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,
      2005





**OR**





o
            **Transition
                Report Pursuant to Section 13 or 15(d) of****The
                Securities Exchange Act of
                1934**


For
      the
      transition period from __________ to ___________





Commission
      File Number 005-57091








FIRST
      MUTUAL BANCSHARES, INC.


(Exact
      name of registrant as specified in its charter)











WASHINGTON
            91-2005970(State
                or other jurisdiction of incorporation
            (I.R.S.
                Employeror
                organization)
            Identification
                Number)











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








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








Indicate
      by check mark whether the registrant (1) has filed all reports required to
      be
      filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
      the
      preceding 12 months (or for such shorter period that the registrant was required
      to file such reports), and (2) has been subject to such filing requirements
      for
      the past 90 days.





Yes  x  No  o





Indicate
      by check mark whether the registrant is an accelerated filer (as defined in
      Rule
      12b-2 of the Exchange Act).





Yes  x  No  o


Indicate
        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, 2005  5,355,542















FIRST
        MUTUAL BANCSHARES, INC.
 
 QUARTERLY
        REPORT ON FORM 10-Q
 September
        30, 2005
 
 TABLE
        OF
        CONTENTS
 
 PagePART
                    I:
                FINANCIAL
                    INFORMATION
                1Forward-Looking
                    Statements Disclaimer
                1ITEM
                    1.
                Financial
                    Statements
                2ITEM
                    2.
                Management’s
                    Discussion and Analysis of Financial Condition andResults
                    of Operations
                15General
                15Overview
                15Results
                    of Operations
                17Net
                    Income
                17Net
                    Interest Income
                17Noninterest
                    Income
                21Noninterest
                    Expense
                25Review
                    of Financial Condition
                28Asset
                    Quality
                30Portfolio
                    Information
                31Commercial
                    Real Estate Loans
                31Sales
                    Finance (Home Improvement) Loans
                32Residential
                    Lending
                34Portfolio
                    Distribution
                35Deposit
                    Information
                35Business
                    Segments
                36Consumer
                    Lending
                36Residential
                    Lending
                39Business
                    Banking Lending
                40Income
                    Property Lending
                41Liquidity
                42Planned
                    Expenditures for Plant and Equipment
                44Capital
                45ITEM
                    3.
                Quantitative
                    and Qualitative Disclosures About Market Risk
                45ITEM
                    4.
                Controls
                    and Procedures
                53PART
                    II:
                OTHER
                    INFORMATION
                53ITEM
                    1.
                Legal
                    Proceedings
                53ITEM
                    2.
                Unregistered
                    Sales of Equity Securities and Use of Proceeds
                53ITEM
                    3.
                Defaults
                    Upon Senior Securities
                53ITEM
                    4.
                Submission
                    of Matters to a Vote of Security Holders
                53ITEM
                    5.
                Other
                    Information
                53ITEM
                    6.
                Exhibits
                53SIGNATURES
                54CERTIFICATIONS


**PART
          I :** **FINANCIAL
          INFORMATION**
  **FORWARD-LOOKING
          STATEMENTS DISCLAIMER**
 
 Our
          Form
          10-Q contains statements concerning future operations, trends, expectations,
          plans, capabilities, and prospects of First Mutual Bancshares, Inc. and
          First
          Mutual Bank (together, the “Bank”) that are forward-looking statements for the
          purposes of the safe harbor provisions under the Private Securities Litigation
          Reform Act of 1995. Such forward-looking statements include statements
          regarding
          our goals and expectations regarding earnings growth and return on equity;
          as
          well as references to potential changes in interest income and interest
          rate
          margins and our efforts to reduce interest expense, anticipated growth
          in loan
          production and modifications of our program to sell consumer loans and
          commercial real estate loans, trends in income, expectations regarding
          our
          Business Banking segment, observations pertaining to the potential disparate
          movement and repricing of assets and liabilities, expectations regarding
          near
          term remodeling costs, and information based on our market risk models,
          simulations and analysis. Although we believe that the expectations expressed
          in
          these forward-looking statements are based on reasonable assumptions within
          the
          bounds of our knowledge of our business, operations, and prospects, these
          forward-looking statements are subject to numerous uncertainties and risks,
          and
          actual events, results, and developments will ultimately differ from the
          expectations and may differ materially from those expressed or implied
          in such
          forward-looking statements. Factors which could affect actual results include
          economic conditions in our market area and the nation as a whole, interest
          rate
          fluctuations, the impact of competitive products, services, and pricing,
          our
          credit risk management, our ability to control our costs and expenses,
          loan
          delinquency rates, and the legislative and regulatory changes affecting
          the
          banking industry. There are other risks and uncertainties that could affect
          us
          which are discussed from time to time in our filings with the Securities
          and
          Exchange Commission. These risks and uncertainties should be considered
          in
          evaluating the forward-looking statements, and undue reliance should not
          be
          placed on such statements. We are not responsible for updating any such
          forward-looking statements.
  ITEM
          1. Financial
          Statements
 
 In
          the
          opinion of management, the accompanying consolidated statements of financial
          condition and related interim consolidated statements of income, comprehensive
          income, stockholders’ equity and cash flows reflect all adjustments (which
          include reclassifications and normal recurring adjustments) that are necessary
          for a fair presentation in conformity with accounting principles generally
          accepted in the United States of America (“GAAP”). The preparation of financial
          statements in conformity with GAAP requires management to make estimates
          and
          assumptions that affect amounts reported in the financial statements. Changes
          in
          these estimates and assumptions are considered reasonably possible and
          may have
          a material impact on the financial statements.
 
 Certain
          reclassifications have been made to the 2004 financial statements to conform
          to
          the 2005 presentation. All significant inter-company transactions and balances
          have been eliminated.
  The
          information included in this Form 10-Q should be read in conjunction with
          the
          First Mutual Bancshares, Inc. Year 2004 Annual Report on Form 10-K to the
          Securities and Exchange Commission. Interim results are not necessarily
          indicative of results for a full year.
 
 Consolidated
          Financial Statements of the Company begin on page 2.
  1
  Item
        1. Financial
        Statements
  **FIRST
          MUTUAL BANCSHARES, INC.**
 **CONSOLIDATED
            STATEMENTS OF FINANCIAL CONDITION**
  September
                  30,
              
              December
                  31,2005
              
              2004**ASSETS:**
              
              *(Unaudited)***CASH
                  AND CASH EQUIVALENTS:**Interest-earning
                  deposits
              
              $
              2,393,690
              
              $
              309,125Noninterest-earning
                  demand depositsand
                  cash on hand
              
              
              20,183,906
              
              
              13,536,31622,577,596
              
              
              13,845,441**MORTGAGE-BACKED
                  AND OTHER SECURITIES****AVAILABLE-FOR-SALE**
              
              
              114,737,746
              
              
              124,224,683**LOANS
                  RECEIVABLE, HELD-FOR-SALE**
              
              
              21,329,520
              
              
              10,064,155**MORTGAGE-BACKED
                  AND OTHER SECURITIES HELD-TO-MATURITY****fair
                  value of $7,398,694 and $7,826,994**
              
              
              7,346,866
              
              
              7,719,542**LOANS
                  RECEIVABLE**
              
              
              851,935,670
              
              
              808,642,531**RESERVE
                  FOR LOAN LOSSES**
              
              
              (9,861,226
              )
              
              (9,300,854
              )**LOANS
                  RECEIVABLE, net**
              
              
              842,074,444
              
              
              799,341,677**ACCRUED
                  INTEREST RECEIVABLE**
              
              
              5,062,479
              
              
              4,300,131**LAND,
                  BUILDINGS AND EQUIPMENT, net**
              
              
              32,706,840
              
              
              27,994,532**FEDERAL
                  HOME LOAN BANK (FHLB) STOCK,**
              
              
              13,122,300
              
              
              12,918,700at
                  cost**SERVICING
                  ASSETS**
              
              
              1,971,954
              
              
              1,525,085**OTHER
                  ASSETS**
              
              
              2,077,886
              
              
              1,849,401**TOTAL**
              
              $
              1,063,007,631
              
              $
              1,003,783,347






See
      Accompanying Notes.


2




**FIRST
        MUTUAL BANCSHARES, INC.**
 **CONSOLIDATED
        STATEMENTS OF FINANCIAL CONDITION**
 **(Continued)**
  September
                  30,
              
              December
                  31,2005
              
              2004*(Unaudited)***LIABILITIES:**Deposits:Money
                  market deposit andchecking
                  accounts
              
              $
              250,532,457
              
              $
              254,435,583Savings
              
              
              8,043,021
              
              
              8,434,423Time
                  deposits
              
              
              468,927,816
              
              
              412,498,902Total
                  deposits
              
              
              727,503,294
              
              
              675,368,908Drafts
                  payable
              
              
              981,540
              
              
              377,814Accounts
                  payable and other liabilities
              
              
              10,490,220
              
              
              14,106,402Advance
                  payments by borrowers fortaxes
                  and insurance
              
              
              3,249,072
              
              
              1,676,175FHLB
                  advances
              
              
              235,756,012
              
              
              234,206,775Other
                  advances
              
              
              1,600,000
              
              
              1,600,000Long-term
                  debentures payable
              
              
              17,000,000
              
              
              17,000,000Total
                  liabilities
              
              
              996,580,138
              
              
              944,336,074**STOCKHOLDERS’
                  EQUITY:**Common
                  stock, $1 par value-Authorized,
                  30,000,000 sharesIssued
                  and outstanding, 5,355,542and
                  5,288,489 shares, respectively
              
              $
              5,355,542
              
              $
              5,288,489Additional
                  paid-in capital
              
              
              46,529,604
              
              
              45,595,319Retained
                  earnings
              
              
              15,557,853
              
              
              9,220,450Accumulated
                  other comprehensive income(loss):Unrealized
                  (loss) on securities available-for-saleand
                  interest rate swap, net of federal income tax
              
              
              (1,015,506
              )
              
              (656,985
              )Total
                  stockholders**’** equity
              
              
              66,427,493
              
              
              59,447,273**TOTAL**
              
              $
              1,063,007,631
              
              $
              1,003,783,347




See Accompanying Notes.


3




**FIRST
        MUTUAL BANCSHARES, INC.**
 **CONSOLIDATED
        STATEMENTS OF INCOME**
  Quarter
                  ended September 30,
              
              Nine
                  months ended September 30,2005
              
              2004
              
              2005
              
              2004*(Unaudited)***INTEREST
                  INCOME:**Loans
                  receivable
              
              $
              15,759,340
              
              $
              12,722,386
              
              $
              44,514,943
              
              $
              36,925,337Interest
                  on available for sale securities
              
              
              1,209,921
              
              
              1,209,939
              
              
              3,747,565
              
              
              2,872,226Interest
                  on held to maturity securities
              
              
              97,635
              
              
              102,647
              
              
              294,294
              
              
              319,006Interest
                  other
              
              
              97,020
              
              
              150,566
              
              
              292,757
              
              
              434,63317,163,916
              
              
              14,185,538
              
              
              48,849,559
              
              
              40,551,202**INTEREST
                  EXPENSE:**Deposits
              
              
              4,913,080
              
              
              3,106,614
              
              
              12,738,459
              
              
              8,965,459FHLB
                  advances and other
              
              
              2,234,239
              
              
              1,819,609
              
              
              6,467,518
              
              
              4,979,5757,147,319
              
              
              4,926,223
              
              
              19,205,977
              
              
              13,945,034Net
                  interest income
              
              
              10,016,597
              
              
              9,259,315
              
              
              29,643,582
              
              
              26,606,168**PROVISION
                  FOR LOAN LOSSES**
              
              
              325,000
              
              
              525,000
              
              
              1,175,000
              
              
              1,215,000Net
                  interest income, after provisionfor
                  loan losses
              
              
              9,691,597
              
              
              8,734,315
              
              
              28,468,582
              
              
              25,391,168**NONINTEREST
                  INCOME:**Gain
                  on sales of loans
              
              
              173,394
              
              
              528,065
              
              
              1,117,887
              
              
              1,195,328Servicing
                  fees, net of amortization
              
              
              317,988
              
              
              88,825
              
              
              1,013,541
              
              
              202,466Gain
                  on sales of investments
              
              
              —
              
              
              —
              
              
              —
              
              
              70,870Fees
                  on deposits
              
              
              166,343
              
              
              147,569
              
              
              472,232
              
              
              438,734Other
              
              
              454,135
              
              
              424,588
              
              
              1,449,866
              
              
              1,107,688Total
                  noninterest income
              
              
              1,111,860
              
              
              1,189,047
              
              
              4,053,526
              
              
              3,015,086




See Accompanying Notes.


4




**FIRST
        MUTUAL BANCSHARES, INC.**
 **CONSOLIDATED
        STATEMENTS OF INCOME**
 **(Continued)**
 Quarter
                  ended September 30,
              
              Nine
                  months ended September 30,2005
              
              2004
              
              2005
              
              2004*(Unaudited)***NONINTEREST
                  EXPENSE:**Salaries
                  and employee benefits
              
              $
              3,738,866
              
              $
              3,553,389
              
              $
              12,017,046
              
              $
              10,208,582Occupancy
              
              
              851,397
              
              
              674,449
              
              
              2,483,684
              
              
              2,018,962Other
              
              
              2,043,631
              
              
              1,861,167
              
              
              6,138,971
              
              
              5,541,761Total
                  noninterest expense
              
              
              6,633,894
              
              
              6,089,005
              
              
              20,639,701
              
              
              17,769,305Income
                  before federal income taxes
              
              
              4,169,563
              
              
              3,834,357
              
              
              11,882,407
              
              
              10,636,949**FEDERAL
                  INCOME TAXES**
              
              
              1,440,202
              
              
              1,308,553
              
              
              4,051,441
              
              
              3,610,153**NET
                  INCOME**
              
              $
              2,729,361
              
              $
              2,525,804
              
              $
              7,830,966
              
              $
              7,026,796**PER
                  SHARE DATA:**Basic
                  earnings per common share
              
              $
              0.51
              
              $
              0.48
              
              $
              1.47
              
              $
              1.34Earnings
                  per common share, assuming dilution
              
              $
              0.49
              
              $
              0.46
              
              $
              1.41
              
              $
              1.28**WEIGHTED
                  AVERAGE SHARES OUTSTANDING**
              
              
              5,350,733
              
              
              5,279,971
              
              
              5,323,843
              
              
              5,256,990**WEIGHTED
                  AVERAGE SHARES OUTSTANDING****INCLUDING
                  DILUTIVE STOCK OPTIONS**
              
              
              5,573,837
              
              
              5,529,531
              
              
              5,560,299
              
              
              5,505,854




See Accompanying Notes.


5




First
        Mutual Bancshares, Inc, and Subsidiaries
 Consolidated
        Statements of Stockholders' Equity and Comprehensive Income
  AccumulatedAdditional
              
              
              
              ComprehensiveCommon
                  Stock
              
              Paid-in
              
              Retained
              
              IncomeShares
              
              Amount
              
              Capital
              
              Earnings
              
              (Loss)
              
              TotalBALANCE,
                  December 31, 2002
              
              
              4,247,166
              
              $
              4,247,166
              
              $
              24,028,610
              
              $
              15,214,220
              
              $
              793,841
              
              $
              44,283,837Comprehensive
                  income:Net
                  income
              
              
              
              
              
              
              
              
              
              
              
              8,395,738
              
              
              
              
              
              8,395,738Other
                  comprehensive income (loss), net of tax:Unrealized
                  (loss) on securities available-for-sale
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (1,294,797
              )
              
              (1,294,797
              )Unrealized
                  gain on interest rate swap
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              87,186
              
              
              87,186Total
                  comprehensive income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              7,188,127Options
                  exercised, including tax benefit of $219,124
              
              
              53,040
              
              
              53,040
              
              
              571,618
              
              
              
              
              
              
              
              
              624,658Issuance
                  of stock through employees' stock plans
              
              
              1,386
              
              
              1,386
              
              
              23,617
              
              
              
              
              
              
              
              
              25,00310%
                  stock dividend
              
              
              428,101
              
              
              428,101
              
              
              9,054,336
              
              
              (9,482,437
              )
              
              
              
              
              —Cash
                  dividend declared ($0.28 per share)
              
              
              
              
              
              
              
              
              
              
              
              (1,294,869
              )
              
              
              
              
              (1,294,869
              )BALANCE,
                  December 31, 2003
              
              
              4,729,693
              
              $
              4,729,693
              
              $
              33,678,181
              
              $
              12,832,652
              
              $
              (413,770
              )
              $
              50,826,756Comprehensive
                  income:Net
                  income
              
              
              
              
              
              
              
              
              
              
              
              9,287,813
              
              
              
              
              
              9,287,813Other
                  comprehensive income (loss), net of tax:Unrealized
                  (loss) on securities available-for-sale
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (414,879
              )
              
              (414,879
              )Unrealized
                  gain on interest rate swap
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              171,664
              
              
              171,664Total
                  comprehensive income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              9,044,598Options
                  exercised, including tax benefit of $337,052
              
              
              80,697
              
              
              80,697
              
              
              1,138,303
              
              
              
              
              
              
              
              
              1,219,000Issuance
                  of stock through employees' stock plans
              
              
              2,019
              
              
              2,019
              
              
              47,992
              
              
              
              
              
              
              
              
              50,01110%
                  stock dividend
              
              
              476,080
              
              
              476,080
              
              
              10,730,843
              
              
              (11,206,923
              )
              
              
              
              
              —Cash
                  dividend declared ($0.32 per share)
              
              
              
              
              
              
              
              
              
              
              
              (1,693,092
              )
              
              
              
              
              (1,693,092
              )BALANCE,
                  December 31, 2004
              
              
              5,288,489
              
              $
              5,288,489
              
              $
              45,595,319
              
              $
              9,220,450
              
              $
              (656,985
              )
              $
              59,447,273Comprehensive
                  income:Net
                  income
              
              
              
              
              
              
              
              
              
              
              
              7,830,966
              
              
              
              
              
              7,830,966Other
                  comprehensive income (loss), net of tax:Unrealized
                  (loss) on securities available-for-sale
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (501,132
              )
              
              (501,132
              )Unrealized
                  gain on interest rate swap
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              142,611
              
              
              142,611Total
                  comprehensive income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              7,472,445Options
                  exercised, including tax benefit of $260,655
              
              
              63,207
              
              
              63,207
              
              
              838,135
              
              
              
              
              
              
              
              
              901,342Issuance
                  of stock through employees' stock plans
              
              
              3,846
              
              
              3,846
              
              
              96,150
              
              
              
              
              
              
              
              
              99,996Cash
                  dividend declared ($0.28 per share)
              
              
              
              
              
              
              
              
              
              
              
              (1,493,563
              )
              
              
              
              
              (1,493,563
              )BALANCE,
                  September 30, 2005
              
              
              5,355,542
              
              $
              5,355,542
              
              $
              46,529,604
              
              $
              15,557,853
              
              $
              (1,015,506
              )
              $
              66,427,493




See Accompanying Notes.


6




**FIRST
        MUTUAL BANCSHARES, INC.**
 **CONSOLIDATED
        STATEMENTS OF CASH FLOWS**
  Nine
                  months ended September 30,2005
              
              2004*(Unaudited)***OPERATING
                  ACTIVITIES:**Net
                  income
              
              $
              7,830,966
              
              $
              7,026,796Adjustments
                  to reconcile net income to net cashfrom
                  operating activities:Provision
                  for loan losses
              
              
              1,175,000
              
              
              1,215,000Depreciation
                  and amortization
              
              
              1,202,468
              
              
              1,027,413Deferred
                  loan origination fees, net of accretion
              
              
              (123,477
              )
              
              (51,829
              )Amortization
                  of servicing assets
              
              
              701,935
              
              
              543,144Gain
                  on sales of loans
              
              
              (1,117,887
              )
              
              (1,195,327
              )Loss
                  on sale of repossessed real estate and other assets
              
              
              —
              
              
              7,200Gain
                  on sale of securities available-for-sale
              
              
              —
              
              
              (70,870
              )FHLB
                  stock dividends
              
              
              (52,900
              )
              
              (338,800
              )Changes
                  in operating assets & liabilities:Loans
                  receivable held-for-sale
              
              
              (11,265,365
              )
              
              (6,157,009
              )Accrued
                  interest receivable
              
              
              (762,348
              )
              
              (492,754
              )Other
                  assets
              
              
              (228,485
              )
              
              463,818Drafts
                  payable
              
              
              603,726
              
              
              135,979Accounts
                  payable and other liabilities
              
              
              (3,675,720
              )
              
              449,692Advance
                  payments by borrowers for taxes and insurance
              
              
              1,572,897
              
              
              1,535,042Net
                  cash (used) provided by operating activities
              
              
              (4,139,190
              )
              
              4,097,495**INVESTING
                  ACTIVITIES:**Loan
                  originations
              
              
              (349,582,133
              )
              
              (267,703,629
              )Loan
                  principal repayments
              
              
              273,768,006
              
              
              189,454,472Increase in
                  undisbursed loan proceeds
              
              
              32,592,214
              
              
              15,783,029Principal
                  repayments & redemptions onmortgage-backed
                  and other securities
              
              
              15,351,545
              
              
              10,196,197Purchase
                  of securities held-to-maturity
              
              
              (1,015,435
              )
              
              (1,126,983
              )Purchase
                  of securities available-for-sale
              
              
              (5,188,637
              )
              
              (55,243,492
              )Purchases
                  of premises and equipment
              
              
              (5,893,796
              )
              
              (1,900,661
              )Purchase
                  of FHLB stock
              
              
              (150,700
              )
              
              (1,544,400
              )Proceeds
                  from sale of securities
              
              
              —
              
              
              2,228,958Net
                  cash (used) by investing activities
              
              
              (40,118,936
              )
              
              (109,856,509
              )




See Accompanying Notes.


7




**FIRST
        MUTUAL BANCSHARES, INC.**
 **CONSOLIDATED
        STATEMENTS OF CASH FLOWS**
 (Continued)
  Nine
                    months ended September 30,2005
                
                2004*(Unaudited)***FINANCING
                    ACTIVITIES:**Net
                    increase in deposit accounts
                
                $
                40,166,530
                
                $
                66,064,933Interest
                    credited to deposit accounts
                
                
                11,967,856
                
                
                8,345,920Issuance
                    of stock through employees stock plans
                
                
                99,996
                
                
                50,011Proceeds
                    from advances
                
                
                825,760,500
                
                
                733,007,196Repayment
                    of advances
                
                
                (824,211,263
                )
                
                (694,522,810
                )Dividends
                    paid
                
                
                (1,434,025
                )
                
                (1,072,518
                )Proceeds
                    from exercise of stock options
                
                
                640,687
                
                
                856,570Net
                    cash provided by financing activities
                
                
                52,990,281
                
                
                112,729,302**NET
                    INCREASE IN CASH AND CASH****EQUIVALENTS**
                
                $
                8,732,155
                
                $
                6,970,288**CASH
                    & CASH EQUIVALENTS:**Beginning
                    of year
                
                
                13,845,441
                
                
                7,427,055End
                    of quarter
                
                $
                22,577,596
                
                $
                14,397,343**SUPPLEMENTAL
                    DISCLOSURES OF CASH FLOW****INFORMATION:**Loans
                    originated for mortgage banking activities
                
                $
                56,578,281
                
                $
                79,779,185Loans
                    originated for investment activities
                
                $
                349,582,133
                
                $
                267,703,629Proceeds
                    from sales of loans held-for-sale
                
                $
                45,312,916
                
                $
                73,622,176Cash
                    paid during the year for:Interest
                
                $
                19,182,790
                
                $
                13,819,639Income
                    taxes
                
                $
                2,987,000
                
                $
                2,528,000
  See Accompanying Notes.


8




**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


***(Unaudited)***




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




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




The
        Bank
        has three stock-based employee/director compensation plans, which are described
        more
        fully in the 2004 annual report. The plans are accounted for under the
        recognition and measurement principles of
        APB
        Opinion No. 25,*Accounting
        for Stock Issued to Employees,*and
        related interpretations. No stock-based employee
        or director compensation cost is reflected in net income, as all options
        granted
        under those plans had an
        exercise price equal to the market value of the underlying common stock on
        the
        date of grant. The following table
        illustrates the effect on net income and earnings per share if the fair value
        recognition provisions of FASB Statement
        No. 123,*Accounting
        for Stock-Based Compensation*,
        had
        been adopted.





Quarters
                  Ended September 30,
              
              Nine
                  Months Ended September 30,2005
              
              2004
              
              2005
              
              2004Net
                  Income, as reported
              
              $
              2,729,361
              
              $
              2,525,805
              
              $
              7,830,966
              
              $
              7,026,796Deduct:
                  Total stock-based employee/director
                  compensation expensedetermined
                  under fair value basedmethod
                  for all awards, net of relatedtax
                  effects
              
              
              (128,350
              )
              
              (123,956
              )
              
              (350,858
              )
              
              (321,091
              )Pro
                  forma net income
              
              $
              2,601,011
              
              $
              2,401,849
              
              $
              7,480,108
              
              $
              6,705,705Earnings
                  per share:Basic
                  - as reported
              
              $
              0.51
              
              $
              0.48
              
              $
              1.47
              
              $
              1.34Basic
                  - pro forma
              
              $
              0.49
              
              $
              0.45
              
              $
              1.41
              
              $
              1.28Diluted
                  - as reported
              
              $
              0.49
              
              $
              0.46
              
              $
              1.41
              
              $
              1.28Diluted
                  - pro forma
              
              $
              0.47
              
              $
              0.43
              
              $
              1.35
              
              $
              1.22Weighted
                  average shares outstanding:Basic
              
              
              5,350,733
              
              
              5,279,971
              
              
              5,323,843
              
              
              5,256,990Diluted
              
              
              5,573,837
              
              
              5,529,531
              
              
              5,560,299
              
              
              5,505,854
  The
        compensation expense included in the pro forma net income and net income
        per
        share figures in the previous
        table is not likely to be representative of the effect on reported net income
        for future years because options
        vest over several years and additional awards generally are made each
        year.




On
        April
        14, 2005 the Securities and Exchange Commission announced a change in the
        compliance date for
        Financial Accounting Standards Board’s Statement of Financial Accounting
        Standards No. 123 (revised 2004), *Share-Based
        Payment*(Statement 123R). The compliance date has been changed to first quarter of
        2006
        from July
        of
        2005. We expect to adopt Statement 123R on January 1,
        2006.
   9




**Note
      2.**




**Mortgage-Backed
        and Other Securities Available-for-Sale**




The
        amortized cost and estimated fair value of securities available-for-sale
        at
        September 30, 2005, and December
        31, 2004 are summarized as follows:


Gross
              
              GrossGross
              
              Unrealized
              
              Unrealized
              
              EstimatedAmortized
              
              Unrealized
              
              Losses
              
              Losses
              
              FairCost
              
              Gains
              
              <1
                  Year
              
              >1
                  Year
              
              Value**September
                  30, 2005**Freddie
                  Mac securities
              
              $
              17,310,639
              
              $
              21,177
              
              $
              59,391
              
              $
              379,654
              
              $
              16,892,771Fannie
                  Mae securities
              
              
              34,441,495
              
              
              40,326
              
              
              289,769
              
              
              509,508
              
              
              33,682,544Ginnie
                  Mae securities
              
              
              46,351,047
              
              
              40,809
              
              
              145,413
              
              
              115,249
              
              
              46,131,194US
                  agency securities
              
              
              18,190,111
              
              
              —
              
              
              104,174
              
              
              54,700
              
              
              18,031,237$
              116,293,292
              
              $
              102,312
              
              $
              598,747
              
              $
              1,059,111
              
              $
              114,737,746**December
                  31, 2004**Freddie
                  Mac securities
              
              $
              19,127,613
              
              $
              48,719
              
              $
              173,913
              
              $
              115,062
              
              $
              18,887,357Fannie
                  Mae securities
              
              
              39,095,463
              
              
              75,726
              
              
              87,354
              
              
              308,837
              
              
              38,774,998Ginnie
                  Mae securities
              
              
              48,839,639
              
              
              38,712
              
              
              270,022
              
              
              —
              
              
              48,608,329US
                  agency securities
              
              
              17,946,544
              
              
              57,761
              
              
              50,306
              
              
              —
              
              
              17,953,999$
              125,009,259
              
              $
              220,918
              
              $
              581,595
              
              $
              423,899
              
              $
              124,224,683
  Certain
        investment securities shown above currently have fair values less
        than amortized cost and therefore contain unrealized
        losses. The
        Bank
        has evaluated these securities and has determined that the decline in value
        is
        temporary and is related to the change in market interest
        rates since purchase. The decline in value is not related to any company
        or
        industry specific event. At September 30, 2005 and December 31, 2004 there
        were 31 and 23 investment securities with unrealized losses, respectively.
        The
        Bank anticipates full recovery of amortized cost with respect to
        these
        securities at maturity or sooner in the event of a more favorable market
        interest rate environment.
  **Note
          3.**  **Mortgage-Backed
            and Other Securities Held-to-Maturity**
  The
          amortized cost and estimated fair value of mortgage-backed and other securities
          are summarized
          as follows:
 Gross
                
                GrossGross
                
                Unrealized
                
                Unrealized
                
                EstimatedAmortized
                
                Unrealized
                
                Losses
                
                Losses
                
                FairCost
                
                Gains
                
                <1
                    Year
                
                >1
                    Year
                
                Value**September
                    30, 2005**Fannie
                    Mae securities
                
                $
                5,678,800
                
                $
                94,744
                
                $
                10,202
                
                $
                43,252
                
                $
                5,720,090Freddie
                    Mac securities
                
                
                476,498
                
                
                8,906
                
                
                —
                
                
                —
                
                
                485,404Municipal
                    bonds
                
                
                1,191,568
                
                
                1,632
                
                
                —
                
                
                —
                
                
                1,193,200$
                7,346,866
                
                $
                105,282
                
                $
                10,202
                
                $
                43,252
                
                $
                7,398,694**December
                    31, 2004**Fannie
                    Mae securities
                
                $
                6,010,318
                
                $
                125,722
                
                $
                30,472
                
                $
                —
                
                $
                6,105,568Freddie
                    Mac securities
                
                
                492,607
                
                
                13,408
                
                
                —
                
                
                —
                
                
                506,015Municipal
                    bonds
                
                
                1,216,617
                
                
                2,622
                
                
                —
                
                
                3,828
                
                
                1,215,411$
                7,719,542
                
                $
                141,752
                
                $
                30,472
                
                $
                3,828
                
                $
                7,826,994
  Certain
          investment securities shown above currently have fair values less
          than amortized cost and therefore contain unrealized
          losses. The
          Bank
          has evaluated these securities and has determined that the decline in value
          is
          temporary and is related to the change in market interest
          rates since purchase. The decline in value is not related to any company
          or
          industry specific event. At both September 30, 2005 and December 31, 2004
there
          were 3 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.
  10
  **Note
            4.**
  **Nonperforming
              Assets**
  Non-performing
            loans are summarized as follows:
  September
                        30, 2005
                    
                    December
                        31, 2004Impaired
                        loans with a valuation allowance
                    
                    $
                    308,728
                    
                    $
                    317,023Valuation
                        allowance related to impaired loans
                    
                    
                    172,475
                    
                    
                    177,190Total
                        non-accrual loans
                    
                    
                    496,450
                    
                    
                    864,464Total
                        loans past due 90-days or more and still accruing interest
                    
                    
                    30,000
                    
                    
                    34,000Interest
                        income recognized on impaired loans
                    
                    
                    623
                    
                    
                    1,108
  **Note
              5.**
 **Earnings
                Per Share**
  Basic
                  Earnings Per Share is computed by dividing net income by the weighted-average
                  number of shares outstanding
                  during the 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 periods ending September 30, 2005 and September 30,
                    2004:
 Income
                    
                    Shares
                    
                    Per
                        share(numerator)
                    
                    (denominator)
                    
                    amountQuarter
                        ended September 30, 2005Basic
                        EPS:Income
                        available to common shareholders
                    
                    $
                    2,729,361
                    
                    
                    5,350,733
                    
                    $
                    0.51Effect
                        of dilutive stock options
                    
                    
                    —
                    
                    
                    223,104Diluted
                        EPS:Income
                        available to common shareholdersplus
                        assumed stock options exercised
                    
                    $
                    2,729,361
                    
                    
                    5,573,837
                    
                    $
                    0.49Nine
                        months ended September 30, 2005Basic
                        EPS:Income
                        available to common shareholders
                    
                    $
                    7,830,966
                    
                    
                    5,323,843
                    
                    $
                    1.47Effect
                        of dilutive stock options
                    
                    
                    —
                    
                    
                    236,456Diluted
                        EPS:Income
                        available to common shareholdersplus
                        assumed stock options exercised
                    
                    $
                    7,830,966
                    
                    
                    5,560,299
                    
                    $
                    1.41Quarter
                        ended September 30, 2004Basic
                        EPS:Income
                        available to common shareholders
                    
                    $
                    2,525,804
                    
                    
                    5,279,971
                    
                    $
                    0.48Effect
                        of dilutive stock options
                    
                    
                    —
                    
                    
                    249,560Diluted
                        EPS:Income
                        available to common shareholdersplus
                        assumed stock options exercised
                    
                    $
                    2,525,804
                    
                    
                    5,529,531
                    
                    $
                    0.46Nine
                        months ended September 30, 2004Basic
                        EPS:Income
                        available to common shareholders
                    
                    $
                    7,026,796
                    
                    
                    5,256,990
                    
                    $
                    1.34Effect
                        of dilutive stock options
                    
                    
                    —
                    
                    
                    248,864Diluted
                        EPS:Income
                        available to common shareholdersplus
                        assumed stock options exercised
                    
                    $
                    7,026,796
                    
                    
                    5,505,854
                    
                    $
                    1.28
   11




**Note
        6.**




**Rate
        Volume Analysis**
 (Dollars
        in thousands)
  THIRD
                  QUARTER 2005
              
              NINE
                  MONTHS ENDED 2005VS
              
              VSTHIRD
                  QUARTER 2004
              
              NINE
                  MONTHS ENDED 2004INCREASE
                  (DECREASE) DUE TO
              
              INCREASE
                  (DECREASE) DUE TOTOTAL
              
              
              
              
              
              TOTALVOLUME
              
              RATE
              
              CHANGE
              
              VOLUME
              
              RATE
              
              CHANGEINTEREST
                  INCOMEInvestments:Available-for-sale
                  securities
              
              $
              6
              
              $
              (6
              )
              $
              —
              
              $
              637
              
              $
              239
              
              $
              876Held-to-maturity
                  securities
              
              
              (10
              )
              
              5
              
              
              (5
              )
              
              (24
              )
              
              (1
              )
              
              (25
              )Other
                  equity investments
              
              
              48
              
              
              (102
              )
              
              (54
              )
              
              93
              
              
              (235
              )
              
              (142
              )Total
                  investments
              
              
              44
              
              
              (103
              )
              
              (59
              )
              
              706
              
              
              3
              
              
              709Loans:Residential
              
              
              625
              
              
              246
              
              
              871
              
              
              1,832
              
              
              529
              
              
              2,361Residential
                  construction
              
              
              227
              
              
              581
              
              
              808
              
              
              606
              
              
              1,169
              
              
              1,775Multifamily
              
              
              (176
              )
              
              334
              
              
              158
              
              
              (350
              )
              
              777
              
              
              427Multifamily
                  construction
              
              
              (27
              )
              
              91
              
              
              64
              
              
              (194
              )
              
              139
              
              
              (55
              )Commercial
                  real estate and business
              
              
              137
              
              
              566
              
              
              703
              
              
              583
              
              
              1,517
              
              
              2,100Commercial
                  real estate construction
              
              
              48
              
              
              75
              
              
              123
              
              
              171
              
              
              141
              
              
              312Consumer
                  & other
              
              
              240
              
              
              71
              
              
              311
              
              
              573
              
              
              98
              
              
              671Total
                  loans
              
              
              1,074
              
              
              1,964
              
              
              3,038
              
              
              3,221
              
              
              4,370
              
              
              7,591Total
                  interest income
              
              
              1,118
              
              
              1,861
              
              
              2,979
              
              
              3,927
              
              
              4,373
              
              
              8,300INTEREST
                  EXPENSEDeposits:Money
                  market deposit and checking
              
              
              86
              
              
              342
              
              
              428
              
              
              329
              
              
              699
              
              
              1,028Savings
              
              
              —
              
              
              1
              
              
              1
              
              
              (2
              )
              
              —
              
              
              (2
              )Time
                  deposits
              
              
              255
              
              
              1,123
              
              
              1,378
              
              
              815
              
              
              1,933
              
              
              2,748Total
                  deposits
              
              
              341
              
              
              1,466
              
              
              1,807
              
              
              1,142
              
              
              2,632
              
              
              3,774FHLB
                  advances and other
              
              
              (176
              )
              
              590
              
              
              414
              
              
              223
              
              
              1,265
              
              
              1,488Total
                  interest expense
              
              
              165
              
              
              2,056
              
              
              2,221
              
              
              1,365
              
              
              3,897
              
              
              5,262Net
                  interest income
              
              $
              953
              
              $
              (195
              )
              $
              758
              
              $
              2,562
              
              $
              476
              
              $
              3,038






12




**Note
      7.**




**Business
        Segments**
  The
          management reporting process measures the performance of the operating
          segments
          based on the management structure of the Bank and is not necessarily
          comparable with similar information for any other financial institution.




The
        reportable segments include the following:
  Consumer
        Lending - Consumer lending includes home equity lending, direct consumer
        loans,
        and indirect home improvement loans (sales finance). These
        loans include lines of credit and loans for primarily consumer purposes.
  Residential
          Lending - Residential lending offers loans to borrowers to purchase, refinance,
          or build homes secured by one-to-four-unit family dwellings. They
          also
          finance the purchase or refinance of buildable residential lots.  Business
              Banking Lending- Business banking lending offers a full range of banking
              services to small and medium size businesses including deposit and
              cash management
              products, loans for financing receivables, inventory, equipment as
              well as
              permanent and interim construction loans for commercial real estate.
The
              underlying real estate collateral or business asset being financed
              typically
              secures these loans. Income
                    Property Lending - Income property lending offers permanent and
                    interim
                    construction loans for multi-family housing (over four units),
manufactured
                    housing communities, commercial real estate properties, and spec
                    single-family
                    construction. The underlying real estate collateral being
                    financed typically secures these loans.


Each
        of
        these business segments also sells loans into the secondary market. We may
        choose to retain or sell the right to service the loans sold (i.e., collection
        of principal and interest payments) depending upon market
        conditions.
  These
        segments are managed separately because each business unit requires different
        processes and different marketing strategies to reach the customer
        base that purchases the products and services. The segments derive a majority
        of
        their revenue from interest income, and we
        rely
        primarily on net interest revenue in managing these segments. No single customer
        provides more than 10% of the Bank’s revenues.




Financial
        information for the Bank’s segments
        is
        shown below for September 30, 2005, 2004, and 2003:
   **Consumer**
              
              **Residential**
              
              **Business
                  Banking**
              
              **Income
                  Property****Quarter
                  ended September 30:**
              
              
              
              **Lending**
              
              **Lending**
              
              **Lending**
              
              **Lending**
              
              **Totals**Interest
                  income
              
              
              2005
              
              $
              2,654,621
              
              $
              5,641,118
              
              $
              2,151,781
              
              $
              6,716,396
              
              $
              17,163,9162004
              
              
              2,368,071
              
              
              4,057,970
              
              
              1,478,372
              
              
              6,281,125
              
              
              14,185,5382003
              
              
              1,791,768
              
              
              3,015,371
              
              
              1,352,364
              
              
              6,364,589
              
              
              12,524,092Interest
                  Expense
              
              
              2005
              
              
              717,063
              
              
              2,757,251
              
              
              631,081
              
              
              3,041,924
              
              
              7,147,3192004
              
              
              655,417
              
              
              1,609,897
              
              
              384,618
              
              
              2,276,290
              
              
              4,926,2222003
              
              
              578,637
              
              
              1,306,029
              
              
              325,779
              
              
              2,402,924
              
              
              4,613,369Net
                  Interest Income
              
              
              2005
              
              
              1,937,558
              
              
              2,883,867
              
              
              1,520,700
              
              
              3,674,472
              
              
              10,016,5972004
              
              
              1,712,654
              
              
              2,448,073
              
              
              1,093,754
              
              
              4,004,835
              
              
              9,259,3162003
              
              
              1,213,131
              
              
              1,709,342
              
              
              1,026,585
              
              
              3,961,665
              
              
              7,910,723Provision
                  for loan losses
              
              
              2005
              
              
              123,600
              
              
              38,675
              
              
              45,355
              
              
              117,370
              
              
              325,0002004
              
              
              132,290
              
              
              208,765
              
              
              45,310
              
              
              138,635
              
              
              525,0002003
              
              
              99,351
              
              
              33,740
              
              
              48,397
              
              
              168,512
              
              
              350,000Net
                  interest income, after provision for loan losses
              
              
              2005
              
              
              1,813,958
              
              
              2,845,192
              
              
              1,475,345
              
              
              3,557,102
              
              
              9,691,5972004
              
              
              1,580,364
              
              
              2,239,308
              
              
              1,048,444
              
              
              3,866,200
              
              
              8,734,3162003
              
              
              1,113,780
              
              
              1,675,602
              
              
              978,188
              
              
              3,793,153
              
              
              7,560,723Noninterest
                  income
              
              
              2005
              
              
              511,948
              
              
              301,905
              
              
              109,963
              
              
              188,044
              
              
              1,111,8602004
              
              
              575,549
              
              
              289,897
              
              
              108,352
              
              
              215,249
              
              
              1,189,0472003
              
              
              178,422
              
              
              331,840
              
              
              93,559
              
              
              353,422
              
              
              957,243Noninterest
                  expense
              
              
              2005
              
              
              1,694,304
              
              
              1,740,708
              
              
              1,461,466
              
              
              1,737,416
              
              
              6,633,8942004
              
              
              1,524,205
              
              
              1,512,514
              
              
              1,269,703
              
              
              1,782,583
              
              
              6,089,0052003
              
              
              1,216,730
              
              
              1,196,906
              
              
              931,512
              
              
              1,743,193
              
              
              5,088,341Income
                  before federal income taxes
              
              
              2005
              
              
              631,602
              
              
              1,406,389
              
              
              123,842
              
              
              2,007,730
              
              
              4,169,5632004
              
              
              631,708
              
              
              1,016,691
              
              
              (112,907
              )
              
              2,298,866
              
              
              3,834,3582003
              
              
              75,472
              
              
              810,536
              
              
              140,235
              
              
              2,403,382
              
              
              3,429,625Federal
                  income taxes
              
              
              2005
              
              
              217,324
              
              
              485,230
              
              
              41,703
              
              
              695,945
              
              
              1,440,2022004
              
              
              215,409
              
              
              347,100
              
              
              (39,513
              )
              
              785,557
              
              
              1,308,5532003
              
              
              24,931
              
              
              273,955
              
              
              47,169
              
              
              814,345
              
              
              1,160,400Net
                  income
              
              
              2005
              
              
              414,278
              
              
              921,159
              
              
              82,139
              
              
              1,311,785
              
              
              2,729,3612004
              
              
              416,299
              
              
              669,591
              
              
              (73,394
              )
              
              1,513,309
              
              
              2,525,8052003
              
              
              50,541
              
              
              536,581
              
              
              93,066
              
              
              1,589,037
              
              
              2,269,225Total
                  interest earning assets (ending period balances)
              
              
              2005
              
              
              123,903,285
              
              
              344,195,402
              
              
              130,046,461
              
              
              407,784,711
              
              
              1,005,929,8592004
              
              
              112,932,675
              
              
              279,687,177
              
              
              107,201,051
              
              
              444,847,887
              
              
              944,668,7902003
              
              
              93,244,409
              
              
              202,616,402
              
              
              85,879,137
              
              
              432,864,165
              
              
              814,604,113




13




**Note
        7.**
  **Segments
          (continued)**
  **Year-to-date
                  ended September 30:****Consumer**
              
              **Residential**
              
              **Business
                  Banking**
              
              **Income
                  Property****Lending**
              
              **Lending**
              
              **Lending**
              
              **Lending**
              
              **Totals**Interest
                  income
              
              
              2005
              
              $
              7,224,772
              
              $
              15,323,644
              
              $
              6,227,199
              
              $
              20,073,944
              
              $
              48,849,5592004
              
              
              6,453,804
              
              
              11,592,479
              
              
              4,085,381
              
              
              18,419,538
              
              
              40,551,2022003
              
              
              4,544,282
              
              
              8,331,555
              
              
              4,082,976
              
              
              19,850,381
              
              
              36,809,194Interest
                  expense
              
              
              2005
              
              
              2,316,597
              
              
              6,841,796
              
              
              1,772,267
              
              
              8,275,317
              
              
              19,205,9772004
              
              
              1,752,923
              
              
              4,522,289
              
              
              1,016,769
              
              
              6,653,053
              
              
              13,945,0342003
              
              
              1,714,034
              
              
              3,552,754
              
              
              1,229,706
              
              
              7,889,785
              
              
              14,386,279Net
                  interest income
              
              
              2005
              
              
              4,908,175
              
              
              8,481,848
              
              
              4,454,932
              
              
              11,798,627
              
              
              29,643,5822004
              
              
              4,700,881
              
              
              7,070,190
              
              
              3,068,611
              
              
              11,766,486
              
              
              26,606,1682003
              
              
              2,830,248
              
              
              4,778,801
              
              
              2,853,270
              
              
              11,960,596
              
              
              22,422,915Provision
                  for loan losses
              
              
              2005
              
              
              413,815
              
              
              144,450
              
              
              177,595
              
              
              439,140
              
              
              1,175,0002004
              
              
              381,924
              
              
              278,169
              
              
              126,704
              
              
              428,203
              
              
              1,215,0002003
              
              
              214,846
              
              
              83,799
              
              
              107,686
              
              
              403,669
              
              
              810,000Net
                  interest income, after provision for loan losses
              
              
              2005
              
              
              4,494,360
              
              
              8,337,398
              
              
              4,277,337
              
              
              11,359,487
              
              
              28,468,5822004
              
              
              4,318,957
              
              
              6,792,021
              
              
              2,941,908
              
              
              11,338,282
              
              
              25,391,1682003
              
              
              2,615,402
              
              
              4,695,002
              
              
              2,745,584
              
              
              11,556,927
              
              
              21,612,915Non
                  interest income
              
              
              2005
              
              
              1,985,025
              
              
              826,339
              
              
              490,741
              
              
              751,421
              
              
              4,053,5262004
              
              
              1,322,551
              
              
              652,410
              
              
              281,940
              
              
              758,185
              
              
              3,015,0862003
              
              
              385,318
              
              
              961,601
              
              
              299,475
              
              
              1,179,741
              
              
              2,826,135Non
                  interest expense
              
              
              2005
              
              
              5,071,239
              
              
              5,312,799
              
              
              4,641,700
              
              
              5,613,963
              
              
              20,639,7012004
              
              
              4,149,611
              
              
              4,335,059
              
              
              3,655,838
              
              
              5,628,797
              
              
              17,769,3052003
              
              
              3,109,595
              
              
              3,485,346
              
              
              2,883,998
              
              
              5,310,184
              
              
              14,789,123Income
                  before federal income taxes
              
              
              2005
              
              
              1,408,146
              
              
              3,850,938
              
              
              126,378
              
              
              6,496,945
              
              
              11,882,4072004
              
              
              1,491,897
              
              
              3,109,372
              
              
              (431,990
              )
              
              6,467,670
              
              
              10,636,9492003
              
              
              (108,875
              )
              
              2,171,257
              
              
              161,061
              
              
              7,426,484
              
              
              9,649,927Federal
                  income taxes
              
              
              2005
              
              
              480,044
              
              
              1,312,716
              
              
              41,093
              
              
              2,217,588
              
              
              4,051,4412004
              
              
              506,567
              
              
              1,055,311
              
              
              (149,181
              )
              
              2,197,456
              
              
              3,610,1532003
              
              
              (38,924
              )
              
              734,007
              
              
              52,928
              
              
              2,515,916
              
              
              3,263,927Net
                  income
              
              
              2005
              
              
              928,102
              
              
              2,538,222
              
              
              85,285
              
              
              4,279,357
              
              
              7,830,9662004
              
              
              985,330
              
              
              2,054,061
              
              
              (282,809
              )
              
              4,270,214
              
              
              7,026,7962003
              
              
              (69,951
              )
              
              1,437,250
              
              
              108,133
              
              
              4,910,568
              
              
              6,386,000Total
                  interest earning assets (averages)
              
              
              2005
              
              
              116,869,334
              
              
              325,552,575
              
              
              128,386,695
              
              
              422,055,517
              
              
              992,864,1212004
              
              
              105,868,685
              
              
              266,403,325
              
              
              100,951,018
              
              
              441,549,203
              
              
              914,772,2312003
              
              
              82,438,926
              
              
              183,120,043
              
              
              87,327,342
              
              
              434,261,850
              
              
              787,148,161






14


ITEM
        2. Management’s
        Discussion and Analysis of Financial Condition and Results of
        Operations
 
 **GENERAL**
 
 First
        Mutual Bancshares, Inc. (the “Company”),
        a Washington
        corporation, is a bank holding company owning all of the equity of its wholly
        owned subsidiary, First Mutual Bank. The Company is subject to regulation
        by the
        Federal Reserve Bank of San Francisco. This discussion refers to the
        consolidated statements of the Company and the Bank, and therefore the
        references to “Bank” in this discussion refer to both entities.
 
 First
        Mutual Bank is a Washington-chartered savings bank subject to regulation
        by the
        State of Washington Department of Financial Institutions and the Federal
        Deposit
        Insurance Corporation (“FDIC”). The Bank conducts business from its headquarters
        in Bellevue, Washington, and has 12 full-service retail banking centers located
        in Bellevue (3), Issaquah, Kirkland (2), Monroe, Redmond, Sammamish, Seattle
        (2), and Woodinville. We also have an income property office in Tacoma, WA and a consumer loan office located in
        Jacksonville, Florida. The Bank's business consists mainly of attracting
        deposits from the general public as well as wholesale funding sources, and
        investing those funds primarily in real estate loans, small and mid-sized
        business loans, and consumer loans.
 
 **OVERVIEW**
 
 The
        third
        quarter of 2005 marked our fifty-second consecutive quarter of year-over-year
        quarterly earnings growth, as net income increased 8% for the quarter, totaling
        $2.7 million, or $0.49 per diluted share, compared to $2.5 million, or $0.46
        per
        diluted share in the same quarter a year ago. Through the first three quarters
        of the year, net income increased 11% to $7.8 million, or $1.41 per diluted
        share, compared to $7.0 million, or $1.28 per diluted share in the first
        nine
        months of 2004.
 
 As
        general corporate goals, we seek to obtain a 15% or better return on equity
        (ROE) and year-over-year net income growth in the range of 10% to 12%. This
        net
        income growth goal was established in the first quarter of 2005, and represented
        a reduction from our previous target of a 15% year-over-year increase. We
        elected to reduce our target in response to a number of factors including
        general economic conditions and trends, the current competitive environment
        for
        loan and deposit products in our local market, and the continued investment
        required in our Business Banking division. We consider these targets to be
        our
        corporate goals and not indicative of current forecasts or expected future
        operating results.
 
 While
        our
        return on equity has typically met or exceeded our corporate objective, our
        net
        income growth has generally fallen short of our target. Over the last several
        years, we have utilized part of our earnings for the purpose of investing
        in new
        business lines. We realized that in order to continue to achieve our goal
        of
        consistent earnings, we needed to expand our business lines from two to four.
        At
        that time, our operations consisted of residential and income property
  15
  (commercial
        real estate) lending. Those business lines were, and continue to be, solid
        operations. However, for the Bank to continue to produce consistent earnings,
        we
        needed to broaden the operating base with two new lines, Business Banking
        and
        Consumer Lending. The process of developing these lines has been expensive
        and
        has added to both our staff and other operating costs. The encouraging news
        is
        that the Consumer Lending business line has been contributing to the Bank’s
        profit goals for some time. Although the Business Banking division has not
        yet
        achieved its objectives, we remain committed to developing this business
        line,
        based upon its ability to attract low-cost core deposits, which help reduce
        our
        overall cost of funds, the diversification it brings to our portfolio of
        earning
        assets, and the potential it offers for generating longer-term
        relationship-banking opportunities and additional sources of noninterest
        income.
  The
        primary source of revenue for each of our business lines is net interest
        income,
        which is generally measured with the net interest margin ratio. While we
        did not
        quite achieve the improvement for which we had hoped this quarter, our overall
        net interest margin improved to 4.03% for the third quarter, compared to
        4.01%
        in the previous quarter, and 3.99% in the third quarter of 2004. On a
        year-to-date basis, our margin of 4.04% exceeded the 4.00% earned through
        the
        first three quarters of last year. With continued increases in short-term
        interest rates, the yield on our earning assets grew to 6.69% in the third
        quarter of 2005, compared to 6.39% in the second quarter, and 5.85% in the
        third
        quarter of 2004. Partially offsetting this improvement, however, the cost
        of
        interest-bearing liabilities increased to 2.87% in the third quarter, from
        2.62%
        in the second quarter and 2.06% in the third quarter of 2004. We consider
        controlling the interest expense paid on these liabilities to be a critical
        element to maintaining a consistent net interest margin in the current economic
        environment. As a result, we continue to focus our efforts on improving the
        percentage of lower-cost, non-maturity deposit products in our funding mix,
        reduce as significantly as is prudent the occurrence of promotional deposit
        rates, and utilize wholesale funding sources when estimates of marginal funding
        costs indicate it may be advantageous to do so.
 
 Another
        key driver of net interest income is the growth of the business lines’ earning
        assets, which averaged $995 million during the third quarter, an increase
        of
        nearly $66 million, or 7% over the third quarter of 2004. Nearly all of this
        growth can be attributed to additional balances in our loan portfolio, with
        our
        Residential Lending and Business Banking segments showing the most substantial
        asset growth over the last 12 months. Please see the “Net Interest
        Income,”“Business Segments,” and “Asset and Liability Management” sections for
        further discussions of net interest income, earning assets, and the processes
        by
        which we manage that source of revenue.
 
 A
        secondary source of revenue is our noninterest income, which declined $77,000,
        or 6% for the third quarter, based on significant reductions in loan sales
        and
        gains thereon compared to the same quarter last year. A lack of any significant
        growth in noninterest income relative to the third quarter of last year was
        anticipated in our outlook for the third quarter. In our second quarter press
        release we noted our intention to substantially reduce our sales of consumer
        loans, which have typically been the primary driver of our gains on loan
        sales.
        While the reduction in gains on sales of these loans negatively impacted
        our
        noninterest income in the current period, reducing our sales allowed us to
        retain a greater volume of these higher-yielding assets within our portfolio.
        Additionally, the reduction in gains on sales was largely offset by additional
        service fee income relative to the prior year. Through the nine months ended
        September 30, our noninterest income exceeded the 2004 level by $1.0 million,
        or
        34%. Please refer to the “Noninterest Income” section for a further discussion
        of this subject.
 
 16
  A
        critical factor in achieving our goal of consistent earnings is the credit
        quality of our loan portfolio, which has exceeded the national average for
        many
        years. For the third quarter of 2005, our credit quality remained strong,
        with
        total non-performing assets (NPAs) declining to $635,000, or 0.06% of total
        assets as of the quarter-end. For the third quarter we reserved $325,000
        in
        provision for loan losses, while net charge-offs totaled $173,000. As a result,
        the loan loss reserve grew to $9.9 million, up from $9.2 million at the end
        of
        the third quarter of last year. For additional information regarding our
        credit
        quality please refer to the “Asset Quality” section.
 
 **RESULTS
        OF OPERATIONS**
 
 **Net
        Income**
 
 Net
        income increased 8%, from $2.5 million in the third quarter of 2004 to $2.7
        million in the same period of 2005. Net interest income, after provision
        for
        loan losses, rose $957,000, while noninterest income declined $77,000 and
        noninterest expense rose $545,000 on a third quarter comparison.
 
 **Net
        Interest Income**
  For
        the
        quarter and nine months ended September 30, 2005, net interest income increased
        by $758,000 and $3.0 million, respectively, or 8% and 11%, relative to the
        same
        periods last year. For the quarter, the improvement was attributable to growth
        in our earning assets, partially offset by asset and liability repricing.
        On a
        year-to-date basis, both the growth in earning assets and the net effects
        of
        asset and liability repricing resulted in additional net interest income,
        though
        asset growth accounted for the vast majority of the improvement. The following
        table illustrates the impact to our net interest income of balance sheet
        growth
        and rate changes on our assets and liabilities, with the results attributable
        to
        the level of earning assets classified as “volume” and the effect of asset and
        liability repricing labeled “rate.”
  **Rate/Volume
                  Analysis**Quarter
                  Ended
              
              Nine
                  Months EndedSeptember
                  30, 2005 vs. September 30, 2004
              
              September
                  30, 2005 vs. September 30, 2004Increase/(Decrease)
                  due to
              
              Increase/(Decrease)
                  due toVolume
              
              Rate
              
              Total
              
              Volume
              
              Rate
              
              TotalInterest
                  Income
              
              (Dollars
                  in thousands)Total
                  Investments
              
              $
              44
              
              $
              (103
              )
              $
              (59
              )
              $
              706
              
              $
              3
              
              $
              709Total
                  Loans
              
              
              1,074
              
              
              1,964
              
              
              3,038
              
              
              3,221
              
              
              4,370
              
              
              7,591Total
                  Interest Income
              
              $
              1,118
              
              $
              1,861
              
              $
              2,979
              
              $
              3,927
              
              $
              4,373
              
              $
              8,300Interest
                  ExpenseTotal
                  Deposits
              
              $
              341
              
              $
              1,466
              
              $
              1,807
              
              $
              1,142
              
              $
              2,632
              
              $
              3,774FHLB
                  and Other
              
              
              (176
              )
              
              590
              
              
              414
              
              
              223
              
              
              1,265
              
              
              1,488Total
                  Interest Expense
              
              $
              165
              
              $
              2,056
              
              $
              2,221
              
              $
              1,365
              
              $
              3,897
              
              $
              5,262Net
                  Interest Income
              
              $
              953
              
              $
              (195
              )
              $
              758
              
              $
              2,562
              
              $
              476
              
              $
              3,038
 
 17
  **Earning
        Asset Growth (Volume)**
  For
        the
        third quarter of 2005, the growth in our earning assets contributed an
        additional $1.1 million in interest income relative to the third quarter
        of last
        year, which was partially offset by $165,000 of additional interest expense
        incurred from the funding sources used to fund the asset growth. Consequently,
        the net impact of asset growth was an improvement in net interest income
        of
        $953,000 compared to the third quarter of last year.
  For
        the
        first nine months of 2005, asset growth over the prior year resulted in $3.9
        million in additional interest income, partially offset by a $1.4 million
        increase in interest expense for the corresponding funding sources. This
        resulted in a roughly $2.6 million net impact from asset growth, or 84% of
        the
        overall improvement in net interest income.
  
 **Quarter
                  Ended**
              **Average
                  Earning**
                **Assets**
              **Average
                  Net Loans**
              **Average
                  Deposits**(Dollars
                  in thousands)September
                  30, 2004
              $
                  929,335
              $
                  790,319
              $
                  647,560December
                  31, 2004
              $
                  945,684
              $
                  801,235
              $
                  666,835March
                  31, 2005
              $
                  962,613
              $
                  816,127
              $
                  683,521June
                  30, 2005
              $
                  979,981
              $
                  834,064
              $
                  705,680September
                  30, 2005
              $
                  995,159
              $
                  854,343
              $
                  723,595
   Our
        average earning assets totaled $995 million during the third quarter, an
        increase of nearly $66 million, or 7% over the third quarter of 2004, with
        nearly all of the growth attributable to additional balances in our loan
        portfolio.
  18
  Most
        of
        our asset growth was funded with additional deposits, including certificates
        issued in institutional markets through deposit brokerage services. To the
        extent that deposit growth was not sufficient to fully support our asset
        growth,
        we also utilized advances from the Federal Home Loan Bank of Seattle (FHLB)
        as
        an alternative funding source. For the third quarter, our deposits averaged
        nearly $724 million, representing growth of $76 million over the average
        level
        of third quarter 2004. At September 30, 2005, total deposits were up $69
        million
        from the end of the third quarter last year, with checking and money market
        balances accounting for $14 million of the growth, or 20%. Although checking
        and
        money market deposits exhibited growth over their year-ago levels, these
        balances showed declines in the first and third quarters of this year,
        corresponding to offerings of promotional time deposit rates.
  Between
        the 2004 year-end and the end of March 2005, our checking and money market
        balances declined by approximately $12 million. At that time, the increases
        in
        short-term market interest rates that began in the second quarter of 2004
        started to affect the yields on retail deposits, with the rates paid on time
        deposits increasing more significantly than those paid on money market accounts.
        This made it difficult to retain or grow checking and money market balances
        without incurring excessive marginal costs, as any rate increases would apply
        not only to any newly opened accounts but existing balances as well. By the
        end
        of June 2005, the trend appeared to have changed, with checking and money
        market
        balances rising to $253 million, approximately $1 million below the 2004
        year-end level. In the third quarter, however, some of our competitors began
        offering deposit rates that threatened our ability to retain deposit balances.
        As a result, we were forced to offer a promotional time deposit rate and
        increase our non-maturity deposit rates in late August. Despite the increased
        rates on our money market accounts and the greater liquidity offered by these
        deposits, many customers found the promotional time deposit rate more attractive
        than our money market products. Consequently, following continued growth
        in
        July, checking and money market balances began declining, ending the third
        quarter at $251 million.
  **Asset
        Yields and Funding Costs (Rate)**
  For
        the
        quarter ended September 30, 2005, the net effects of repricing on our assets
        and
        liabilities reduced our net interest income by $195,000 relative to the third
        quarter of 2004. For the year-to-date period, repricing contributed an
        additional $476,000 to our net interest income, or approximately 16% of the
        total increase relative to the first nine months of last year.
  On
        the
        asset side of the balance sheet, our loan portfolio accounted for $2.0 million
        and $4.4 million in additional interest income for the three- and nine- month
        periods. With adjustable-rate loans accounting for the vast majority of our
        loan
        portfolio, virtually all of the Bank’s loan types benefited from rising interest
        rate indexes.
  By
        comparison, the effects of repricing reduced the third quarter interest income
        earned on our securities portfolio by $103,000. On a year-to-date basis,
        repricing resulted in virtually no impact relative to 2004. For both the
        quarter
        and year-to-date periods, the effects of repricing were heavily influenced
        by
        our holdings of stock in the Federal Home Loan Bank of Seattle.
  As
        a
        member of the FHLB and to utilize FHLB advances as a funding source for our
        lending and investment activities, we maintain a position in FHLB stock.
        Our
        position in this stock, which totaled approximately $13 million at the end
        of
        the third quarter, has historically paid dividends on a quarterly basis.
        Based
        on events at the FHLB, however, the dividend rate for the first quarter of
        2005
        was well below the rate paid in the first quarter of last year, and no dividend
        was received in the second or third quarters. This offset any rate-related
        benefits from the repricing
  19
  of
        adjustable-rate securities in our portfolio. At this time, we do not anticipate
        receiving any dividend income on our FHLB stock in the foreseeable future.
        Excluding the FHLB stock, the impact of repricing observed among the
        fixed-income securities in our portfolio was relatively modest due to the
        percentage of the portfolio invested in fixed-rate and hybrid ARM securities,
        which have not yet benefited from rising rate indices.
  On
        the
        liability side of the balance sheet, repricing increased our interest expense
        on
        both deposits and advances for the quarter and nine-month period ended September
        30, relative to the prior year. The interest rate increases that drove loan
        and
        wholesale funding rates higher over the last year began to influence the
        deposit
        rates offered by our competitors in our market earlier this year, resulting
        in
        rate-related increases in interest expense on both our non-maturity and time
        deposit accounts.
  **Net
        Interest Margin**
  Quarter
                  Ended
              Net
                  Interest MarginSeptember
                  30, 2004
              3.99%December
                  31, 2004
              3.99%March
                  31, 2005
              4.08%June
                  30, 2005
              4.01%September
                  30, 2005
              4.03%
  Our
        net
        interest margin was 4.03% for the third quarter of 2005. While this represented
        a two basis point improvement from the second quarter level, it fell short
        of
        the 4.05% to 4.10% range we had forecast in our second-quarter press release.
        The forecast for improvement in the margin was based primarily on the large
        number of commercial loans scheduled to reprice in the third quarter. The
        impact
        of this repricing, however, was partially offset by a greater than expected
        increase in interest expense, including the effects of raising rates on our
        non-maturity deposit products.
  Adjustable-rate
        loans, which reprice according to terms specified in our loan agreements
        with
        the borrowers, accounted for approximately 88% of our loan portfolio as of
        September 30, 2005. For the majority of these loans, repricing occurs on
        an
        annual basis. A notable exception to this would be those loans tied to the
        prime
        rate, which typically reprice within one or two days of any increase in the
        Federal Funds target rate by the Federal Reserve. Consequently, most of the
        loans in our portfolio benefited from increases in short-term market interest
        rate indices over the last 18 months and earned additional interest income
        relative to the quarter and nine months ended September 30, 2004.
  By
        comparison, rates on our retail deposits are managed internally and are not
        typically subject to any sort of systematic adjustments based on market-rate
        indices. Consequently, while loan rates continued to systematically reprice
        upwards, we postponed raising our retail deposit rates for as long as practical
        given our funding requirements and the rates offered by other institutions
        in
        our market. In doing so, we hoped to increase our net interest margin, primarily
        by avoiding the high marginal costs associated with increasing rates on our
        non-maturity deposits, as rate increases on these products result in an
        immediate impact on the margin as the rates paid on tens,
  20
  or
        even
        hundreds, of millions of dollars in balances increase overnight. By the middle
        of the third quarter, however, some of our competitors had begun offering
        deposit rates that threatened our ability to retain deposit balances, including
        non-maturity deposit balances. As a result, in late August, we believed it
        necessary to offer a special time deposit promotional rate and increase rates
        on
        our non-maturity deposits.
  While
        these promotional time deposit rates allow us to attract deposit balances
        without the high marginal costs associated with higher non-maturity deposit
        rates, they can result in a migration of existing deposit balances from
        non-maturity accounts, particularly money market products, into time deposits.
        Although our checking and money market deposits showed growth over their
        September 30, 2004, levels, these balances showed declines in the first and
        third quarters of this year corresponding to the offerings of promotional
        time
        deposit rates.
  Any
        future migration of checking and money market balances to time deposit accounts
        could put additional pressure on our net interest margin. Our checking and
        money
        market account balances typically represent a lower-cost source of funding
        for
        us, and time deposits a higher-cost source, becoming progressively more so
        as
        rates rise. While we do not anticipate significant future migration from
        checking and money market accounts to time deposits, in the event that movement
        were to resume in a manner similar to that observed earlier this year, our
        net
        interest margin could be subject to compression.
  Additionally,
        movements of retail deposit rates tend to lag major interest rate indices,
        remaining static as the market indices begin moving, and then continuing
        to move
        for some time after the market rates stabilize or plateau at a given level.
        Consequently, if short-term rates were to stabilize, we could potentially
        see
        additional compression in our net interest margin in subsequent quarters
        as the
        effects of systematic loan repricing would diminish, while deposit rates
        could
        continue to trend upward for some time afterwards based on the lagging nature
        of
        retail deposit rate movements. However, given that intense competition has
        already driven deposit rates higher, with what seems to be faster than
        historically typical velocity, it is also possible that these rates would
        not
        continue to trend upwards as long or as far as in previous rate
        cycles.
  **Noninterest
        Income**
  For
        the
        third quarter, our noninterest income declined by $77,000, or 6%, due to
        reductions in loan sales, and gains thereon, compared to the same quarter
        last
        year. However, the reduction in gain on sales was largely offset by additional
        service fee income relative to the prior year. Through the nine months ended
        September 30, our noninterest income exceeded the 2004 level by $1.0 million,
        or
        34%, again primarily attributable to an increase in service fee income compared
        to 2004.
  **Gain
        on Sales of Loans**
  
 **Gain
                    on Loan Sales**
                
                3Q
                    2005
                
                3Q
                    2004
                
                YTD
                    2005
                
                YTD
                    2004Consumer
                    Loan Sale Gains
                
                $
                117,000
                
                $
                442,000
                
                $
                820,000
                
                $
                974,000Residential
                    Loan Sale Gains
                
                
                59,000
                
                
                49,000
                
                
                120,000
                
                
                113,000Commercial
                    Loan Sale Gains
                
                
                (3,000
                )
                
                37,000
                
                
                178,000
                
                
                108,000Total
                    Gains on Loan Sales
                
                $
                173,000
                
                $
                528,000
                
                $
                1,118,000
                
                $
                1,195,000
  21
  **Loans
                    Sold**Consumer
                    Loans Sold
                
                $
                2,207,000
                
                $
                11,029,000
                
                $
                17,883,000
                
                $
                26,293,000Residential
                    Loans Sold
                
                
                9,440,000
                
                
                8,307,000
                
                
                21,530,000
                
                
                24,963,000Commercial
                    Loans Sold*
                
                
                3,330,000
                
                
                4,820,000
                
                
                5,900,000
                
                
                22,366,000Total
                    Loans Sold
                
                $
                14,977,000
                
                $
                24,156,000
                
                $
                45,313,000
                
                $
                73,622,000
  *
        The
        commercial loans sold for the nine months ended September 30, 2005, of
        $5,900,000 include $2,570,000 representing two loans sold in the second quarter.
        The first of these loans, which accounted for $1,920,000, was fully disbursed.
        The second loan was a construction loan for $7,500,000 of which $650,000
        was
        disbursed at origination.
  For
        the
        third quarter of 2005, the volume of loans sold, specifically consumer loans
        sold, declined significantly relative to the prior year, resulting in a 67%
        reduction in gains on loan sales for the quarter. As we noted in our
        second-quarter press release, we made a significant change in our strategy
        regarding sales of consumer loans. Previously, our plan had been to sell
        approximately $6 million to $8 million in sales finance loans each quarter,
        though actual sales in a given quarter could fall above or below this range
        depending on loan production, market conditions, and other factors. In the
        second quarter, we elected to change this strategy and substantially reduce
        our
        sales of these loans, selling only sufficient volumes to ensure the continuity
        of the market. Accordingly, our third-quarter loan sales were well below
        those
        for the same period last year. While the reduction in gains on sales negatively
        impacted our noninterest income in the current period, reducing our sales
        of
        consumer loans allowed us to retain a greater volume of these higher-yielding
        assets within our portfolio. Although no changes to this plan are anticipated
        at
        this time, this strategy may be reevaluated in the future and subject to
        further
        modification based on factors including, but not limited to, future loan
        production and/or market conditions.
  Despite
        the reduction in sales volume, consumer loan sales remained the largest
        contributor to our loan sale gains, with gains of $117,000 in the third quarter.
        While this represented a 73% decline from the gains realized in the third
        quarter of 2004, our pricing and execution improved relative to last year,
        as
        the volume of loans sold declined 80% to $2.2 million, versus $11.0 million
        in
        the same quarter last year. Similarly, through the first nine months of 2005,
        gains on consumer loan sales declined by $155,000, or 16%, while the volume
        of
        loans sold fell 32%.
  In
        our
        second-quarter press release, we noted that we had experienced increased
        interest in, and opportunities for, sales of participations in our commercial
        real-estate loans. Consequently, we added that we were considering the merits
        of
        expanding our commercial real-estate loan sales and potentially originating
        credits with the intent to sell, rather than retain the loans in our portfolio.
        While the volume of commercial real-estate loans sold in the third quarter
        was
        modest, we would note that the volume does not reflect a decision to moderate
        our commercial real-estate loan sales. Instead, we still regard an increase
        in
        such sales as likely in the fourth quarter. 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 sales
        transactions.
  22
 
 Residential
        loan sale gains were little changed from the prior year, up $10,000 for the
        quarter and $7,000 for the nine months ended September 30, 2005, as the volume
        of loans sold increased 14% for the quarter and declined 14% compared to
        the
        same periods last year.
  **Service
        Fee Income**
 3Q
                  2005
              
              3Q
                  2004
              
              YTD
                  2005
              
              YTD
                  2004Consumer
                  Loans
              
              $
              314,000
              
              $
              69,000
              
              $
              955,000
              
              $
              157,000Commercial
                  Loans
              
              
              9,000
              
              
              19,000
              
              
              59,000
              
              
              47,000Residential
                  Loans
              
              
              (5,000
              )
              
              1,000
              
              
              (1,000
              )
              
              (1,000
              )Service
                  Fee Income
              
              $
              318,000
              
              $
              89,000
              
              $
              1,013,000
              
              $
              203,000
  For
        the
        quarter and nine months ended September 30, 2005, our total servicing fee
        income
        rose 258% and 401% over the levels earned in the same periods of 2004, based
        on
        substantial increases in fees earned on consumer loans sold to, and serviced
        for, other institutions. The growth in consumer loan service fees this year
        is
        largely attributable to a change made earlier this year to the amortization
        period assumed for the underlying servicing asset. Additional loan sales,
        particularly the larger sales last year and in the first quarter of this
        year,
        as well as corresponding growth in our portfolio of consumer loans serviced
        for
        others, contributed to the additional servicing income.
  Servicing
        assets are recorded when we sell loans to other investors and continue to
        service those loans following the sale. To determine the fair value of the
        servicing assets, we utilize a valuation model that calculates the present
        value
        of future cash flows for the loans sold, based on assumptions including market
        discount rates, anticipated prepayment speeds, estimated servicing cost per
        loan, and other relevant factors. These factors are subject to significant
        fluctuations, and the estimates used in the models are subject to review
        and
        revision based on actual experience and changes in expectations for the future.
        The calculated value of the servicing rights is then capitalized and amortized
        in proportion to, and over the period of, estimated future net servicing
        income.
  Based
        on
        a review of our assumptions in the first quarter of 2005, we determined that
        the
        amortization period for the servicing rights on our consumer loan servicing
        portfolio was significantly shorter than the term over which these loans
        would
        be expected to provide net servicing income. Consequently, we revised the
        amortization period such that the average life of the amortization schedule
        would correspond with the average life we are currently observing for the
        underlying loan portfolio. This resulted in a significant increase in our
        net
        servicing income. Note that any projection of servicing asset amortization
        in
        future periods is limited by the conditions that exist at the time the
        calculations are performed, and may not be indicative of actual amortization
        expense that will be recorded in future periods.
  The
        income received for servicing consumer loans has also grown as a result of
        our
        sales finance loan sales, particularly the larger sales last year and in
        the
        first quarter of this year, and the corresponding growth in our portfolio
        of
        consumer loans serviced for others. Based on our decision to reduce sales
        of
        consumer loans in the future and instead retain a greater percentage of
  23
  these
        loans within our portfolio, the rapid growth in fee income earned on the
        portfolio of serviced consumer loans in recent quarters is not expected to
        continue in future quarters.
  Fee
        income earned on our commercial loans serviced for others did not factor
        significantly in our total third quarter or year-to-date 2005 service fee
        income. As we expand our sales of commercial real estate loans, we would
        expect
        this income to grow and potentially become a significant percentage of total
        service fee income in the future. In contrast, residential loans are typically
        sold servicing released, which means we no longer service those loans once
        they
        are sold. Consequently, we do not view these loans as a significant source
        of
        servicing fee income.
  **Other
        Noninterest Income**
 3Q
                  2005
              
              3Q
                  2004
              
              YTD
                  2005
              
              YTD
                  2004Rental
                  Income
              
              $
              160,000
              
              $
              141,000
              
              $
              471,000
              
              $
              475,000Loan
                  Fees
              
              
              111,000
              
              
              159,000
              
              
              469,000
              
              
              268,000ATM/Wires/Safe
                  Deposit
              
              
              69,000
              
              
              52,000
              
              
              188,000
              
              
              139,000Late
                  Charges
              
              
              53,000
              
              
              45,000
              
              
              146,000
              
              
              118,000Miscellaneous
              
              
              61,000
              
              
              28,000
              
              
              176,000
              
              
              108,000Total
                  Other Noninterest Income
              
              $
              454,000
              
              $
              425,000
              
              $
              1,450,000
              
              $
              1,108,000
  For
        the
        third quarter, our noninterest income from sources other than those described
        earlier was little changed, totaling $454,000, or 7% over the same quarter
        last
        year. This represented a significant reduction from the double-digit
        year-over-year growth observed in the first and second quarters of 2005,
        as loan
        fees, and particularly prepayment fees, declined significantly from their
        third
        quarter 2004 levels.
  Through
        the first nine months of the year, the majority of the growth in other
        noninterest income could be attributed to loan fees, specifically prepayment
        fees. On a year-to-date basis, loan fees rose by $201,000 with prepayment
        fees
        increasing $147,000. For the third quarter, however, loan fees actually declined
        by $48,000 with prepayment fees down $64,000 from the same quarter last
        year.
  We
        believe that a flattening of the yield curve, which resulted from rising
        short-term interest rates and relatively static longer-term interest rates,
        contributed to the higher level of loan payoffs and prepayment fees observed
        from mid-2004 through the second quarter of 2005. As this flattening of the
        yield curve reduced the rate differential between short- and long-term financing
        costs, it provided a financial incentive for borrowers with short-term or
        adjustable-rate loans to refinance with long-term fixed rates. With prepayment
        fees declining in the third quarter, it is possible that, given the current
        interest rate environment, the majority of borrowers with a financial incentive
        to refinance and the inclination to do so may have already taken advantage
        of
        the opportunity presented by the flattened yield curve. If this is the case,
        and
        no movement conducive to additional refinance activity occurs in the yield
        curve, it is likely that the level of prepayment fees over the next few quarters
        will continue to decline relative to the same periods for the prior year.
        Given
        the uncertainties regarding interest rates and borrower
  24
  behaviors,
        however, we cannot predict the level of prepayment fees in future quarters
        with
        any reasonable degree of accuracy.
  **Noninterest
        Expense**
  **Salaries
        and Employee Benefits Expense**
  Salaries
        and benefits expense increased by $186,000, or 5%, to $3.7 million in the
        third
        quarter of 2005, accounting for approximately 34% of the overall increase
        in
        total noninterest expense. On a year-to-date basis, salaries and benefits
        expense increased by $1.8 million, or 18%, over the nine-month period ended
        September 30, 2004.
  3Q
                  2005
              
              3Q
                  2004
              
              YTD
                  2005
              
              YTD
                  2004Salaries
              
              $
              2,527,000
              
              $
              2,278,000
              
              $
              7,674,000
              
              $
              6,716,000Commissions
                  & Incentive Bonuses
              
              
              434,000
              
              
              541,000
              
              
              1,873,000
              
              
              1,315,000Employment
                  Taxes & Insurance
              
              
              189,000
              
              
              195,000
              
              
              751,000
              
              
              676,000Temporary
                  Office Help
              
              
              95,000
              
              
              69,000
              
              
              206,000
              
              
              152,000Benefits
              
              
              494,000
              
              
              470,000
              
              
              1,513,000
              
              
              1,349,000Total
                  Salary & Benefit Expenses
              
              $
              3,739,000
              
              $
              3,553,000
              
              $
              12,017,000
              
              $
              10,208,000
  Contributing
        to the increase in salary and benefit expense were our annual salary increases
        for existing staff in April 2005, as well as net growth in our
        full-time-equivalent (FTE) employee count from 214 a year ago to 221 FTE
        at the
        end of September 2005. However, while our third-quarter salary expense increased
        nearly 11% relative to the same quarter last year, on a sequential quarter
        basis
        it remained virtually unchanged from the second quarter. This followed a
        decline
        in our salary expense between the first and second quarters of 2005. The
        deferral of salary expenses related to loan originations has helped contain
        our
        salary expense over the last two quarters.
  In
        accordance with current accounting standards, certain loan origination costs
        are
        deferred and amortized over the life of each loan originated, rather than
        expensed in the current period. Expenses are then reported in the financial
        statements net of these deferrals. The amount of expense subject to deferral
        and
        amortization can vary from one period to the next based upon the number of
        loans
        originated, the mix of loan types, and year-to-year changes in “standard loan
        costs.” In this instance, the number of loans originated by our Income Property,
        Business Banking, Residential, and Sales Finance divisions in both the second
        and third quarters of 2005 exceeded the number of loans originated in the
        first
        quarter. Consequently, the amount of salary expense to be deferred and amortized
        in the second and third quarters exceeded the amount for the first quarter,
        reducing our net second and third quarter salary expense.
  Quarter
                  Ended
              FTE
                  at Quarter End
              Salaries
              Commissions
                  & Incentive
                BonusesJune
                  30, 2004
              201
              $
                  2,239,000
              $
                  441,000September
                  30, 2004
              214
              $
                  2,278,000
              $
                  541,000December
                  31, 2004
              220
              $
                  2,481,000
              $
                  855,000March
                  31, 2005
              219
              $
                  2,621,000
              $
                  511,000June
                  30, 2005
              218
              $
                  2,526,000
              $
                  927,000September
                  30, 2005
              221
              $
                  2,527,000
              $
                  434,000
  25
  A
        reduction in commission and incentive compensation expense offset some of
        the
        effect of the increase in salary expense relative to the third quarter of
        last
        year. For those personnel not participating in a specified commission or
        incentive compensation plan, we maintain a separate bonus pool, with accruals
        made to the pool at the end of each quarter based on our year-to-date
        performance. Based on our results through June 30, 2005, we accrued $426,000
        year-to-date. Inherent in this accrual was the assumption that our results
        for
        the remainder of the year would meet or exceed the outlook presented in our
        second-quarter press release. This did not materialize, as our net interest
        margin totaled 4.03% for the quarter, versus the forecasted 4.05% to 4.10%,
        for
        the reasons described above in the “Net Interest Income” section, and a
        reduction in loan sales resulted in our noninterest income coming in at the
        low
        end of our $1.1 million to $1.3 million range. As a result, at the end of
        the
        third quarter our year-to-date performance didn’t support the bonus that had
        been accrued. Consequently, for the third quarter, we made a reversal of
        $165,000, leaving a year-to-date balance of $261,000. As decisions regarding
        accruals to the bonus pool are made at or near the end of each quarter and
        based
        on our results for the year-to-date period, we cannot anticipate at this
        time
        what accrual, if any, is likely to be made for the fourth quarter.
  Increased
        commission expense paid to our Residential, Business Banking, and Income
        Property lending officers as well as our Banking Center personnel partially
        offset the reduction in the bonus pool accrued for non-commissioned staff.
        The
        increase in commission expense for our lending officers was attributable
        to the
        loan volumes originated in the third quarter, as incentive plans for lending
        officers tend to vary with the production of the business line.
  **Occupancy
        Expense**
  Occupancy
        expense increased $176,000, or 26% relative to the third quarter of last
        year,
        based primarily on higher depreciation expense, software licensing costs,
        and
        expenditures for computer equipment. For the nine months ended September
        30,
        2005, occupancy expenses increased $464,000, or 23%, from the same period
        in
        2004.
  3Q
                  2005
              
              3Q
                  2004
              
              YTD
                  2005
              
              YTD
                  2004Rent
                  Expense
              
              $
              82,000
              
              $
              76,000
              
              $
              241,000
              
              $
              237,000Utilities
                  & Maintenance
              
              
              154,000
              
              
              135,000
              
              
              483,000
              
              
              448,000Depreciation
                  Expense
              
              
              410,000
              
              
              341,000
              
              
              1,144,000
              
              
              974,000Other
                  Occupancy Costs
              
              
              205,000
              
              
              123,000
              
              
              616,000
              
              
              361,000Total
                  Occupancy Expenses
              
              $
              851,000
              
              $
              675,000
              
              $
              2,484,000
              
              $
              2,020,000
  Depreciation
        expense increased by $69,000 and $170,000 compared to the third quarter and
        first nine months of last year, largely as a result of capital expenditures
        made
        over the last 12 months for remodeling projects at several of our banking
        centers and our headquarters building, growth in our information systems
        infrastructure, and investment in enterprise software. We expect these costs
        to
        continue to rise in the remainder of 2005 as we complete our remaining
        remodeling projects, including work on our First Mutual Center headquarters
        building, and begin depreciating those new assets.
  26
  Other
        occupancy costs, which include items such as real estate and personal property
        taxes, the purchase of non-capitalized equipment, and software licensing,
        were a
        significant part of the overall increase in occupancy expense. For the third
        quarter of 2005, our computer equipment costs accounted for most of this
        category’s increase, rising $43,000 over the prior year, primarily as a result
        of non-capitalized equipment expenditures, including many associated with
        the
        relocation of several departments to recently remodeled areas of the First
        Mutual Center. Another factor contributing to the additional occupancy expenses
        this year was higher software licensing fees, which resulted from our licensing
        agreement with Microsoft. Relative to the same periods in 2004, software
        licensing costs increased by $33,000 for the quarter and $78,000 for the
        first
        nine months of the year.
  **Other
        Noninterest Expense**
  Other
        noninterest expense increased by $183,000, or 10% from the third quarter
        of last
        year, driven by greater expenditures for credit insurance premiums on our
        sales
        finance loans, marketing, office supplies, and loan processing expenses.
        Partially offsetting these increases were reductions in expenditures for
        legal
        fees and information systems related items. For the nine-month period ending
        September 30, 2005, other noninterest expense increased by $598,000, or 11%,
        over the same nine-month period in 2004.
  3Q
                  2005
              
              3Q
                  2004
              
              YTD
                  2005
              
              YTD
                  2004Marketing
                  & Public Relations
              
              $
              353,000
              
              $
              297,000
              
              $
              1,056,000
              
              $
              885,000Credit
                  Insurance
              
              
              365,000
              
              
              280,000
              
              
              1,043,000
              
              
              782,000Outside
                  Services
              
              
              162,000
              
              
              145,000
              
              
              514,000
              
              
              462,000Taxes
              
              
              137,000
              
              
              120,000
              
              
              363,000
              
              
              355,000Information
                  Systems
              
              
              232,000
              
              
              261,000
              
              
              705,000
              
              
              760,000Other
              
              
              795,000
              
              
              758,000
              
              
              2,458,000
              
              
              2,297,000Total
                  Other Noninterest Expenses
              
              $
              2,044,000
              
              $
              1,861,000
              
              $
              6,139,000
              
              $
              5,541,000
  The
        most
        significant growth in the third quarter’s other noninterest expense was observed
        in our credit insurance expense, which increased $85,000 relative to the
        third
        quarter of 2004. For the year-to-date period, our credit insurance expense
        rose
        $261,000, or 33%, based on growth in the balances of insured sales finance
        loans, including both the loans in our portfolio as well as those serviced
        for
        other institutions. We expect this expense to continue to increase in the
        future
        based on continued portfolio growth, as well as an agreement recently negotiated
        with a second insurer (Insurer #2). Per this agreement, Insurer #2 will not
        only
        offer credit insurance on future loan originations, but also supplemental
        insurance on a seasoned pool of loans already insured by our existing insurer
        (Insurer #1). As this represents additional insurance expense on an existing
        pool of loans, this is expected to increase our insurance cost by an estimated
        $75,000 in the fourth quarter prior to any expense associated with new
        originations. As Insurer #2’s pricing and underwriting are very similar to those
        of Insurer #1, we do not expect that the choice of insurer will impact the
        cost
        of insurance on future loan originations. Please refer to the “Sales Finance
        (Home Improvement) Loans” commentary in the “Portfolio Information” section for
        further information.
  Advertising
        expenses, which represent the majority of our marketing and public relations
        expenses, rose by $53,000, or 21% in the third quarter, and $156,000, also
        21%,
        on a year-to-
  27
  date
        basis relative to the same periods in 2004. The growth in these expenses
        can be
        attributed to an increase in radio and local newspaper advertising.
  While
        expenditures for forms and office supplies increased by $46,000, or 61% relative
        to the third quarter of 2004, this variance is largely attributable to
        differences in the timing of purchases, as year-to-date expenditures were
        up
        only 9%.
  Loan
        processing costs included in the “other” noninterest expense category also
        contributed to the growth in noninterest expense, rising $35,000 for the
        quarter
        and $113,000 on a year-to-date basis compared to the prior year. As with
        salaries, loan processing costs are another category of expense subject to
        deferral and capitalization of loan origination costs, and the majority of
        the
        increase was attributable to a reduction in the amount of expenses deferred
        compared to 2004. The amount of processing expense eligible for deferral
        for
        several loan types, most notably custom construction loans, declined relative
        to
        last year. This caused our net expenses to rise substantially as we were
        unable
        to defer and amortize as much of these costs as we did in 2004.
  Reductions
        in our information systems expenses and legal costs from the third quarter
        last
        year helped offset some of the increases in other noninterest expense
        categories. For the third quarter and year-to-date periods, information systems
        expenses fell $29,000 and $55,000, or 11% and 7%, compared to the same periods
        last year, based largely on a rate reduction for 2005 following negotiations
        with our core service provider late last year. Additionally, legal expenses
        were
        down $25,000, or 30% for the quarter and $76,000, or 22% for the nine months
        ended September 30, 2005. These reductions were attributable to lower levels
        of
        expenditures in our sales finance and general corporate operations compared
        to
        the third quarter of last year, as well as declines in spending by our business
        banking and direct consumer lending operations earlier in the year.
 
 **REVIEW
        OF FINANCIAL CONDITION**
 
 **Assets**
 
 Through
        the first three quarters of 2005, our assets increased 6%, totaling $1,063
        million at the September 30, 2005 quarter-end, up from $1,004 million at
        the
        2004 year-end, based primarily on growth in our loan portfolio.
 
 **Securities**
 
 Security
        investments (available-for-sale and held-to-maturity) declined from their
        level
        as of the 2004 year-end, decreasing nearly $10 million over the last nine
        months, to approximately $122 million as of September 30, 2005. Consequently,
        we
        anticipate securities purchases in an amount between $5 million and $15 million
        in the fourth quarter to replace the year-to-date and expected fourth-quarter
        portfolio run-off.
 
 We
        classify investment securities in one of the following categories: 1) trading,
        2) available-for-sale, or 3) held-to-maturity. Securities classified as
        available-for-sale are reviewed regularly, and any unrealized gains or losses
        are recorded in the shareholders’ equity account. Generally, falling interest
        rates will increase the amount recorded as unrealized gain, and rising rates
        will decrease any unrealized gains, as the market value of securities inversely
        adjusts to the change in interest rates.
 
 28
  **Loans**
 
 Net
        loans
        receivable, including loans held-for-sale, increased by $54 million from
        $809
        million at the 2004 year-end to $863 million at the end of the third quarter,
        as
        loan originations increased 24% over the third quarter of last year to $151
        million. Income property loans accounted for 36% of our loan portfolio at
        the
        end of the third quarter, down 4% relative to the 2004 year-end and down
        from
        42% as of September 2004. Business banking loans totaled 13% of the loan
        portfolio, unchanged compared to the 2004 year-end and 2% higher than a year
        ago, while commercial construction loans remained unchanged at 3% of loans.
        Single-family mortgage loans, generally non-conforming and including loans
        held-for-sale, increased to 25% of the portfolio at quarter-end, compared
        to 21%
        at the end of the third quarter last year and 22% as of the 2004 year-end.
        Single-family construction loans remained relatively consistent and accounted
        for 11% of total loans for this quarter and for the third quarter last year.
        Single-family construction loans at year end 2004 were slightly lower at
        10%.
        Consumer loans, largely home-improvement loans originated on a national scale
        through the Sales Finance Division, remained at 12% of the loan portfolio
        for
        the quarter, which was unchanged compared to the prior year’s third quarter and
        year-end.
 
 When
        taking into account our expected production volumes, payoffs, and loan sales
        for
        all lending divisions, we expect loan growth in the range of $10-$15 million
        for
        the fourth quarter of 2005. The anticipated increase in commercial loan sales
        is
        projected to offset loan growth in the other business lines.
 
 **Servicing
        Assets**
 
 Servicing
        assets grew by $447,000 or 29%, in the nine-month period ended September
        30,
        2005. In the first quarter of this year, most of the growth in our servicing
        assets was attributable to large sales of consumer loans originated by our
        Sales
        Finance lending area. In the second and third quarters of 2005, however,
        sales
        of these loans fell significantly relative to prior quarters after we revised
        our loan sales strategy and decided to substantially reduce our consumer
        loan
        sales, selling only sufficient volumes to ensure the continuity of the market.
        This strategy may be reevaluated and subject to further modification based
        on
        factors including, but not limited to future loan production and/or market
        conditions.
 
 Historically,
        the commercial real estate loans we originate have been retained in our
        portfolio, and sales of participations in these loans have been utilized
        to
        limit our aggregate credit exposure to specific borrowers. In our second-quarter
        press release, however, we noted that we had experienced increased interest
        in,
        and opportunities for, sales of participations in our commercial real estate
        loans. Consequently, we added that we were considering the merits of expanding
        our commercial real estate loan sales and potentially originating credits
        with
        the intent to sell, rather than retain the loans in our portfolio. While
        the
        volume of commercial real-estate loans sold in the third quarter was modest,
        we
        would note that the volume does not reflect a decision against expanding
        our
        commercial real-estate loan sales. Instead, we still regard an increase in
        such
        sales as likely in the fourth quarter. 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 sales
        transactions.
 
 29
  Servicing
        assets represent the deferred servicing rights generated from sales of loans
        that are sold servicing retained, offset by the amortization and prepayments
        of
        loans serviced, as well as any impairment charges that may occur. Although
        the
        increases in servicing assets have not been a major factor in our overall
        asset
        growth, this area is expected to continue increasing with the anticipated
        future
        sales of commercial loans.
 
 **Liabilities**
 
 In
        the
        first nine months of this year, our total deposit balances rose 8% from their
        year-end levels, totaling nearly $728 million at the end of the third quarter,
        with our time deposit balances up more than $56 million. Our checking and
        money
        market balances, however, had declined approximately $4 million from their
        2004
        year-end level. In the first quarter, we observed a migration of balances
        from
        these accounts to time deposits, as rates on time deposits had risen while
        money
        market rates had remained relatively stable. This resulted in time deposits
        becoming more attractive, and made it more difficult to retain or grow checking
        and money market balances without incurring exorbitant marginal expense to
        do
        so, as any rate increases would apply not only to any newly opened accounts,
        but
        all existing balances as well. By the end of the first quarter, our checking
        and
        money market balances had declined approximately $12 million. In the second
        quarter, the migration appeared to have abated, as checking and money market
        balances grew $11 million, or 5%, nearly returning to their year-end level.
        In
        the third quarter, however, some of our competitors began offering deposit
        rates
        that threatened our ability to retain deposit balances. As a result, we were
        forced to offer a promotional time deposit rate and increase our non-maturity
        deposit rates in late August. Despite the increased rates on our money market
        accounts and the greater liquidity offered by these deposits, many customers
        found the promotional time deposit rate more attractive than money market
        products. Consequently, following continued growth in July, checking and
        money
        market balances began declining, ending the third quarter approximately $4
        million below the 2004 year-end level, and currently appear to be exhibiting
        a
        relatively sideways movement with considerable volatility.
 
 Utilization
        of FHLB advances, our preferred supplemental funding mechanism, remained
        little
        changed from the year-end, rising less than $2 million to nearly $236 million
        for the September 30, 2005 quarter-end, as the deposit growth described above,
        along with retained earnings largely supported our asset growth. As of September
        30, 2005, we had the authority to borrow up to a total of nearly $425 million
        in
        FHLB advances, subject to sufficient collateral to support those
        advances.
  **ASSET
        QUALITY**
 
 **Provision
        and Reserve for Loan Loss**
  The
        third
        quarter’s provision for reserve for loan losses, which was approved by the Audit
        Committee of the Board of Directors, totaled $325,000, representing a
        significant decline from the third quarter 2004 level of $525,000. On a
        year-to-date basis, however, the provision was little changed at slightly
        less
        than $1.2 million. The provision for loan losses reflects the amount deemed
        appropriate to produce an adequate reserve for possible loan losses inherent
        in
        the risk characteristics of the loan portfolio. In determining the appropriate
        reserve balance, we consider the amount and type of new loans added to the
        portfolio, our level of non-performing loans, the amount of loans charged
        off,
        and the economic conditions in which we currently operate.
  30
  The
        provision taken for the third quarter was attributable to the inherent risks
        identified in the portfolio. Net portfolio loans totaled $842 million as
        of
        September 30, 2005, an increase of 8% from $777 million at the end of September
        last year. Also affecting the level of our reserve for loan losses were our
        net
        loan charge-offs, which totaled $173,000 for the quarter, down significantly
        from the $233,000 level for the same quarter last year. On a sequential
        quarterly basis, the charge-offs totaled $231,000 in the previous quarter
        and
        $211,000 in the first quarter of 2005. Due to their unique characteristics,
        our
        consumer loans comprise the bulk of our loan write-offs, though they only
        constitute approximately 12% of the total loan portfolio. This pattern of
        consumer loans representing the largest category of charge-offs is generally
        consistent with the trends that we have experienced in prior years.
 
 Our
        non-performing assets declined from $1,000,000 at September 2004 to $635,000
        at
        the September 2005 quarter-end. The current level of non-performing assets
        also
        improved relative to the year-end 2004 level of $1,007,000. The ratio of
        non-performing assets to total assets was 0.06% as of September 30, 2005,
        which
        compared to 0.10% at both the 2004 year-end and September 30, 2004. By
        comparison, the annualized ratio for all FDIC insured institutions as of
        June
        30, 2005 totaled 0.48%.*
 
 *
        FDIC
        Quarterly Banking Profile, Second Quarter 2005
 
 Noted
        below is a summary of our exposure to non-performing loans and repossessed
        assets as of September 30, 2005:
  Eighty-six
                  consumer loans. Full recovery anticipated from insurance
                  claims.
              
              $
              401,000One
                  single-family residential loan in Western WA. Possible loss of
                  $50,000.
              
              
              125,000Twelve
                  consumer loans. Possible loss of $76,000.
              
              
              76,000One
                  residential land loan in Eastern WA. No anticipated loss.
              
              
              29,000One
                  consumer loan. No anticipated loss.
              
              
              2,000TOTAL
                  NON-PERFORMING LOANS
              
              $
              633,000TOTAL
                  REAL ESTATE OWNED AND REPOSSESSED ASSETS
              
              
              2,000TOTAL
                  NON-PERFORMING ASSETS
              
              $
              635,000
  **PORTFOLIO
        INFORMATION**
  **Commercial
        Real Estate Loans** ****
  The
        average loan size (excluding construction loans) in the Commercial Real Estate
        portfolio was $722,000 as of September 30, 2005, with an average loan-to-value
        ratio of 63% (based upon the appraised value at origination or subsequent
        appraisal, if applicable). At quarter-end, none of these commercial loans
        were
        delinquent for 30 days or more. Small individual investors or their limited
        liability companies and business owners typically own the properties securing
        these loans. At quarter-end, the portfolio was 48% residential (multi-family
        or
        mobile home parks) and 52% commercial.
  The
        loans
        in our commercial real-estate portfolio are well diversified, secured by
        small
        retail shopping centers, office buildings, warehouses, mini-storage facilities,
        restaurants and gas stations,
  31
  as
        well
        as other properties classified as general commercial use. To diversify our
        risk
        and to continue serving our customers, we sell participation interests in
        some
        loans to other financial institutions. About 11% of commercial real-estate
        loan
        balances originated by the Bank have been sold in this manner. We continue
        to
        service the customer’s loan and are paid a servicing fee by the participant.
        Likewise, we occasionally buy an interest in loans originated by other lenders.
        About $13 million of the portfolio, or 4%, has been purchased in this
        manner.
  **Sales
        Finance (Home Improvement) Loans** ****
  Loan
        production was $18 million in the third quarter and $54 million in the first
        nine months of 2005. The portfolio balance of Sales Finance loans increased
        by
        $7 million to $81 million. Prepayment speeds continue to remain in a range
        of
        between 30% and 40%.
  **Bank
                  Portfolio Balance**
              **Servicing
                  Balance**
              **Insured
                  Balance (Bank Portfolio and**
                **Servicing
                  Balance)**September
                  30, 2004
              $68
                  million
              $31
                  million
              $45
                  millionDecember
                  31, 2004
              $69
                  million
              $37
                  million
              $48
                  millionMarch
                  31, 2005
              $67
                  million
              $44
                  million
              $50
                  millionJune
                  30, 2005
              $74
                  million
              $45
                  million
              $53
                  millionSeptember
                  30, 2005
              $81
                  million
              $43
                  million
              $54
                  million
  During
        the third quarter of 2005, the average new loan amount was $10,200. The average
        loan balance in the entire portfolio is $9,200. The yield on this portfolio
        is
        10.39%. Loans with credit insurance in place represent 40% of the Bank’s
        portfolio balance, and 34% (by balance) of the loans originated in the third
        quarter were insured.
  **UNINSURED
                  PORTFOLIO - BANK BALANCES****Bank
                  Balance**
              **Net
                  Charge-Offs**
              **Charge-offs**
                **(%
                  of Bank portfolio)**
              **Delinquent
                  Loans**
                **(%
                  of Bank Portfolio)**September
                  30, 2004
              $40
                  million
              $
                  71,000
              0.18%
              0.75%December
                  31, 2004
              $41
                  million
              $100,000
              0.24%
              0.66%March
                  31, 2005
              $40
                  million
              $141,000
              0.35%
              0.62%June
                  30, 2005
              $44
                  million
              $
                  147,000
              0.33%
              0.77%September
                  30, 2005
              $48
                  million
              $
                  98,000
              0.21%
              1.20%
  **INSURED
                  PORTFOLIO - BANK AND INVESTOR LOANS****Claims
                  Paid**
              **Claims
                  (% of Insured Balance)**
              **Delinquent
                  Loans**
                **(%
                  of Bank Portfolio)**September
                  30, 2004
              $265,000
              0.64%
              2.11%December
                  31, 2004
              $492,000
              1.06%
              2.58%March
                  31, 2005
              $516,000
              1.05%
              2.75%June
                  30, 2005
              $359,000
              0.70%
              3.23%September
                  30, 2005
              $483,000
              0.89%
              3.64%
  As
        of
        September 30, 2005, the total Sales Finance portfolio was $81 million, of
        which
        $33 million was insured and $48 million was uninsured. The uninsured portfolio,
        which has an average credit
  32
  score
        of
        737, has experienced consistent and reasonably acceptable loan losses as
        a
        percent of the portfolio during the last five quarters, ranging from 0.18%
        to
        0.35%. The insured portfolio, which has an average credit score of 671, has
        not
        performed as well. Losses incurred in that portfolio are submitted to our
        credit
        insurers for reimbursement, and the claims experience in the last 12 months
        has
        ranged between 0.64% and 1.06% of insured balances. The delinquency rates
        on the
        insured portfolio have ranged between 2.11% and 3.64% of insured balances
        during
        the last five quarters.
  Until
        recently, the Bank maintained a relationship with a single credit insurance
        company (Insurer #1). Insurer #1 provided credit insurance on Sales Finance
        loans as well as insurance on a small number of home equity products. In
        August
        2005, the Bank entered into an agreement with another credit insurance company
        (Insurer #2), providing similar insurance products with very similar
        underwriting and pricing terms as Insurer #1.
  With
        two
        insurers in place, the Bank began to split the Sales Finance loans requiring
        insurance between the two insurers (see table below). In October of 2005,
        the
        Bank and Insurer #1 did not reach agreement on the pricing of insurance for
        loans originated after October 1, 2005. Therefore, effective on that date,
        all
        newly insured loans will be insured by Insurer #2. This decision does not
        affect
        the pricing or coverage in place on loans currently insured with Insurer
        #1. The
        Bank continues to have a relationship with Insurer #1 for home equity loan
        products.
  In
        addition to purchasing insurance from Insurer #2 on a prospective basis,
        the
        Bank has also purchased back-up insurance from Insurer #2 on loans that are
        currently also insured by Insurer #1, and that were originated during the
        2002/2003 policy year (adding $1.07 million in additional coverage). Our contract with both insurers provides them with a
        maximum exposure limit of 10% of the loan balances insured in each policy
        year.  In the event that Insurer #1’s maximum exposure limit on the
        2002/2003 policy year is exhausted, Insurer #2 will provide credit insurance
        coverage on the remaining loans in that pool subject to policy limitations
        (see
        table below). We took additional insurance because the loans in the 2002/2003
        policy year have not performed to expectations. We recognized this trend
        in 2004
        and, in response, tightened our underwriting approval criteria. The performance
        of the loans in the 2003/2004 and 2004/2005 policy years appear to positively
        reflect these changes. The following table shows the standing of each policy
        year for each insurer as of September 30, 2005.
  **Insurer
        #1**
 **Current**
                **Original**
                
                **Remaining**
                **Limit
                    as % of**
                **Current****Policy**
                **Loans**
                **Loan**
                **Loss**
                **Claims**
                **Loss**
                **Remaining**
                **Delinquency****Year***
                **Insured**
                **Balance**
                **Limit**
                **Paid**
                **Limit**
                **Balance**
                **Rate**2002/2003
                $21,442,000
                $10,439,000
                $2,144,000
                $1,696,000
                $448,000
                4.29%
                5.68%2003/2004
                $35,242,000
                $21,759,000
                $3,524,000
                $1,168,000
                $2,356,000
                10.83%
                5.27%2004/2005
                $23,964,000
                $20,306,000
                $2,396,000
                $64,000
                $2,332,000
                11.48%
                2.27%
  *
            Policy
            years close on 9/30 of each year
 33
  **Insurer
        #2**
 **Current**
                **Original**
                
                **Remaining**
                **Limit
                    as % of**
                **Current****Policy**
                **Loans**
                **Loan**
                **Loss**
                **Claims**
                **Loss**
                **Remaining**
                **Delinquency****Year**
                **Insured**
                **Balance**
                **Limit**
                **Paid**
                **Limit**
                **Balance**
                **Rate**2002/2003*
                $10,768,000
                $10,439,000
                $1,077,000
                $0
                $1,077,000
                10.32%
                5.68%2005/2006**
                $1,957,000
                $1,898,000
                Not
                    Applicable
                $0
                Not
                    Applicable
                Not
                    Applicable
                0.00%
  *
            Loans
            in this policy year are the same loans insured with Insurer #1 during
            the same
            time period. **Policy year closes on 7/31 of each year
 **Residential
          Lending**
  The
        residential lending portfolio (including loans held for sale) totaled $297
        million on September 30, 2005. The breakdown of that portfolio is as
        follows:
  **Bank
                  Balance**
              
              **%
                  of Portfolio**Adjustable
                  rate permanent loans
              
              $
              167
                  million
              
              
              56%Fixed
                  rate permanent loans
              
              $
              5
                  million
              
              
              2%Residential
                  building lots
              
              $
              35
                  million
              
              
              12%Disbursed
                  balances on custom construction loans
              
              $
              83
                  million
              
              
              28%Loans
                  held-for-sale
              
              $
              7
                  million
              
              
              2%Total
              
              $
              297
                  million
              
              
              100%
  The
        portfolio has performed in an exceptional manner, and currently has only
        three
        loans, or 0.28% of loan balances, that are delinquent more than one payment.
  The
        average loan balance in the permanent-loan portfolio is $195,000, and the
        average balance in the building lot portfolio is $113,000. Owner-occupied
        properties constitute 67% of the loan balances. Our portfolio program
        underwriting is typically described as non-conforming. The portfolio generally
        consists of loans that, for a variety of reasons, are not readily salable
        in the
        secondary market at the time of origination. The yield earned on the portfolio
        is generally much higher than the yield earned on a more typical “conforming
        underwriting” portfolio. We underwrite the portfolio permanent loans by focusing
        primarily on the borrower’s good or excellent credit and our overall exposure on
        the loan. We manually underwrite all loans and review the loans for compensating
        factors to offset the non-conforming elements of those loans.
  On
        September 30, 2005, we had $10.6 million of loans in the portfolio that had
        “interest only” payment plans until their first interest rate change date (at
        which time the loan converts to normal amortizing payments). This represents
        about 6% of the permanent residential lending portfolio. The loans with the
        interest-only feature are underwritten using a payment of full principal
        and
        interest in the calculation of monthly debts. This insures that loans are
        not
        made to borrowers who only qualify due to the interest-only payment feature
        on
        the loan. Although we believe that those loans are well underwritten, and
        to
        date our experience with those loans has been favorable, we made the decision
        to
        sell a majority of these loans to other investors. We have a sale pending
        of
        approximately $7.8 million of the loans for tentative settlement in November.
        We
        do not originate an “Option ARM” product, where borrowers are given a variety of
        monthly payment options that allow for the possibility of negative
        amortization.
  34
 
 As
        of
        September 30, 2005, we held about $2.4 million of low-documentation permanent
        residential loans on our books. We also held about $8.3 million in disbursed
        balances (and another $10.9 million in additional commitments) on
        low-documentation custom construction loans. These loans allow lower levels
        of
        documentation verifying a borrower’s income or assets. Through a combination of
        the borrower’s equity in the property and the purchase of mortgage insurance on
        each individual loan, all low-documentation loans have a loan-to-value of
        no
        more than 70% exposure to the Bank. Until such time as we have an established
        track record with the performance of low-documentation residential mortgages,
        we
        have set an internal limit of 1% of the Bank’s loan portfolio (approximately $9
        million). Due to unexpected demand for this product during the third quarter,
        that limit has been exceeded. In response to this demand, we have raised
        the
        pricing on low-documentation custom construction loans and have begun to
        explore
        the sale of low-documentation loans to other investors. We believe that the
        successful implementation of these measures over time will bring the portfolio
        balances of low-documentation loans below the internal limit.
  **Portfolio
        Distribution**
  The
        loan
        portfolio distribution at the end of the third quarter was as
        follows:
  Single
                    Family (including loans held-for-sale)
                25%Income
                    Property
                36%Business
                    Banking
                13%Commercial
                    Construction
                3%Single
                    Family Construction:Spec
                1%Custom
                10%Consumer
                12%
 
 Adjustable-rate
        loans accounted for 88% of our total portfolio.
  **DEPOSIT
        INFORMATION**
  The
        number of business checking accounts increased by 16%, from 1,877 at September
        30, 2004, to 2,182 as of September 30, 2005, a gain of 305 accounts. The
        deposit
        balances for those accounts grew 40%. Consumer checking accounts also increased,
        from 6,546 in the third quarter of 2004 to 7,350 this year, an increase of
        804
        accounts, or 12%. Our total balances for consumer checking accounts rose
        13%.
  The
        following table shows the distribution of our deposits.
  Time
                  Deposits
              Checking
              Money
                  Market Accounts
              SavingsSeptember
                  30, 2004
              63%
              13%
              23%
              1%December
                  31, 2004
              61%
              14%
              24%
              1%March
                  31, 2005
              64%
              13%
              22%
              1%June
                  30, 2005
              64%
              14%
              21%
              1%September
                  30, 2005
              65%
              14%
              20%
              1%
 
 35
  **BUSINESS
        SEGMENTS**
 
 The
        management reporting process measures the performance of the operating segments
        based on the management structure of the Bank and is not necessarily comparable
        with similar information for any other financial institution.
 
 The
        reportable segments include the following:
 
 ·
              Consumer
                  Lending - Consumer lending includes home equity lending, direct
                  consumer
                  loans, and indirect home improvement loans (Sales Finance). These
                  loans
                  include lines of credit and loans for primarily consumer purposes.
 
 ·
              Residential
                  Lending - Residential lending offers loans to borrowers to purchase,
                  refinance, or build homes secured by one-to-four-unit family dwellings.
                  They also finance the purchase or refinance of buildable residential
                  lots.
 
 ·
              Business
                  Banking Lending - Business Banking offers a full range of banking
                  services
                  to small and medium size businesses including deposit and cash
                  management
                  products, loans for financing receivables, inventory, equipment
                  as well as
                  permanent and interim construction loans for commercial real estate.
                  The
                  underlying real estate collateral or business asset being financed
                  typically secures these loans.
 
 ·
              Income
                  Property Lending - Income Property Lending offers permanent and
                  interim
                  construction loans for multifamily housing (over four units), manufactured
                  housing communities, commercial real estate properties, and spec
                  single-family construction. The underlying real estate collateral
                  being
                  financed typically secures these
                  loans.
 
 Each
        of
        these business segments also sells loans into the secondary market. We may
        choose to retain or sell the right to service the loans sold (i.e. collection
        of
        principal and interest payments) depending upon market conditions.
 
 These
        segments are managed separately because each business unit requires different
        processes and different marketing strategies to reach the customer base that
        purchases the products and services. The segments derive a majority of their
        revenue from interest income, and we rely primarily on net interest revenue
        in
        managing these segments. No single customer provides more than 10% of the
        Bank’s
        revenues.
 
 **Consumer
        Lending**
 
 Quarter
                  Ended
              
              Nine
                  Months EndedNet
                  Income
              
              Return
                  on Equity
              
              Net
                  Income
              
              Return
                  on EquitySeptember
                  30, 2003
              
              $
              51,000
              
              
              3.12
              %
              $
              (70,000
              )
              
              (1.63
              %)September
                  30, 2004
              
              $
              416,000
              
              
              18.34
              %
              $
              985,000
              
              
              15.83
              %September
                  30, 2005
              
              $
              414,000
              
              
              16.24
              %
              $
              928,000
              
              
              13.19
              %
 
 Net
        income for the Consumer Lending segment totaled $414,000 and $928,000 for
        the
        quarter and nine months ended September 30, 2005, virtually unchanged for
        the
        quarter and down 6% on
  36
  a
        year-to-date basis relative to the comparable 2004 results. For the quarter,
        improvement in the segment’s net interest income was offset by a reduction in
        noninterest income and rising noninterest expense. On a year-to-date basis,
        the
        decline was attributable to rising noninterest expense more than offsetting
        modest growth in net interest income and a significant increase in noninterest
        income.
 
 The
        Consumer segment’s earning assets totaled nearly $124 million as of September
        30, 2005, an increase of almost 10% over the prior year level. This represented
        a significant reduction from the 21% earning asset growth achieved between
        September 30, 2003 and 2004. The decline in asset growth can be attributed
        to a
        combination of a reduction in originations of our sales finance (home
        improvement) loans relative to last year, as well as some large volumes of
        loan
        sales, particularly in the first quarter of 2005. With the modest earning
        asset
        growth relative to the prior year, and the primarily fixed-rate nature of
        the
        loans in the portfolio, the Consumer Lending segment’s interest income increased
        approximately 12% for both the quarter and nine months ended September 30,
        2005
        relative to the same periods in 2004.
 
 By
        comparison, interest expense rose 9% and 32% relative to the quarter and
        nine
        months ended September 30, 2004, based on increases in the retail deposit
        and
        wholesale funding rates, as well as the cost of the additional funds required
        to
        support the growth in earning assets. Overall, the Consumer segment’s net
        interest income rose approximately $225,000 and $207,000 from the levels
        in the
        third quarter and first nine months of 2004. Following a reduction in the
        provision for loan loss of $9,000 for the third quarter, and an increase
        of
        $32,000 on a year-to-date basis, the segment’s net interest income after
        provision increased $234,000 and $175,000 relative to the same periods in
        2004.
 
 The
        segment’s third-quarter noninterest income declined 11% relative to the prior
        year, attributable largely to a significant reduction in loan sale volumes.
        On a
        year-to-date basis, however, noninterest income exceeded the prior year level
        by
        $662,000, an increase of approximately 50%. Growth in service fee income
        contributed significantly to the year-to-date increase in noninterest income,
        and helped offset the reduced level of gains on loan sales in the third
        quarter.
 
 As
        we
        noted in our second-quarter press release, in the second quarter of this
        year we
        made a significant change in our strategy regarding sales of consumer loans.
        Previously, our plan had been to sell approximately $6 million to $8 million
        in
        sales finance loans each quarter, though actual sales in a given quarter
        could
        fall above or below this range depending on loan production, market conditions,
        and other factors. In the second quarter, we elected to change this strategy
        and
        substantially reduce our sales of these loans, selling only sufficient volumes
        to ensure the continuity of the market. Accordingly, our third-quarter loan
        sales were well below those for the same period last year. While the reduction
        in gains on sales negatively impacted our noninterest income in the current
        period, reducing our sales of consumer loans allows us to retain a greater
        volume of these higher-yielding assets within our portfolio. Additionally,
        although no changes to this plan are anticipated at this time, this strategy
        may
        be reevaluated in the future and subject to further modification based on
        factors including, but not limited to, future loan production and/or market
        conditions.
 
 Despite
        the reduction in sales volume, consumer loan sales remained the largest
        contributor to our loan sale gains, with gains of $118,000 in the third quarter.
        While this represented a 73% decline from the gains realized in the third
        quarter of 2004, our pricing and execution improved relative to last year,
        as
        the volume of loans sold declined 80% to $2.2 million, versus $11.0
  37
  million
        in the same quarter last year. Similarly, through the first nine months of
        2005,
        gains on consumer loan sales declined $155,000, or 16%, while the volume
        of
        loans sold fell 32%, from $26.3 million to $17.9 million.
 
 Servicing
        fees earned on the consumer loans serviced for others totaled $314,000 and
        $955,000 for the quarter and nine months ended September 30, 2005, up from
        $69,000 and $157,000 for the same periods in 2004. This increase in consumer
        loan service fees was attributable in large part to a change in the amortization
        period assumed for the underlying servicing asset.
 
 Servicing
        assets are recorded when we sell loans from our portfolio to other investors
        and
        continue to service those loans for the investors following the sale. To
        determine the fair value of the servicing assets, we utilize a valuation
        model
        that calculates the present value of future cash flows from the loans sold
        based
        on assumptions which include market discount rates, anticipated prepayment
        speeds, estimated servicing cost per loan, and other relevant factors. These
        factors are subject to significant fluctuations, and the estimates used in
        the
        models are subject to review and revision based on actual experience and
        changes
        in expectations for the future. The calculated value of the servicing rights
        is
        then capitalized and amortized in proportion to, and over the period of,
        estimated future net servicing income.
 
 Based
        on
        a review of our assumptions in the first quarter of 2005, we determined that
        the
        amortization period for the servicing rights on our consumer loan servicing
        portfolio was significantly shorter than the term over which these loans
        would
        be expected to provide net servicing income. Consequently, we revised the
        amortization period such that the average life of the amortization schedule
        would correspond with the average life we are currently observing for the
        underlying loan portfolio.
 
 Any
        projection of servicing asset amortization in future periods is limited by
        the
        conditions that existed at the time the calculations were performed, and
        may not
        be indicative of actual amortization expense that will be recorded in future
        periods.
 
 For
        the
        third quarter of 2005, the Consumer Lending segment’s noninterest expense
        increased $170,000, or 11% compared to the prior year, with the most significant
        growth observed in our credit insurance expense based on growth in the balances
        of insured sales finance loans, including both the loans in our portfolio
        as
        well as those serviced for other institutions. We expect this expense to
        continue to increase in the future based on continued portfolio growth, as
        well
        as an agreement recently negotiated with a second insurer (Insurer #2). Per
        this
        agreement, Insurer #2 will not only offer credit insurance on future loan
        originations, but also supplemental insurance on a seasoned pool of loans
        already insured by our existing insurer (Insurer #1). As this represents
        additional insurance expense on an existing pool of loans, this is expected
        to
        increase our insurance expense by an estimated $75,000 in the fourth quarter
        prior to any expense associated with new originations. As Insurer #2’s pricing
        and underwriting are very similar to those of Insurer #1, we do not expect
        that
        the choice of insurer will impact the cost of insurance on future loan
        originations.
 
 Also
        contributing to the increase in costs relative to the prior year was a reduction
        in the Consumer segment’s FAS 91 benefit. In accordance with current accounting
        standards, certain costs associated with loan origination are deferred and
        amortized over the life of each loan originated, rather than expensed in
        the
        current period. Expenses are then reported in the financial statements net
        of
        these deferrals. The amount of expense subject to deferral and amortization
        can
        vary from one period to the next based upon the number of loans originated,
        the
        mix of loan
  38
  types,
        and year-to-year changes in “standard loan costs.” In this instance, fewer sales
        finance loans were originated this year compared to last, and the standard
        cost
        associated with each sales finance loan originated in 2005 was lower than
        the
        comparable figure for 2004. Consequently, the amount of noninterest expense
        to
        be deferred and amortized this year declined relative to 2004, resulting
        in a
        higher level of noninterest expense in 2005.
  For
        the
        nine months ended September 30, 2005, noninterest expense increased $922,000,
        or
        22% relative to the prior year. In addition to the increased credit insurance
        premium expense and reduced FAS 91 benefits described above, administrative
        and
        support costs allocated to this segment contributed to the additional expense.
        Included in these allocated costs are expenses related to our Consumer Loan
        Administration and Asset Management departments. The Consumer Loan
        Administration and Asset Management expenses allocated to this segment have
        risen based on the increased efforts required to manage the growing sales
        finance portfolio, including those loans serviced for others.
 
 **Residential
        Lending**
 
 Quarter
                  Ended
              
              Nine
                  Months EndedNet
                  Income
              
              Return
                  on Equity
              
              Net
                  Income
              
              Return
                  on EquitySeptember
                  30, 2003
              
              $
              537,000
              
              
              27.83
              %
              $
              1,437,000
              
              
              27.58
              %September
                  30, 2004
              
              $
              670,000
              
              
              24.21
              %
              $
              2,054,000
              
              
              26.24
              %September
                  30, 2005
              
              $
              921,000
              
              
              24.79
              %
              $
              2,538,000
              
              
              24.65
              %
 
 Net
        income for the Residential Lending segment totaled $921,000 for the third
        quarter of 2005, representing a 38% increase over the same quarter in 2004.
        Through the first nine months of this year, net income of $2.5 million exceeded
        the prior year’s mark by nearly 24%. The increase in net income resulted from
        growth in both net interest and noninterest income and a reduction in the
        provision for loan loss. These improvements were, however, partly offset
        by
        rising operating expenses.
 
 Earning
        assets for the Residential segment totaled $344 million as of September 30,
        2005, a 23% increase over the September 30, 2004 level. With these additional
        assets and the repricing effects resulting from increases in interest rate
        indexes from which the loan rates are set, interest income earned on the
        portfolio totaled $5.6 million and $15.3 million for the three and nine months
        ended September 30, 2005, representing increases of 39% and 32% over the
        same
        periods last year. Interest expense, however, rose 71% and 51% relative to
        the
        third quarter and first nine months of last year due to the rising retail
        deposit and wholesale funding rates mentioned earlier, as well as the cost
        of
        the additional funds required to support the earning asset growth. The increase
        in funding costs, combined with $170,000 and $134,000 reductions in the
        quarterly and year-to-date provisions for loan losses, reduced the overall
        increase in the Residential segment’s net interest income after provision to
        approximately 27% and 23% over the third quarter and nine month 2004
        levels.
 
 The
        Residential Lending segment’s third-quarter noninterest income was little
        changed from the prior year, increasing $12,000, or 4% relative to the third
        quarter of 2004. On a year-to-date basis, however, noninterest income rose
        $174,000, or 27%, based largely on higher loan fees, particularly prepayment
        fees, earlier in the year. We believe that a flattening of the yield curve,
        which resulted from rising short-term interest rates and relatively static
        longer-term interest rates,
  39
  contributed
        to the higher level of loan payoffs and prepayment fees observed from mid-2004
        through the second quarter of 2005. As this flattening of the yield curve
        reduced the rate differential between short- and long-term financing costs,
        it
        provided a financial incentive for borrowers with short-term or adjustable-rate
        loans to refinance with long-term fixed rates. With prepayment fees declining
        in
        the third quarter, it is possible that, given the current interest rate
        environment, the majority of borrowers with a financial incentive to refinance
        and the inclination to do so may have already taken advantage of the opportunity
        presented by the flattened yield curve. If this is the case, and no movement
        conducive to additional refinance activity occurs in the yield curve, it
        is
        likely that the level of prepayment fees over the next few quarters will
        continue to decline relative to the same periods for the prior year. Given
        the
        uncertainties regarding interest rates and borrower behaviors, however, we
        do
        not believe we can predict the level of prepayment fees in future quarters
        with
        any reasonable degree of accuracy.
 
 Partially
        offsetting this year’s income growth were increases of $228,000 and $978,000, or
        15% and 23% in the Residential segment’s noninterest expense. Among the
        segment’s direct expenses, the most significant contribution to the increase was
        additional compensation expense, including incentive compensation driven
        by
        increased loan production volumes, which resulted in higher loan officer
        commissions. Also contributing to the additional expense in 2005 were rising
        allocations of administrative and other costs. The administrative costs include
        expenses for both general corporate activities, which are allocated to all
        the
        business segments, as well as loan servicing and administration costs
        attributable to the Residential Lending segment’s originations and portfolio
        management. Other allocated expenses included expenses incurred at the banking
        centers and allocated to the Residential Lending segment. These allocations
        have
        increased with the growth of the Residential segment.
 
 **Business
        Banking Lending**
 
 Quarter
                  Ended
              
              Nine
                  Months EndedNet
                  Income
              
              Return
                  on Equity
              
              Net
                  Income
              
              Return
                  on EquitySeptember
                  30, 2003
              
              $
              93,000
              
              
              5.72
              %
              $
              108,000
              
              
              2.20
              %September
                  30, 2004
              
              $
              (73,000
              )
              
              (3.63
              %)
              $
              (283,000
              )
              
              (4.92
              %)September
                  30, 2005
              
              $
              82,000
              
              
              3.02
              %
              $
              85,000
              
              
              1.09
              %
 
 Our
        Business Banking segment is one of the newer business lines in which we have
        invested and will continue to invest our resources with the eventual goal
        of
        achieving our targeted 15% return on equity and consistent year-over-year
        earnings growth. At this time, these results have not yet been achieved,
        nor do
        we anticipate reaching these goals in 2005. We continue to invest in this
        segment, however, based upon its ability to attract low-cost core deposits,
        which help reduce our overall cost of funds, the diversification it brings
        to
        our portfolio of earning assets, and the potential it offers for generating
        longer-term relationship-banking opportunities and additional sources of
        noninterest income.
 
 For
        the
        quarter and nine months ended September 30, 2005, the Business Banking segment’s
        net interest income after provision for loan losses rose $427,000 and $1.3
        million or 41% and 45%, relative to the same periods in 2004. These were
        the
        highest percentage net interest income increases among our four business
        lines,
        and the second highest dollar increases behind the Residential Lending segment.
        Like the Consumer and Residential segments, the Business Banking segment
        succeeded in building incremental assets over the third quarter of last year,
        with earning assets totaling nearly $130 million as of September 30, 2005,
        an
        increase of 21%
  40
  over
        the
        prior year level. Earning assets were, however, down from their $132 million
        level as of June 30, 2005. Given the nature of the Business Banking segment’s
        credit relationships which include a number of large-balance and revolving
        credits, we do not consider this decline to be indicative of a downward trend
        in
        the segment’s earning assets.
 
 Also
        contributing to the increase in interest income was the prevalence of
        prime-based loans in the business banking portfolio. Most of the adjustable-rate
        loans in our portfolio reprice according to contractually defined schedules,
        most commonly on an annual basis. The rates on prime-based loans, on the
        other
        hand, typically adjust in response to any change in the prime rate.
        Consequently, these loans reprice within days of any change to the index,
        rather
        than at a specified reset date potentially months into the future, and may
        reprice on several occasions over the course of the year, as has been the
        case
        over the last 12 months.
 
 The
        Business Banking segment’s third-quarter noninterest income was virtually
        unchanged from the prior year, increasing less than $2,000. On a year-to-date
        basis, however, the segment’s noninterest income rose $209,000, or 74%, driven
        in large part by a $151,000 second-quarter gain on the sale of a commercial
        real
        estate credit that included both the construction financing as well as the
        permanent mortgage to refinance that loan following the completion of
        construction. Given the unique nature of this transaction, we cannot predict
        the
        probability that similar deals could occur in the future. Also contributing
        to
        the segment’s noninterest income growth has been the expansion of the Business
        Banking segment’s deposit base, measured by both total deposit balances as well
        as the number of open accounts. Fee income earned on these additional deposits
        has contributed to the improvement in noninterest income, and is expected
        to
        generate additional noninterest income for the segment in the
        future.
 
 Partially
        offsetting the additional net interest and noninterest income, however, were
        an
        additional $192,000 in noninterest expense for the quarter and $986,000 for
        the
        nine-month period relative the prior year. The primary drivers of the additional
        noninterest expense were increases in expenses from our retail banking centers
        and other administrative departments allocated to the Business Banking segment,
        as well as compensation and marketing expenses. The expenses from our retail
        banking centers allocated to the Business Banking segment have increased
        largely
        as a result of the strong growth of our business checking and other commercial
        deposit accounts. On a year-to-date basis, additional compensation expense
        was
        due, in large part, to a return to a normal level of loan officer commissions
        this year, compared to a below average level of expense in early
        2004.
 
 **Income
        Property Lending**
 
 Quarter
                  Ended
              
              Nine
                  Months EndedNet
                  Income
              
              Return
                  on Equity
              
              Net
                  Income
              
              Return
                  on EquitySeptember
                  30, 2003
              
              $
              1,589,000
              
              
              22.51
              %
              $
              4,911,000
              
              
              23.05
              %September
                  30, 2004
              
              $
              1,513,000
              
              
              20.34
              %
              $
              4,270,000
              
              
              19.49
              %September
                  30, 2005
              
              $
              1,312,000
              
              
              17.21
              %
              $
              4,279,000
              
              
              18.75
              %
 
 For
        the
        third quarter of 2005, the Income Property segment’s net income declined 13%
        from its level in the same quarter of 2004 based on declining net interest
        and
        noninterest income. For the year-to-date period, net income was virtually
        unchanged, with minimal changes impacting net interest income, noninterest
        income, and noninterest expense.
  41
 The
        segment’s net interest income after provision for loan loss declined $309,000,
        or 8%, for the quarter based on 7% interest income growth and a more than
        offsetting 34% increase in interest expense. Unlike our other business segments,
        the Income Property segment did not benefit from year-over-year earning asset
        growth, and instead saw its earning assets fall to $408 million as of September
        30, 2005, a decline of over 8% relative to September 30 of last year. The
        decline was largely attributable to a high level of prepayments on the loan
        portfolio, likely motivated by the same factors described earlier in the
        Residential segment section.
 
 Noninterest
        income for the Income Property segment declined $27,000 for the third quarter
        and $7,000 on a year-to-date basis, or 13% and 1%, relative to 2004. For
        the
        quarter, gains on commercial loan sales were down significantly relative
        to the
        prior year, while on a year-to-date basis, the decline in noninterest income
        was
        attributable to a reduction in the amount of rental income received from
        First
        Mutual Center tenants allocated to the Income Property segment.
 
 In
        our
        second-quarter press release, we noted that we had experienced increased
        interest in, and opportunities for, sales of participations in our commercial
        real-estate loans. Consequently, we added that we were considering the merits
        of
        expanding our commercial real estate loan sales and potentially originating
        credits with the intent to sell, rather than retain the loans in our portfolio.
        While the volume of commercial real-estate loans sold in the third quarter
        was
        modest, we would note that the volume does not reflect a decision against
        expanding our commercial real-estate loan sales. Instead, we still regard
        an
        increase in such sales as likely in the fourth quarter. 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
        sales transactions.
 
 In
        contrast to the other business segments, noninterest expense for the Income
        Property segment exhibited modest reductions compared to the same timeframe
        last
        year, declining $45,000, or 3% for the quarter, and $15,000, or less than
        1% for
        the year-to-date period. As noted above, the asset growth exhibited by the
        other
        business lines was not observed with the Income Property segment. Instead,
        the
        Income Property segment saw balances decline as the other business lines
        grew
        their operations and became larger components of our overall asset mix.
        Consequently, for a number of different expenses that we allocate out to
        the
        business segments, such as banking center and administrative costs, the
        percentages allocated to other business lines increased with their activity
        and
        asset balances, and reduced the percentage allocated to the Income Property
        segment relative to last year.
 
 **LIQUIDITY**
 
 Our
        primary sources of liquidity are loan and security sales and repayments,
        deposits, and wholesale funds. A secondary source of liquidity is cash from
        operations, which, though not a significant source of liquidity, is a consistent
        source based upon the quality of our earnings. Our principal uses of liquidity
        are the origination and acquisition of loans and securities. Liquidity is
        also
        used to purchase facilities and equipment.
  42
  3Q
                  2005
              
              3Q
                  2004
              
              YTD
                  2005
              
              YTD
                  2004(Dollars
                  in thousands)Loan
                  Originations (disbursed)
              
              $
              130,000
              
              $
              101,000
              
              $
              374,000
              
              $
              332,000Security
                  Purchases
              
              
              0
              
              
              12,000
              
              
              6,000
              
              
              56,000Total
                  Originations and Purchases
              
              $
              130,000
              
              $
              113,000
              
              $
              380,000
              
              $
              388,000Loan
                  and Security Repayments
              
              $
              103,000
              
              $
              74,000
              
              $
              289,000
              
              $
              200,000Sales
                  of Securities
              
              
              0
              
              
              0
              
              
              0
              
              
              2,000Sales
                  of Loans
              
              
              15,000
              
              
              24,000
              
              
              45,000
              
              
              74,000Total
                  Repayments and Sales
              
              $
              118,000
              
              $
              98,000
              
              $
              334,000
              
              $
              276,000Net
                  Difference
              
              $
              12,000
              
              $
              15,000
              
              $
              46,000
              
              $
              112,000
 
 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 2005, compared to 30% for the same period
        one
        year earlier.
 
 Movements
        in rates and the resulting shape of the yield curve have likely contributed
        to
        the sustained high prepayment levels. As short-term rates continued to rise
        in
        2005, longer-term rates tended to move within a range, with no discernible
        upward or downward tendency. This has resulted in a flattening of the yield
        curve, which continued into the third quarter of 2005. With this flattening,
        the
        rate differential between short- and long-term financing diminished, thus
        reducing the financial incentive for borrowers to use shorter-term,
        adjustable-rate financing rather than longer-term, fixed-rate loans. This,
        in
        turn, provides borrowers with an incentive to refinance with long-term fixed
        rates. We believe this situation has contributed to the sustained high
        prepayment rates observed in 2005.
 
 Our
        preferred method of funding the net difference between originations/purchases
        and repayments/sales is with deposits. To the extent that deposit growth
        is
        insufficient to fully fund the difference, we may rely on wholesale funding
        sources including, but not limited to FHLB advances, brokered certificates
        of
        deposit, and reverse repurchase agreements. During the third quarters of
        2004
        and 2005, growth in funds from deposits and borrowings were as
        follows:
  3Q
                    2005
                
                
                3Q
                    2004
                
                
                YTD
                    2005
                
                
                YTD
                    2004(Dollars
                    in thousands)Deposits
                
                $
                8,000
                
                $
                21,000
                
                $
                52,000
                
                $
                21,000Advances
                
                
                8,000
                
                
                (13,000
                )
                
                2,000
                
                
                38,000Total
                
                $
                16,000
                
                $
                8,000
                
                $
                54,000
                
                $
                59,000
 
 The
        inflow of deposits varies from period to period, and our ability to raise
        liquidity from this source is dependent on our effectiveness in competing
        with
        other financial institutions in our local market. That competition tends
        to
        focus on rate and service. Although we control the quality of service that
        we
        provide, we have no control over the prevailing rates in our
        marketplace.
 
 43
  Our
        other
        major source of liquidity is wholesale funds, which include borrowings from
        the
        FHLB, brokered deposits, reverse repurchase agreements, and a revolving line
        of
        credit at the Holding Company level. We rely significantly upon these wholesale
        funds as sources of liquidity, as doing so allows us to avoid maintaining
        balances of lower-yielding assets for liquidity requirements.
 
 Our
        most
        utilized wholesale funding source is FHLB advances, which totaled $236 million
        at September 30, 2005 and $234 million at December 31, 2004. Our credit line
        with the FHLB is reviewed annually, and our maximum allowable borrowing level
        is
        currently set at 40% of assets or $425 million. As a percentage of period-ending
        assets, our FHLB borrowings totaled 22% on September 30, 2005 and 23% at
        the end
        of 2004. Potential risks associated with this funding source include the
        reduction or non-renewal of the line and insufficient collateral to utilize
        the
        line. We try to mitigate the risk of non-renewal of the line by maintaining
        the
        credit quality of our loans and securities and attending to the quality and
        consistency of our earnings. We presently have sufficient collateral to meet
        our
        anticipated year 2005 and 2006 funding needs.
 
 Brokered
        deposits, which are included in the deposit totals, amounted to $40 million
        at
        the 2004 year-end and $27 million as of September 30, 2005. Subsequent to
        the
        quarter-end, the interest rates on brokered deposits fell below those of
        FHLB
        advances. Consequently, we increased our use of this funding source to $42
        million in October, and may continue to increase our use in the future,
        depending on the costs of various wholesale funding sources. Internal policies
        limit our total usage of these deposits to no more than 10% of all
        deposits.
 
 Reverse
        repurchase lines are lines of credit collateralized by securities. We have
        lines
        totaling $60 million, of which the full amount is currently available. There
        has
        been no usage of these lines in the previous three years. The risks associated
        with these lines are the withdrawal of the line based on credit standing
        of the
        Bank and the potential lack of sufficient collateral to support the
        lines.
 
 An
        additional source of liquidity has been our cash from operations, which,
        though
        not a significant source of liquidity, is a consistent source based upon
        the
        quality of our earnings. On a very limited basis it can be viewed as cash
        from
        operations adjusted for items such as the provision for loan loss and
        depreciation. See the “Consolidated Statements of Cash Flows” in the financial
        statements section of this filing for a calculation of net cash provided
        by
        operating activities.
 
 In
        addition to using liquidity to fund loans and securities, we routinely invest
        in
        facilities and equipment. In the first three quarters of 2005, we invested
        $5.9
        million in these assets, up from $1.9 million in the first nine months of
        2004.
 
 **PLANNED
        EXPENDITURES FOR** **PLANT
        AND EQUIPMENT**
 
 In
        2005
        we have completed the interior remodel of three banking centers and completed
        the construction of another. With the completion of these, we do not anticipate
        the need for any further major banking center remodels. In 2004 we also
        completed two land acquisitions, one in West Seattle for $1,046,000 and one
        in
        Canyon Park for $1,356,000. Construction began for our new West Seattle banking
        center third quarter, 2005. It is possible that construction on our Canyon
        Park
        banking center can begin as early as fourth quarter, 2005, but more likely
        will
        begin in first quarter, 2006. In 2004 we also began a
  44
  maintenance
        and upgrade plan for our seven-story corporate headquarters, and we anticipate
        these plans will be completed by first quarter, 2006. We estimate that the
        expenditures in the next two quarters will range from $2.0 million to $3.0
        million depending on what projects are completed this year and the timing
        of
        future projects based on permitting.
 
 We
        review
        the utilization of our properties on a regular basis and believe that we
        have
        adequate facilities for current operations. We may open new banking centers
        from
        time-to-time, depending on the availability of capital resources and the
        location’s potential for growth and profitability.
 
 We
        regularly analyze demographic and geographic data as well as information
        regarding our competitors and our current loan and deposit customers in order
        to
        locate potential future Bank sites.
 
 **CAPITAL**
 
 The
        FDIC’s statutory framework for capital requirements establishes five categories
        of capital strength, ranging from a high of well-capitalized to a low of
        critically under-capitalized. An institution’s category depends upon its capital
        level in relation to relevant capital measures, including a risk-based capital
        measure, a leverage capital measure, and certain other factors. At September
        30,
        2005, we exceeded the capital levels required to meet the definition of a
        well-capitalized institution:
 
 Minimum
                  to beCategorized
                  as “WellMinimum
                  for
              Capitalized”
                  UnderCapital
              Prompt
                  CorrectiveActual
              Adequacy
                  Purposes
              Action
                  ProvisionsTotal
                  capital (to risk-weightedassets):First
                  Mutual Bancshares, Inc.
              12.20%
              8.00%
              N/AFirst
                  Mutual Bank
              11.83
              8.00
              10.00Tier
                  I capital (to risk-weightedassets):First
                  Mutual Bancshares, Inc.
              10.95
              4.00
              N/AFirst
                  Mutual Bank
              10.58
              4.00
              6.00Tier
                  I capital (to average assets):First
                  Mutual Bancshares, Inc.
              7.88
              4.00
              N/AFirst
                  Mutual Bank
              7.75
              4.00
              5.00
 
 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
  45
  inherent
        in our lending, deposit, and borrowing activities. Interest rate risk is
        the
        risk to earnings and capital resulting from adverse movements in interest
        rates.
        To that end, we actively monitor and manage our exposure to interest rate
        risk.
 
 A
        number
        of measures are utilized to monitor and manage interest rate risk, including
        net
        interest income and economic value of equity simulation models, as well as
        traditional “gap” models. We prepare these models on a monthly basis for review
        by our Asset Liability Committee (ALCO), senior management, and Board of
        Directors. The use of these models requires us to formulate and apply
        assumptions to various balance sheet items. Assumptions regarding interest
        rate
        risk are inherent in all financial institutions, and may include, but are
        not
        limited to, prepayment speeds on loans and mortgage-backed securities, cash
        flows and maturities of financial instruments held for purposes other than
        trading, changes in market conditions, loan volumes and pricing, deposit
        sensitivities, consumer preferences, and management’s capital leverage plans. We
        believe that the data and assumptions used for our models are reasonable
        representations of our portfolio and possible outcomes under the various
        interest rate scenarios. Nonetheless, these assumptions are inherently
        uncertain; therefore, the models cannot precisely estimate net interest income
        or predict the impact of higher or lower interest rates on net interest income.
        Actual results may differ significantly from simulated results due to timing,
        magnitude, and frequency of interest rate changes, and changes in market
        conditions and specific strategies, among other factors.
 
 **Asset
        and Liability Management**
 
 Our
        primary objective in managing interest rate risk is to minimize the adverse
        impact of changes in interest rates on our net interest income and capital,
        while structuring the asset and liability components to maximize net interest
        margin, utilize capital effectively, and provide adequate liquidity. We rely
        primarily on our asset and liability structure to control interest rate
        risk.
 
 Asset
        and
        liability management is the responsibility of the Asset Liability Committee,
        which acts within policy directives established by the Board of Directors.
        This
        committee meets regularly to monitor the composition of the balance sheet,
        to
        assess projected earnings trends, and to formulate strategies consistent
        with
        the objectives for liquidity, interest rate risk, and capital adequacy. The
        objective of asset/liability management is to maximize long-term shareholder
        returns by optimizing net interest income within the constraints of credit
        quality, interest rate risk policies, levels of capital leverage, and adequate
        liquidity. Assets and liabilities are managed by matching maturities and
        repricing characteristics in a systematic manner.
 
 **Hedging
        Techniques**
 
 We
        review
        interest rate trends on a monthly basis and employ hedging techniques where
        appropriate. These techniques may include financial futures, options on
        financial futures, interest rate caps and floors, interest rate swaps, and
        extended commitments on future lending activities. Typically, the extent
        of our
        off-balance-sheet derivative agreements has been the use of forward loan
        commitments, which are used to hedge our loans held-for-sale. Additionally,
        in
        2002 we entered into an interest rate swap with the FHLB. The purpose of
        the
        swap is to protect against potential adverse interest rate volatility that
        could
        be realized from the Trust Preferred Securities (TPS) issued in June 2002.
        The
        swap accomplished this by fixing the interest rate payable for the first
        five
        years of the TPS’ life.
 
 46
  **Net
        Interest Income (NII) and Economic Value of Equity (EVE) Simulation Model
        Results**
 
 September
                  30, 2005
              
              December
                  31, 2004Change
                  in
              
              Percentage
                  Change
              
              Percentage
                  ChangeInterest
                  Rates
              
              Net
                  Interest
              Economic
                  Value
              
              Net
                  Interest
              Economic
                  Value(in
                  basis points)
              
              Income
              Of
                  Equity
              
              Income
              Of
                  Equity+200
              
              (0.11%)
              (1.82%)
              
              0.89%
              (2.51%)+100
              
              n/a
              0.15%
              
              n/a
              (0.40%)-100
              
              n/a
              (2.26%)
              
              (1.26%)
              (1.26%)-200
              
              (1.33%)
              (6.94%)
              
              *
              *
 
 *
        Because
        a large percentage of our loan portfolio is tied to indexes that were at
        very
        low levels as of December 31, 2004, the downward 200 bps scenario was not
        computed at that time.
  **Net
        Interest Income Simulation**
 
 The
        results of our income simulation model constructed using data as of September
        30, 2005 project modest declines in our net interest income from its “base case”
        level in scenarios in which interest rates are assumed to gradually increase
        or
        decline by 200 bps over a 12-month period. The magnitudes of the changes,
        however, suggest that there is little sensitivity in net interest income
        from
        the “base case” level over a 12-month horizon, as an impact of 1.33% was
        indicated in the falling rate scenario, and 0.11% in the rising rate
        environment.
 
 The
        changes indicated by the simulation model represent variances from a “base case”
        scenario, which is a projection of net interest income assuming interest
        rates
        remain unchanged from their current levels over the life of the forecast,
        and
        that the size of the balance sheet remains stable over the forecast timeframe,
        with no growth or contraction regardless of interest rate movements. The
        base
        model will, however, illustrate the future effects of rate changes that have
        already occurred but have not yet flowed through to all the assets and
        liabilities on our balance sheet. These changes can either increase or decrease
        net interest income, depending on the timing and magnitudes of those changes.
        Additionally, the tendencies for loan and investment prepayments to accelerate
        in falling interest rate scenarios and slow when interest rates rise have
        been
        incorporated into the model assumptions. Implicit in these assumptions are
        additional assumptions for increased securities purchases and loan originations
        at lower interest rate levels to offset accelerated prepayments, and conversely,
        reduced securities purchases and loan production when rates increase and
        prepayments slow.
 
 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 movements of the yield curve, then a parallel 200 basis
        point increase or decrease in rates will not significantly degrade net interest
        income from what is presently expected in the “base case.” In the event the
        simulation model indicated that the increase or decrease in interest rates
        over
        the following 12 months would adversely affect our net interest income over
        the
        same period by more than 10% relative to the “base case” scenario, we would
        consider the indicated risk to have exceeded our internal policy
        limit.
 
 47
 
 **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 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, 2005 indicate
        that
        our assets and liabilities would be expected to exhibit similar levels of
        sensitivity to rising rates, with the economic value of assets declining
        by
        2.49%, compared to a decline of 2.57% for our liabilities. Given the comparable
        sensitivities and greater asset balance than liabilities balance, the reduction
        in the economic value of assets exceeded the impact on liabilities.
        Consequently, the economic value of our equity was negatively impacted in
        this
        scenario, declining 1.82%.
 
 The
        opposite occurs when rates decline, as the discount rates used to calculate
        the
        present values of assets and liabilities will decrease, causing the present
        values of both assets and liabilities to rise. Counteracting this effect
        for
        assets, however, is the tendency for cash flows from assets to accelerate
        in a
        falling rate scenario, as borrowers refinance their existing loans at lower
        interest rates. These loan prepayments prevent the present values of these
        assets from increasing in a declining rate scenario, illustrating an effect
        referred to as negative convexity. Taking this negative convexity into account,
        the simulation results indicated a negative impact to EVE in the falling
        rate
        scenario. In this case, the economic values of both assets and liabilities
        at
        September 30, 2005 were positively impacted when rates were assumed to fall
        by
        200 bps, assets by 1.76% and liabilities by 2.82%. 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 6.94%.
 
 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
  48
  assets
        maturing, repricing, or prepaying within a period, and liabilities maturing
        or
        repricing within the same period. A gap is considered positive when the amount
        of interest-rate-sensitive assets exceeds the amount of interest-rate-sensitive
        liabilities within a given period. A gap is considered negative in the reverse
        situation.
 
 Certain
        shortcomings are inherent in gap analysis, including the failure to recognize
        differences in the frequencies and magnitudes of repricing for different
        balance
        sheet instruments. Additionally, some assets and liabilities may have similar
        maturities or repricing characteristics, but they may react differently to
        changes in interest rates. This illustrates a facet of interest rate exposure
        referred to as “basis risk.” Assets, such as adjustable-rate mortgage loans, may
        also have features that limit the effect that changes in interest rates have
        on
        the asset in the short-term and/or over the life of the loan, for example
        a
        limit on the amount by which the interest rate on the loan is allowed to
        adjust
        each year. This illustrates another area of interest rate exposure referred
        to
        as “option risk.” Due to the limitations of the gap analysis, these features are
        not taken into consideration. Additionally, in the event of a change in interest
        rates, prepayment and early withdrawal penalties could deviate significantly
        from those assumed in the gap calculation. As a result, we utilize the gap
        report as a complement to our income simulation and economic value of equity
        models.
 
 Our
        12-month interest rate sensitivity gap, expressed as a percentage of assets,
        fell from a positive, or asset sensitive 2.6% at December 31, 2004 to a
        negative, or liability sensitive 5.9% at the end of the third quarter. These
        results indicated that more liabilities than assets were expected to mature,
        reprice, or prepay within the 12 months, whereas the opposite was true at
        the
        year-end.
 
 **One
        Year Interest Rate Sensitivity Gap**
 
 September
                  30, 2005
              
              December
                  31, 2004(Dollars
                  in thousands)One-Year
                  Repricing/Maturing Assets
              
              $
              692,692
              
              $
              665,665One-Year
                  Repricing/Maturing Liabilities
              
              
              755,044
              
              
              639,430One-Year
                  Gap
              
              
              ($
                  62,352
              )
              $
              26,235Total
                  Assets
              
              $
              1,063,009
              
              $
              1,012,783(Dec.
                  31, 2004 figure includes a $9 million off-balance-sheet
                  item)One-Year
                  Interest Rate Gap as a Percentage of Assets
              
              
              (5.9
              %)
              
              2.6
              %
 
 The
        decline in our gap ratio since December 2004 has been primarily attributable
        to
        developments on the liabilities side of the balance sheet, as the percentage
        of
        total assets subject to mature, reprice, or estimated to prepay within a
        one-year timeframe has changed little since the 2004 year-end. In particular,
        the rolling of existing long-term FHLB advances to within the 12-month timeframe
        and a reduction in the use of longer-term funding instruments to replace
        maturing liabilities have both contributed significantly to the reduction
        in our
        gap ratio.
  49
 While
        our
        total outstanding FHLB advances showed little change relative to December
        2004,
        the volume of advances scheduled to mature or reprice within the following
        12
        months increased $45 million between the year-end and the end of the third
        quarter. In the first half of 2004, we increased our utilization of longer-term
        FHLB advances in order to extend liability durations as well as match fund
        purchases of hybrid ARM securities. Over the course of 2005, many of these
        longer-term advances have rolled to within the gap ratio’s 12-month timeframe.
        Given our asset/liability position over the first three quarters of 2005,
        we
        have elected to replace maturing advances with new short-term advances rather
        than extend these liabilities. This combination of last year’s advances moving
        closer to maturity and the use of shorter-term replacement advances contributed
        to this year’s reduction in our one-year interest rate gap.
 
 The
        balance of outstanding time deposits scheduled to mature within the next
        12
        months also increased relative to the year-end levels, particularly for 11-,
        13-, and 15-month “bump” certificates promoted in late 2004 and earlier this
        year. Based on the terms of these certificates, all balances will appear
        within
        the gap report’s 12-month horizon at the certificate’s origination or very
        shortly thereafter. While our 15-month “bump” time deposits are issued with a
        15-month term to maturity, the depositor is granted an option to reprice
        the
        certificate to the prevailing 15-month certificate rate on one occasion at
        any
        time during those 15 months. For the purposes of the gap report, we assume
        that
        the majority of depositors will reprice their certificates within one year
        of
        issue. Consequently, the majority of these certificates are considered to
        be
        less than one-year instruments for gap purposes.
 
 A
        change
        in modeling procedure impacted the total asset base used for the gap ratio
        calculation by $9 million. As previously noted, in 2002 we entered into an
        interest rate swap agreement to fix the interest rate on our first trust
        preferred security issue for a period of five years. As of the December 2004
        year-end, we classified the TPS as a variable rate liability, offset by the
        asset side of the swap, under which the Bank receives payments tied to the
        same
        quarterly adjustable rate as the TPS issue. The other side of the swap, under
        which the Bank makes payments based on a fixed interest rate, was applied
        to the
        liability side of the gap report based on the remaining life of the swap.
        Beginning in the second quarter of 2005, the fixed-payment side of the swap,
        formerly a $9 million liability, was moved to the asset side as a $9 million
        contra-asset. As a result of this modification, our asset base for gap purposes
        now corresponds to the level of total assets reflected on our financial
        statements, rather than exceeding that amount by the $9 million notional
        principal of the swap.
 
 The
        greater increase of liabilities maturing or repricing in the next 12 months
        versus assets resulted in a net $89 million reduction in our dollar gap,
        which
        led to the decline in the one-year gap ratio from 2.6% to (5.9%) of total
        assets.
  50
  **ITEM
        3**






The
        following table sets forth certain information regarding carrying values
        and
        percentage of total carrying values of the Bank’s consolidated
        portfolio
        of securities classified as available-for-sale and held-to-maturity (dollars
        in
        thousands).


September
                30,2005
            
            2004**Available-for-Sale:**
            
            Carrying
                Value
            
            Percent
                of Total
            
            Carrying
                Value
            
            Percent
                of TotalUS
                Government Treasury and agency obligations
            
            $
            18,031
            
            
            16
            %
            $
            23,093
            
            
            19
            %Mortgage
                backed securities:Freddie
                Mac
            
            
            16,893
            
            
            15
            %
            
            15,800
            
            
            13
            %Ginnie
                Mae
            
            
            46,131
            
            
            40
            %
            
            43,267
            
            
            35
            %Fannie
                Mae
            
            
            33,683
            
            
            29
            %
            
            40,422
            
            
            33
            %Total
                mortgage-backed securities
            
            
            96,707
            
            
            84
            %
            
            99,489
            
            
            81
            %**Total
                securities available-for-sale**
            
            **$**
            **114,738**
            
            
            **100**
            **%**
            **$**
            **122,582**
            
            
            **100**
            **%**September
                30,2005
            
            
            2004**Held-to-Maturity:**
            
            
            Carrying
                Value
            
            
            Percent
                of Total
            
            
            Carrying
                Value
            
            
            Percent
                of TotalMunicipal
                bonds
            
            $
            1,192
            
            
            16
            %
            $
            1,220
            
            
            15
            %Mortgage
                backed securities:Freddie
                Mac
            
            
            476
            
            
            6
            %
            
            497
            
            
            6
            %Fannie
                Mae
            
            
            5,679
            
            
            78
            %
            
            6,263
            
            
            79
            %Total
                mortgage-backed securities
            
            
            6,155
            
            
            84
            %
            
            6,760
            
            
            85
            %**Total
                securities held-to-maturity**
            
            **$**
            **7,347**
            
            
            **100**
            **%**
            **$**
            **7,980**
            
            
            **100**
            **%****Estimated
                market value**
            
            **$**
            **7,399**
            
            
            
            
            **$**
            **8,123**






51




**ITEM
      3A**




The
        following table shows the maturity or period to repricing of the Bank’s consolidated
        portfolio of securities available-for-sale and held-to-maturity (dollars
        in
        thousands):





Available-for-sale
                at September 30, 2005One
                Year or Less
            
            Over
                One to
              Three
                Years
            
            Over
                Three to
              Five
                Years
            
            Over
                Five to
              Ten
                Years
            
            Over
                Ten to
              Twenty
                Years
            
            Over
                Twenty Years
            
            TotalCarrying
                Value
            
            Weighted
                Average Yield
            
            Carrying
                Value
            
            Weighted
                Average Yield
            
            Carrying
                Value
            
            Weighted
                Average Yield
            
            Carrying
                Value
            
            Weighted
                Average Yield
            
            Carrying
                Value
            
            Weighted
                Average Yield
            
            Carrying
                Value
            
            Weighted
                Average Yield
            
            Carrying
                Value
            
            Weighted
                Average Yield**Available-for-Sale:**US
                Government Treasury and
              agency
                obligations
            
            $
            7,179
            
            
            1.82
            %
            $
            —
            
            
            0.00
            %
            $
            5,907
            
            
            4.08
            %
            $
            —
            
            
            0.00
            %
            $
            4,945
            
            
            4.00
            %
            $
            —
            
            
            0.00
            %
            $
            18,031
            
            
            3.16
            %Mortgage
                backed securities:Ginnie
                Mae
            
            
            —
            
            
            0.00
            %
            
            46,131
            
            
            4.07
            %
            
            —
            
            
            0.00
            %
            
            —
            
            
            0.00
            %
            
            —
            
            
            0.00
            %
            
            
            
            
            
            
            
            46,131
            
            
            4.07
            %Freddie
                Mac
            
            
            288
            
            
            5.46
            %
            
            442
            
            
            5.50
            %
            
            5,126
            
            
            3.58
            %
            
            3,478
            
            
            4.60
            %
            
            7,559
            
            
            4.50
            %
            
            —
            
            
            0.00
            %
            
            16,893
            
            
            4.28
            %Fannie
                Mae
            
            
            514
            
            
            5.14
            %
            
            288
            
            
            5.50
            %
            
            4,212
            
            
            4.22
            %
            
            —
            
            
            0.00
            %
            
            28,669
            
            
            4.30
            %
            
            —
            
            
            0.00
            %
            
            33,683
            
            
            4.31
            %Total
                mortgage-backed securities
            
            
            802
            
            
            5.25
            %
            
            46,861
            
            
            4.09
            %
            
            9,338
            
            
            3.87
            %
            
            3,478
            
            
            4.60
            %
            
            36,228
            
            
            4.34
            %
            
            —
            
            
            0.00
            %
            
            96,707
            
            
            4.19
            %Total
                securities available-for-
              sale
                —Carrying
                Value
            
            $
            7,981
            
            
            2.17
            %
            $
            46,861
            
            
            4.09
            %
            $
            15,245
            
            
            3.97
            %
            $
            3,478
            
            
            4.60
            %
            $
            41,173
            
            
            4.30
            %
            $
            —
            
            
            0.00
            %
            **$**
            **114,738**
            
            
            4.03
            %Total
                securities available-for-
              sale
                —Amortized
                Cost
            
            $
            7,983
            
            
            2.16
            %
            $
            47,049
            
            
            4.09
            %
            $
            15,561
            
            
            3.95
            %
            $
            3,502
            
            
            4.60
            %
            $
            42,198
            
            
            4.30
            %
            $
            —
            
            
            0.00
            %
            **$**
            **116,293**
            
            
            4.03
            %Held-to-Maturity
                at September 30, 2005One
                Year or Less
            
            
            Over
                One to
              Three
                Years
            
            
            Over
                Three to
              Five
                Years
            
            
            Over
                Five to
              Ten
                Years
            
            
            Over
                Ten to
              Twenty
                Years
            
            
            Over
                Twenty Years
            
            
            TotalCarrying
                Value
            
            
            Weighted
                Average Yield
            
            
            Carrying
                Value
            
            
            Weighted
                Average Yield
            
            
            Carrying
                Value
            
            
            Weighted
                Average Yield
            
            
            Carrying
                Value
            
            
            Weighted
                Average Yield
            
            
            Carrying
                Value
            
            
            Weighted
                Average Yield
            
            
            Carrying
                Value
            
            
            Weighted
                Average Yield
            
            
            Carrying
                Value
            
            
            Weighted
                Average Yield**Held-to-Maturity:**Municipal
                Bonds
            
            $
            —
            
            
            0.00
            %
            $
            —
            
            
            0.00
            %
            $
            —
            
            
            0.00
            %
            $
            —
            
            
            0.00
            %
            $
            220
            
            
            5.38
            %
            $
            972
            
            
            6.28
            %
            $
            1,192
            
            
            6.11
            %Mortgage
                backed securities:Freddie
                Mac
            
            
            477
            
            
            5.21
            %
            
            —
            
            
            0.00
            %
            
            —
            
            
            0.00
            %
            
            —
            
            
            0.00
            %
            
            —
            
            
            0.00
            %
            
            —
            
            
            0.00
            %
            
            477
            
            
            5.21
            %Fannie
                Mae
            
            
            2,070
            
            
            5.26
            %
            
            274
            
            
            6.48
            %
            
            1,567
            
            
            4.45
            %
            
            —
            
            
            0.00
            %
            
            1,767
            
            
            4.77
            %
            
            —
            
            
            0.00
            %
            
            5,678
            
            
            4.94
            %Total
                mortgage-backed securities
            
            
            2,547
            
            
            5.25
            %
            
            274
            
            
            6.48
            %
            
            1,567
            
            
            4.45
            %
            
            —
            
            
            0.00
            %
            
            1,767
            
            
            4.77
            %
            
            —
            
            
            0.00
            %
            
            6,155
            
            
            4.97
            %Total
                securities held-to-
              maturity
                —Carrying
                Value
            
            $
            2,547
            
            
            5.25
            %
            $
            274
            
            
            6.48
            %
            $
            1,567
            
            
            4.45
            %
            $
            —
            
            
            0.00
            %
            $
            1,987
            
            
            4.83
            %
            $
            972
            
            
            6.28
            %
            $
            7,347
            
            
            5.15
            %Total
                securities held-to-
              maturity
                —Fair
                Market Value
            
            $
            2,627
            
            
            5.25
            %
            $
            286
            
            
            6.48
            %
            $
            1,555
            
            
            4.46
            %
            $
            —
            
            
            0.00
            %
            $
            1,959
            
            
            4.84
            %
            $
            972
            
            
            6.28
            %
            $
            7,399
            
            
            5.16
            %






52
 ITEM
            4. Controls
            and
            Procedures
 
 An
            evaluation of the Company’s disclosure controls and procedures (as defined in
            Rule 13a-15(e) of the Securities Exchange Act of 1934 (the “Act”)) was carried
            out under the supervision and with the participation of the Chief Executive
            Officer, Chief Financial Officer, and other members of the Company’s senior
            management, as of the end of the period covered by this report (the “Evaluation
            Date”).
            Based upon this evaluation, the Chief Executive Officer and Chief Financial
            Officer concluded that, as of the Evaluation Date, the Company’s disclosure
            controls and procedures are effective in providing reasonable assurance
            that the
            material information required to be disclosed by the Company in the reports
            it
            files or submits under the
  **PART
              II:** **OTHER
              INFORMATION**
 
 ITEM
              1. Legal
              Proceedings
 
 At
              September 30, 2005, the Company was not engaged in any litigation,
              which in the
              opinion of management, after consultation with its legal counsel, would
              be
              material to the Company.
 
 ITEM
              2. Unregistered
              Sales of
              Equity Securities and Use of Proceeds
 
 None.
 
 ITEM
              3. Defaults
              Upon Senior
              Securities
 
 None.
 
 ITEM
              4. Submission
              of Matters
              to a Vote of Security Holders
 
 None.
 
 ITEM
              5. Other
              Information
 
 None.
 
 ITEM
              6. Exhibits
  (3.1)
                    Amended
                        and Restated Articles of Incorporation, incorporated by reference
                        on Form
                        10-Q filed with the SEC on August 8, 2005.(3.3)
                    Bylaws
                        (as amended and restated), incorporated by reference on Form
                        10-Q filed
                        with the SEC on August 13, 2004.(11)
                    Statement
                        regarding computation of per share earnings. Reference is
                        made to
                        the
                      Company’s
                        Consolidated Statements of Income attached hereto as part
                        of Item
                        I
                      Financial
                        Statements, which are incorporated herein by reference.(31.1)
                    Certification
                        by President and Chief Executive Officer pursuant to Section
                        302 of the
                        Sarbanes-Oxley Act.(31.2)
                    Certification
                        by Executive Vice President and Chief Financial Officer Pursuant
                        to
                        Section 302 of the Sarbanes-Oxley Act.(32)
                    Certification
                        by Chief Executive Officer and Chief Financial Officer pursuant
                        to
                      Section
                        906 of the Sarbanes-Oxley Act.
 
 
 53
 
  **SIGNATURES**
 
 Pursuant
              to the requirements of the Securities Exchange Act of 1934, the registrant
              has
              duly caused this report to be signed on its behalf by the undersigned
              thereunto
              duly authorized.
 
 Date:
                        November 7, 2005
                    FIRST
                        MUTUAL BANCSHARES, INC.
                      
                      
                      
                      
                      /s/
                        John R. Valaas
                      John
                        R. Valaas
                      President
                        and Chief Executive Officer
                      
                      
                      
                      
                      
                      
                      /s/
                        Roger A. Mandery
                      Roger
                        A. Mandery
                      Executive
                        Vice President
                      (Principal
                        Financial Officer)
 
 
 
  54