                40,000
                
                
                
                0
                
                
                
                98,000
                
                
                
                0Sales
                    of Loans
                
                
                27,000
                
                
                
                37,000
                
                
                
                92,000
                
                
                
                88,000Total
                    Repayments and Sales
                
                $
                141,000
                
                
                $
                137,000
                
                
                $
                469,000
                
                
                $
                405,000Net
                    Difference
                
                $
                9,000
                
                
                $
                4,000
                
                
                $
                54,000
                
                
                $
                (17,000
                )
 
 Loan
          and
          security sales and repayments, our primary sources of funding, are heavily
          influenced by trends in mortgage rates. When rates trend downward, our
          prepayment speeds typically increase as borrowers refinance their loans
          at lower
          interest rates. Conversely, as rates move upwards, prepayments will generally
          tend to slow, as fewer borrowers will have a financial incentive to refinance
          their loans. The loan portfolio, excluding loans sold into the secondary
          market
          and spec construction loans, experienced an annualized prepayment rate
          of nearly
          35% in the first nine months of 2007, comparable to the 37% and 39% rates
          observed for the first nine months of 2006 and fiscal year 2006,
          respectively.
 
 We
          believe the flat-to-inverted shape of the yield curve that has persisted
          since
          mid-2005 to the present time likely contributed to the continued high level
          of
          prepayments, as the rate differential between short- and long-term financing
          diminished and reduced the financial incentive for borrowers to use
          shorter-term, adjustable-rate financing rather than longer-term fixed rate
          loans. This, in turn, provides borrowers holding short-term or adjustable-rate
          loans, which represent the majority of our loan portfolio, with an incentive
          to
          refinance with long-term fixed-rate loans.
 
 -
              45
              -
 Our
          preferred method of funding the net difference between originations/purchases
          and repayments/sales is with deposits. To the extent that deposit growth
          is
          insufficient to fully fund the difference, we may rely on wholesale funding
          sources including, but not limited to FHLB advances, brokered certificates
          of
          deposit, and reverse repurchase agreements. During the third quarter and
          first
          nine months of 2006 and 2007, changes in funds from deposits and borrowings
          were
          as follows:
 
 Quarter
                    Ended Sept. 30,
                
                
                Nine
                    Months Ended Sept. 30,2007
                
                
                2006
                
                
                2007
                
                
                2006Deposits
                
                $
                (9,000
                )
                
                $
                15,000
                
                
                $
                (55,000
                )
                
                $
                14,000Borrowings
                
                
                (4,000
                )
                
                
                (31,000
                )
                
                
                (13,000
                )
                
                
                (8,000
                )Total
                
                $
                (13,000
                )
                
                $
                16,000
                
                
                $
                (68,000
                )
                
                $
                6,000
  Through
          the first nine months of the year, our total deposit balances declined
          $55
          million, or approximately 7%, including $9 million in the most recent
          quarter.  Our non-maturity deposit balances grew more than $21 million
          through the first three quarters of the year, with more than $4 million
          occurring in the most recent quarter, while time deposits, including
          certificates issued through brokerage services, declined $76 million, with
          nearly $14 million occurring in the third quarter.  Brokered
          certificates of deposit accounted for approximately $36 million of the
          year-to-date reduction, including $2 million in the third quarter.
 
 Our
          other
          major source of liquidity is wholesale funds, which include borrowings
          from the
          FHLB, brokered deposits, reverse repurchase agreements, and a revolving
          line of
          credit at the Holding Company level. The most utilized wholesale funding
          source
          is FHLB advances, which totaled $159 million at the end of the third quarter,
          down from $172 million at the 2006 year-end. Our credit line with the FHLB
          is
          reviewed annually, and our maximum allowable borrowing level, subject to
          sufficient collateral, is currently set at 40% of assets, or $407 million
          based
          on assets as of September 30, 2007.
 
 We
          had
          brokered deposits outstanding totaling $11 million as of the end of the
          third
          quarter, down from $47 million as of the 2006 year-end.  In
          anticipation of the closing of the Washington Federal transaction, we elected
          to
          replace $8 million in brokered deposits, which matured shortly before the
          quarter-end, with short-term FHLB advances. Our internal policy limits
          restrict
          our total usage of brokered certificates to no more than 10% of total
          deposits.
 
 Reverse
          repurchase lines are lines of credit collateralized by securities. We currently
          have lines totaling $35 million, of which the full amount is currently
          available. There has been no usage of these lines in the previous three
          years.
          The risks associated with these lines are the withdrawal of the line based
          on
          the credit standing of the Bank and the potential lack of sufficient collateral
          to support the lines.
 
 An
          additional source of liquidity has been our cash from operations, which,
          though
          not a significant source of liquidity, we consider to be a consistent source
          based upon our earnings. On a very limited basis it can be viewed as cash
          from
          operations adjusted for items such as provision for loan loss and depreciation.
          See the “Consolidated Statements of Cash Flows” in the financial statements
          section of this filing for a calculation of net cash provided by operating
          activities.
 
 In
          addition to using liquidity to fund loans and securities, we routinely
          invest in
          facilities and equipment. In the first nine months of 2007 we invested
          $1.3
          million in these assets, down from $3.4 million in the same period in 2006,
          as
          most of our major capital projects were completed by the end of last
          year.
 
 -
              46
              -
 **CAPITAL**
 
 The
          FDIC’s statutory framework for capital requirements establishes five categories
          of capital strength, ranging from a high of well capitalized to a low of
          critically under-capitalized.  An institution’s category depends upon
          its capital level in relation to relevant capital measures, including a
          risk-based capital measure, a leverage capital measure, and certain other
          factors.  At September 30, 2007, we exceeded the capital levels
          required to meet the definition of a well-capitalized institution:
 
 Actual
                Minimum
                    for
                  Capital
                  Adequacy
                    Purposes
                Minimum
                    to be
                  Categorized
                    as “Well
                  Capitalized”
                    Under
                  Prompt
                    Corrective
                  Action
                    ProvisionsTotal
                    capital (to risk-weighted assets):First
                    Mutual Bancshares, Inc.
                11.48%
                8.00%
                N/AFirst
                    Mutual Bank
                11.66
                8.00
                10.00%Tier
                  I capital (to risk-weighted assets):First
                    Mutual Bancshares, Inc.
                10.23
                4.00
                N/AFirst
                    Mutual Bank
                10.41
                4.00
                6.00Tier
                  I capital (to average assets):First
                    Mutual Bancshares, Inc.
                8.33
                4.00
                N/AFirst
                    Mutual Bank
                8.49
                4.00
                5.00
 
 **SUBSEQUENT
          EVENTS**
 
 Subsequent
          to the quarter end, we received unexpected information regarding a borrowing
          relationship in our Income Property portfolio.  While this
          relationship had been subject to a downgrade during the third quarter,
          the
          information we received subsequent to the quarter end necessitated a further
          downgrade of the relationship’s risk rating.  The loans involved
          totaled $6,692,000 at September 30, 2007.  Subsequent to quarter end
          they were downgraded from “other loans especially mentioned” to
“substandard”.  The additional downgrade is expected to increase our
          reserve requirement for the fourth quarter.
 
 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
  -
              47
              -
 the
          risk
          to earnings and capital resulting from adverse movements in interest
          rates.  To that end, we actively monitor and manage our exposure to
          interest rate risk.
 
 A
          number
          of measures are utilized to monitor and manage interest rate risk, including
          net
          interest income and economic value of equity simulation models, as well
          as
          traditional “gap” models.  We prepare these models on a quarterly
          basis for review by our Asset Liability Committee (ALCO), senior management,
          and
          Board of Directors.  The use of these models requires us to formulate
          and apply assumptions to various balance sheet items.  Assumptions
          regarding interest rate risk are inherent in all financial institutions,
          and may
          include, but are not limited to, prepayment speeds on loans and mortgage-backed
          securities, cash flows and maturities of financial instruments held for
          purposes
          other than trading, changes in market conditions, loan volumes and pricing,
          deposit sensitivities, consumer preferences, and management’s capital leverage
          plans.  We believe that the data and assumptions used for our models
          are reasonable representations of our portfolio and possible outcomes under
          the
          various interest rate scenarios.  Nonetheless, these assumptions are
          inherently uncertain; therefore, the models cannot precisely estimate net
          interest income or predict the impact of higher or lower interest rates
          on net
          interest income.  Actual results may differ significantly from
          simulated results due to timing, magnitude, and frequency of interest rate
          changes, and changes in market conditions and specific strategies, among
          other
          factors.
 
 **Asset
          and Liability Management**
 
 Our
          primary objective in managing interest rate risk is to minimize the adverse
          impact of changes in interest rates on our net interest income and capital,
          while structuring the asset and liability components to maximize net interest
          margin, utilize capital effectively, and provide adequate
          liquidity.  We rely primarily on our asset and liability structure to
          control interest rate risk.
 
 Asset
          and
          liability management is the responsibility of the Asset Liability Committee,
          which acts within policy directives established by the Board of
          Directors.  This committee meets regularly to monitor the composition
          of the balance sheet, to assess projected earnings trends, and to formulate
          strategies consistent with the objectives for liquidity, interest rate
          risk, and
          capital adequacy.  The objective of asset/liability management is to
          maximize long-term shareholder returns by optimizing net interest income
          within
          the constraints of credit quality, interest rate risk policies, levels
          of
          capital leverage, and adequate liquidity.  Assets and liabilities are
          managed by matching maturities and repricing characteristics in a systematic
          manner.
 
 **Hedging
          Techniques**
 
 We
          review
          interest rate trends on a regular basis and employ hedging techniques where
          appropriate.  These techniques may include financial futures, options
          on financial futures, interest rate caps and floors, interest rate swaps,
          and
          extended commitments on future lending activities.
 
 Typically,
          the extent of our off-balance-sheet derivative agreements has been the
          use of
          forward loan commitments, which are used to hedge our loans
          held-for-sale.  Additionally, in 2002 we entered into an interest rate
          swap with the FHLB.  The purpose of the swap was to protect against
          potential adverse interest rate volatility that could be realized from
          the Trust
          Preferred Securities (TPS) issued in June 2002.  The swap accomplished
          this by fixing the interest rate payable for the first five years of the
          TPS’
life, and matured in June of this year.
 
 -
              48
              -
 In
          the
          second quarter of 2006, we began to utilize interest rate swaps in connection
          with the underwriting of longer-term, fixed-rate commercial real estate
          loans.  This decision was the result of prospective borrowers’ demand
          for longer-term, fixed-rate loans, and the preference of depositors for
          instruments of significantly shorter terms.  Under this program, we
          originated commercial mortgage loans with amortization schedules of up
          to thirty
          years and initial ten-year fixed rates.  To hedge the interest rate
          risk exposure presented by ten-year, fixed-rate instruments, we utilized
          interest rate swaps on a loan-by-loan basis to convert each loan’s fixed rate to
          an adjustable rate subject to regular repricing relative to a market index
          rate,
          typically the one-month LIBOR rate.  Only a few of these interest rate
          swaps were originated, and we do not consider the notional principal of
          the
          swaps, which totals less than $5 million, to be material relative to the
          size of
          our commercial loan portfolio.  Additionally, the swaps originated
          under this program were used solely for the purpose of managing the interest
          rate risk associated with longer-term, fixed-rate assets, and not for any
          speculative purposes.
 
 In
          the
          first quarter of this year, we elected early adoption of SFAS 157 and 159
          with
          respect to the majority of our securities portfolio, the previously mentioned
          TPS, and selected other financial instruments.  Consequently, these
          assets and liabilities would be reflected on our statements of condition
          at
          their fair values, with any changes in market value over the course of
          a period
          recognized as income or losses in the current period’s operating results. In the
          first week of May, based on the earnings volatility presented by the new
          accounting treatment, we elected to reduce the volatility of the securities
          portfolio by reselling some recently purchased securities in the secondary
          market and utilizing interest rate swaps with notional principal totaling
          $42
          million to partially hedge against movements in the market value of the
          remaining trading portfolio.  Based on our observations of the
          portfolio and hedge over the remainder of the quarter, we elected to further
          reduce the size of the portfolio and unwind the hedge
          position.  Consequently, in early July we sold additional securities
          with market values totaling approximately $40 million and unwound the hedge
          position.
 
 **Net
          Interest Income (NII) and Economic Value of Equity (EVE) Simulation Model
          Results**
 
 **September
                    30, 2007**
                
                **December
                    31, 2006****Percentage
                    Change**
                
                **Percentage
                    Change****Change
                    in**
                  **Interest
                    Rates**
                
                **Net
                    Interest**
                **Economic**
                  **Value**
                
                **Net
                    Interest**
                **Economic**
                  **Value****(in
                    basis points)**
                
                **Income**
                **of
                    Equity**
                
                **Income**
                **of
                    Equity**+200
                
                2.40%
                0.30%
                
                2.40%
                (1.07%)+100
                
                n/a
                1.14%
                
                n/a
                0.06%-100
                
                n/a
                (1.84%)
                
                n/a
                (0.88%)-200
                
                (1.02%)
                (5.97%)
                
                0.23%
                (3.76%)
 
 **Net
          Interest Income Simulation**
 
 Our
          income simulation model based on information as of September 30, 2007 indicated
          that our net interest income over the following twelve months was projected
          to
          increase from its “base case” level in a scenario in which interest rates were
          assumed to gradually increase by 200 bps over a twelve-month period, and
          decline
          assuming a gradual 200 bps reduction in rates.  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
  -
              49
              -
 interest
          income of 2.40% was observed in the rising rate environment and a decline
          of
          1.02% was indicated in the falling rate scenario.
 
 The
          changes indicated by the simulation model represent variances from a “base case”
scenario, which is a projection of net interest income assuming interest
          rates
          remain unchanged from their current levels over the life of the forecast,
          and
          that the size of the balance sheet remains stable over the forecast timeframe,
          with no growth or contraction regardless of interest rate
          movements.  The base model will, however, illustrate the future
          effects of rate changes that have already occurred but have not yet flowed
          through to all the assets and liabilities on our balance sheet.  These
          changes can either increase or decrease net interest income, depending
          on the
          timing and magnitudes of those changes.  Additionally, the tendencies
          for loan and investment prepayments to accelerate in falling interest rate
          scenarios and slow when interest rates rise have been incorporated into
          the
          model assumptions.  Implicit in these assumptions are additional
          assumptions for increased securities purchases and loan originations at
          lower
          interest rate levels to offset accelerated prepayments, and conversely,
          reduced
          securities purchases and loan production when rates increase and prepayments
          slow.
 
 The
          rising and falling rate ramp scenarios then indicate that if the slope
          of the
          yield curve remains the same, and customer loan and deposit preferences
          do not
          change in response to further movements of the yield curve, then a parallel
          200
          basis point increase or decrease in rates will not significantly change
          net
          interest income from what is presently expected in the “base
          case.”  In the event the simulation model indicated that the increase
          or decrease in interest rates over the following twelve months would adversely
          affect our net interest income over the same period by more than 10% relative
          to
          the “base case” scenario, we would consider the indicated risk to have exceeded
          our internal policy limit.
 
 **Economic
          Value of Equity (EVE) Simulation**
 
 The
          EVE
          analysis goes beyond simulating net interest income for a specified period
          to
          estimating the present value of all financial instruments in our portfolio
          and
          then analyzing how the economic value of the portfolio would be affected
          by
          various alternative interest rate scenarios.  The portfolio’s economic
          value is calculated by generating principal and interest cash flows for
          the
          entire life of all assets and liabilities, then discounting these cash
          flows
          back to their present values.  The assumed discount rate used for each
          projected cash flow is based on a current market rate, such as a LIBOR,
          FHLB, or
          swap curve rate, and from alternative instruments of comparable risk and
          duration.  In the event the simulation model demonstrates that a 200
          basis point increase or decrease in rates would adversely affect our EVE
          by more
          than 25%, we consider the indicated risk to have exceeded our internal
          policy
          limit.  Again, as illustrated in the above results, we are operating
          within the 25% internal policy limit in all scenarios.
 
 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, 2007 indicated that our liabilities would
          be
          expected to exhibit a greater level of sensitivity to rising rates than
          assets,
          with the economic value of assets declining by 2.25%, compared to a decline
          of
          2.55% for our liabilities.  Given the
  -
              50
              -
 greater
          sensitivity of liabilities, the reduction in the economic value of liabilities
          exceeded the impact on assets.  Consequently, the economic value of
          our equity was positively impacted in this scenario, rising 0.30%.
 
 The
          opposite occurs when rates decline, as the discount rates used to calculate
          the
          present values of assets and liabilities will decrease, causing the present
          values of both assets and liabilities to rise.  Counteracting this
          effect on assets, however, is the tendency for cash flows from assets to
          accelerate in a falling rate scenario, as borrowers refinance their existing
          loans at lower interest rates.  These loan prepayments prevent the
          economic values of these assets from increasing in a declining rate scenario,
          illustrating an effect referred to as negative convexity.  Taking this
          negative convexity into account, the simulation results indicated a negative
          impact to EVE in the falling rate scenario.  In this case, the
          economic values of both assets and liabilities were positively impacted
          when
          rates were assumed to fall by 200 bps, assets by 1.68% and liabilities
          by
          2.56%.  As a result, with the value of liabilities rising more than
          asset values, our economic value of equity was negatively impacted in this
          scenario, declining 5.97%.
 
 The
          Net
          Interest Income and Economic Value of Equity sensitivity analyses do not
          necessarily represent forecasts.  As previously noted, there are
          numerous assumptions inherent in the simulation models as well as in the
          gap
          report, including the nature and timing of interest levels, the shape of
          the
          yield curve, loan and deposit growth, prepayments on loans and securities,
          deposit decay rates, pricing decisions on loans and deposits,
          reinvestment/replacement of asset and liability cash flows, customer
          preferences, and competitor and economic influences.
 
 **Gap
          Model**
 
 In
          addition to the above simulation models, an interest “gap” analysis is used to
          measure the matching of our assets and liabilities and exposure to changes
          in
          interest rates.  This model, which represents a traditional view of
          interest rate sensitivity, quantifies the mismatch between assets maturing,
          repricing, or prepaying within a period, and liabilities maturing or repricing
          within the same period.  A gap is considered positive when the amount
          of interest-rate-sensitive assets exceeds the amount of interest-rate-sensitive
          liabilities within a given period.  A gap is considered negative in
          the reverse situation.
 
 **One-Year
          Interest Rate Sensitivity Gap**
 
 **September
                    30,**
                  **2007**
                
                
                **December
                    31,**
                  **2006**(Dollars
                    in thousands)One-Year
                    Repricing/Maturing Assets
                
                $
                676,566
                
                
                $
                673,514One-Year
                    Repricing/Maturing Liabilities
                
                
                678,124
                
                
                
                725,636One-Year
                    Gap
                
                $
                (1,559
                )
                
                $
                (52,122
                )Total
                    Assets
                
                $
                1,017,321
                
                
                $
                1,079,272One-Year
                    Interest Rate Gap as a Percentage of Assets
                
                
                (0.2
                %)
                
                
                (4.8
                %)
 
 -
              51
              -
 At
          a
          negative, or liability sensitive, 0.2% of assets, our twelve-month interest
          rate
          sensitivity gap as of September 30, 2007 indicated a virtually neutral
          position
          of asset/liability sensitivity compared to the 4.8% liability sensitive
          position
          observed at the 2006 year-end.  Certain shortcomings are inherent in
          gap analysis, including the failure to recognize differences in the frequencies
          and magnitudes of repricing for different balance sheet
          instruments.  Additionally, some assets and liabilities may have
          similar maturities or repricing characteristics, but they may react differently
          to changes in interest rates.  This illustrates a facet of interest
          rate exposure referred to as “basis risk.”  Assets, such as
          adjustable-rate mortgage loans, may also have features that limit the effect
          that changes in interest rates have on the asset in the short-term and/or
          over
          the life of the loan, for example a limit on the amount by which the interest
          rate on the loan is allowed to adjust each year.  This illustrates
          another area of interest rate exposure referred to as “option
          risk.”  Due to the limitations of the gap analysis, these features are
          not taken into consideration.  Additionally, in the event of a change
          in interest rates, prepayment and early withdrawal penalties could deviate
          significantly from those assumed in the gap calculation.   As a
          result, we utilize the gap report as a complement to our income simulation
          and
          economic value of equity models.
 
 **Securities**
  **ITEM
          3**
 The
              following table sets forth certain information regarding carrying values
              and
              percentage of total carrying values of the Bank’s consolidated portfolio of
              securities classified as available-for-sale and held-to-maturity.
 September
                      30,2007
                  
                  
                  2006**Available-for-Sale:**
                  
                  Carrying
                      Value
                  
                  
                  Percent
                      of Total
                  
                  
                  Carrying
                      Value
                  
                  
                  Percent
                      of Total(Dollars
                      in thousands)US
                      Government treasury and agency obligations
                  
                  $
                  —
                  
                  
                  
                  0
                  %
                  
                  $
                  10,800
                  
                  
                  
                  12
                  %Mortgage-backed
                      securities:Freddie
                      Mac
                  
                  
                  456
                  
                  
                  
                  12
                  %
                  
                  
                  14,504
                  
                  
                  
                  15
                  %Ginnie
                      Mae
                  
                  
                  2,346
                  
                  
                  
                  64
                  %
                  
                  
                  35,688
                  
                  
                  
                  38
                  %Fannie
                      Mae
                  
                  
                  895
                  
                  
                  
                  24
                  %
                  
                  
                  32,683
                  
                  
                  
                  35
                  %Total
                      mortgage-backed securities
                  
                  
                  3,697
                  
                  
                  
                  100
                  %
                  
                  
                  82,875
                  
                  
                  
                  88
                  %**Total
                      securities available-for-sale**
                  
                  **$**
                  **3,697**
                  
                  
                  ****
                  **100**
                  **%**
                  
                  **$**
                  **93,675**
                  
                  
                  ****
                  **100**
                  **%**September
                      30,2007
                  
                  
                  2006**Held-to-Maturity:**
                  
                  Carrying
                      Value
                  
                  
                  Percent
                      of Total
                  
                  
                  Carrying
                      Value
                  
                  
                  Percent
                      of Total(Dollars
                      in thousands)Municipal
                      bonds
                  
                  $
                  4,122
                  
                  
                  
                  54
                  %
                  
                  $
                  1,147
                  
                  
                  
                  20
                  %Mortgage-backed
                      securities:Freddie
                      Mac
                  
                  
                  94
                  
                  
                  
                  1
                  %
                  
                  
                  321
                  
                  
                  
                  6
                  %Fannie
                      Mae
                  
                  
                  3,371
                  
                  
                  
                  45
                  %
                  
                  
                  4,265
                  
                  
                  
                  74
                  %Total
                      mortgage-backed securities
                  
                  
                  3,465
                  
                  
                  
                  46
                  %
                  
                  
                  4,586
                  
                  
                  
                  80
                  %**Total
                      securities held-to-maturity**
                  
                  **$**
                  **7,587**
                  
                  
                  ****
                  **100**
                  **%**
                  
                  **$**
                  **5,733**
                  
                  
                  ****
                  **100**
                  **%****Estimated
                      market value**
                  
                  **$**
                  **7,553**
                  
                  
                  
                  
                  
                  
                  **$**
                  **5,689**
 
 -
                  52
                  -
 **ITEM
              3A**
  The
              following table shows the maturity or period to repricing of the Bank’s
              consolidated portfolio of securities available-for-sale and
              held-to-maturity:
 Available-for-sale
                      at September 30, 2007One
                      Year
                    or
                      Less
                  
                  
                  Over
                      One to
                    Three
                      Years
                  
                  
                  Over
                      Three to
                    Five
                      Years
                  
                  
                  Over
                      Five to
                    Ten
                      Years
                  
                  
                  Over
                      Ten to
                    Twenty
                      Years
                  
                  
                  Over
                      Twenty
                    Years
                  
                  
                  TotalCarrying
                      Value
                  
                  
                  Weighted
                      Average Yield
                  
                  
                  Carrying
                      Value
                  
                  
                  Weighted
                      Average Yield
                  
                  
                  Carrying
                      Value
                  
                  
                  Weighted
                      Average Yield
                  
                  
                  Carrying
                      Value
                  
                  
                  Weighted
                      Average Yield
                  
                  
                  Carrying
                      Value
                  
                  
                  Weighted
                      Average Yield
                  
                  
                  Carrying
                      Value
                  
                  
                  Weighted
                      Average Yield
                  
                  
                  Carrying
                      Value
                  
                  
                  Weighted
                      Average Yield**Available-for-Sale:**
                  
                  (Dollars
                      in thousands)Mortgage-backed
                      securities:Ginnie
                      Mae
                  
                  $
                  2,346
                  
                  
                  
                  3.86
                  %
                  
                  $
                  —
                  
                  
                  
                  0.00
                  %
                  
                  $
                  —
                  
                  
                  
                  0.00
                  %
                  
                  $
                  —
                  
                  
                  
                  0.00
                  %
                  
                  $
                  —
                  
                  
                  
                  0.00
                  %
                  
                  $
                  —
                  
                  
                  
                  0.00
                  %
                  
                  $
                  2,346
                  
                  
                  
                  3.86
                  %Freddie
                      Mac
                  
                  
                  456
                  
                  
                  
                  6.22
                  %
                  
                  
                  —
                  
                  
                  
                  0.00
                  %
                  
                  
                  —
                  
                  
                  
                  0.00
                  %
                  
                  
                  —
                  
                  
                  
                  0.00
                  %
                  
                  
                  —
                  
                  
                  
                  0.00
                  %
                  
                  
                  —
                  
                  
                  
                  0.00
                  %
                  
                  
                  456
                  
                  
                  
                  6.22
                  %Fannie
                      Mae
                  
                  
                  136
                  
                  
                  
                  6.36
                  %
                  
                  
                  145
                  
                  
                  
                  5.50
                  %
                  
                  
                  —
                  
                  
                  
                  0.00
                  %
                  
                  
                  —
                  
                  
                  
                  0.00
                  %
                  
                  
                  614
                  
                  
                  
                  4.50
                  %
                  
                  
                  —
                  
                  
                  
                  0.00
                  %
                  
                  
                  895
                  
                  
                  
                  4.94
                  %Total
                      mortgage-backed securities
                  
                  
                  2,938
                  
                  
                  
                  4.34
                  %
                  
                  
                  145
                  
                  
                  
                  5.50
                  %
                  
                  
                  —
                  
                  
                  
                  0.00
                  %
                  
                  
                  —
                  
                  
                  
                  0.00
                  %
                  
                  
                  614
                  
                  
                  
                  4.50
                  %
                  
                  
                  —
                  
                  
                  
                  0.00
                  %
                  
                  
                  3,697
                  
                  
                  
                  4.42
                  %Total
                      securities available-for-sale -- Carrying Value
                  
                  $
                  2,938
                  
                  
                  
                  4.34
                  %
                  
                  $
                  145
                  
                  
                  
                  5.50
                  %
                  
                  $
                  —
                  
                  
                  
                  0.00
                  %
                  
                  $
                  —
                  
                  
                  
                  0.00
                  %
                  
                  $
                  614
                  
                  
                  
                  4.50
                  %
                  
                  $
                  —
                  
                  
                  
                  0.00
                  %
                  
                  $
                  3,697
                  
                  
                  
                  4.42
                  %Total
                      securities available-for-sale -- Amortized Cost
                  
                  $
                  2,913
                  
                  
                  
                  4.35
                  %
                  
                  $
                  143
                  
                  
                  
                  5.50
                  %
                  
                  $
                  —
                  
                  
                  
                  0.00
                  %
                  
                  $
                  —
                  
                  
                  
                  0.00
                  %
                  
                  $
                  633
                  
                  
                  
                  4.50
                  %
                  
                  $
                  —
                  
                  
                  
                  0.00
                  %
                  
                  $
                  3,689
                  
                  
                  
                  4.42
                  %Held-to-Maturity
                      at September 30, 2007One
                      Year
                    or
                      Less
                  
                  
                  Over
                      One to
                    Three
                      Years
                  
                  
                  Over
                      Three to
                    Five
                      Years
                  
                  
                  Over
                      Five to
                    Ten
                      Years
                  
                  
                  Over
                      Ten to
                    Twenty
                      Years
                  
                  
                  Over
                      Twenty
                    Years
                  
                  
                  TotalCarrying
                      Value
                  
                  
                  Weighted
                      Average Yield
                  
                  
                  Carrying
                      Value
                  
                  
                  Weighted
                      Average Yield
                  
                  
                  Carrying
                      Value
                  
                  
                  Weighted
                      Average Yield
                  
                  
                  Carrying
                      Value
                  
                  
                  Weighted
                      Average Yield
                  
                  
                  Carrying
                      Value
                  
                  
                  Weighted
                      Average Yield
                  
                  
                  Carrying
                      Value
                  
                  
                  Weighted
                      Average Yield
                  
                  
                  Carrying
                      Value
                  
                  
                  Weighted
                      Average Yield**Held-to-Maturity:**
                  
                  (Dollars
                      in thousands)Municipal
                      bonds
                  
                  $
                  —
                  
                  
                  
                  0.00
                  %
                  
                  $
                  —
                  
                  
                  
                  0.00
                  %
                  
                  $
                  —
                  
                  
                  
                  0.00
                  %
                  
                  $
                  —
                  
                  
                  
                  0.00
                  %
                  
                  $
                  3,220
                  
                  
                  
                  5.14
                  %
                  
                  $
                  902
                  
                  
                  
                  6.33
                  %
                  
                  $
                  4,122
                  
                  
                  
                  5.40
                  %Mortgage-backed
                      securities:Freddie
                      Mac
                  
                  
                  94
                  
                  
                  
                  7.38
                  %
                  
                  
                  —
                  
                  
                  
                  0.00
                  %
                  
                  
                  —
                  
                  
                  
                  0.00
                  %
                  
                  
                  —
                  
                  
                  
                  0.00
                  %
                  
                  
                  —
                  
                  
                  
                  0.00
                  %
                  
                  
                  —
                  
                  
                  
                  0.00
                  %
                  
                  
                  94
                  
                  
                  
                  7.38
                  %Fannie
                      Mae
                  
                  
                  881
                  
                  
                  
                  7.57
                  %
                  
                  
                  1,179
                  
                  
                  
                  4.65
                  %
                  
                  
                  —
                  
                  
                  
                  0.00
                  %
                  
                  
                  —
                  
                  
                  
                  0.00
                  %
                  
                  
                  1,311
                  
                  
                  
                  4.76
                  %
                  
                  
                  —
                  
                  
                  
                  0.00
                  %
                  
                  
                  3,371
                  
                  
                  
                  5.46
                  %Total
                      mortgage-backed securities
                  
                  
                  975
                  
                  
                  
                  7.55
                  %
                  
                  
                  1,179
                  
                  
                  
                  4.65
                  %
                  
                  
                  —
                  
                  
                  
                  0.00
                  %
                  
                  
                  —
                  
                  
                  
                  0.00
                  %
                  
                  
                  1,311
                  
                  
                  
                  4.76
                  %
                  
                  
                  —
                  
                  
                  
                  0.00
                  %
                  
                  
                  3,465
                  
                  
                  
                  5.51
                  %Total
                      securities held-to-maturity -- Carrying Value
                  
                  $
                  975
                  
                  
                  
                  7.55
                  %
                  
                  $
                  1,179
                  
                  
                  
                  4.65
                  %
                  
                  $
                  —
                  
                  
                  
                  0.00
                  %
                  
                  $
                  —
                  
                  
                  
                  0.00
                  %
                  
                  $
                  4,531
                  
                  
                  
                  5.03
                  %
                  
                  $
                  902
                  
                  
                  
                  6.33
                  %
                  
                  $
                  7,587
                  
                  
                  
                  5.45
                  %Total
                      securities held-to-maturity -- Fair Market Value
                  
                  $
                  986
                  
                  
                  
                  7.55
                  %
                  
                  $
                  1,185
                  
                  
                  
                  4.66
                  %
                  
                  $
                  —
                  
                  
                  
                  0.00
                  %
                  
                  $
                  —
                  
                  
                  
                  0.00
                  %
                  
                  $
                  4,485
                  
                  
                  
                  5.04
                  %
                  
                  $
                  897
                  
                  
                  
                  6.33
                  %
                  
                  $
                  7,553
                  
                  
                  
                  5.46
                  %
 
 -
                  53
                  -
 ITEM
                    4.
                Controls
                    and Procedures
 
 An
          evaluation of the Company’s disclosure controls and procedures (as defined in
          Rules 13a-15(e) of the Securities Exchange Act of 1934 (the “Act”)) was carried
          out under the supervision and with the participation of the Company’s Chief
          Executive Officer, Principal 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 Principal
          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 Principal 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, 2007, the Company was not engaged in any litigation, which
          in the
          opinion of management, after consultation with its legal counsel, would
          be
          material to the Company.
 
 ITEM
                    1A.
                Risk
                    Factors
 
 For
          information regarding certain Risk Factors, please refer to Part I, Item
          1A, in
          the Company’s Annual Report on Form 10-K for the year ended December 31,
          2006.
 
 -
              54
              -
 ITEM
                    2.
                Unregistered
                    Sales of Equity Securities and Use of
                    Proceeds
 
 None.
 
 ITEM
                    3.
                Defaults
                    Upon Senior Securities
 
 None.
 
 ITEM
                    4.
                Submission
                    of Matters to a Vote of Security
                    Holders
 
 A
          Special
          Meeting of Shareholders of First Mutual Bancshares, Inc. was held on October
          11,
          2007.  The results of votes on the matter presented at the Meeting are
          as follows:
 
 The
          proposal to approve the Agreement and Plan of Merger, dated July 2, 2007,
          and as
          amended on August 27, 2007, as further described in the proxy
          statement/prospectus dated September 5, 2007, received the following
          votes:
  **VOTES**
                  
                  **PERCENT
                      OF OUTSTANDING**For
                  5,697,405
                  
                  85.06Against
                  63,613
                  
                  0.95Abstain
                  713
                  
                  -Broker
                      non votes
                  964,907
                  
                  -
 The
          proposal has been approved.
 
 ITEM
                    5.
                Other
                    Information
 
 None.
 
 ITEM
                    6.
                Exhibits
 
 (2.0)
                Agreement
                    and Plan of Merger Between Washington Federal, Inc. and First
                    MutualBancshares,
                    Inc., incorporated by reference on Form 8-K filed with the SEC
                    on July 3,2007.
 
 (3.1)
                Amended
                    and Restated Articles of Incorporation, incorporated by reference
                    onForm
                    10-Q filed with the SEC on August 8,
                    2005.
 
 (3.3)
                Bylaws
                    (as amended and restated), incorporated by reference on Form
                    8-K filed
                    withthe
                    SEC on July 5, 2006.
 
 (11)
                Statement
                    regarding computation of per share earnings.  Reference is made
                    to theCompany’s
                    Consolidated Statements of Income attached hereto as part of
                    Item
                    IFinancial
                    Statements, which are incorporated herein by
                    reference.
 
 (31.1)
                Certification
                    by President and Chief Executive Officer pursuant to Section
                    302 of
                    theSarbanes-Oxley
                    Act of 2002.
 
 (31.2)
                Certification
                    by Principal Financial Officer pursuant to Section302
                    of the Sarbanes-Oxley Act of 2002.
 
 (32)
                Certification
                    by Chief Executive Officer and Principal Financial Officer pursuant
                    toSection
                    906 of the Sarbanes-Oxley Act of
                    2002.
  -
                55
                -
 **SIGNATURES**
 
 Pursuant
            to the requirements of the Securities Exchange Act of 1934, the registrant
            has
            duly caused this report to be signed on its behalf by the undersigned
            thereunto
            duly authorized.
  FIRST
                    MUTUAL BANCSHARES,
                    INC.Date:
                      November
                      8, 2007
                  By:
                  /s/ John
                    R. ValaasJohn
                    R. ValaasPresident
                    and Chief Executive
                    Officer  By:
                    /s/ Kari
                      A. StenslieKari
                        A. SrenslieSenior
                        Vice President/Controller
                      (Principal
                        Financial Officer)
   -
                  56
                  -