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..................March 31, 2007**OR**o
              **Transition
                  Report Pursuant to Section 13 or 15(d) of****The
                  Securities Exchange Act of 1934**For
                  the transition period from __________ to
                  ___________


Commission
      File Number 005-57091








**FIRST
      MUTUAL BANCSHARES, INC.**


(Exact
      name of registrant as specified in its charter)











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





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








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




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





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




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




Indicate
      the number of shares outstanding of each of the issuer’s classes of common
      stock, as
      of the
      latest practicable date.      May
      7,   2007  6,690,776













FIRST
        MUTUAL BANCSHARES, INC.
 
 QUARTERLY
        REPORT ON FORM 10-Q
 March
        31,
        2007
 
 TABLE
        OF
        CONTENTS
 PagePART
                    I: FINANCIAL INFORMATION
                1Forward-Looking
                    Statements Disclaimer
                1ITEM
                    1. Financial Statements
                1ITEM
                    2. Management’s Discussion and Analysis of Financial Condition and Results
                    of Operations
                21General
                21Overview
                21Results
                    of Operations
                22Net
                    Income
                22Net
                    Interest Income
                22Noninterest
                    Income
                25Noninterest
                    Expense
                28Financial
                    Condition
                31Adoption
                    of SFAS No. 157 and 159
                34Asset
                    Quality
                36Portfolio
                    Information
                37Deposit
                    Information
                42Business
                    Segments
                43Retail
                    Banking
                45Sales
                    Finance
                46Residential
                    Lending
                46Business
                    Banking Lending
                47Income
                    Property Lending
                48Investments
                    and Treasury
                49Liquidity
                50Capital
                52Subsequent
                    Events
                53ITEM
                    3. Quantitative and Qualitative Disclosures About Market
                    Risk
                54ITEM
                    4. Controls and Procedures
                60PART
                    II: OTHER INFORMATION
                60ITEM
                    1. Legal Proceedings
                60ITEM
                    1A. Risk Factors
                60ITEM
                    2. Unregistered Sales of Equity Securities and Use of
                    Proceeds
                60ITEM
                    3. Defaults Upon Senior Securities
                60ITEM
                    4. Submission of Matters to a Vote of Security Holders
                60ITEM
                    5. Other Information
                61ITEM
                    6. Exhibits
                62SIGNATURES
                63CERTIFICATIONS
 
 **PART I:**
              **FINANCIAL
                  INFORMATION**
 
 
 **FORWARD-LOOKING
        STATEMENTS DISCLAIMER**
 
 Our
        Form
        10-Q for the quarter ended March 31, 2007, contains statements concerning
        forecasts of our financial results and condition, expectations of our operations
        and business and our assumptions for those forecasts and expectations that
        are
        forward-looking statements for the purposes of the safe harbor provisions
        under
        the Private Securities Litigation Reform Act of 1995.  Such
        forward-looking statements include statements regarding our forecasts and
        expectations with respect to our target net income and return on equity;
        as well
        as references to potential changes in interest rate margins, anticipated
        growth
        in sales of loans and securities and in servicing assets, our intentions
        regarding our Business Banking segment and other segments, observations
        regarding our loan collections and provision for loan losses, information
        regarding our intentions to move away from offering rates competitive with
        higher rates in our area and the effects of such a move, our intent to refinance
        our trust preferred debenture, information regarding the possible effects
        of
        hedging our trading portfolio and information based on our market risk models
        and analysis.  Although we believe that the expectations expressed in
        these forward-looking statements are based on reasonable assumptions within
        the
        bounds of our knowledge of our business, operations, and prospects, these
        forward-looking statements are subject to numerous uncertainties and risks,
        and
        actual events, results, and developments will ultimately differ from the
        expectations and may differ materially from those expressed or implied in
        such
        forward-looking statements.  Factors which could affect actual results
        include economic conditions in our market area and the nation as a whole,
        interest rate fluctuations, the impact of competitive products, services,
        and
        pricing, our credit risk management, our ability to control our costs and
        expenses, 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 2006 financial statements to conform
        to
        the 2007 presentation.  There is no effect on net income, earnings per
        share, or equity.  All significant intercompany transactions and
        balances have been eliminated.
 
 The
        information included in this Form 10-Q should be read in conjunction with
        the
        First Mutual Bancshares, Inc. Year 2006 Annual Report on Form 10-K to the
        Securities and Exchange Commission.  Interim results are not
        necessarily indicative of results for a full year.
 
 Consolidated
        Financial Statements of the Company begin on page 2.
 
  1


Item
      1.  Financial Statements


FIRST
      MUTUAL BANCSHARES,
      INC.


**CONSOLIDATED
        STATEMENTS OF FINANCIAL CONDITION**
 **(Dollars
        in thousands)**




March
                  31,
              
              
              December
                  31,2007
              
              
              2006**Assets**
              
              *(Unaudited)*Cash
                  and Cash Equivalents:Interest-earning
                  deposits
              
              $
              3,557
              
              
              $
              6,990Noninterest-earning
                  demand deposits and cash on hand
              
              
              13,385
              
              
              
              18,372Total
                  cash and cash equivalents
              
              
              16,942
              
              
              
              25,362Mortgage-backed
                  and other securities available-for-sale (at fair value)
              
              
              4,589
              
              
              
              89,728Mortgage-backed
                  and other securities held for trading (at fair value)
              
              
              86,733
              
              
              
              —Mortgage-backed
                  and other securities held-to-maturityfair
                  value of $5,176 and $5,585
              
              
              5,208
              
              
              
              5,620Loans
                  held for sale
              
              
              20,915
              
              
              
              13,733Loans
                  receivable
              
              
              870,707
              
              
              
              893,431Reserve
                  for loan and lease losses
              
              
              (9,773
              )
              
              
              (9,728
              )Loans
                  receivable, net
              
              
              860,934
              
              
              
              883,703Accrued
                  interest receivable
              
              
              5,585
              
              
              
              5,534Land,
                  buildings and equipment, net
              
              
              35,696
              
              
              
              35,566Federal
                  Home Loan Bank (FHLB) stock, at cost
              
              
              13,122
              
              
              
              13,122Servicing
                  assets
              
              
              4,608
              
              
              
              4,011Other
                  assets
              
              
              2,515
              
              
              
              2,884**Total
                  Assets**
              
              $
              1,056,847
              
              
              $
              1,079,263










See
      Notes
      to the Financial Statements


2


**FIRST
      MUTUAL BANCSHARES, INC.**


**CONSOLIDATED
      STATEMENTS OF FINANCIAL CONDITION**


**(Dollars
      in thousands)**


**(Continued)**




March
                  31,
              
              
              December
                  31,2007
              
              
              2006*(Unaudited)***Liabilities**Deposits:Non-interest-bearing
              
              $
              56,022
              
              
              $
              56,566Interest-bearing
                  transactions and savings accounts
              
              
              275,997
              
              
              
              263,830Interest-bearing
                  time deposits
              
              
              439,640
              
              
              
              485,399Total
                  deposits
              
              
              771,659
              
              
              
              805,795Drafts
                  payable
              
              
              911
              
              
              
              1,314Accounts
                  payable and other liabilities
              
              
              9,600
              
              
              
              7,018Advance
                  payments by borrowers for taxes and insurance
              
              
              2,601
              
              
              
              1,583FHLB
                  advances
              
              
              178,067
              
              
              
              171,932Other
                  advances
              
              
              4,600
              
              
              
              4,600Junior
                  subordinated long-term debentures (at fair value)
              
              
              9,044
              
              
              
              9,000Junior
                  subordinated long-term debentures
              
              
              8,000
              
              
              
              8,000Total
                  liabilities
              
              
              984,482
              
              
              
              1,009,242**Stockholders’
                  Equity**Common
                  stock, $1 par value, 30,000,000 shares authorized,6,687,975
                  and 6,673,528 shares issued and outstanding
              
              $
              6,688
              
              
              $
              6,674Additional
                  paid-in capital
              
              
              45,538
              
              
              
              45,119Retained
                  earnings
              
              
              20,148
              
              
              
              19,589Accumulated
                  other comprehensive income(loss):Unrealized
                  (loss) on securities available-for-sale,net
                  of federal income tax
              
              
              (9
              )
              
              
              (1,361
              )Total
                  stockholders’ equity
              
              
              72,365
              
              
              
              70,021**Total
                  Liabilities and Stockholders’ Equity**
              
              $
              1,056,847
              
              
              $
              1,079,263


See
      Notes
      to the Financial Statements


3


**FIRST
      MUTUAL BANCSHARES, INC.**


**CONSOLIDATED
      STATEMENTS OF INCOME**


**(Dollars
      in thousands)**




Quarter
                  ended March 31,2007
              
              
              2006*(Unaudited)***Interest
                  Income**Loans
                  receivable
              
              $
              18,500
              
              
              $
              17,547Interest
                  on available-for-sale securities-taxable
              
              
              54
              
              
              
              1,193Interest
                  on held-to-maturity securities-taxable
              
              
              61
              
              
              
              74Interest
                  on held-to-maturity securities-non taxable
              
              
              16
              
              
              
              16Interest
                  on held-for-trading securities-taxable
              
              
              833
              
              
              
              —Interest
                  on held-for-trading securities-non taxable
              
              
              112
              
              
              
              —Interest
                  other
              
              
              206
              
              
              
              118Total
                  interest income
              
              
              19,782
              
              
              
              18,948**Interest
                  Expense**Deposits
              
              
              7,710
              
              
              
              5,916FHLB
                  and other advances
              
              
              2,721
              
              
              
              2,801Total
                  interest expense
              
              
              10,431
              
              
              
              8,717Net
                  interest income
              
              
              9,351
              
              
              
              10,231Provision
                  for loan and lease losses
              
              
              (152
              )
              
              
              (71
              )Net
                  interest income, after provisionfor
                  loan and lease losses
              
              
              9,199
              
              
              
              10,160**Noninterest
                  Income**Gain
                  on sales of loans
              
              
              973
              
              
              
              756Gain
                  from mark to market (SFAS No. 159)
              
              
              447
              
              
              
              —Servicing
                  fees, net of amortization
              
              
              437
              
              
              
              335Fees
                  on deposits
              
              
              188
              
              
              
              182Other
              
              
              618
              
              
              
              442Total
                  noninterest income
              
              
              2,663
              
              
              
              1,715


See
      Notes
      to the Financial Statements





4


**FIRST
      MUTUAL BANCSHARES, INC.**


**CONSOLIDATED
      STATEMENTS OF INCOME**


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


**(Continued)**




Quarter
                  ended March 31,2007
              
              
              2006*(Unaudited)***Noninterest
                  Expense**Salaries
                  and employee benefits
              
              $
              4,509
              
              
              $
              4,446Occupancy
              
              
              982
              
              
              
              1,010Credit
                  insurance premiums
              
              
              426
              
              
              
              463Other
              
              
              1,819
              
              
              
              1,769Total
                  noninterest expense
              
              
              7,736
              
              
              
              7,688Income
                  before provision for federal income tax
              
              
              4,126
              
              
              
              4,187Provision
                  for federal income tax
              
              
              1,411
              
              
              
              1,473**Net
                  Income**
              
              $
              2,715
              
              
              $
              2,714**Per
                  Share Data(1):**Basic
                  earnings per common share
              
              $
              0.41
              
              
              $
              0.41Diluted
                  earnings per common share
              
              $
              0.39
              
              
              $
              0.40**Weighted
                  Average Number of Shares Outstanding**
              
              
              6,682,000
              
              
              
              6,627,298**Weighted
                  Average Number of Shares Outstanding****Including
                  Dilutive Stock Options**
              
              
              6,933,269
              
              
              
              6,758,785




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




See
      Notes
      to the Financial Statements





5


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


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


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







AccumulatedAdditional
                                    
                                    
                                    
                                    
                                    
                                    ComprehensiveCommon
                                        Stock (1)
                                    
                                    
                                    Paid-in
                                    
                                    
                                    Retained
                                    
                                    
                                    IncomeShares
                                    
                                    
                                    Amount
                                    
                                    
                                    Capital
                                        (1)
                                    
                                    
                                    Earnings
                                    
                                    
                                    (Loss)
                                    
                                    
                                    TotalBALANCE,
                                        December 31, 2004
                                    
                                    
                                    6,611
                                    
                                    
                                    $
                                    6,611
                                    
                                    
                                    $
                                    44,273
                                    
                                    
                                    $
                                    9,220
                                    
                                    
                                    $
                                    (657
                                    )
                                    
                                    $
                                    59,447Comprehensive
                                        income:Net
                                        income
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    10,319
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    10,319Other
                                        comprehensive income (loss), net of tax:Unrealized
                                        (loss) on securities available-for-sale
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    (945
                                    )
                                    
                                    
                                    (945
                                    )Unrealized
                                        gain on interest rate swap
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    166
                                    
                                    
                                    
                                    166Total
                                        comprehensive income
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    9,540Options
                                        exercised, including tax benefit of $479
                                    
                                    
                                    185
                                    
                                    
                                    
                                    185
                                    
                                    
                                    
                                    1,727
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    1,912Retirement
                                        of shares repurchased
                                    
                                    
                                    (180
                                    )
                                    
                                    
                                    (180
                                    )
                                    
                                    
                                    (2,130
                                    )
                                    
                                    
                                    (1,344
                                    )
                                    
                                    
                                    
                                    
                                    
                                    
                                    (3,654
                                    )Issuance
                                        of stock through employees’ stock plans
                                    
                                    
                                    5
                                    
                                    
                                    
                                    5
                                    
                                    
                                    
                                    95
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    100Cash
                                        dividend declared ($1.11 per share)
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    (7,318
                                    )
                                    
                                    
                                    
                                    
                                    
                                    
                                    (7,318
                                    )—BALANCE,
                                        December 31, 2005
                                    
                                    
                                    6,621
                                    
                                    
                                    $
                                    6,621
                                    
                                    
                                    $
                                    43,965
                                    
                                    
                                    $
                                    10,877
                                    
                                    
                                    $
                                    (1,436
                                    )
                                    
                                    $
                                    60,027Comprehensive
                                        income:Net
                                        income
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    10,980
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    10,980Other
                                        comprehensive income (loss), net of tax:Unrealized
                                        gain on securities available-for-sale
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    75
                                    
                                    
                                    
                                    75Total
                                        comprehensive income
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    11,055Compensation
                                        related to stock options
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    633
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    633Options
                                        exercised, including tax benefit of $110
                                    
                                    
                                    48
                                    
                                    
                                    
                                    48
                                    
                                    
                                    
                                    427
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    475Issuance
                                        of stock through employees’ stock plans
                                    
                                    
                                    5
                                    
                                    
                                    
                                    5
                                    
                                    
                                    
                                    95
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    100Cash
                                        in lieu of shares issued for 5 for 4 stock
                                        split
                                    
                                    
                                    
                                    
                                    
                                    
                                    —
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    —Cash
                                        dividend declared ($0.32 per share)
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    (2,268
                                    )
                                    
                                    
                                    
                                    
                                    
                                    
                                    (2,268
                                    )—BALANCE,
                                        December 31, 2006
                                    
                                    
                                    6,674
                                    
                                    
                                    $
                                    6,674
                                    
                                    
                                    $
                                    45,120
                                    
                                    
                                    $
                                    19,589
                                    
                                    
                                    $
                                    (1,361
                                    )
                                    
                                    $
                                    70,022Cummulative-effect
                                        adjustment for the initial adoption of SFAS
                                        No. 159
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    (1,554
                                    )
                                    
                                    
                                    
                                    
                                    
                                    
                                    (1,554
                                    )Comprehensive
                                        income:Net
                                        income
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    2,715
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    2,715Other
                                        comprehensive income, net of tax:Unrealized
                                        gain on securities available-for-sale
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    1,352
                                    
                                    
                                    
                                    1,352Total
                                        comprehensive income
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    4,067Compensation
                                        related to stock options
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    184
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    184Options
                                        exercised, including tax benefit of $37
                                    
                                    
                                    9
                                    
                                    
                                    
                                    9
                                    
                                    
                                    
                                    120
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    129Issuance
                                        of stock through employees’ stock plans
                                    
                                    
                                    5
                                    
                                    
                                    
                                    5
                                    
                                    
                                    
                                    114
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    119Cash
                                        dividend declared ($0.09 per share)
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    (602
                                    )
                                    
                                    
                                    
                                    
                                    
                                    
                                    (602
                                    )—BALANCE,
                                        March 31, 2007
                                    
                                    
                                    6,688
                                    
                                    
                                    $
                                    6,688
                                    
                                    
                                    $
                                    45,538
                                    
                                    
                                    $
                                    20,148
                                    
                                    
                                    $
                                    (9
                                    )
                                    
                                    $
                                    72,365


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





6


**FIRST
        MUTUAL BANCSHARES, INC.**
 **CONSOLIDATED
        STATEMENTS OF CASH FLOWS**
 **(Dollars
        in thousands)**
  Three
                                                months ended March 31,2007
                                            
                                            
                                            2006*(Unaudited)***Cash
                                                Flows from Operating Activities**Net
                                                income
                                            
                                            $
                                            2,715
                                            
                                            
                                            $
                                            2,714Adjustments
                                                to reconcile net income to net cash
                                                from operating
                                                activities:Provision
                                                for loan and lease losses
                                            
                                            
                                            152
                                            
                                            
                                            
                                            71Depreciation
                                                and amortization
                                            
                                            
                                            461
                                            
                                            
                                            
                                            448Deferred
                                                loan origination fees, net of accretion
                                            
                                            
                                            (275
                                            )
                                            
                                            
                                            247Amortization
                                                of servicing assets
                                            
                                            
                                            495
                                            
                                            
                                            
                                            251Gain
                                                on sales of loans
                                            
                                            
                                            (973
                                            )
                                            
                                            
                                            (756
                                            )Stock-based
                                                compensation
                                            
                                            
                                            184
                                            
                                            
                                            
                                            135Excess
                                                tax benefit from stock-based compensation
                                            
                                            
                                            (37
                                            )
                                            
                                            
                                            (5
                                            )Changes
                                                in operating assets and liabilities:Loans
                                                held-for-sale
                                            
                                            
                                            (7,182
                                            )
                                            
                                            
                                            764Accrued
                                                interest receivable
                                            
                                            
                                            (51
                                            )
                                            
                                            
                                            (11
                                            )Other
                                                assets
                                            
                                            
                                            186
                                            
                                            
                                            
                                            (108
                                            )Drafts
                                                payable
                                            
                                            
                                            (403
                                            )
                                            
                                            
                                            438Accounts
                                                payable and other liabilities
                                            
                                            
                                            2,629
                                            
                                            
                                            
                                            (2,901
                                            )Advance
                                                payments by borrowers for taxes and
                                                insurance
                                            
                                            
                                            1,018
                                            
                                            
                                            
                                            1,206Net
                                                cash provided/(used) by operating
                                                activities
                                            
                                            
                                            (1,081
                                            )
                                            
                                            
                                            2,493**Cash
                                                Flows from Investing Activities**Loan
                                                originations
                                            
                                            
                                            (61,691
                                            )
                                            
                                            
                                            (98,760
                                            )Loan
                                                principal repayments
                                            
                                            
                                            100,470
                                            
                                            
                                            
                                            99,693Decrease
                                                in undisbursed loan proceeds
                                            
                                            
                                            (16,561
                                            )
                                            
                                            
                                            (4,734
                                            )Principal
                                                  repayments and redemptions on mortgage-backed
                                                  and other
                                                  securities
                                            
                                            
                                            4,343
                                            
                                            
                                            
                                            11,398Purchase
                                                of securities available-for-sale
                                            
                                            
                                            (4,955
                                            )
                                            
                                            
                                            (7,170
                                            )Purchases
                                                of premises and equipment
                                            
                                            
                                            (591
                                            )
                                            
                                            
                                            (1,329
                                            )Proceeds
                                                from sale of impaired loan
                                            
                                            
                                            —
                                            
                                            
                                            
                                            340Net
                                                cash provided/(used) by investing
                                                activities
                                            
                                            
                                            21,015
                                            
                                            
                                            
                                            (562
                                            )
   See
                            Notes
                            to the Financial
                            Statements
  7
 **FIRST
        MUTUAL BANCSHARES, INC.**
 **CONSOLIDATED
        STATEMENTS OF CASH FLOWS**
 **(Dollars
        in thousands)**
 (Continued)
  Three
                        months ended March 31,2007
                    
                    
                    2006*(Unaudited)***Cash
                        Flows from Financing Activities**Net
                        increase/(decrease) in deposit accounts
                    
                    $
                    (41,330
                    )
                    
                    $
                    17,497Interest
                        credited to deposit accounts
                    
                    
                    7,194
                    
                    
                    
                    5,397Issuance
                        of stock through employees’ stock plans
                    
                    
                    119
                    
                    
                    
                    100Proceeds
                        from advances
                    
                    
                    135,032
                    
                    
                    
                    143,556Repayment
                        of advances
                    
                    
                    (128,897
                    )
                    
                    
                    (162,292
                    )Dividends
                        paid
                    
                    
                    (601
                    )
                    
                    
                    (5,824
                    )Proceeds
                            from exercise of stock options and excess tax benefit
                            of $37 and $5 from
                            stock-based compensation
                    
                    
                    129
                    
                    
                    
                    126Net
                        cash (used) by financing activities
                    
                    
                    (28,354
                    )
                    
                    
                    (1,440
                    )**Increase/(decrease)
                        in cash and cash equivalents**
                    
                    $
                    (8,420
                    )
                    
                    $
                    491Cash
                        and cash equivalents, beginning of the year
                    
                    
                    25,362
                    
                    
                    
                    25,781Cash
                        and cash equivalents, end of quarter
                    
                    $
                    16,942
                    
                    
                    $
                    26,272**Supplemental
                        Disclosures of Cash Flow Information**Loans
                        originated for sale in the secondary market
                    
                    $
                    33,710
                    
                    
                    $
                    22,657Loans
                        originated for investment activities
                    
                    
                    61,691
                    
                    
                    
                    98,760Proceeds
                        from sale of loans held-for-sale
                    
                    
                    26,527
                    
                    
                    
                    23,421Additions
                        to servicing assets
                    
                    
                    1,092
                    
                    
                    
                    860Cash
                        paid during the year for:Interest
                    
                    
                    10,581
                    
                    
                    
                    8,272**Supplemental
                        Disclosures of Noncash Investing Activities**Loans
                        transferred to real estate, held-for-sale, net
                    
                    $
                    —
                    
                    
                    $
                    28
   See
        Notes
        to the Financial Statements
  8


**NOTES
      TO CONSOLIDATED FINANCIAL
      STATEMENTS**


**(Unaudited)**
 
 **Note
        1.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**
 
 The
        results of operations for the interim periods shown in this report are not
        necessarily indicative of results to  be expected for the fiscal
        year.  In the opinion of management, the information contained herein
        reflects all adjustments necessary to make the results of operations for
        the
        interim periods a fair statement of such operations.
 
 **Note
        2.  ADOPTION OF NEW ACCOUNTING STANDARDS**
 
 **Financial
        Accounting Standards Board Interpretation No. 48,*Accounting for
        Uncertainty in Income Taxes*(FIN No. 48)**
 
 In
        June
        2006, the Financial Accounting Standards Board (FASB) issued FIN No. 48 -
        an
        interpretation of FASB Statement No. 109, *Accounting for Income
        Taxes*.  FIN No. 48 establishes a single model to address
        accounting for uncertain tax positions.  FIN No. 48 clarifies the
        accounting for income taxes by prescribing a minimum recognition threshold
        a tax
        position is required to meet before being recognized in the financial
        statements.  FIN No. 48 also provides guidance on derecognition,
        measurement classification, interest and penalties, accounting in interim
        periods, disclosure and transition.  We adopted FIN No. 48 on January
        1, 2007, no adjustments have been made to our financial statements as a result
        of this adoption.  We do not believe that we have any uncertain tax
        positions that would rise to the level of having a material impact on our
        financial statements.
 
 Our
        continuing practice is to recognize interest and/or penalties related to
        income
        tax matters in income tax expense.
 
 **Statement
        of Financial Accounting Standards No. 156 (SFAS 156),*Accounting for
        Servicing of Financial Assets***
 
 In
        March
        of 2006, the FASB published SFAS No. 156, which amends SFAS No. 140,
*Accounting for Transfers and Servicing of Financial Assets and
        Extinguishments of Liabilities*, with respect to the accounting for
        servicing of financial assets. SFAS No. 156 requires that all seperately
        recognized servicing rights be initially measured at fair value, if
        practicable.  For each class of seperately recognized servicing assets
        and liabilities, SFAS No. 156 permits an entity to choose either of the
        following subsequent measurement methods:  (1) the amortization of
        servicing assets or liabilities in proportion to and over the period of
        estimated net servicing income or net servicing loss or (2) the reporting
        of
        servicing assets or liabilities at fair value at each reporting date and
        reporting changes in fair value in earnings in the period in which the changes
        occur. SFAS No. 156 also requires additional disclosures for all seperately
        recognized servicing rights.  We adopted SFAS No. 156 on January 1,
        2007 and have elected to continue to amortize our servicing assets or
        liabilities in proportion to and over the period of estimated net servicing
        income or net servicing loss.
 
 Originated
        servicing assets are recorded when loans are originated and subsequently
        sold or
        securitized (and held as available-for-sale securities) with the servicing
        rights retained.  Servicing assets are initially recognized at fair
        value on the balance sheet.  Fair value is based on market prices for
        comparable servicing contracts, when available, or alternatively, is based
        on a
        valuation model that calculates the present value of the estimated future
        cash
        flows.  Assumptions used in the valuation model include market
        discount rates and anticipated prepayment speeds.  The prepayment
        speeds of the servicing portfolio are based on our prepayment experience
        for
        those stratas for which market data is not readily available.  These
        servicing assets include sales finance loans, construction loan participations,
        lot loans, and other commercial loans for which there is no readily available
        online quotation data.  In addition, estimates of the cost of
        servicing per loan, an inflation rate, ancillary income per loan, and default
        rates are used.  The cost relating to the servicing rights is
        capitalized and amortized into noninterest income in proportion to, and over
        the
        period of, estimated future net servicing income. Amounts capitalized are
        recorded at cost, net of accumulated amortization and valuation
        allowance.
 
 We
        assess
        impairment of the capitalized servicing assets based on recalculations of
        the
        present value of the remaining future cash flows using updated market discount
        rates and prepayment speeds.  Subsequent loan prepayments and changes
        in prepayment assumptions in excess of those forecasted can adversely impact
        the
        carrying value of the servicing assets.  Impairment is assessed on a
        stratum-by-stratum basis with any impairment recognized through a valuation
        allowance for each impaired stratum.  The servicing assets are
        stratified based on the types of loans and the underlying
        collateral.  We have three strata or classes of servicing
        assets:  consumer (sales finance), commercial, and
        residential.
 
 The
        effect of changes in market interest rates on estimated rates of loan
        prepayments is the predominant risk characteristic for mortgage servicing
        rights.  For those loans that do not have quoted prepayment rates we
        utilize our own prepayment experience over the previous three months to reflect
        the actual prepayment environment in our underlying assumptions of the estimated
        fair value of the servicing rights upon recognition.  The significant
        assumption used in the valuation model is the discount rate.  This is
        generally the weighted average note rate of the underlying loans.
 
 Changes
        in the servicing asset balances, the fair values, discount and prepayment
        assumptions by strata are as follows:
  9


First
                        Quarter 2007Consumer
                    
                    
                    Commercial
                    
                    
                    Residential
                    
                    
                    Total(Dollars
                        in thousands)Balance,
                        beginning of year
                    
                    $
                    3,724
                    
                    
                    $
                    224
                    
                    
                    $
                    63
                    
                    
                    $
                    4,011Additions
                    
                    
                    1,092
                    
                    
                    
                    —
                    
                    
                    
                    —
                    
                    
                    
                    1,092Amortization
                    
                    
                    (430
                    )
                    
                    
                    (49
                    )
                    
                    
                    (6
                    )
                    
                    
                    (485
                    )Impairment
                    
                    
                    —
                    
                    
                    
                    (10
                    )
                    
                    
                    —
                    
                    
                    
                    (10
                    )Balance
                        at March 31, 2007
                    
                    $
                    4,386
                    
                    
                    $
                    165
                    
                    
                    $
                    57
                    
                    
                    $
                    4,608Fair
                        Values atJanuary
                        1, 2007
                    
                    $
                    4,071
                    
                    
                    $
                    334
                    
                    
                    $
                    83Fair
                        Values atMarch
                        31, 2007
                    
                    $
                    4,544
                    
                    
                    $
                    165
                    
                    
                    $
                    97Discount
                        rate
                    
                    
                    11.4
                    %
                    
                    
                    9.9
                    %
                    
                    
                    8.0
                    %Prepayment
                        speed
                    
                    
                    35.6
                    %
                    
                    
                    45.6
                    %
                    
                    
                    18.8
                    %First
                        Quarter 2006Consumer
                    
                    
                    Commercial
                    
                    
                    Residential
                    
                    
                    Total(Dollars
                        in thousands)Balance,
                        beginning of year
                    
                    $
                    1,460
                    
                    
                    $
                    292
                    
                    
                    $
                    114
                    
                    
                    $
                    1,866Additions
                    
                    
                    839
                    
                    
                    
                    21
                    
                    
                    
                    —
                    
                    
                    
                    860Amortization
                    
                    
                    (192
                    )
                    
                    
                    (38
                    )
                    
                    
                    (22
                    )
                    
                    
                    (252
                    )Impairment
                    
                    
                    —
                    
                    
                    
                    —
                    
                    
                    
                    —
                    
                    
                    
                    —Balance
                        at March 31, 2006
                    
                    $
                    2,107
                    
                    
                    $
                    275
                    
                    
                    $
                    92
                    
                    
                    $
                    2,474Fair
                        Values atJanuary
                        1, 2006
                    
                    $
                    1,973
                    
                    
                    $
                    516
                    
                    
                    $
                    150Fair
                        Values atMarch
                        31, 2006
                    
                    $
                    2,314
                    
                    
                    $
                    488
                    
                    
                    $
                    160Discount
                        rate
                    
                    
                    10.7
                    %
                    
                    
                    10.2
                    %
                    
                    
                    8.7
                    %Prepayment
                        speed
                    
                    
                    38.5
                    %
                    
                    
                    31.4
                    %
                    
                    
                    37.1
                    %
  Servicing
          fee income, net of amortization, consisted of the following for the quarters
          ended March 31, 2007, 2006 and 2005:
  First
                        Quarter 2007Consumer
                    
                    
                    Commercial
                    
                    
                    Residential
                    
                    
                    Total(Dollars
                        in thousands)Servicing
                        fees
                    
                    $
                    892
                    
                    
                    $
                    33
                    
                    
                    $
                    7
                    
                    
                    $
                    932Amortization
                    
                    
                    (430
                    )
                    
                    
                    (59
                    )
                    
                    
                    (6
                    )
                    
                    
                    (495
                    )Loan
                        servicing fees, net
                    
                    $
                    462
                    
                    
                    $
                    (26
                    )
                    
                    $
                    1
                    
                    
                    $
                    437First
                        Quarter 2006Consumer
                    
                    
                    Commercial
                    
                    
                    Residential
                    
                    
                    Total(Dollars
                        in thousands)Servicing
                        fees
                    
                    $
                    523
                    
                    
                    $
                    47
                    
                    
                    $
                    16
                    
                    
                    $
                    586Amortization
                    
                    
                    (191
                    )
                    
                    
                    (38
                    )
                    
                    
                    (22
                    )
                    
                    
                    (251
                    )Loan
                        servicing fees, net
                    
                    $
                    332
                    
                    
                    $
                    9
                    
                    
                    $
                    (6
                    )
                    
                    $
                    335
  10
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **(Unaudited)**
 
 **Note
        2.  ADOPTION OF NEW ACCOUNTING STANDARDS
        (Continued)**
 
 **Statement
        of Financial Accounting Standards No. 157, *Fair Value
        Measurements*****and
        No 159, *The Fair Value Option for Financial Assets and Financial
        Liabilities*,****(SFAS
        No. 157 and SFAS No. 159)**
 
 We
        elected early adoption of SFAS No. 157 and SFAS No. 159 effective January
        1,
        2007.
 
 In
        September 2006, the FASB issued SFAS No. 157 which defines fair value,
        establishes a consistent framework for measuring fair value in Generally
        Accepted Accounting Principles, and expands disclosure requirements about
        fair value measurements. SFAS No. 157 among other things requires us to maximize
        the use of observable inputs and minimize the use of unobservable inputs
        when
        measuring fair value.
  Valuation
        techniques are based upon observable and
        unobservable inputs. Observable inputs reflect market data obtained from
        independent sources, while unobservable inputs reflect our market assumptions.
        These two types of inputs create the following fair value
        hierarchy:
 Level
            1 - Quoted prices for identical instruments in
            active markets. Level
            2 - Quoted prices for similar instruments in
            active markets; quoted prices for identical or similar instruments in
            markets
            that are not active; and model-derived valuations whose inputs are
            observable. Level
            3 - Instruments whose significant value drivers
            are observable. In
        February 2007, the FASB issued SFAS No. 159.  SFAS 159 allows entities
        to voluntarily choose, at specified election dates, to measure many financial
        assets and financial liabilities at fair value.  The election is made
        on an instrument-by-instrument basis and is irrevocable.  If the fair
        value option is elected for an instrument, all subsequent changes in fair
        value
        for that instrument shall be reported in earnings.
 
 The
        following is a breakdown of the cumulative effect adjustment that was made
        to
        retained earnings upon adoption of SFAS 159:
 **Description**
                  
                  **Balance
                      Sheet**
                    **at
                      January 1,**
                    **2007
                      prior to**
                    **Adoption**
                  
                  
                  **Net**
                    **Gain/(Loss)**
                    **upon
                      Adoption**
                  
                  
                  **Balance
                      Sheet**
                    **at
                      January 1,**
                    **2007
                      after**
                    **Adoption
                      of the**
                    **Fair
                      Value**
                    **Option**(Dollars
                      in thousands)Mortgage-backed
                      and agency securities - gross
                  
                  $
                  87,148
                  
                  
                  $
                  (2,149
                  )
                  
                  $
                  84,999(excluding
                      premiums and discounts)Premiums
                      and discounts related to securities
                  
                  
                  (97
                  )
                  
                  
                  97
                  
                  
                  
                  —Long-term
                      debentures payable (trust preferred securities)
                  
                  
                  9,000
                  
                  
                  
                  (89
                  )
                  
                  
                  8,911Issuance
                      costs related to long-term debentures
                  
                  
                  249
                  
                  
                  
                  (249
                  )
                  
                  
                  —Pretax
                      cumulative effect of adoption ofthe
                      fair value option
                  
                  
                  
                  
                  
                  
                  (2,390
                  )Increase
                      in deferred tax asset
                  
                  
                  
                  
                  
                  
                  836Cumulative
                      effect of adoption of the fair valueoption
                      (charge to retained earnings)
                  
                  
                  
                  
                  
                  $
                  (1,554
                  )


Mortgage-Backed
          and Agency Securities
 
 The
          mortgage-backed and agency securities selected for treatment under SFAS
          No. 159
          consisted of $87.1 million or 89% of the securities
          portfolio.  Securities with a remaining balance less than one
  11
 million
          dollars and instruments held for Community Reinvestment Act (CRA) investments
          were not included in the adoption of SFAS No. 159.  Securites with
          small balances are much less attractive to potential purchasers and the
          CRA
          investments were purchased to facilitate compliance with the Community
          Reinvestment Act.  The initial fair value of the securities selected
          for SFAS No. 159 adoption resulted in a $1,334,000 cummulative-effect
          adjustment, net of tax, recorded as a reduction in retained earnings as
          of
          January 1, 2007.  Under SFAS No. 159, this one-time charge will not be
          recognized in earnings.  As a result of the fair value measurement
          election for these securities, we recorded gains in the first quarter 2007
          earnings of $402,000.  The early adoption of the standard will enable
          us to manage interest rate risk more effectively.
 
 The
          securities selected to be accounted for under SFAS No. 159 are presented
          seperately from the securities that are accounted for at cost and titled
“Held
          for Trading (at fair value)”.
 
 Junior
          Subordinated Long-Term Debentures Payable (Trust Preferred
          Securities)
 
 The
          junior subordinated long-term debentures selected for treatment under SFAS
          No.
          159 totaled $9 million.  The initial fair value measurement resulted
          in a $220,000, net of tax, charge to retained earnings for unamortized
          issuance
          costs and excess interest.  In the first quarter of 2007, we recorded
          $45,000 in pre-tax mark-to-market gains.  We elected to account for
          our first $9 million junior subordinated long-term debenture issuance and
          not
          the other two issuances of $4 million each under SFAS No. 159 because this
          particular security is hedged with an interest-rate swap that is carried
          at fair
          value, with changes in value reflected in our earnings (the other two debentures
          are not hedged).  The election to fair value the debentures matches
          the change in value of the interest-rate swap with the change in value
          of the
          debentures - effectively reducing the volitility in earnings.  This
          security is eligible for prepayment on September 30, 2007. We have entered
          into
          a committment to replace this instrument with another long-term
          debenture.
 
 The
          long-term debentures payable selected to be accounted for under SFAS No.
          159 are
          presented seperately from the long-term debentures payable that are accounted
          for at cost and titled “long-term debentures payable (at fair
          value)”.
 
 Interest-Rate
          Swaps
 
 The
          interest-rate swaps and related commercial loans were included in the early
          adoption of SFAS 159 for administrative reasons.  We have two fair
          value swaps that are hedged with commercial loans and are evaluated quarterly
          in
          accordance with SFAS 133, the hedge accounting statement.  The
          inclusion of these two swaps and loans in the adoption of SFAS 159 did not
          impact retained earnings or net income, however, the administrative burden
          associated with accounting for these instruments will be greatly reduced
          under
          the new accounting statement.  These two swaps were the only swaps
          that were accounted for in accordance with the long-haul accounting method,
          under SFAS No. 133, as amended.
  The
            fair
            value of the swaps are included in “Accounts Payable and Other” and the fair
            value of the commercial loans that are being hedged are included in “Loans
            Receivable” on the balance sheet. On January 1, 2007 the fair value of the two
            swaps was $23,517 and the fair value of the loans totaled $22,742.  On
            March 31, 2007 the fair value of the swaps included in “Accounts Payable and
            Other” totaled $23,689 and the fair value of the loans amounted to
            $23,698.
  12


Fair
                        Value Measurements at March 31, 2007
                    
                    Changes
                        in Fair Values for the 3-
                      Month
                        Period Ended March 31,
                      2007,
                        for Items Measured at Fair
                      Value
                        Pursuant to Election of the
                      Fair
                        Value OptionDescription
                    
                    Fair
                        Value
                      Measurements
                      3/31/07
                    
                    
                    Quoted
                        Prices in
                      Active
                        Markets
                      for
                        Identical
                      Assets
                        (Level 1)
                    
                    
                    Significant
                      Other
                      Observable
                      Inputs
                        (Level 2)
                    
                    Significant
                        Unobservable
                      Inputs
                        (Level 3)
                    
                    Interest
                      Expense
                        -
                      FHLB
                        and
                      Other
                      Advances
                    
                    Interest
                      Income
                      on
                        Loans
                    
                    Total
                      Changes
                      in
                        Fair
                      Values
                      Included
                      in
                        Current-
                      Period
                      Earnings(Dollars
                        in thousands)Trading
                        securities
                    
                    
                    86,733
                    
                    
                    
                    86,733
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    —Long-term
                        debentures payable
                    
                    
                    9,044
                    
                    
                    
                    
                    
                    
                    
                    9,044
                    
                    
                    
                    
                    209
                    
                    
                    
                    
                    209Loans
                        Receivable
                    
                    
                    24
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    24
                    
                    
                    
                    
                    27
                    
                    
                    27




The
        contractual long-term debenture payable totaled $9.0 million and the unpaid
        principal balance on the two loans that were selected to be carried
        at fair value totaled $1.4 million at March 31, 2007.




13


**Note
      3.**


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




The
        amortized cost and estimated fair value of securities available-for-sale
        at
        March 31, 2007 and December 31, 2006 are summarized as
        follows:




Gross
                        
                        
                        GrossGross
                        
                        
                        Unrealized
                        
                        
                        Unrealized
                        
                        
                        EstimatedAmortized
                        
                        
                        Unrealized
                        
                        
                        Losses
                        
                        
                        Losses
                        
                        
                        FairCost
                        
                        
                        Gains
                        
                        
                        <1
                            Year
                        
                        
                        >1
                            Year
                        
                        
                        Value**March
                            31, 2007**
                        
                        (Dollars
                            in thousands)Freddie
                            Mac securities
                        
                        $
                        548
                        
                        
                        $
                        6
                        
                        
                        —
                        
                        
                        $
                        —
                        
                        
                        $
                        554Fannie
                            Mae securities
                        
                        
                        1,188
                        
                        
                        
                        6
                        
                        
                        —
                        
                        
                        
                        18
                        
                        
                        
                        1,176Ginnie
                            Mae securities
                        
                        
                        2,868
                        
                        
                        
                        2
                        
                        
                        —
                        
                        
                        
                        11
                        
                        
                        
                        2,859$
                        4,604
                        
                        
                        $
                        14
                        
                        
                        $
                        —
                        
                        
                        $
                        29
                        
                        
                        $
                        4,589**December
                            31, 2006**Freddie
                            Mac securities
                        
                        $
                        14,657
                        
                        
                        $
                        9
                        
                        
                        
                        —
                        
                        
                        $
                        565
                        
                        
                        $
                        14,101Fannie
                            Mae securities
                        
                        
                        32,222
                        
                        
                        
                        8
                        
                        
                        
                        —
                        
                        
                        
                        1,090
                        
                        
                        
                        31,140Ginnie
                            Mae securities
                        
                        
                        34,053
                        
                        
                        
                        2
                        
                        
                        
                        —
                        
                        
                        
                        397
                        
                        
                        
                        33,658US
                            agency securities
                        
                        
                        10,990
                        
                        
                        
                        —
                        
                        
                        
                        —
                        
                        
                        
                        161
                        
                        
                        
                        10,829$
                        91,922
                        
                        
                        $
                        19
                        
                        
                        $
                        —
                        
                        
                        $
                        2,213
                        
                        
                        $
                        89,728




Certain
      investment securities shown above currently have fair values less than amortized
      cost and therefore contain unrealized losses. The
      Bank
      has evaluated these securities and has determined that the decline in value
      is
      temporary and is related to the change in market interest rates
      since purchase.  The decline in value is not related to any company or
      industry specific event.  At March 31, 2007 and December 31, 2006 there
      were 5 and 32 investment securities with unrealized losses,
      respectively.  The Bank anticipates full recovery of amortized cost
      with respect to
      these
      securities at maturity or sooner in the event of a more favorable market
      interest rate environment.




**Note
        4.**




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




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




Gross
            
            
            GrossGross
            
            
            Unrealized
            
            
            Unrealized
            
            
            EstimatedAmortized
            
            
            Unrealized
            
            
            Losses
            
            
            Losses
            
            
            FairCost
            
            
            Gains
            
            
            <1
                Year
            
            
            >1
                Year
            
            
            Value**March
                31, 2007**
            
            (Dollars
                in thousands)Fannie
                Mae securities
            
            $
            3,863
            
            
            $
            30
            
            
            
            —
            
            
            $
            63
            
            
            $
            3,830Freddie
                Mac securities
            
            
            205
            
            
            
            4
            
            
            
            —
            
            
            
            —
            
            
            
            209Municipal
                bonds
            
            
            1,140
            
            
            
            1
            
            
            
            —
            
            
            
            4
            
            
            
            1,137$
            5,208
            
            
            $
            35
            
            
            $
            —
            
            
            $
            67
            
            
            $
            5,176**December
                31, 2006**Fannie
                Mae securities
            
            $
            4,176
            
            
            $
            35
            
            
            
            —
            
            
            $
            74
            
            
            $
            4,137Freddie
                Mac securities
            
            
            300
            
            
            
            7
            
            
            
            —
            
            
            
            —
            
            
            
            307Municipal
                bonds
            
            
            1,144
            
            
            
            1
            
            
            
            —
            
            
            
            4
            
            
            
            1,141$
            5,620
            
            
            $
            43
            
            
            $
            —
            
            
            $
            78
            
            
            $
            5,585




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




14


**Note
        5.**


**Nonperforming
        Assets**
  Nonperforming
        loans are summarized as follows:
   March
                            31, 2007
                        
                        
                        December
                            31, 2006(Dollars
                            in thousands)Impaired
                            loans with a valuation allowance
                        
                        $
                        870
                        
                        
                        $
                        1,283Valuation
                            allowance related to impaired loans
                        
                        
                        (198
                        )
                        
                        
                        (236
                        )Net
                            impaired loans
                        
                        
                        672
                        
                        
                        
                        1,047Non
                            accrual loans
                        
                        
                        1,309
                        
                        
                        
                        2,415Total
                            nonperforming or non-accrual loans
                        
                        
                        1,981
                        
                        
                        
                        3,462Real
                            estate owned
                        
                        
                        —
                        
                        
                        
                        —Nonperforming
                            Assets
                        
                        $
                        1,981
                        
                        
                        $
                        3,462Total
                            loans past due 90-days or more and still accruing interest
                        
                        $
                        —
                        
                        
                        $
                        —Average
                            balance of impaired loans
                        
                        $
                        860
                        
                        
                        $
                        592Interest
                            income recognized on impaired loans
                        
                        $
                        —
                        
                        
                        $
                        1
  **Note
        6.**
 **Earnings
        Per Share**




Basic
        Earnings Per Share is computed by dividing net income by the weighted-average
        number of shares outstanding
        during the year.  Diluted EPS reflects the potential dilutive effect
        of stock options and is computed by
        dividing net income by the weighted-average number of shares outstanding
        during
        the year, plus the dilutive common
        shares that would have been outstanding had the stock options been
        exercised.


The
          following is a reconciliation of the numerators and denominators of the
          basic
          and diluted earnings per share computations
          for quarters ending March 31, 2007 and March 31, 2006:
  Income
                                    
                                    
                                    Shares
                                    
                                    
                                    Per
                                        share(numerator)
                                    
                                    
                                    (denominator)
                                    
                                    
                                    amount(Dollars
                                        and shares in thousands except per share
                                        amounts)Quarter
                                        ended March 31, 2007Basic
                                        EPS:Income
                                        available to common shareholders
                                    
                                    $
                                    2,715
                                    
                                    
                                    
                                    6,682
                                    
                                    
                                    $
                                    0.41Effect
                                        of dilutive stock options
                                    
                                    
                                    —
                                    
                                    
                                    
                                    251Diluted
                                        EPS:Income
                                        available to common shareholdersplus
                                        assumed stock options exercised
                                    
                                    $
                                    2,715
                                    
                                    
                                    
                                    6,933
                                    
                                    
                                    $
                                    0.39Quarter
                                        ended March 31, 2006 (2)Basic
                                        EPS:Income
                                        available to common shareholders
                                    
                                    $
                                    2,714
                                    
                                    
                                    
                                    6,627
                                    
                                    
                                    $
                                    0.41Effect
                                        of dilutive stock options
                                    
                                    
                                    —
                                    
                                    
                                    
                                    132Diluted
                                        EPS:Income
                                        available to common shareholdersplus
                                        assumed stock options exercised
                                    
                                    $
                                    2,714
                                    
                                    
                                    
                                    6,759
                                    
                                    
                                    $
                                    0.40
 (2) Shares
          and EPS have been adjusted to reflect the five-for-four stock split paid on
          October 4, 2006.
  15
 **Note
        7.**
 **Rate
        Volume Analysis**
   FIRST
                            QUARTER 2007VSFIRST
                            QUARTER 2006INCREASE
                            (DECREASE) DUE TOTOTALVOLUME
                        
                        
                        RATE
                        
                        
                        CHANGEINTEREST
                            INCOME
                        
                        (Dollars
                            in thousands)Investments:Available-for-sale
                            securities
                        
                        $
                        (692
                        )
                        
                        $
                        (447
                        )
                        
                        $
                        (1,139
                        )Held-for-trading
                            securities
                        
                        
                        945
                        
                        
                        $
                        —
                        
                        
                        
                        945Held-to-maturity
                            securities
                        
                        
                        (17
                        )
                        
                        
                        4
                        
                        
                        
                        (13
                        )Other
                            equity investments
                        
                        
                        5
                        
                        
                        
                        83
                        
                        
                        
                        88Total
                            investments
                        
                        
                        241
                        
                        
                        
                        (360
                        )
                        
                        
                        (119
                        )Loans:Residential
                        
                        $
                        701
                        
                        
                        $
                        522
                        
                        
                        $
                        1,223Residential
                            construction
                        
                        
                        (447
                        )
                        
                        
                        112
                        
                        
                        
                        (335
                        )Multifamily
                        
                        
                        (563
                        )
                        
                        
                        327
                        
                        
                        
                        (236
                        )Multifamily
                            construction
                        
                        
                        85
                        
                        
                        
                        9
                        
                        
                        
                        94Commercial
                            real estate and business
                        
                        
                        305
                        
                        
                        
                        67
                        
                        
                        
                        372Commercial
                            real estate construction
                        
                        
                        186
                        
                        
                        
                        55
                        
                        
                        
                        241Consumer
                            and other
                        
                        
                        (346
                        )
                        
                        
                        (60
                        )
                        
                        
                        (406
                        )Total
                            loans
                        
                        
                        (79
                        )
                        
                        
                        1,032
                        
                        
                        
                        953Total
                            interest income
                        
                        $
                        162
                        
                        
                        $
                        672
                        
                        
                        $
                        834INTEREST
                            EXPENSEDeposits:Money
                            market deposit and checking
                        
                        $
                        204
                        
                        
                        $
                        515
                        
                        
                        $
                        719Savings
                        
                        
                        (3
                        )
                        
                        
                        —
                        
                        
                        
                        (3
                        )Time
                            deposits
                        
                        
                        (111
                        )
                        
                        
                        1,189
                        
                        
                        
                        1,078Total
                            deposits
                        
                        
                        90
                        
                        
                        
                        1,704
                        
                        
                        
                        1,794FHLB
                            advances and other
                        
                        
                        (684
                        )
                        
                        
                        604
                        
                        
                        
                        (80
                        )Total
                            interest expense
                        
                        
                        (594
                        )
                        
                        
                        2,308
                        
                        
                        
                        1,714Net
                            interest income
                        
                        $
                        756
                        
                        
                        $
                        (1,636
                        )
                        
                        $
                        (880
                        )


16


**Note
      8.**


**Business
      Segments**




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


**Quarter
                                                    ended March 31**RetailBanking
                                                
                                                
                                                SalesFinance
                                                
                                                
                                                ResidentialLending
                                                
                                                
                                                BusinessBanking
                                                
                                                
                                                IncomeProperty
                                                
                                                
                                                Investment
&Treasury
                                                
                                                
                                                ConsolidatedTotals(Dollars
                                                    in thousands)**Interest
                                                    income**
                                                2005
                                                
                                                $
                                                616
                                                
                                                
                                                $
                                                1,693
                                                
                                                
                                                $
                                                4,099
                                                
                                                
                                                $
                                                1,510
                                                
                                                
                                                $
                                                6,014
                                                
                                                
                                                $
                                                1,467
                                                
                                                
                                                $
                                                15,3992006
                                                
                                                
                                                820
                                                
                                                
                                                
                                                2,047
                                                
                                                
                                                
                                                5,957
                                                
                                                
                                                
                                                2,241
                                                
                                                
                                                
                                                6,481
                                                
                                                
                                                
                                                1,402
                                                
                                                
                                                
                                                18,9482007
                                                
                                                
                                                854
                                                
                                                
                                                
                                                1,616
                                                
                                                
                                                
                                                6,310
                                                
                                                
                                                
                                                2,867
                                                
                                                
                                                
                                                6,897
                                                
                                                
                                                
                                                1,238
                                                
                                                
                                                
                                                19,782**Treasury
                                                    and interest income**
                                                2005
                                                
                                                
                                                5,272
                                                
                                                
                                                
                                                48
                                                
                                                
                                                
                                                227
                                                
                                                
                                                
                                                294
                                                
                                                
                                                
                                                204
                                                
                                                
                                                
                                                2,760
                                                
                                                
                                                
                                                8,805**on
                                                    funding sources**
                                                2006
                                                
                                                
                                                8,531
                                                
                                                
                                                
                                                21
                                                
                                                
                                                
                                                101
                                                
                                                
                                                
                                                556
                                                
                                                
                                                
                                                93
                                                
                                                
                                                
                                                3,738
                                                
                                                
                                                
                                                13,0402007
                                                
                                                
                                                9,139
                                                
                                                
                                                
                                                17
                                                
                                                
                                                
                                                102
                                                
                                                
                                                
                                                880
                                                
                                                
                                                
                                                137
                                                
                                                
                                                
                                                3,242
                                                
                                                
                                                
                                                13,517**Funding
                                                    costs**
                                                2005
                                                
                                                
                                                286
                                                
                                                
                                                
                                                643
                                                
                                                
                                                
                                                2,501
                                                
                                                
                                                
                                                614
                                                
                                                
                                                
                                                3,175
                                                
                                                
                                                
                                                1,586
                                                
                                                
                                                
                                                8,8052006
                                                
                                                
                                                529
                                                
                                                
                                                
                                                1,066
                                                
                                                
                                                
                                                4,065
                                                
                                                
                                                
                                                1,366
                                                
                                                
                                                
                                                4,263
                                                
                                                
                                                
                                                1,751
                                                
                                                
                                                
                                                13,0402007
                                                
                                                
                                                543
                                                
                                                
                                                
                                                942
                                                
                                                
                                                
                                                4,307
                                                
                                                
                                                
                                                1,955
                                                
                                                
                                                
                                                4,324
                                                
                                                
                                                
                                                1,446
                                                
                                                
                                                
                                                13,517**Interest
                                                    expense**
                                                2005
                                                
                                                
                                                3,263
                                                
                                                
                                                
                                                —
                                                
                                                
                                                
                                                —
                                                
                                                
                                                
                                                92
                                                
                                                
                                                
                                                16
                                                
                                                
                                                
                                                2,228
                                                
                                                
                                                
                                                5,5992006
                                                
                                                
                                                5,242
                                                
                                                
                                                
                                                —
                                                
                                                
                                                
                                                —
                                                
                                                
                                                
                                                282
                                                
                                                
                                                
                                                14
                                                
                                                
                                                
                                                3,179
                                                
                                                
                                                
                                                8,7172007
                                                
                                                
                                                6,616
                                                
                                                
                                                
                                                —
                                                
                                                
                                                
                                                —
                                                
                                                
                                                
                                                555
                                                
                                                
                                                
                                                53
                                                
                                                
                                                
                                                3,207
                                                
                                                
                                                
                                                10,431**Net
                                                    interest income**
                                                2005
                                                
                                                
                                                2,339
                                                
                                                
                                                
                                                1,098
                                                
                                                
                                                
                                                1,825
                                                
                                                
                                                
                                                1,098
                                                
                                                
                                                
                                                3,027
                                                
                                                
                                                
                                                413
                                                
                                                
                                                
                                                9,8002006
                                                
                                                
                                                3,580
                                                
                                                
                                                
                                                1,002
                                                
                                                
                                                
                                                1,993
                                                
                                                
                                                
                                                1,149
                                                
                                                
                                                
                                                2,297
                                                
                                                
                                                
                                                210
                                                
                                                
                                                
                                                10,2312007
                                                
                                                
                                                2,834
                                                
                                                
                                                
                                                691
                                                
                                                
                                                
                                                2,105
                                                
                                                
                                                
                                                1,237
                                                
                                                
                                                
                                                2,657
                                                
                                                
                                                
                                                (173
                                                )
                                                
                                                
                                                9,351**Provision
                                                    for loan and lease losses**
                                                2005
                                                
                                                
                                                22
                                                
                                                
                                                
                                                120
                                                
                                                
                                                
                                                49
                                                
                                                
                                                
                                                53
                                                
                                                
                                                
                                                156
                                                
                                                
                                                
                                                —
                                                
                                                
                                                
                                                4002006
                                                
                                                
                                                11
                                                
                                                
                                                
                                                18
                                                
                                                
                                                
                                                (132
                                                )
                                                
                                                
                                                60
                                                
                                                
                                                
                                                114
                                                
                                                
                                                
                                                —
                                                
                                                
                                                
                                                712007
                                                
                                                
                                                (5
                                                )
                                                
                                                
                                                161
                                                
                                                
                                                
                                                (34
                                                )
                                                
                                                
                                                14
                                                
                                                
                                                
                                                16
                                                
                                                
                                                
                                                —
                                                
                                                
                                                
                                                152**Net
                                                    interest income, after**
                                                2005
                                                
                                                
                                                2,317
                                                
                                                
                                                
                                                978
                                                
                                                
                                                
                                                1,776
                                                
                                                
                                                
                                                1,045
                                                
                                                
                                                
                                                2,871
                                                
                                                
                                                
                                                413
                                                
                                                
                                                
                                                9,400**provision
                                                    for loan and**
                                                2006
                                                
                                                
                                                3,569
                                                
                                                
                                                
                                                984
                                                
                                                
                                                
                                                2,125
                                                
                                                
                                                
                                                1,089
                                                
                                                
                                                
                                                2,183
                                                
                                                
                                                
                                                210
                                                
                                                
                                                
                                                10,160**lease
                                                    losses**
                                                2007
                                                
                                                
                                                2,839
                                                
                                                
                                                
                                                530
                                                
                                                
                                                
                                                2,139
                                                
                                                
                                                
                                                1,223
                                                
                                                
                                                
                                                2,641
                                                
                                                
                                                
                                                (173
                                                )
                                                
                                                
                                                9,199**Noninterest
                                                    income**
                                                2005
                                                
                                                
                                                298
                                                
                                                
                                                
                                                844
                                                
                                                
                                                
                                                134
                                                
                                                
                                                
                                                36
                                                
                                                
                                                
                                                57
                                                
                                                
                                                
                                                1
                                                
                                                
                                                
                                                1,3702006
                                                
                                                
                                                362
                                                
                                                
                                                
                                                1,126
                                                
                                                
                                                
                                                83
                                                
                                                
                                                
                                                46
                                                
                                                
                                                
                                                97
                                                
                                                
                                                
                                                1
                                                
                                                
                                                
                                                1,7152007
                                                
                                                
                                                415
                                                
                                                
                                                
                                                1,453
                                                
                                                
                                                
                                                204
                                                
                                                
                                                
                                                63
                                                
                                                
                                                
                                                97
                                                
                                                
                                                
                                                431
                                                
                                                
                                                
                                                2,663**Noninterest
                                                    expense**
                                                2005
                                                
                                                
                                                3,126
                                                
                                                
                                                
                                                1,267
                                                
                                                
                                                
                                                931
                                                
                                                
                                                
                                                722
                                                
                                                
                                                
                                                788
                                                
                                                
                                                
                                                29
                                                
                                                
                                                
                                                6,8632006
                                                
                                                
                                                3,327
                                                
                                                
                                                
                                                1,509
                                                
                                                
                                                
                                                1,059
                                                
                                                
                                                
                                                892
                                                
                                                
                                                
                                                874
                                                
                                                
                                                
                                                27
                                                
                                                
                                                
                                                7,6882007
                                                
                                                
                                                3,397
                                                
                                                
                                                
                                                1,473
                                                
                                                
                                                
                                                1,169
                                                
                                                
                                                
                                                832
                                                
                                                
                                                
                                                842
                                                
                                                
                                                
                                                23
                                                
                                                
                                                
                                                7,736**Income/(loss)
                                                     before provision**
                                                2005
                                                
                                                
                                                (511
                                                )
                                                
                                                
                                                555
                                                
                                                
                                                
                                                979
                                                
                                                
                                                
                                                359
                                                
                                                
                                                
                                                2,140
                                                
                                                
                                                
                                                385
                                                
                                                
                                                
                                                3,907**for
                                                    federal income taxes**
                                                2006
                                                
                                                
                                                604
                                                
                                                
                                                
                                                601
                                                
                                                
                                                
                                                1,149
                                                
                                                
                                                
                                                243
                                                
                                                
                                                
                                                1,406
                                                
                                                
                                                
                                                184
                                                
                                                
                                                
                                                4,1872007
                                                
                                                
                                                (143
                                                )
                                                
                                                
                                                510
                                                
                                                
                                                
                                                1,174
                                                
                                                
                                                
                                                454
                                                
                                                
                                                
                                                1,896
                                                
                                                
                                                
                                                235
                                                
                                                
                                                
                                                4,126**Provision
                                                    for federal**
                                                2005
                                                
                                                
                                                (173
                                                )
                                                
                                                
                                                189
                                                
                                                
                                                
                                                333
                                                
                                                
                                                
                                                122
                                                
                                                
                                                
                                                727
                                                
                                                
                                                
                                                125
                                                
                                                
                                                
                                                1,323**income
                                                    taxes**
                                                2006
                                                
                                                
                                                213
                                                
                                                
                                                
                                                211
                                                
                                                
                                                
                                                406
                                                
                                                
                                                
                                                87
                                                
                                                
                                                
                                                497
                                                
                                                
                                                
                                                59
                                                
                                                
                                                
                                                1,4732007
                                                
                                                
                                                (49
                                                )
                                                
                                                
                                                175
                                                
                                                
                                                
                                                403
                                                
                                                
                                                
                                                156
                                                
                                                
                                                
                                                651
                                                
                                                
                                                
                                                75
                                                
                                                
                                                
                                                1,411**Net
                                                    income/(loss)**
                                                2005
                                                
                                                
                                                (338
                                                )
                                                
                                                
                                                366
                                                
                                                
                                                
                                                646
                                                
                                                
                                                
                                                237
                                                
                                                
                                                
                                                1,413
                                                
                                                
                                                
                                                260
                                                
                                                
                                                
                                                2,5842006
                                                
                                                
                                                391
                                                
                                                
                                                
                                                390
                                                
                                                
                                                
                                                743
                                                
                                                
                                                
                                                156
                                                
                                                
                                                
                                                909
                                                
                                                
                                                
                                                125
                                                
                                                
                                                
                                                2,7142007
                                                
                                                
                                                (94
                                                )
                                                
                                                
                                                335
                                                
                                                
                                                
                                                771
                                                
                                                
                                                
                                                298
                                                
                                                
                                                
                                                1,245
                                                
                                                
                                                
                                                160
                                                
                                                
                                                
                                                2,715**Total
                                                    assets (average)**
                                                2005
                                                
                                                
                                                39,369
                                                
                                                
                                                
                                                67,679
                                                
                                                
                                                
                                                253,443
                                                
                                                
                                                
                                                93,710
                                                
                                                
                                                
                                                378,670
                                                
                                                
                                                
                                                150,652
                                                
                                                
                                                
                                                983,5232006
                                                
                                                
                                                41,293
                                                
                                                
                                                
                                                82,362
                                                
                                                
                                                
                                                313,289
                                                
                                                
                                                
                                                117,782
                                                
                                                
                                                
                                                336,364
                                                
                                                
                                                
                                                136,427
                                                
                                                
                                                
                                                1,027,5172007
                                                
                                                
                                                40,437
                                                
                                                
                                                
                                                68,910
                                                
                                                
                                                
                                                327,098
                                                
                                                
                                                
                                                144,792
                                                
                                                
                                                
                                                319,357
                                                
                                                
                                                
                                                113,575
                                                
                                                
                                                
                                                1,014,169**Total
                                                    liabilities (average)**
                                                2005
                                                
                                                
                                                605,821
                                                
                                                
                                                
                                                —
                                                
                                                
                                                
                                                —
                                                
                                                
                                                
                                                26,328
                                                
                                                
                                                
                                                7,059
                                                
                                                
                                                
                                                310,245
                                                
                                                
                                                
                                                949,4532006
                                                
                                                
                                                670,371
                                                
                                                
                                                
                                                —
                                                
                                                
                                                
                                                —
                                                
                                                
                                                
                                                44,156
                                                
                                                
                                                
                                                3,843
                                                
                                                
                                                
                                                285,196
                                                
                                                
                                                
                                                1,003,5662007
                                                
                                                
                                                674,881
                                                
                                                
                                                
                                                —
                                                
                                                
                                                
                                                —
                                                
                                                
                                                
                                                64,234
                                                
                                                
                                                
                                                6,952
                                                
                                                
                                                
                                                232,209
                                                
                                                
                                                
                                                978,276**Allocated
                                                    equity (average)**
                                                2005
                                                
                                                
                                                13,398
                                                
                                                
                                                
                                                4,878
                                                
                                                
                                                
                                                9,436
                                                
                                                
                                                
                                                6,840
                                                
                                                
                                                
                                                24,201
                                                
                                                
                                                
                                                2,172
                                                
                                                
                                                
                                                60,9252006
                                                
                                                
                                                13,659
                                                
                                                
                                                
                                                5,642
                                                
                                                
                                                
                                                10,903
                                                
                                                
                                                
                                                8,122
                                                
                                                
                                                
                                                21,195
                                                
                                                
                                                
                                                1,870
                                                
                                                
                                                
                                                61,3912007
                                                
                                                
                                                15,320
                                                
                                                
                                                
                                                5,463
                                                
                                                
                                                
                                                13,048
                                                
                                                
                                                
                                                12,015
                                                
                                                
                                                
                                                23,782
                                                
                                                
                                                
                                                1,802
                                                
                                                
                                                
                                                71,430**Return
                                                    on equity**
                                                2005
                                                
                                                
                                                -10.09
                                                %
                                                
                                                
                                                30.01
                                                %
                                                
                                                
                                                27.38
                                                %
                                                
                                                
                                                13.86
                                                %
                                                
                                                
                                                23.35
                                                %
                                                
                                                
                                                47.88
                                                %
                                                
                                                
                                                16.97
                                                %2006
                                                
                                                
                                                11.45
                                                %
                                                
                                                
                                                27.65
                                                %
                                                
                                                
                                                27.26
                                                %
                                                
                                                
                                                7.68
                                                %
                                                
                                                
                                                17.15
                                                %
                                                
                                                
                                                26.74
                                                %
                                                
                                                
                                                17.68
                                                %2007
                                                
                                                
                                                -2.45
                                                %
                                                
                                                
                                                24.53
                                                %
                                                
                                                
                                                23.64
                                                %
                                                
                                                
                                                9.92
                                                %
                                                
                                                
                                                20.94
                                                %
                                                
                                                
                                                35.52
                                                %
                                                
                                                
                                                15.20
                                                %**Net
                                                    interest margin**
                                                2005
                                                
                                                
                                                23.76
                                                %
                                                
                                                
                                                6.49
                                                %
                                                
                                                
                                                2.88
                                                %
                                                
                                                
                                                4.69
                                                %
                                                
                                                
                                                3.20
                                                %
                                                
                                                
                                                1.10
                                                %
                                                
                                                
                                                3.99
                                                %2006
                                                
                                                
                                                34.68
                                                %
                                                
                                                
                                                4.87
                                                %
                                                
                                                
                                                2.54
                                                %
                                                
                                                
                                                3.90
                                                %
                                                
                                                
                                                2.73
                                                %
                                                
                                                
                                                0.62
                                                %
                                                
                                                
                                                3.98
                                                %2007
                                                
                                                
                                                28.03
                                                %
                                                
                                                
                                                4.01
                                                %
                                                
                                                
                                                2.57
                                                %
                                                
                                                
                                                3.42
                                                %
                                                
                                                
                                                3.33
                                                %
                                                
                                                
                                                -0.61
                                                %
                                                
                                                
                                                3.69
                                                %




19


**Note
      9.**


**Trading
      Securities**




The
        Company’s short-term investments in debt securities, all of which are classified as
        trading securities, are carried at their fair value based on the quoted prices
        of the securities
        at March 31, 2007.  Net realized and unrealized gains and losses on
        trading securities
        are included in net earnings.  For purpose of determining realized
        gains and losses,
        the cost of securities sold is based on specific
        identification.
  The
        composition of trading securities is as follows at March 31, 2007. There
        were no trading securities in 2006.




Cost
                
                
                Fair
                    Value(Dollars
                    in thousands)Freddie
                    Mac securities
                
                $
                13,580
                
                
                $
                13,036Fannie
                    Mae securities
                
                
                29,405
                
                
                
                28,416Ginnie
                    Mae securities
                
                
                34,494
                
                
                
                34,385US
                    agency securities
                
                
                11,000
                
                
                
                10,896Total
                    trading securities
                
                $
                88,479
                
                
                $
                86,733Investment
                      income for the quarter ended March 31, 2007 consists of the
                      following.2007Dividend
                    and interest income
                
                $
                833Net
                    unrealized holding gains
                
                
                402Net
                    investment income
                
                $
                1,235






20




ITEM 2.
            Management’s
                Discussion and Analysis of Financial Condition andResults
                of Operations





**GENERAL**





First
      Mutual Bancshares, Inc. (the “Company”),
      a Washington
      corporation, is a bank holding company owning all of the equity of its wholly
      owned subsidiary, First Mutual Bank.  The Company is subject to
      regulation by the Federal Reserve Bank of San Francisco.  This
      discussion refers to the consolidated statements of the Company and the Bank,
      and therefore the references to “Bank” in this discussion refer to both
      entities.





First
      Mutual Bank is a Washington-chartered savings bank subject to regulation by
      the
      State of Washington Department of Financial Institutions and the Federal Deposit
      Insurance Corporation (“FDIC”).  The Bank conducts business from its
      headquarters in Bellevue, Washington, and has 12 full-service retail banking
      centers located in Bellevue (3), Issaquah, Kirkland (2), Monroe, Redmond,
      Sammamish, Seattle (2), and Woodinville.  We also have consumer loan
      offices located in Orange Park, Florida and Mt. Clemens,
      Michigan.  The Bank’s business
      consists mainly of attracting deposits from the general public as well as
      wholesale funding sources, and investing those funds primarily in real estate
      loans, small and mid-sized business loans, and consumer loans.








**OVERVIEW**





The
      first
      quarter of 2007, our net income remained virtually unchanged from the same
      period last year at $2.7 million, as our earnings per diluted share fell to
      $0.39, compared to $0.40 per diluted share in the first quarter of last
      year.  Our return on average equity (ROE) totaled 15.25% for the
      quarter, compared to 17.79% in the first quarter of last year.  As a
      result, we were able to meet one of our general corporate goals, obtaining
      an
      ROE of at least 15%, but were unsuccessful in the other, achieving
      year-over-year net income growth in the range of 10% to 12%.





The
      primary source of revenue for each of our business lines is net interest income,
      which is generally measured with the net interest margin ratio.  For
      the first quarter of 2007, our net interest income totaled $9.4 million, down
      $880,000 from the level earned in the prior year.  Our net interest
      margin for the quarter totaled 3.73%, down from 3.78% in the fourth quarter
      of
      2006 and 4.02% in the first quarter of last year, as the increase observed
      in
      our funding costs far exceeded that of our interest income. We consider
      controlling the interest expense paid on our liabilities to be a critical
      element to our overall performance in the current economic environment, and
      continue to focus our efforts on improving the percentage of lower-cost
      non-maturity deposit products in our funding mix - - reducing as significantly
      as is prudent the occurrence of promotional deposit rates, and utilizing
      wholesale funding sources when estimates of marginal funding costs indicate
      it
      may be advantageous to do so.





21


A
      second
      key driver of net interest income is the level of our earning assets, which
      declined in the first quarter of 2007, averaging nearly $1,004 million,
      representing a decrease of more than $14 million from the first quarter of
      last
      year. The drop in earning assets was due largely to a substantial reduction
      in
      loan originations, which fell from $121 million in the first quarter of last
      year to $95 million in the most recent quarter, as well as continued high levels
      of loan payoffs and sales.  While we continued to see portfolio growth
      in our Business Banking and Residential Lending segments in the first quarter
      of
      2007, a substantial part of this growth was offset by reductions in the
      portfolios of our other segments.  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 increased 55%
      compared to the first quarter of 2006. A large part of that gain was due to
      the
      early adoption of Statement of Financial Accounting Standard (SFAS) No. 157
      and
      159, which resulted in $447,000 in income from marking affected financial
      instruments, particularly investment securities, to market
      values.  Also contributing to the increase relative to last year was a
      higher level of loan sales and resulting gains thereon, additional service
      fees
      collected on assets serviced for other institutions, and an increase in other
      loan fee income.  During the first quarter, we sold approximately $16
      million of sales finance loans, which resulted in a significant increase in
      gains on sales of loans in the current period, and should contribute incremental
      servicing fee income in future quarters.  Please see the “Noninterest
      Income” section for additional discussion.





Our
      noninterest expenses remained virtually unchanged from the prior year, rising
      only $48,000, or less than 1% for the quarter, to $7.7 million, as reductions
      in
      occupancy and credit insurance expenses largely offset increases in personnel
      and other noninterest expenses.  Please refer to the “Noninterest
      Expense” section for additional information.





For
      the
      quarter ended March 31, 2007, our credit quality remained strong, with total
      non-performing assets (NPAs) declining to $2.0 million, or 0.19% of total
      assets, compared to $3.5 million, or 0.32% at the 2006 year-end.  For
      the quarter, we reserved $152,000 in provisions for loan losses and our reserve
      for loan losses totaled approximately $10.1 million, including the reserve
      for
      unfunded commitments, little changed from the year-end level.  The
      allowance for loan losses represented 1.13% of gross loans at the quarter-end,
      up from 1.11% at the 2006 year-end.  For additional information
      regarding our credit quality please refer to the “Asset Quality”
section.








**RESULTS
      OF OPERATIONS**





**Net
      Income**





Net
      income remained relatively flat for the first quarter of 2007 as compared to
      the
      like quarter last year.  Net interest income, after provision for loan
      losses, declined $961,000, and noninterest income increased $948,000 on a
      first-quarter comparison, while noninterest expense increased
      $48,000.





22


**Net
      Interest
      Income**







For
      the
      first quarter of 2007, our net interest income declined $880,000 relative to
      the
      same period last year, as improvements resulting from changes in our earning
      assets and funding mix were more than offset by the negative net impact of
      asset
      and liability repricing. The following table illustrates the impacts to our
      net
      interest income from balance sheet growth and rate changes on our assets and
      liabilities, with the results attributable to the level of earning assets
      classified as “volume” and the effect of asset and liability repricing labeled
“rate.”





**Rate/Volume
      Analysis**





Quarter
                EndedMarch
                31, 2007 vs. March 31, 2006Increase/(Decrease)
                due toVolume
            
            
            Rate
            
            
            TotalInterest
                Income
            
            (Dollars
                in thousands)Total
                Investments
            
            $
            241
            
            
            $
            (360
            )
            
            $
            (119
            )Total
                Loans
            
            
            (79
            )
            
            
            1,032
            
            
            
            953Total
                Interest Income
            
            $
            162
            
            
            $
            672
            
            
            $
            834Interest
                ExpenseTotal
                Deposits
            
            $
            90
            
            
            $
            1,704
            
            
            $
            1,794FHLB
                and Other
            
            
            (684
            )
            
            
            604
            
            
            
            (80
            )Total
                Interest Expense
            
            $
            (594
            )
            
            $
            2,308
            
            
            $
            1,714Net
                Interest Income
            
            $
            756
            
            
            $
            (1,636
            )
            
            $
            (880
            )




**Earning
      Asset Growth (Volume)**





For
      the
      first quarter of 2007, changes in our earning asset levels contributed an
      additional $162,000 in interest income compared to the first quarter of last
      year, as movement in our mix of funding sources contributed an additional
      $594,000. Consequently, the net impact was an improvement in net interest income
      of $756,000 compared to the quarter ended March 31, 2006.




Quarter
                  Ending
              Earning
                  Assets
              Net
                  Loans (incl.LHFS)
              Deposits(Dollars
                  in thousands)March
                  31, 2006
              $
                  1,018,058
              $
                  885,295
              $
                  783,614June
                  30, 2006
              $
                  1,036,750
              $
                  919,418
              $
                  760,344September
                  30, 2006
              $
                  1,034,332
              $
                  919,837
              $
                  774,914December
                  31, 2006
              $
                  1,012,896
              $
                  897,436
              $
                  805,795March
                  31, 2007
              $    995,058
              $
                  881,849
              $
                  771,659


As
      can be
      seen in the table above, our earning assets have been following a declining
      trend since the third quarter of last year, with our loan portfolio contracting
      in the two most recent quarters.





The
      decline observed in the loan portfolio during the first quarter was
      disappointing and contrary to our expectation for the quarter of flat to modest
      growth in loan balances. During the quarter, we experienced declines in our
      income property, consumer, and all categories of construction loans, which
      include spec, custom, and commercial construction.  On a positive
      note, our balances of business banking loans and single-family residential
      mortgages ended the quarter at levels higher than those observed at the 2006
      year-end. Additionally, while consumer loan




23


balances
      declined relative to the year-end, they did so largely as a result of
      first-quarter loan sales totaling nearly $16 million.  Were it not for
      these sales, growth would likely have been observed in this portfolio segment
      as
      well.





Historically,
      we have generally relied upon growth in our deposit balances, including
      certificates issued in institutional markets through deposit brokerage services,
      to support our asset growth. When our deposit growth has been insufficient
      to
      fully support our asset growth, we have utilized advances from the Federal
      Home
      Loan Bank of Seattle (FHLB) as an alternative funding source.




For
      the
      quarter, our total deposit balances declined $34.1 million, as non-maturity
      deposit balances rose $11.6 million, while time deposits, including certificates
      issued through brokerage services, declined nearly $45.8
      million.  Brokered and other institutional certificates of deposit
      accounted for approximately $29.0 million of this reduction. With the quarter’s
      reduction in deposit balances exceeding the decline in assets, we experienced
      a
      modest increase in our utilization of FHLB advances relative to the year-end
      level.




**Asset
      Yields and Funding Costs (Rate)**





Adjustable-rate
      loans accounted for approximately 78% of our loan portfolio as of March 31,
      2007, and the effects of interest rate movements and repricing accounted for
      $672,000 in additional interest income relative to the first quarter of last
      year. On the liability side of the balance sheet, however, the effects of
      interest rate movements and repricing increased our interest expense on deposits
      and wholesale funding by $2.3 million for the quarter. As a result, the net
      effects of rate movements and repricing negatively impacted our net interest
      income by $1.6 million relative to the first quarter of 2006.





Quarter
                Ended
            Net
                Interest MarginMarch
                31, 2006
            4.02%June
                30, 2006
            3.91%September
                30, 2006
            3.94%December
                31, 2006
            3.78%March
                31, 2007
            3.73%





While
      we
      had indicated in our 2006 year-end press release that we expected to see
      continued pressure on our net interest margin, our actual first-quarter net
      interest margin fell short of the 3.75% to 3.80% range in our forecast. This
      forecast had been based on the assumptions that we would experience no
      significant change in our loan portfolio in the first quarter, with estimated
      growth of $0 to $5 million, and approximately $19 million in retail deposit
      growth. Instead, as previously noted, we experienced a decrease in our loan
      portfolio during the quarter, including balance reductions among some of our
      higher-yielding loan types. Specifically, one of the factors contributing to
      the
      compression in our net interest margin has been the increased sales over the
      last several quarters of sales finance loans, which are generally among our
      highest-yielding assets. While sales of these loans negatively impacts our
      net
      interest margin, they result in substantial noninterest income, including gains
      on loan sales recognized at the times of the transactions, as well as servicing
      fee income earned on an ongoing basis following the sales.




24


In
      addition to the decline in our loan portfolio, the expected growth in retail
      deposits failed to materialize. At the same time that we were experiencing
      a net
      reduction in our level of retail deposits, our funding costs continued to rise
      as a result of competition for deposit balances in our local
      market.





**Noninterest
      Income**





Our
      noninterest income for the first quarter of 2007 increased $948,000, or 55%
      relative to the same quarter last year.  While mark-to-market gains
      related to the early adoption of Statement of Financial Accounting Standards
      (SFAS) No. 157, *Fair Value Measurements*, and No. 159, *The Fair
      Value Option for Financial Assets and Financial Liabilities*, made the
      greatest contribution to the additional income, all major categories of
      noninterest income showed improvement relative to the prior year.





**SFAS
      No. 157 and 159 Related Gains/(Losses)**




We
      have
      elected early adoption of SFAS No. 157 and 159, effective January 1,
      2007.  SFAS No. 159, which was issued in February 2007, generally
      permits the mark-to-market of selected eligible financial
      instruments.  The affected securities totaled $87.1 million (principal
      only), representing 89% of our securities portfolio at December 31, 2006. As
      a
      result of the fair value measurement election for these securities, the Bank
      recorded gains in the first-quarter earnings of $402,000.  We also
      elected the adoption of SFAS No. 159 for a $9 million long term debenture
      payable (trust preferred security).  In the first quarter of 2007, we
      recorded $45,000 in pre-tax mark-to-market gains related to this instrument
      for
      total pre-tax, SFAS No. 159-related, mark-to-market gains of $447,000 for the
      first quarter.





**Gains/(Losses)
      on Sales of Loans**





Quarter
                EndedMarch
                31, 2007
            
            
            March
                31, 2006Gains/(Losses)
                on Sales:Consumer
            
            $
            933,000
            
            
            $
            749,000Residential
            
            
            40,000
            
            
            
            (20,000
            )Commercial
            
            
            —
            
            
            
            27,000Total
                Gains on Loan
              Sales
            
            $
            973,000
            
            
            $
            756,000Loans
                Sold:Consumer
            
            $
            15,649,000
            
            
            $
            13,016,000Residential
            
            
            10,878,000
            
            
            
            9,395,000Commercial
            
            
            -
            
            
            
            1,010,000Total
                Loans Sold
            
            $
            26,527,000
            
            
            $
            23,421,000




Continuing
      the trend observed throughout 2006, our first-quarter gains on loan sales,
      primarily consumer loans, significantly exceeded those of the prior year,
      increasing $217,000, or 29% over the prior year’s level.





25


For
      the
      first quarter of 2007, consumer loan sales totaled nearly $16 million, which
      was
      within the $12 million to $18 million range estimated in the outlook presented
      in our 2006 year-end press release. Based on our current levels of loan
      production and market demand, our expectation is for our second-quarter 2007
      consumer loan sales to total in the same $12 million to $18 million range.
      Note
      that these expectations may be subject to change based on changes in loan
      production, market conditions, and other factors.





After
      selling participations in several commercial real-estate loans during the
      second, third, and fourth quarters of 2006, no participations were sold in
      the
      first quarter of 2007. Despite the lack of sales in the most recent quarter,
      we
      expect to continue our sales of commercial real-estate loan participations
      and
      reiterate our comment made in previous quarters that commercial real-estate
      loan
      transactions, particularly those that are candidates for sales of participations
      to other institutions, tend to be larger-dollar credits and unpredictable in
      their timing and frequency of occurrence. As a result, the volumes of commercial
      real-estate loans sold, and gains thereon, will vary considerably from one
      quarter to the next depending on the timing of the loan and sales
      transactions.




Compared
      to the markets for our consumer and commercial loan sales, the market for
      residential loan sales is significantly larger and more efficient. As a result,
      residential loan sales are typically sold for very modest gains or potentially
      even at slight losses when interest rates are rising quickly. We believe the
      construction phase to be the most profitable facet of residential lending and
      the primary objective in a residential lending relationship. Following the
      construction process, our practice is to retain in our portfolio those
      residential mortgages that we consider to be beneficial to the bank, but to
      sell
      those that we consider less attractive assets. Included in these less attractive
      assets would be those mortgages with fixed rates, which we offer for competitive
      reasons. Additionally, as residential loans are typically sold servicing
      released, sales do not result in future servicing income.




**Service
      Fee Income/(Expense)**





Quarter
                EndedMarch
                31, 2007
            
            
            March
                31, 2006Consumer
                Loans
            
            $
            462,000
            
            
            $
            332,000Commercial
                Loans
            
            
            (26,000
            )
            
            
            9,000Residential
                Loans
            
            
            1,000
            
            
            
            (6,000
            )Service
                Fee Income
            
            $
            437,000
            
            
            $
            335,000





Servicing
      fee income represents the net of servicing income received less the amortization
      of servicing assets, which are recorded when we sell loans from our portfolio
      to
      other investors. The values of these servicing assets are determined at the
      time
      of the sale using a valuation model that calculates the present value of future
      cash flows for the loans sold, including cash flows related to the servicing
      of
      the loans.  The servicing rights are then amortized in proportion to,
      and over the period of, the estimated future servicing income.





For
      the
      first quarter of 2007, service fee income earned on consumer loans serviced
      for
      other investors exceeded that earned in the same period of the prior year.
      This
      improvement was based on a significant increase in the balances of consumer
      loans serviced, which was in turn a product of the increased volume of loan
      sales in 2006 and the first quarter of 2007.





26


In
      the
      case of commercial loans serviced, payoffs during the quarter of balances sold
      to and serviced for other institutional investors required us to immediately
      write-off the related servicing assets, which resulted in the loss presented
      above.




In
      contrast to consumer and commercial loans, residential loans are typically
      sold
      servicing released, which means we no longer service those loans once they
      are
      sold. Consequently, we do not view these loans as a significant source of
      servicing fee income.




**Fees
      on Deposits**




Fee
      income earned on our deposit accounts increased approximately $6,000, or 3%,
      compared to the first quarter of last year. The improvement over the prior
      year
      level is attributable to increased checking account service charges, which
      have
      grown as we have continued our efforts to expand our base of business and
      consumer checking accounts.  The reduction in time deposit balances
      during the quarter did not have an impact on deposit fees as these balances
      do
      not represent a significant source of fee income.




**Other
      Noninterest Income**





Quarter
                EndedMarch
                31, 2007
            
            
            March
                31, 2006Debit
                Card/Wire/Safe
              Deposit
                Fees
            
            $
            88,000
            
            
            $
            74,000Late
                Charges
            
            
            72,000
            
            
            
            51,000Loan
                Fee Income
            
            
            217,000
            
            
            
            96,000Rental
                Income
            
            
            168,000
            
            
            
            157,000Miscellaneous
            
            
            73,000
            
            
            
            64,000Other
                Noninterest
              Income
            
            $
            618,000
            
            
            $
            442,000





Noninterest
      income from sources other than those previously described rose $176,000, or
      40%
      relative to the first quarter of last year.  The improvement relative
      to the prior year was largely attributable to a substantial increase in loan
      fees.





Loan
      fee
      income increased relative to the prior year based on a higher level of
      non-deferred loan fees. These typically include fees collected in connection
      with loan modifications or extensions, non-conversion of construction loans
      to
      permanent mortgages, and letters of credit originated for commercial
      borrowers.  Further contributing to the additional income were
      increases of $31,000 in loan brokerage fees and approximately $8,000 in loan
      prepayment fees relative to the first quarter of last year.





Rental
      income increased $11,000, or 7%, relative to the prior year, based on the
      arrival of new lessees to the First Mutual Center building following the first
      quarter of last year.





27


We
      continued to observe significant growth in our Debit Card/Wire/Safe Deposit
      Fees, which totaled $88,000 for the quarter, representing an increase of 19%
      over the prior year. Most of this growth is attributable to debit card fee
      income, which we expect to continue rising as checking accounts become a greater
      piece of our overall deposit mix.





**Noninterest
      Expense**





Our
      first
      quarter noninterest expense remained virtually unchanged from that of the same
      period last year, rising approximately $48,000, or less than 1%, as reductions
      in occupancy and credit insurance expenses largely offset increases in personnel
      and other noninterest expenses.




**Salaries
      and Employee Benefits Expense**





Our
      personnel-related expenses remained well contained in the first quarter of
      2007,
      increasing slightly more than 1% relative to the first quarter of last year,
      as
      the majority of a 6% increase in compensation expense was offset by improvements
      across other expense categories.





Quarter
                EndedMarch
                31, 2007
            
            
            March
                31, 2006Salaries
            
            $
            3,161,000
            
            
            $
            2,973,000Commissions
                and
              Incentive
                Bonuses
            
            
            526,000
            
            
            
            540,000Employment
                Taxes and
              Insurance
            
            
            290,000
            
            
            
            300,000Temporary
                Office Help
            
            
            78,000
            
            
            
            95,000Benefits
            
            
            454,000
            
            
            
            538,000Total
            
            $
            4,509,000
            
            
            $
            4,446,000





The
      increase in overall personnel-related expenses was attributable to salaries
      expense, which increased 6% relative to the first quarter of
      2006.  The most significant contribution to the increase came from
      regular compensation expense, which grew largely as a result of annual increases
      in staff salaries, which took effect in April 2006 and generally fell within
      the
      2% to 4% range.  Also contributing to the increase in salaries expense
      was a higher level of stock option compensation expense, which rose from
      $135,000 in the first quarter of 2006 to $184,000 this year, and a $17,000
      increase in Board of Directors compensation.





Commissions
      and incentive compensation declined relative to the prior year level, based
      in
      large part on the elimination of the general staff bonus. 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 in
      the
      first quarter of 2006, expenses related to this bonus totaled $32,000 for the
      year. By comparison, in the first quarter of 2007, we elected to forego the
      staff bonus, resulting in a reduction relative to the prior year’s incentive
      compensation expense.





Among
      the
      other categories of incentive compensation, loan officer commissions declined
      $48,000, or 12%, for the quarter while other incentive compensation increased
      $67,000. The incentive compensation plans for loan production staff tend to
      vary
      directly with the production




28


of
      the
      business lines.  Other incentive compensation includes payments to all
      areas of the bank, but consists primarily of bonuses paid to banking center
      personnel.





Expenditures
      on temporary office help declined significantly relative to the first quarter
      of
      2006. Temporary office help is frequently used to staff positions left vacant
      as
      a result of employee turnover. As permanent employees were placed in these
      positions, reliance upon temporary staff was reduced.




Employee
      benefit expense also declined significantly relative to the first quarter of
      last year, falling nearly $84,000, or 16%. The reduction was largely
      attributable to a decision to forego a contribution to our 401(k) profit sharing
      plan for the first quarter.  By comparison, a $50,000 contribution had
      been made for the first quarter of 2006.  Also contributing to the
      improvement were a reduction in director and officer insurance expense and
      a
      decline in 401(k) matching contributions.




**Occupancy
      Expense**





Occupancy
      expense declined by more than $28,000, or nearly 3%, compared to the first
      quarter of last year, as reductions in depreciation and rent expenses more
      than
      offset increases in utilities, maintenance, and other occupancy
      expenses.





Quarter
                EndedMarch
                31, 2007
            
            
            March
                31, 2006Rent
                Expense
            
            $
            70,000
            
            
            $
            79,000Utilities
                and Maintenance
            
            
            228,000
            
            
            
            204,000Depreciation
                Expense
            
            
            461,000
            
            
            
            509,000Other
                Occupancy Expenses
            
            
            223,000
            
            
            
            218,000Total
                Occupancy Expense
            
            $
            982,000
            
            
            $
            1,010,000





The
      reduction in rent expense was attributable to the closings of Income Property
      lending offices as well as the relocation of the West Seattle Banking Center
      from a leased space to a new building that we own, all of which occurred in
      2006.





Utilities
      and maintenance expenses increased $24,000, or nearly 12% relative to the same
      quarter in 2006, due in large part to higher than expected utilities costs
      for
      December 2006.  Utilities expense for that month exceeded our accrual
      by approximately $11,000, with the difference being posted in January
      2007.




Depreciation
      expense for the first quarter declined $48,000, or nearly 10% relative to the
      same period last year.  This reduction was largely attributable to the
      correction of a booking error associated with the purchase of our Juanita
      Banking Center.  In that transaction, the value of the land had been
      included in the cost of the building and consequently depreciated based on
      the
      building’s amortization schedule.  As land is not depreciable, this
      error was corrected upon its discovery and resulted in a one-time $40,000 credit
      to depreciation for the quarter.




29


**Other
      Noninterest Expense (including Credit Insurance)**





Totaling
      $2.2 million, our other operating expenses (including credit insurance) for
      the
      first quarter of 2007 were little changed from 2006 increasing less than 1%
      from
      the prior year’s level, as reductions in marketing, credit insurance, and legal
      expenses nearly offset higher outside service, information systems, taxes,
      and
      other miscellaneous operating expenses.





Quarter
                EndedMarch
                31, 2007
            
            
            March
                31, 2006Marketing
                and Public
              Relations
            
            $
            222,000
            
            
            $
            252,000Credit
                Insurance
            
            
            426,000
            
            
            
            463,000Outside
                Services
            
            
            182,000
            
            
            
            168,000Information
                Systems
            
            
            242,000
            
            
            
            204,000Taxes
            
            
            163,000
            
            
            
            145,000Legal
                Fees
            
            
            173,000
            
            
            
            186,000Other
            
            
            837,000
            
            
            
            814,000Total
                Other
              Noninterest
                Expense
            
            $
            2,245,000
            
            
            $
            2,232,000





Our
      marketing and investor relations costs for the first quarter declined $30,000
      relative to the same period last year.  We expect this level of
      expense to be in line with expenditures in future quarters.





Credit
      insurance premium costs fell nearly 8% in the first quarter compared to the
      same
      period in 2006. As we stated in our 2006 year-end press release, it was our
      expectation that expenditures for credit insurance would decline in the first
      quarter of 2007 and continue to decline in future quarters. The majority of
      credit insurance premiums are attributable to our sales finance loans, including
      both those loans retained in our portfolio as well as those loans serviced
      for
      other institutions.  In mid-2006, after evaluating our use of credit
      insurance, we concluded that the benefits of the insurance no longer outweighed
      the costs and chose to forego the insurance and assume the credit risk on future
      sales finance loan production.  Those loans insured prior to August 1,
      2006 remain insured under their existing policies.  Additionally, some
      loans originated on or after August 1, 2006 were sold to institutional investors
      with insurance placed prior to sale and remain insured under the policy
      effective August 1, 2006.  All other loan volumes originated on or
      after August 1 have not been insured. To a much lesser extent, residential
      land
      loans and a small percentage of the consumer and income property loan portfolios
      are also insured. While these insured balances may continue to increase in
      future quarters, the premiums paid on these balances are sufficiently small
      relative to those paid on sales finance loans such that total premiums paid
      are
      still expected to decline.





These
      expense reductions were offset, in part, by increases in expenditures for
      outside services, information systems, taxes, and other operating
      costs.  The most significant contributor to the increase in other
      operating expense was expenditures for employee recruiting, which increased
      $59,000, or 690%, relative to the prior year as a result of expenses associated
      with our search for a new CFO as well as the hiring of a new commercial loan
      officer.





30


**FINANCIAL
      CONDITION**





**Assets**





For
      the
      quarter ended March 31, 2007, our assets totaled $1.057 billion, representing
      a
      decline of approximately 2% from the $1.079 billion 2006 year-end level, based
      on reductions in cash and equivalent balances and our loan
      portfolio.  While the level of cash and equivalents fluctuates on a
      daily basis according to activity across our assets and liabilities, the decline
      in the loan portfolio was attributable to a substantial reduction in loan
      originations relative to the first quarter of the previous year combined with
      continued high levels of loan payoffs and sales.





**Cash
      and Equivalents**





Our
      total
      balances of cash and equivalents declined $8 million, or 33% relative to the
      2006 year-end level, with the noninterest earning balances accounting for $5
      million of the reduction.  We view the reduction in cash balances as a
      positive event, as reducing noninterest earning or low yielding asset balances
      does not result in a significant loss of interest income, but does allow us
      to
      retire a corresponding level of funding sources and avoid the related interest
      expense.





**Securities**





With
      the
      purchase of a $5 million security in February, the balance of our securities
      portfolio (including trading, available-for-sale and held-to-maturity
      securities) increased by slightly more than $1 million from its year-end level,
      ending the first quarter at nearly $97 million.  Of much greater
      significance, however, was the early adoption of SFAS No. 159 with respect
      to
      the majority of our investment portfolio and the resulting reclassification
      of
      $87 million (principal balances only as of December 31, 2006) in securities
      to
      trading instruments.





Any
      investment security purchased is classified in one of the following categories:
      1) trading, 2) available-for-sale, or 3) held-to-maturity. Prior to our early
      adoption of SFAS No. 159, the majority of the securities in our portfolio had
      been classified as available-for-sale, while no securities were classified
      in
      the trading category. Available-for-sale securities are reviewed regularly,
      and
      any unrealized gains or losses are recorded in comprehensive income in the
      shareholders’ equity account. In contrast, any change in market value of trading
      securities during the period is reflected in current period income. Generally,
      falling interest rates will increase the market values of securities, thus
      enhancing the amounts recorded as gains or reducing losses, while rising rates
      will have the opposite effect. The passage of time partially counteracts these
      interest rate effects, as the unrealized gain or loss on a given security will
      gradually decline to zero as the security approaches its maturity
      date.





In
      April,
      subsequent to the quarter end, we sold several longer-maturity securities from
      the newly established trading portfolio, replaced the sold issues with
      approximately $34 million in shorter-term hybrid ARM securities, and began
      evaluating the potential risks and benefits of employing strategies to hedge
      against movements in the market value of the trading portfolio. In the first
      week of May, based on the earnings volatility presented by the new accounting
      treatment, we elected to proceed with a plan to reduce the size and volatility
      of the portfolio by reselling our recently purchased securities in the secondary
      market and utilizing $42 million in interest rate swaps to partially hedge
      against movements in the market value of the trading portfolio.  Based on
      the size of the remaining portfolio, this equates to only a partial hedge,
      and
      not a total immunization against movements in the market value of the trading
      portfolio.




Given
      the
      movement in the market following the end of the first quarter, our trading
      portfolio experienced a mark-to-market loss of $138,000 for the month of
      April.  While we were




31


successful
      in reselling approximately $28 million of the $34 million in recently acquired
      securities at the same prices at which they were purchased, establishing this
      partial hedge will likely result in effectively locking-in a portion of the
      loss
      that occurred as a result of market movements between the quarter-end and the
      first week of May.





**Loans**





Loans
      receivable, excluding loans held-for-sale, declined $23 million, or
      approximately 3%, from $893 million at the close of 2006 to less than $871
      million at March 31, 2007 as loan originations declined to $95 million compared
      to $121 million in the first quarter of last year.  In addition to the
      decline in originations, the reduction in loan portfolio balances during the
      quarter was largely attributable to a combination of high prepayment speeds
      across loan types and significant volumes of loan sales.





**Portfolio
                Composition**
            
            **March
                31, 2007**
            
            
            **December
                31, 2006**(Dollars
                in thousands)Single-Family
                Residential
            
            $
            256,583
            
            
            $
            254,374Income
                Property
            
            
            234,527
            
            
            
            248,100Business
                Banking
            
            
            153,552
            
            
            
            144,771Commercial
                Construction
            
            
            40,944
            
            
            
            47,153Single-Family
                Construction:Spec
                Construction
            
            
            29,043
            
            
            
            31,315Custom
                Construction
            
            
            62,482
            
            
            
            70,541Consumer
            
            
            93,576
            
            
            
            97,177**Total**
            
            **$**
            **870,707**
            
            
            **$**
            **893,431**





The
      decline observed in the loan portfolio during the first quarter was
      disappointing and contrary to our expectation for the quarter of flat to modest
      growth in loan balances. During the quarter, we experienced declines in our
      income property, consumer, and all categories of construction loans, which
      include spec, custom, and commercial construction.  On a positive
      note, our balances of business banking loans and single-family residential
      mortgages ended the quarter at levels higher than those observed at the 2006
      year-end. Additionally, while consumer loan balances declined relative to the
      year-end, they did so largely as a result of first quarter loan sales totaling
      nearly $16 million.  Were it not for these sales, growth would likely
      have been observed in this portfolio segment as well.





While
      our
      total loan portfolio experienced a decline relative to its year-end level,
      respectable growth was observed among Business Banking loan
      balances.  This segment has been very successful in building earning
      assets in recent years, and is looked to as a key contributor for expected
      asset
      growth going forward.  Additionally, modest loan growth was observed
      in our Residential Lending segment, largely as a result of purchases of
      CRA-qualifying (Community Reinvestment Act) mortgages.  The single
      family residential loans held in our portfolio are typically non-conforming
      loans that do not meet the requirements for resale in the secondary market,
      but
      generally offer higher yields than conforming residential mortgages and are
      still considered eligible collateral for borrowing from the FHLB.





Income
      property loans, which consist of mortgages on investor-owned commercial real
      estate and multifamily properties, have demonstrated a gradual declining trend
      in recent years.  This decline has been largely attributable to lower
      originations of permanent multifamily and commercial real estate loans, along
      with a high level of prepayments on the loan portfolio, which




32


we
      attribute to a combination of increased competition from other lenders,
      including conduit programs, and a flat to inverted yield curve.  The
      flattening of the yield curve reduced the rate differential between short-
      and
      long-term financing costs and provided a financial incentive for borrowers
      to
      select longer-term, fixed-rate loans as opposed to short-term or adjustable-rate
      financing.  As we have historically been an originator of short-term
      and adjustable-rate loans, this has impacted us in two ways.  First,
      as prospective buyers sought loans with terms that fell outside of our typical
      underwriting structures, our originations of permanent multifamily and
      commercial real estate loans declined.  Second, with the yield curve
      providing borrowers with a financial incentive to refinance adjustable-rate
      loans, which make up the majority of our loan portfolio, with longer-term,
      fixed-rate debt, the prepayment rates on our income property portfolio remained
      at relatively high levels.  Increased competition among lenders in our
      local market accelerated both the decline in new loans as well as portfolio
      payoffs, as the competition frequently resulted in lenders offering prospective
      borrowers new loan commitments or existing borrowers the opportunity to
      refinance at lower margins than we would consider appropriate for the risks
      presented by the credits.





Over
      the
      course of 2006, we introduced several initiatives aimed at reducing the high
      prepayment rates in the income property loan portfolio and addressing borrowers’
requests for fixed-rate loans.  In an effort to prevent prepayments of
      certain loans this year, we offered rate modifications to some of our
      borrowers.  While these modifications effectively reduced asset yields
      and negatively impacted our net interest margin, we believe that the benefits
      of
      reducing these borrowers’ rates outweighed the costs of losing the borrowing
      relationships altogether.  The impact to net interest income, and
      ultimately earnings, as a result of these modifications is less than what the
      reduction in net interest income would have been had these loans paid off and
      refinanced elsewhere, effectively compressing our income property
      portfolio.  Additionally, in the second quarter of 2006, we began to
      utilize interest-rate swaps to hedge interest rate risk associated with
      extending longer-term, fixed-rate loans to certain commercial real estate
      borrowers.  The use of these swaps allows us to provide loans with the
      longer terms sought by certain borrowers, and then convert the loan’s fixed rate
      to a floating rate through an institutional counterparty, thus offsetting any
      potential interest rate risk to the Bank as a consequence of offering loans
      with
      longer fixed-rate terms.





**Servicing
      Assets**





Servicing
      assets represent the deferred servicing rights generated from sales of loans
      that are sold servicing retained, reduced by the amortization and prepayments
      of
      those loans, as well as any impairment charges that may occur. While our
      servicing assets have not and do not represent a significant percentage of
      our
      total assets, this area has grown and is expected to continue growing with
      future loan sales.





**Servicing
                Assets**
            
            **March
                31, 2007**
            
            
            **December
                31, 2006**Commercial
            
            $
            165,000
            
            
            $
            224,000Residential
            
            
            57,000
            
            
            
            63,000Consumer
            
            
            4,386,000
            
            
            
            3,724,000**Total**
            
            **$**
            **4,608,000**
            
            
            **$**
            **4,011,000**Loan
                Balances Serviced for Others
            
            $
            150,437,000
            
            
            $
            155,025,000





As
      a
      result of the nearly $16 million in consumer loan sales during the quarter,
      our
      servicing assets related to consumer loans increased $662,000, or approximately
      18%, over the 2006 year-




33


end
      level
      for the three-month period.  Based on our current expectation for
      second-quarter consumer loan sales of $12 million to $18 million, we would
      expect to see similar servicing asset growth in the second quarter of
      2007.





Servicing
      assets related to commercial loans declined from their year-end level as no
      commercial loan participations were sold and some existing commercial loan
      pools
      were paid off in the first quarter of 2007.  These payoffs required us
      to immediately write-off the remaining servicing assets associated with these
      credits. While we expect to continue our sales of commercial real-estate loan
      participations and consequently growing the related servicing assets, those
      commercial real-estate loan transactions that are candidates for participation
      sales 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 resulting servicing assets, will vary
      considerably from one quarter to the next depending on the timing of the loan
      and sales transactions.





Residential
      loans are generally sold servicing released.  Consequently, no
      servicing assets are recognized following the vast majority of residential
      loan
      sales.





**Deposits
      and Borrowings**





For
      the
      first quarter of the year, our total deposit balances declined $34 million,
      or
      approximately 4% from their year-end level, with non-maturity deposit balances
      rising nearly $12 million for the quarter, while time deposits, including
      certificates issued through brokerage services, declined nearly $46
      million.  Brokered and other institutional certificates of deposit
      accounted for approximately $33 million of this reduction.





The
      growth of checking and money market accounts typically helps us reduce our
      overall cost of funds. Consequently, we consider the growth of these types
      of
      accounts to be an important part of our funding strategy for the future. To
      encourage this growth, we actively monitor the products and rates offered by
      our
      competition in the local market and develop new products and/or offer aggressive
      rates to attract new balances in the most cost-effective manner
      possible.





We
      experienced a decrease in retail certificate balances over the first three
      months of 2007 as we attempted to move away from offering rates competitive
      with
      the higher rates in the local market. While this has resulted, and will continue
      to result in the months ahead, in a minority of depositors exiting the Bank
      for
      higher rates elsewhere, the majority of balances are remaining on our books
      at
      significantly lower costs to the Bank.





Our
      preferred supplemental funding mechanism is borrowing funds from the
      FHLB.  With the quarter’s reduction in deposit balances exceeding the
      decline in assets, we experienced a modest increase in our utilization of FHLB
      advances to $178 million at the end of the first quarter compared to $172
      million at the 2006 year-end.  As of March 31, 2007, we had the
      authority to borrow up to approximately $423 million from the FHLB, subject
      to
      maintaining a sufficient level of eligible collateral.








**ADOPTION
      OF SFAS No. 157 AND 159**





We
      elected early adoption of Statements of Financial Accounting Standard (SFAS)
      159
      and 157, effective January 1, 2007. SFAS No. 159 permits the measurement of
      selected financial




34


instruments
      at fair value at specified election dates. With the adoption of SFAS No. 159
      we
      marked-to-market most of our securities, a long term debenture payable (trust
      preferred security) and two commercial loans that were hedged using
      interest-rate swaps.





Our
      securities portfolio totaled $97.6 million (principal only) at year end 2006,
      of
      which $87.1 million (principal only), or 89%, was marked-to-market with the
      adoption of SFAS No. 159. Securities with a remaining balance less than one
      million dollars and instruments held for Community Reinvestment Act (CRA)
      investments were not included in the adoption of SFAS No. 159.  The
      net of tax impact of that fair value measurement was a loss of $1,334,000,
      which
      was charged directly to retained earnings and not recognized in net income.
      In
      the first quarter of 2007 the change in fair value of the securities portfolio
      was $402,000, pre tax, and that amount was recognized in net income. The
      securities portfolio selected with the adoption of SFAS No. 159 is recorded
      in
      the balance sheet as a “trading” portfolio and as such will be marked-to-market
      each quarter with the change in value recognized in earnings. We have placed
      a
      partial hedge on that trading portfolio as a means of reducing the volatility
      in
      net income from the quarterly fair value measurements.  See
“Subsequent Events” section for a further discussion of that hedge.





Subsequent
      to March 31, 2007 we have sold approximately $30 million of the long-term
      securities and purchased 3/1 and 5/1 hybrid ARM securities. The balance of
      the
      securities in the trading portfolio are instruments with remaining maturities,
      or repricing terms, of 1-3 years (about $25 million) and hybrid ARM securities
      that are due for repricing between April and August of this year (about $36
      million). The loans sold had coupon rates ranging from 4%-4.5% and they were
      replaced with securities yielding 5%-5.5%.  In early May we sold $28
      million of the new securities.  For additional information regarding
      that sale please see the “Subsequent Events” section.





We
      also
      elected to mark-to-market a $9 million dollar long term debenture payable (trust
      preferred security). That debenture is hedged with an interest-rate swap that
      is
      carried at fair value, with the change in value reflected in our earnings.
      The
      election to fair value the debenture matches the change in value of the
      interest-rate swap with the change in value of the debenture - - effectively
      reducing the volatility in earnings. That debenture is eligible for prepayment
      on September 30, 2007 and we have entered into a commitment to prepay that
      instrument and replace it with another debenture. The current interest rates
      on
      long-term debentures are about 1.80% lower than our rate.





The
      impact on retained earnings from the adoption of SFAS No. 159 for the long-term
      debenture payable was $220,000, net of tax. Like the securities portfolio the
      charge to retained earnings was not reflected in net income. The change in
      value, however, in the first quarter 2007 was included in earnings and amounted
      to $45,000 gain before tax.





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








35


**ASSET
      QUALITY**





**Provision
      and Reserve for Loan Loss and Loan Commitments Liability**





The
      provision for loan loss for the first quarter was $152,000 compared to a
      provision of $71,000 in the same quarter of last year.  The increase
      in the loan loss provision was prompted by a rise in net charge-offs from
      $53,000 in the first quarter of 2006 to $156,000 in the first quarter of 2007.
      As has typically been the case, our sales finance loan portfolio accounted
      for
      the majority of charged-off balances in the first quarter.  Please see
      the “Sale Finance (Home Improvement) Loans” segment in the “Portfolio
      Information” section for detail on this area’s borrowers’ credit scores,
      charge-offs, delinquencies, and credit insurance coverage.





Also
      adding to the need for a larger provision in the fourth quarter was an increase
      in nonperforming assets from $496,000 as of March 31, 2006, to nearly $2.0
      million at the most recent quarter-end. Partially offsetting the effects of
      the
      growth in charge-offs and nonperforming assets, however, was a substantial
      decline in the loan portfolio during the first quarter.





Nonperforming
      Assets divided by Assets declined from 0.32% at year-end 2006 to 0.19% at the
      end of the first quarter.  That level of nonperforming assets is well
      below industry standards and consistent with our historical
      experience.  Noted below are the ratios from 1998 and the comparative
      industry ratios.





Year
            First
                Mutual Bank
            FDIC
                Insured Commercial
              Banks1998
            0.07%
            0.65%1999
            0.06%
            0.63%2000
            0.38%
            0.74%2001
            0.08%
            0.92%2002
            0.28%
            0.94%2003
            0.06%
            0.77%2004
            0.10%
            0.55%2005
            0.08%
            0.48%2006
            0.32%
            0.51%First
                Quarter 2007
            0.19%
            N/A





At
      the
      end of the first quarter, our nonperforming assets totaled slightly less than
      $2.0 million, down from $3.5 million at the 2006 year-end.  Included
      in the quarter-end total are two custom construction loans in the Oregon market
      for which we have already taken impairment charges and do not anticipate further
      losses. An additional residential loan, also in that market, in the amount
      of
      $825,000 appears to be fully collectable and the borrowers are current on their
      monthly payments.  We have one other residential loan in the Puget
      Sound area with a loan balance of $167,000, on which we do not expect any
      loss.





The
      remaining loans are sales finance loans, most of which are covered by credit
      insurance (subject to the remaining loss limit), and one land loan.





**Non-Performing
      Assets**




Our
      exposure to non-performing assets as of March 31, 2007 was:




36





One
                single-family residential loan in Oregon market.  No anticipated
                loss.
            
            $
            825,000Two
                custom construction loans in Oregon market.  Impairment
                chargestaken
                in 2006.  No further losses anticipated.
            
            
            660,000Thirty-six
                consumer loans.  Full recovery expected from insurance
                claims.
            
            
            178,000One
                single-family residential loan in the Puget Sound
                market.  Noanticipated
                loss.
            
            
            167,000One
                land loan in Western WA.  No anticipated loss.
            
            
            86,000Six
                insured consumer loans from insured pools that have exceeded
                thecredit
                insurance limit.  Possible loss of $33,000.
            
            
            33,000Eight
                consumer loans.  No anticipated loss.
            
            
            30,000Two
                consumer loans.  Possible loss of $2,000.
            
            
            2,000Total
                Non-Performing Assets
            
            $
            1,981,000




NOTE:  In
      April we placed a $1.9 million custom construction loan into non-accrual status
      based upon information received near the end of April.  We expect a
      full recovery of all principal due.





**PORTFOLIO
      INFORMATION**





**Commercial
      Real Estate Loans**




The
      average loan size (excluding construction loans) in the Commercial Real Estate
      portfolio was $693,000 as of March 31, 2007, with an average loan-to-value
      ratio
      of 62%.  At quarter-end, one of these commercial loans was delinquent
      for over 60 days.  Small individual investors or their limited
      liability companies and business owners typically own the properties securing
      these loans.  At quarter-end, the portfolio was 35% residential
      (multifamily or mobile home parks) and 65% commercial.




The
      loans
      in our commercial real estate portfolio are well diversified, secured by small
      retail shopping centers, office buildings, warehouses, mini-storage facilities,
      restaurants and gas stations, as well as other properties classified as general
      commercial use.  To diversify our risk and to continue serving our
      customers, we sell participation interests in some loans to other financial
      institutions.  About 15% 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 $15 million of the portfolio, or
      5%, has been purchased in this manner.




**Sales
      Finance (Home Improvement) Loans**




Our
      Sales
      Finance loan portfolio consists of two sub-portfolios:




·
            Loans
                owned by the bank, i.e., the “bank-owned” portfolio.  This
                includes both loan accounts wholly owned by the bank and the 10%
                ownership
                stake in loan accounts sold to investors.  In the first quarter,
                the bank-owned Sales Finance balance decreased by $6 million to $65
                million based on $17 million in new loan production, $16 million
                in loan
                sales, and loan prepayments of between 30% and 40%
                annualized.




·
            Loans
                owned by investors, i.e., the “investor-owned”
                portfolio.   The loans that make up this segment are
                serviced by First Mutual.  In the first quarter, the
                investor-owned portfolio increased by $7 million to $83
                million.




37


Combined,
      the bank-owned and investor-owned sub-portfolios comprise the Sales Finance
      servicing portfolio.  The Sales Finance servicing portfolio increased
      by $1 million in the first quarter to a total of $148 million.  Our
      average new loan amount was $10,900 in the first quarter.  The average
      loan balance in the servicing portfolio is currently $9,200, and the yield
      on
      this portfolio is 10.64%.




**Loan
      Sales**





When
      we
      sell Sales Finance loans, we offer investors two purchase options: one that
      includes limited credit recourse to First Mutual Bank and the other with no
      credit recourse.  The limited recourse option includes a lower
      pass-through rate on the purchased pool, designed to approximate the insurance
      coverage previously offered to investors, and is limited to an agreed-upon
      level
      of losses.  If the loss limit is reached on a pool of loans, the
      investor is solely responsible for losses beyond the limit.  During
      the first quarter 2007 we sold $510,000 with limited recourse (approximately
      3%
      of the $16 million sold), with an exposure limit of 10% of the balance of the
      loans.  The impact of these limited recourse agreements was an expense
      of $35,000 which was offset against the gain on loan sale.  We ended
      the quarter with a limited recourse obligation on the balance sheet of
      $270,000.




**Portfolio
      Credit Score Breakdown, Servicing Portfolio**





The
      following table shows the current credit score breakdown in the Sales Finance
      servicing portfolio.  The credit score table contains, when available,
      the most recent update to our credit score information for each loan
      (approximately 99% of the portfolio).  When a current credit score is
      unavailable, or when the loan was originated too recently to have been
      re-scored, the credit score at the time of origination is used.  We
      plan to update the credit scores in our portfolio semi-annually, though we
      may
      change the frequency as circumstances dictate.  Loans with full
      recourse to another party are excluded from this table.





Credit
                Score Range
            %
                of Servicing
              Portfolio
                Balance
            Cumulative
                % of
              Servicing
              Portfolio
                Balance780+
            16.1%
            16.1%720-779
            30.4%
            46.5%660-719
            29.1%
            75.6%600-659
            14.4%
            90.0%<
                600
            10.0%
            100.0%Total
            100.0%




**Charge-Offs
      and Delinquency, Bank-Owned Portfolio**





We
      are
      responsible for losses on uninsured loans in the bank-owned
      portfolio.  Uninsured, bank-owned balances totaled $42 million at the
      end of the first quarter, while the insured balance amounted to $23
      million.  As illustrated in the following table, the charge-offs for
      this portion of the bank-owned portfolio during the last five quarters have
      ranged between a low of $55,000 in




38


net
      recoveries in second-quarter 2006 to a high of $344,000 in charge-offs in the
      fourth-quarter 2006.




**BANK-OWNED
                PORTFOLIO**Total
              Balance
            Uninsured
              Balance
            Net
                Charge-
              Offs
            Charge-offs
              (%
                of
              Uninsured
              Balance)
            Delinquent
              Loans
              (%
                of
              Uninsured
              Balance)
            Charge-offs
              (%
                of Total
              Balance)
            Delinquent
              Loans
                (% of
              Total
              Balance)March
                31, 2006
            $79
                million
            $47
                million
            $
                223,000
            0.47%
            0.77%
            0.28%
            1.86%June
                30, 2006
            $82
                million
            $50
                million
            (
                $55,000)
            (0.11%)
            0.87%
            (0.07%)
            1.81%September
                30, 2006
            $78
                million
            $48
                million
            $63,000
            0.13%
            1.22%
            0.08%
            3.05%December
                31, 2006
            $71
                million
            $45
                million
            $344,000
            0.76%
            1.28%
            0.48%
            2.87%March
                31, 2007
            $65
                million
            $42
                million
            $153,000
            0.36%
            0.84%
            0.24%
            1.95%




The
      delinquency rate as a percentage of all bank-owned loans dropped from 1.95%,
      at
      the end of March 2007, to 1.80%, at the end of April 2007; the fourth
      consecutive month of improvement.




**Claims
      and Delinquency, Insured Loans**





Until
      the
      fourth quarter of 2006, the bank insured a portion of the servicing portfolio
      against credit default.  New production is no longer insured, but
      loans with credit insurance in place still account for 32% of our servicing
      portfolio balance, or $47 million.  Losses sustained in the insured
      bank and investor-owned portfolios are reimbursed by an insurance
      carrier.  As shown in the following table, the claims to the insurance
      carriers have varied in the last five quarters from a low of $483,000 to a
      high
      of $1,012,000 in the current quarter 2007.  The standard limitation on
      loss coverage for this portion of the portfolio is 10% of the original pool
      of
      loans for any given pool year.





**INSURED
                PORTFOLIO: BANK AND INVESTOR-OWNED BALANCES**Claims
                Paid
            Claims
                (% of
              Insured
                Balance)
            Delinquent
                Loans
              (%
                of Bank-Owned
              Portfolio
                Balance)**March
                31, 2006
            $985,000
            1.81%
            3.46%June
                30, 2006
            $483,000
            0.86%
            3.22%September
                30, 2006
            $555,000
            0.97%
            5.97%December
                31, 2006
            $946,000
            1.83%
            5.69%March
                31, 2007
            $1,012,000
            2.15%
            3.95%




The
      tables below show the details of the insurance policies in place for both
      bank-owned and investor-owned loans.  In March 2006, the pool for the
      policy year 2002/2003 reached the 10% cap from Insurer
      #1.  Periodically, as Insurer #1 experiences recoveries on losses, a
      portion of those recoveries is added back to the remaining loss limit on both
      pools.




**Insured
      Pools by Insurer #1**


Policy
              Year
            Loans
              Insured
            Current
              Loan
              Balance
                *
            Original
              Loss
              Limit
            Claims
              Paid
            Remaining
              Loss
              Limit
            Remaining
              Limit
                as  %
              of
                Current
              Balance
            Current
              Delinquency
              Rate2002/2003
            $21,442,000
            $6,292,000
            $2,144,000
            $2,217,000
            $0
            0.00%
            4.60%2003/2004
            $35,242,000
            $13,147,000
            $3,524,000
            $3,504,000
            $20,000
            0.15%
            3.55%2004/2005
            $23,964,000
            $12,594,000
            $2,396,000
            $1,639,000
            $757,000
            6.01%
            4.14%




Policy
      years closed on 9/30 of each year.




39


*
      Following is the breakdown of the current loan balance between First Mutual
      Bank
      and the investor’s portion:




Policy
              Year
            Bank-Owned
            Investor-Owned2002/2003
            $5,715,000
            $577,0002003/2004
            $5,644,000
            $7,503,0002004/2005
            $7,892,000
            $4,702,000




**Insured
      Pools by Insurer #2**




Policy
              Year
            Loans
              Insured
            Current
              Loan
              Balance
            Original
              Loss
              Limit
            Claims
              Paid
            Remaining
              Loss
              Limit
            Remaining
              Limit
                as  %
              of
                Current
              Balance
            Current
              Delinquency
              Rate2005/2006
            $19,992,000
            $12,815,000
            $2,985,000*
            $772,000
            $2,213,000*
            17.27%*
            2.06%2006
            $2,965,000
            $2,560,000
            $297,000
            $0
            $297,000
            11.60%
            2.47%




Policy
      years closed on 7/31 of each year.




*The
      2005/2006 policy with Insurer #2 provides insurance for sales finance loans
      along with lot loans and home equity loans.  The “Original Loss Limit”
shown is the full 10% loss limit associated with the 2005/2006 policy, which
      was
      calculated on the balances of the sales finance loans plus the other loans
      covered by the policy (calculations not shown).  We disclose the
      higher “Original Loss Limit” here because we have the ability, under certain
      circumstances, to access the insurance coverage for lot loans or home equity
      loans to pay sales finance claims if we determine that such action is in the
      bank’s best interest. To date, we have submitted no claims on the 2005/2006
      policy for loan types other than sales finance loans.  Note that the
“Remaining Loss Limit” and the “Remaining Limit as % of Current Balance”
calculations are based on the disclosed “Original Loss Limit”.




**
      This
      delinquency rate is limited to the bank-owned portion of delinquent loans
      divided by the total bank-owned portion of the insured segment of the
      portfolio.  Balances not owned by the bank are not
      included.




**Residential
      Lending**




The
      residential lending portfolio (including loans held for sale) totaled $336
      million on March 31, 2007.  This represents an increase of $1 million
      from the end of the fourth quarter, 2006.  The breakdown of that
      portfolio at quarter-end was:





Total
                Bank
              Balance
            
            
            Less
                Loans
              Held
                for
              Sale
            
            
            Net
                Bank
              Balance
            
            
            %
                of
              Portfolio(Dollars
                in thousands)Adjustable-rate
                permanent loans
            
            $
            195,000
            
            
            $
            (5,000
            )
            
            $
            190,000
            
            
            
            60
            %Fixed-rate
                permanent loans
            
            $
            41,000
            
            
            $
            (3,000
            )
            
            $
            38,000
            
            
            
            12
            %Residential
                building lots
            
            $
            37,000
            
            
            $
            (9,000
            )
            
            $
            28,000
            
            
            
            9
            %Disbursed
                balances on custom construction loans
            
            $
            63,000
            
            
            $
            (2,000
            )
            
            $
            61,000
            
            
            
            19
            %Total
            
            $
            336,000
            
            
            $
            (19,000
            )
            
            $
            317,000
            
            
            
            100
            %




40


As
      of
      March 31, 2007, of the 1,630 loans in the residential portfolio, there were
      nine
      loans, or 1.50% of loan balances, delinquent more than one payment and another
      two loans representing 0.28% of the overall balances that were one month past
      due for their March payment.  The remaining 1,619 residential loans
      representing 98.2% of the balances were current on their monthly
      payments.  Since quarter end (as of April 12th), two of those past due
      loans representing $2.3 million (or 0.69% of balances) have paid
      current.




The
      average loan balance in the permanent-loan portfolio is $214,000, and the
      average balance in the building-lot portfolio is
      $120,000.  Owner-occupied properties, excluding building lots,
      constitute 70% of the portfolio.




First
      Mutual Bank’s portfolio lending strategy is to provide credit to borrowers who
      typically possess at minimum, average to better-than-average credit profiles
      (see “Credit Score” table below).  These are borrowers who have
      residential real estate financing needs that do not typically fit within the
      traditional Agency (FHLMC/FNMA) guidelines.




With
      that
      in mind we take a more hands-on, qualitative approach to making lending
      decisions.  Unlike the current trend toward automated underwriting
      systems, our lending decisions are made manually by experienced residential
      underwriters who possess knowledge of our geographic lending
      territory.  We also tend to look critically at the appraised value and
      order appraisal reviews on a higher percentage of loan requests than is
      customary in the industry.




Additionally,
      we employ the application of the available credit enhancement tools (i.e.
      Private Mortgage Insurance and Credit Insurance) to reduce the Bank’s overall
      exposure on the loan.




We
      do not
      currently originate portfolio loans with interest-only payment plans nor do
      we
      originate an “Option ARM” product, where borrowers are given a variety of
      monthly payment options that allow for the possibility of negative
      amortization.  We have virtually no Option ARM and Interest Only loans
      in the Bank’s portfolio.




The
      following are detailed Credit Score and LTV tables on the residential
      portfolio.  The credit score table contains, when available, the
      current credit score information on the portfolio (approximately 90% of the
      portfolio), or when unavailable, the credit score at the time of
      origination.





Credit
            PercentScore
            of
            CumulativeRange
            Dollars
            Percent800-820
            6.5%
            6.5%780-799
            12.4%
            18.9%760-779
            13.8%
            32.7%740-759
            12.3%
            45.0%720-739
            10.0%
            55.0%700-719
            12.0%
            67.0%680-699
            11.3%
            78.3%660-679
            7.9%
            86.2%640-659
            4.6%
            90.8%620-639
            4.0%
            94.8%600-619
            1.8%
            96.6%580-599
            1.0%
            97.6%<580
            2.4%
            100.0%Total
            100.0%




41


Loan-to-Value
      Information







Residential
                MortgagesFMB
            Current
            BankLTV
                Range*
            Balance
            LTV*
            Exposure**95.1%-100%
            $    2,107,000
            98%
            69%90.1%
                - 95%
            $  10,002,000
            93%
            71%85.1%
                - 90%
            $  19,815,000
            88%
            73%80.1%
                - 85%
            $    8,452,000
            83%
            74%75.1%
                - 80%
            $  99,750,000
            78%
            78%to
                75.0%
            $159,000,000
            63%
            63%Total
            $299,126,000
            72%
            69%Lot
                LoansFMB
            Current
            BankLTV
                Range*
            Balance
            LTV*
            Exposure**90.1%
                - 95%
            $  10,037,000
            94%
            60%85.1%
                - 90%
            $    6,280,000
            89%
            60%80.1%
                - 85%
            $    1,079,000
            84%
            66%75.1%
                - 80%
            $    4,251,000
            80%
            59%70.1%
                - 75%
            $    5,752,000
            73%
            69%to
                70%
            $    9,966,000
            58%
            57%Total
            $  37,365,000
            79%
            61%





*
                Current LTV is the current principal balance divided
              by
                the original appraised value (or sales price if
              lower)**  Bank
                exposure reflects the private mortgage
              insurance
                and credit risk insurance purchased onthese
                loans.






**DEPOSIT
      INFORMATION**




The
      number of business checking accounts increased by 12%, from 2,354 at March
      31,
      2006, to 2,638 as of March 31, 2007, a gain of 284 accounts.  The
      deposit balances for those accounts grew 24%.  Consumer checking
      accounts also increased, from 7,521 in the first quarter of 2006 to 7,987 this
      year, an increase of 466 accounts, or 6%.  Our total balances for
      consumer checking accounts rose 4%.




The
      following table shows the distribution of our deposits.




42


Time
                Deposits
            Checking
            Money
                Market
              Accounts
            SavingsMarch
                31, 2006
            62%
            13%
            24%
            1%June
                30, 2006
            62%
            13%
            24%
            1%September
                30, 2006
            63%
            13%
            23%
            1%December
                31, 2006
            60%
            14%
            25%
            1%March
                31, 2007
            57%
            15%
            27%
            1%




**BUSINESS
      SEGMENTS**





Beginning
      January 1, 2007, we changed the presentation of our Business Segments to more
      accurately reflect the way these segments are managed within the
      Bank.  Prior to 2007, we recognized four business
      segments:  1) Consumer Lending, 2) Residential Lending, 3) Business
      Banking Lending, and 4) Income Property Lending.  All other
      departments, including our Banking Centers and investment portfolio were assumed
      to support these business lines.  Consequently, all income generated
      and expenses incurred at these support centers were allocated to the four
      business segments, resulting in no net income or loss at any department except
      the four lending units.





To
      better
      reflect how we manage the Bank we have changed our business segments as
      follows:





·
            Established
                a “Retail Banking” segment which includes our Banking Centers and direct
                consumer lending.  The Home Equity Lines of Credit (HELOC’s) and
                other consumer lending originated through the Banking Centers, which
                were
                previously included in the “Consumer Lending” segment, are included in
                this segment.  The “Retail Banking” segment does not include
                Sales Finance lending.  This segment also includes Community
                Business Banking (small business lending) which had been previously
                included in the “Business Banking”
segment.





·
            Isolated
                our Investment Securities activities as a separate business segment
                so
                that any changes in the investment portfolio’s market value or level of
                earning assets do not distort the reported operating results of our
                other
                business segments.





In
      moving
      the banking centers, our primary source of funds generation, from an allocated
      overhead category to an operating segment, it became necessary to implement
      a
      new process for transferring funds from our funds generating operations to
      the
      users of such funds.  The objective of the funds transfer process is
      to isolate the true profit contribution of each side of the balance
      sheet.  Prior to 2007, the profitability of the funds-generating
      operations, such as the banking centers, was defined as break-even with the
      lending segments collectively compensating the funds-generating operations
      such
      that this result was achieved.  Under the new methodology, the rates
      at which funds are transferred between the generators and users of funds are
      based on market rates of interest.  The profitability of the business
      segments, including retail banking, then varies depending on the actual rates
      earned on assets and paid on liabilities as well as expenses incurred in the
      segments’ operations.  To assist in tracking and evaluating the
      profitability of such funds transfers, we now utilize four line items in
      determining each segment’s net interest income:





43


·
            Interest
                Income – This represents the actual interest received from the segment’s
                loans or securities.





·
            Interest
                Income on Funding Sources – This represents the interest income received
                from selling funding sources generated by the segment (i.e. deposits
                or
                FHLB advances) to a centralized Treasury function.  The interest
                rate paid to the segment is based on the point on the FHLB rate curve
                for
                advances of a duration comparable to the segment’s funding
                source.





·
            Funding
                Costs – This represents the interest paid to the centralized treasury
                function by each business segment for the funding sources necessary
                to
                support earning asset balances.  Again, the interest rate
                charged to the segment is based on the point on the FHLB rate curve
                for
                advances of a duration comparable to the segment’s earning
                assets.





·
            Interest
                Expense – This represents the actual interest paid on the segment’s
                liabilities (i.e. deposits or FHLB
                advances).





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





The
      reportable segments include the following:





·
            Retail
                Banking – Retail Banking is the segment primarily responsible for the
                generation of funding sources, specifically our consumer and small
                business deposit accounts.  In addition to our banking centers,
                the segment includes our direct consumer and Community Business Banking
                (small business) lending
                departments.





·
            Sales
                Finance Lending – Sales Finance indirectly generates unsecured consumer
                loans in connection with home improvement projects.  A large
                percentage of this segment’s loan volume is sold into the secondary market
                on a servicing-retained basis, meaning we continue to process payments
                and
                service the loan following the
                sale.





·
            Residential
                Lending - Residential lending offers loans to borrowers to purchase,
                refinance, or build homes secured by one-to-four-unit family
                dwellings.  This segment also sells loans into the secondary
                market.  We may choose to retain or sell the right to service
                the loans sold (i.e., collection of principal and interest payments)
                depending upon market conditions.





·
            Business
                Banking Lending – Business Banking offers a full range of banking services
                to middle-market size businesses including deposit and cash management
                products, loans for financing receivables, inventory, equipment as
                well as
                permanent and interim construction loans for commercial real
                estate.  The underlying real estate collateral or business asset
                being financed typically secures these
                loans.





·
            Income
                Property Lending – Income Property Lending offers permanent and interim
                construction loans for multifamily housing (over four units) and
                commercial real estate properties.  The underlying real estate
                collateral being financed typically secures these
                loans.





44


·
            Investment
                Securities - The investment securities segment includes the investment
                securities portfolio, FHLB stock, and interest-earning cash
                balances.  Although management does not consider this to be an
                operating business line, security investments represent a necessary
                part
                of liquidity management for the
                Bank.





These
      segments are managed separately because each business unit requires different
      processes and different marketing strategies to reach the customer base that
      purchases the products and services.  The segments derive a majority
      of their revenue from interest income, and we rely primarily on net interest
      revenue in managing these segments.  No single customer provides more
      than 10% of the Bank’s revenues.





**Retail
      Banking**





Quarter
                Ended
            Net
                Income/(Loss)
            Return
                on Equity
            Average
                LiabilitiesMarch
                31, 2005
            ($
                338,000)
            (10.09%)
            $    605,821,000March
                31, 2006
            $  391,000
            11.45%
            $    670,371,000March
                31, 2007
            ($   94,000)
            (2.45%)
            $    674,881,000





First-quarter
      net income for our Retail Banking segment declined $485,000 relative to the
      prior year based on a sharp reduction in net interest income, as rates paid
      on
      deposits continued to increase while market rates of interest, and thus the
      rates at which the retail operations are credited for their deposits, remained
      comparably stable over the last three quarters.





As
      our
      Retail Banking segment includes our banking centers, the majority of this
      segment’s income is received from selling funding sources, specifically deposits
      generated and serviced in the banking centers, to lending units in need of
      funding to support earning asset balances.  This income appears in the
      accompanying notes to our financial statements as “Treasury Income and Interest
      Income on Funding Sources” The line labeled “Funding
      Costs”  represents the expense paid by the users of these funds to
      support their earning asset balances.





Relative
      to the first quarter of last year, the segment’s transferable funding sources
      (deposit balances) increased approximately $4.5 million, or less than
      1%.  Combined with the movements in market rates of interest, at which
      these funds are transferred to our lending units, the Retail segment’s interest
      income from funding sources rose $608,000, or approximately 7% from its first
      quarter 2006 level.  Other interest income for the segment, which
      consists of interest received on home equity, personal, and small business
      loans
      and lines, totaled $854,000, up $34,000 from the same period last
      year.





By
      comparison, the interest paid on deposits rose nearly $1.4 million, or more
      than
      26%, as competition in the local marketplace continued to push deposit rates
      higher despite the leveling off of market rates of interest.  As a
      result, the segment’s net interest income declined $746,000 relative to the
      prior year.





While
      noninterest income improved as compared to the like quarter in 2006, noninterest
      expense for the segment was relatively little changed compared to the prior
      year.  Noninterest income rose $53,000, or nearly 15%, based on
      improvements observed in checking account service charges, debit card fees,
      and
      other miscellaneous fee income, while noninterest expense increased $70,000,
      or
      approximately 2% over the first quarter of last year.





45


**Sales
      Finance**





Quarter
                Ended
            Net
                Income
            Return
                on Equity
            Average
                AssetsMarch
                31, 2005
            $
                366,000
            30.01%
            $    67,679,000March
                31, 2006
            $  390,000
            27.65%
            $    82,362,000March
                31, 2007
            $  335,000
            24.53%
            $    68,910,000





Net
      income for our Sales Finance segment declined $55,000, or approximately 14%
      from
      the level earned in the first quarter of 2006, as a significant increase in
      noninterest income, specifically gains on loan sales, was insufficient to offset
      a reduction in net interest income and increase in the loan loss
      provision.





The
      Sales
      Finance segment’s earning assets declined significantly relative to the first
      quarter of 2006 because of a substantial increase in the level of loan sales
      relative to prior years.  Loan sales totaled roughly $59 million for
      2006, a more than threefold increase over the $18 million sold in 2005, and
      sales of nearly $16 million in the first quarter of this year exceeded the
      $13
      million sold in the first quarter of last year.  With these sales, and
      resulting decline in earning assets, the segment’s interest income fell more
      than 21% relative to the prior year.  While the lower level of earning
      assets also reduced the segment’s funding requirement, and consequently its
      interest expense, the 12% reduction in funding costs offset only a portion
      of
      the lost interest income.  As a result, the segment’s net interest
      income declined $311,000 or 31% from the first-quarter 2006
      level.  With the segment’s loan loss provision increasing $143,000
      relative to the prior year, net interest income after the loan loss provision
      declined $454,000, or 46%.  The increase in the loan loss provision
      relative to the prior year was related to the insured loan pools for years
      2002-2003 and 2003-2004 reaching their 10% coverage limits.  In
      anticipation of charge-offs from those pools, we have increased the segment’s
      loan loss provision.





While
      the
      increased level of loan sales over the last five quarters has negatively
      impacted the segment’s net interest income, it has contributed to improvements
      in noninterest income, which rose $327,000 relative to the first quarter of
      last
      year.  The increase was attributable to additional gains on loan
      sales, which rose from $749,000 in the first quarter of 2006 to $933,000 this
      year, as well as service fee income, which increased from $332,000 to
      $462,000.





The
      segment’s noninterest expense remained well contained relative to the first
      quarter of last year, actually declining $36,000 or approximately 2% compared
      to
      the first quarter of 2006, based in part on a reduction in credit insurance
      premiums. As we stated in our 2006 year-end press release, after evaluating
      our
      use of credit insurance, we concluded that the benefits of the insurance no
      longer outweighed the costs and chose to forego the insurance and assume the
      credit risk on future sales finance loan production.  Consequently, it
      was our expectation that expenditures for credit insurance would decline in
      the
      first quarter of 2007 and continue to decline in future
      quarters.  Those loans insured prior to August 1, 2006 remain insured
      under their existing policies, and some loans originated on or after August
      1,
      2006 were sold to institutional investors with insurance placed prior to sale
      and remain insured under the policy effective August 1, 2006.





**Residential
      Lending**





Quarter
                Ended
            Net
                Income
            Return
                on Equity
            Average
                AssetsMarch
                31, 2005
            $
                646,000
            27.38%
            $    253,443,000March
                31, 2006
            $  743,000
            27.26%
            $    313,289,000March
                31, 2007
            $  771,000
            23.64%
            $    327,098,000





46


The
      Residential Lending segment’s net income for the first quarter of 2007 totaled
      $771,000, representing a 4% increase over the same period last year, as
      improvements in net interest and noninterest income exceeded increases in the
      provision for loan loss and operating expenses.





The
      Residential segment, along with Business banking, has been one of the largest
      contributors to our earning asset growth in recent years, as it was in the
      first
      quarter of this year, with asset growth of $14 million, or approximately 4%,
      relative to the level as of March 31, 2006.  This represented,
      however, a significant decline from the level of growth observed in the prior
      year, as a regional slowdown in residential lending resulted in a substantial
      reduction in both the number of loans originated and the portfolio balances.
      Still, between the asset growth and the repricing effects resulting from
      increases in interest rate indexes from which the loan rates are set, interest
      income earned on the portfolio increased nearly 6% relative to the first quarter
      of last year.  The segment’s funding costs and resulting net interest
      income also increased approximately 6% relative to the first quarter of
      2006.  The segment’s provision for loan loss rose $98,000 from the
      first quarter 2006 level.  Note that the first quarter 2006 provision
      for the segment reflected a large recovery on a residential loan that had been
      charged-off in a prior period, and was consequently considered an unusually
      low
      provision for loan losses.





The
      Residential Lending segment’s noninterest income rose $121,000, or nearly 146%,
      based largely on additional loan fee income and gains on loan
      sales.  Loan fee income increased relative to the prior year based on
      a higher level of fees collected in connection with loan modifications or
      extensions and non-conversion of construction loans to permanent
      mortgages.  Gains on residential loan sales fluctuate from quarter to
      quarter, and typically result in modest gains or even slight losses when
      interest rates are rising quickly.  We believe the construction phase
      to be the most profitable facet of residential lending and the primary objective
      in a residential lending relationship.  Following the construction
      process, our practice is to retain in our portfolio those residential mortgages
      that we consider to be beneficial to the bank, but to sell those that we
      consider less attractive assets.





The
      Residential segment’s noninterest expense increased $110,000, or 10%, partially
      offsetting the quarter’s income growth over the same period last
      year.  A reduction in the amount of loan origination expenses eligible
      for deferral and amortization contributed significantly to the increase relative
      to the first quarter of last year.





In
      accordance with current accounting standards, certain loan origination costs,
      including some salary expenses tied to loan origination, are deferred and
      amortized over the life of each loan originated, rather than expensed in the
      current period.  Expenses are then reported in the financial
      statements net of these deferrals.  The amount of expense subject to
      deferral and amortization can vary from one period to the next based upon the
      number of loans originated, the mix of loan types, and year-to-year changes
      in
“standard loan costs”.   In this instance, both the number of
      loans originated by our Residential lending area in the first quarter of 2007
      as
      well as the deferred costs associated with each origination declined relative
      to
      the prior year.  This resulted in a higher level of expense being
      recognized in the current period.





**Business
      Banking Lending**





Quarter
                Ended
            Net
                Income
            Return
                on Equity
            Average
                AssetsMarch
                31, 2005
            $
                237,000
            13.86%
            $      93,710,000March
                31, 2006
            $  156,000
            7.68%
            $    117,782,000March
                31, 2007
            $  298,000
            9.92%
            $    144,792,000





47


Our
      Business Banking segment is one of the newer business lines in which we have
      invested, and will continue to invest our resources with the eventual goal
      of
      achieving our targeted 15% return on equity and consistent year-over-year
      earnings growth.  While these results have not yet been achieved, we
      continue to invest in this segment based upon its ability to attract low-cost
      core deposits, which help reduce our overall cost of funds, the diversification
      it brings to our portfolio of earning assets, and the potential it offers for
      generating longer-term relationship-banking opportunities and additional sources
      of noninterest income.





With
      assets averaging $145 million for the quarter, an increase of nearly 23% over
      the prior year level and by far the highest rate of increase among our business
      segments, the segment’s interest income grew $626,000, or 28% over the level
      earned in the first quarter of 2006.  Additionally, with deposit
      growth of $20 million, or approximately 46%, income credited for funding sources
      generated rose $324,000, or 58% over the prior year.  Partially
      offsetting these improvements, however, were an additional $589,000 in funding
      costs to support earning assets and $273,000 in interest expense paid on deposit
      accounts. The Business Banking segment’s first quarter net interest income after
      provision for loan losses rose $134,000, or 12%, over the first quarter of
      last
      year.





The
      Business Banking segment’s noninterest income rose $17,000 over the
      first-quarter 2006 level.  Contributing to the segment’s noninterest
      income growth has been the expansion of the segment’s deposit base, measured by
      both total deposit balances as well as the number of open accounts, as well
      as
      loan fee income, which includes fees collected in connection with loan
      modifications or extensions as well as letters of credit originated for
      commercial borrowers.





Further
      contributing to the segment’s improved performance was a $60,000 reduction in
      noninterest expense relative the first quarter of last year.  Under
      the previous method of segmenting our business lines, our banking centers were
      deemed to be overhead cost centers rather than an operating segment, and
      consequently all income and expenses associated with the banking centers was
      allocated among the four lending units.  Consequently, the Business
      Banking segment’s deposit growth in prior years resulted in increasing
      allocations of banking center-related expense, which frequently negated the
      benefit of the additional deposits.  With the banking centers now
      representing the majority of the Retail Banking segment, the Business Banking
      and other lending segments are no longer subject to allocations of banking
      center expense.  Similarly, the lending segments no longer receive any
      benefit to the extent that the banking centers generate funds at below-market
      rates of interest.  The segment results for 2005 and 2006 have been
      restated to reflect this methodology consistently throughout the three years
      presented here.





**Income
      Property Lending**





Quarter
                Ended
            Net
                Income
            Return
                on Equity
            Average
                AssetsMarch
                31, 2005
            $  1,413,000
            23.35%
            $      378,670,000March
                31, 2006
            $     909,000
            17.15%
            $      336,364,000March
                31, 2007
            $  1,245,000
            20.94%
            $      319,357,000





The
      Income Property segment’s first quarter net income rose $336,000, or 37%
      relative to the same period last year, based primarily on growth in interest
      income and a reduction in the provision for loan loss.





48


The
      segment’s net interest income after provision for loan loss grew $458,000, or
      21%, based on interest income growth of $416,000 and an additional $44,000
      in
      interest income on transferred funding sources against an offsetting $61,000
      increase in funding costs and $39,000 in interest expense on deposit
      accounts.  The provision for loan loss declined $98,000 compared to
      the first quarter of 2006, due in large part to the continued decline in
      portfolio balances.





The
      Income Property segment’s decline in earning assets during the first quarter of
      2007 continued a trend observed over the last couple of years, and is primarily
      a product of declining originations of permanent multifamily and commercial
      real
      estate loans, combined with a high level of prepayments on the loan portfolio,
      which we attribute to a combination of increased competition from other lenders
      and the flat yield curve.  Increased competition from conduit lenders
      as well as lenders in our local market accelerated both the decline in new
      volumes as well as portfolio payoffs, as the competition frequently resulted
      in
      lenders offering prospective borrowers new loan commitments, or existing
      borrowers the opportunity to refinance, at unusually low margins.  The
      flat yield curve, which has resulted from a number of increases in short-term
      interest rates, has reduced the rate differential between short- and long-term
      financing costs and provided a financial incentive for borrowers to select
      longer-term, fixed-rate loans as opposed to adjustable-rate
      financing.  As we have historically been an originator of short-term
      and adjustable-rate loans, this impacted us in two ways.  First, as
      prospective borrowers sought loans with terms that fell outside of our typical
      underwriting structures, our originations of permanent multifamily and
      commercial real estate loans declined.  Second, with the yield curve
      providing borrowers with a financial incentive to refinance adjustable-rate
      loans, which make up the majority of our loan portfolio, with longer-term,
      fixed-rate debt, the prepayment rates on our Income Property portfolio remained
      at relatively high levels.





Noninterest
      income for the Income Property segment remained unchanged from the first quarter
      of last year, while the segment’s noninterest expense for the Income Property
      segment declined by $32,000, or 4% compared to the first quarter of
      2006.  As noted above, the Income Property segment has seen its
      earning asset balances decline over the last couple of years, and as a result,
      the segment has become a smaller component of our overall asset
      mix.  Consequently, for a number of different administrative and
      overhead expenses that we allocate out to the business segments, such as
      accounting and information systems related costs, the percentages allocated
      to
      other business lines has tended to increase, thus reducing the percentage
      allocated to the Income Property segment.





**Investment
      and Treasury**





Quarter
                Ended
            Net
                Income
            Return
                on Equity
            Average
                AssetsMarch
                31, 2005
            $  260,000
            47.88%
            $      150,652,000March
                31, 2006
            $  125,000
            26.74%
            $      136,427,000March
                31, 2007
            $  160,000
            35.52%
            $      113,575,000





The
      Investment and Treasury segment includes our investment securities portfolio
      on
      the asset side and, on the liability side, our FHLB advances and certificates
      of
      deposit issued through brokerage services.  While management does not
      consider this to be an operating business line, our security investments and
      wholesale borrowings represent a necessary part of liquidity management, and
      their impact on our operations has been recognized as its own segment so as
      not
      to distort the results of our other business lines.





49


For
      the
      first quarter of 2007, this segment posted a net interest loss of $173,000,
      compared to net interest income of $210,000 in the prior year.  In
      each year, the cost of funding the securities portfolio exceeded its yield,
      while the FHLB advances and brokered deposits originated by the segment were
      “sold” to the lending units at rates exceeding the cost of those funding
      sources.  In 2005 and 2006, the profitability of the funding sources
      was sufficient to offset the loss on the securities.  In 2007,
      however, the funding sources were only marginally profitable, resulting in
      the
      net interest loss.





Noninterest
      income for the segment, which had been virtually nonexistent prior to this
      year,
      totaled $431,000 for the first quarter as a result of our early adoption of
      SFAS
      No. 157 and 159, effective January 1, 2007. SFAS No. 159, which was issued
      in
      February 2007, generally permits the mark-to-market of selected eligible
      financial instruments.  In the case of our early adoption, the
      affected securities totaled $87 million (principal only), or approximately
      89%
      of our securities portfolio. As a result of the fair value measurement election
      for these securities, we recorded gains in the first quarter of
      $402,000.  We also elected the adoption of SFAS No. 159 for a $9
      million trust preferred security, recording $45,000 in pre-tax mark-to-market
      gains related to this instrument for total pre-tax, SFAS No. 159-related,
      mark-to-market gains of $447,000 for the first quarter.





The
      segment’s noninterest expense is virtually immaterial, totaling $23,000 for the
      first quarter, and represents allocations of accounting and administrative
      overhead costs associated with the management of the portfolio.








**LIQUIDITY**





Our
      primary sources of liquidity are loan and security sales and repayments,
      deposits, and wholesale funds. A secondary source of liquidity is cash from
      operations, which, though not a significant source of liquidity, is a consistent
      source based upon the quality of our earnings. Our principal uses of liquidity
      are the origination and acquisition of loans and securities, and to a lesser
      extent, purchases of facilities and equipment.





Quarter
                EndedMarch
                31, 2007
            
            
            March
                31, 2006(Dollars
                in thousands)Loan
                Originations (disbursed)
            
            $
            (95,000
            )
            
            $
            (121,000
            )Decrease
                in Undisbursed Loan Proceeds
            
            
            (17,000
            )
            
            
            (5,000
            )Security
                Purchases
            
            
            (5,000
            )
            
            
            (7,000
            )Total
                Originations and Purchases
            
            $
            (117,000
            )
            
            $
            (133,000
            )Loan
                and Security Repayments
            
            $
            106,000
            
            
            $
            111,000Sales
                of Loans
            
            
            27,000
            
            
            
            23,000Total
                Repayments and Sales
            
            $
            133,000
            
            
            $
            134,000Net
                Difference
            
            $
            16,000
            
            
            $
            1,000





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




50


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 41% in the first quarter of 2007, compared to
      40%
      and 39% for the first quarter of 2006 and the fiscal year 2006,
      respectively.





We
      believe the flat to inverted shape of the yield curve that has persisted since
      mid-2005 to the present time likely contributed to the continued high level
      of
      prepayments, as the rate differential between short- and long-term financing
      diminished and reduced the financial incentive for borrowers to use
      shorter-term, adjustable-rate financing rather than longer-term fixed rate
      loans. This, in turn, provides borrowers holding short-term or adjustable-rate
      loans, which represent the majority of our loan portfolio, with an incentive
      to
      refinance with long-term fixed-rate loans.





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 first quarters of 2006
      and 2007, changes in funds from deposits and borrowings were as
      follows:





Quarter
                EndedMarch
                31, 2007
            
            
            March
                31, 2006(Dollars
                in thousands)Deposits
            
            $
            (34,000
            )
            
            $
            23,000Borrowings
            
            
            6,000
            
            
            
            (19,000
            )Total
            
            $
            (28,000
            )
            
            $
            4,000





For
      the
      first quarter of the year, our total deposit balances declined $34 million,
      or
      approximately 4% from their year-end level, with non-maturity deposit balances
      rising nearly $12 million for the quarter, while time deposits, including
      certificates issued through brokerage services, declined nearly $46
      million.  Brokered and other institutional certificates of deposit
      accounted for approximately $33 million of this reduction.





The
      inflows and outflows of deposits vary from period to period, and our ability
      to
      raise liquidity from this source is dependent on our effectiveness in competing
      with other financial institutions in our local market. That competition tends
      to
      focus on rate and service. Although we control the quality of service that
      we
      provide, we have no control over the prevailing rates in our
      marketplace.





Our
      other
      major source of liquidity is wholesale funds, which include borrowings from
      the
      FHLB, brokered deposits, reverse repurchase agreements, and a revolving line
      of
      credit at the Holding Company level. The most utilized wholesale funding source
      is FHLB advances, which totaled $178 million at the end of the first quarter,
      up
      slightly from $172 million at the 2006 year-end, but down from the $207 million
      outstanding at March 31, 2006. Our credit line with the FHLB is reviewed
      annually, and our maximum allowable borrowing level is currently set at 40%
      of
      assets, or $423 million based on assets as of March 31, 2007. As a percentage
      of
      quarter-end assets, our FHLB borrowings totaled 17% at March 31, 2007, compared
      to 19% at March 31, 2006 and 16% at the 2006 year-end. Potential risks
      associated with this funding source include the reduction or non-renewal of
      the
      line and insufficient collateral to utilize the line. We attempt to mitigate
      the
      risk of non-renewal by maintaining the credit quality of our loans and
      securities and attending to the quality and consistency of our
      earnings.





51


The
      potential risk of not holding enough collateral to fully utilize our available
      FHLB advances is monitored to ensure that ample collateral is available to
      meet
      our funding needs. Our two principal sources of preferred collateral are
      single-family residential and multifamily loans. Because single-family lending
      has exhibited significant growth in recent years, we are encouraged that the
      business line will be able to provide sufficient collateral to meet our FHLB
      borrowing requirements.





Brokered
      deposits, which are included in the deposit totals, amounted to $18 million
      as
      of March 31, 2007, compared to $47 million as of the 2006 year-end and $51
      million at March 31, 2006.  While the rates on these deposits are
      typically very comparable to those of FHLB advances, at various times in late
      2005 and throughout 2006, the rates on brokered deposits fell below those of
      similar term FHLB advances.  At such times, and subject to our funding
      needs, we elected to increase our use of this funding source and routinely
      issued brokered deposits to replace maturing FHLB advances.  As of
      March 31, 2007, brokered deposits represented 3.0% of total deposits compared
      to
      5.9% at the 2006 year-end and 6.5% as of March 31, 2006. We may increase our
      use
      of brokered deposits in the future, depending on the costs of various wholesale
      funding sources and subject to internal policy limits, which restrict our total
      usage of these deposits to no more than 10% of total deposits.





Reverse
      repurchase lines are lines of credit collateralized by securities. We currently
      have lines totaling $35 million, of which the full amount is currently
      available. There has been no usage of these lines in the previous three years.
      The risks associated with these lines are the withdrawal of the line based
      on
      the credit standing of the Bank and the potential lack of sufficient collateral
      to support the lines.





An
      additional source of liquidity has been our cash from operations, which, though
      not a significant source of liquidity, we consider to be a consistent source
      based upon our earnings. On a very limited basis it can be viewed as cash from
      operations adjusted for items such as provision for loan loss and depreciation.
      See the “Consolidated Statements of Cash Flows” in the financial statements
      section of this filing for a calculation of net cash provided by operating
      activities.





In
      addition to using liquidity to fund loans and securities, we routinely invest
      in
      facilities and equipment. In the first quarter of 2007 we invested $591,000
      in
      these assets, down from $1.3 million in the first quarter of 2006, as most
      of
      our major capital projects were completed by the end of last year. Over the
      remainder of this year, planned projects include the completion of remodeling
      projects in First Mutual Center and our Canyon Park banking center, which we
      expect to open later this year.








**CAPITAL**





The
      FDIC’s statutory framework for capital requirements establishes five categories
      of capital strength, ranging from a high of well capitalized to a low of
      critically under-capitalized.  An institution’s category depends upon
      its capital level in relation to relevant capital measures, including a
      risk-based capital measure, a leverage capital measure, and certain other
      factors.  At March 31, 2007, we exceeded the capital levels required
      to meet the definition of a well-capitalized institution:




52




Actual
            Minimum
                for
              Capital
              Adequacy
                Purposes
            Minimum
                to be
              Categorized
                as “Well
              Capitalized”
                Under
              Prompt
                Corrective
              Action
                ProvisionsTotal
                capital (to risk-weighted assets):First
                Mutual Bancshares, Inc.
            12.37%
            8.00%
            N/AFirst
                Mutual Bank
            12.63
            8.00
            10.00%Tier
              I capital (to risk-weighted assets):First
                Mutual Bancshares, Inc.
            11.12
            4.00
            N/AFirst
                Mutual Bank
            11.38
            4.00
            6.00Tier
              I capital (to average assets):First
                Mutual Bancshares, Inc.
            8.22
            4.00
            N/AFirst
                Mutual Bank
            8.64
            4.00
            5.00





**SUBSEQUENT
      EVENTS**





In
      April,
      subsequent to the quarter-end, we sold several longer-maturity securities from
      our newly established trading portfolio, replaced the sold issues with
      approximately $34 million in shorter-term hybrid ARM securities, and began
      evaluating the potential risks and benefits of employing strategies to hedge
      against movements in the market value of the trading portfolio. In the first
      week of May, based on the earnings volatility presented by the new accounting
      treatment, we elected to reduce the size of the portfolio by reselling our
      recently purchased securities in the secondary market and utilized interest
      rate
      swaps totaling $42 million to partially hedge against movements in the market
      value of the remaining trading portfolio.  Based on the size of the
      remaining portfolio, this equates to only a partial hedge, and not a total
      immunization against movements in the market value of the trading
      portfolio.  Additionally, given the movement in the market between the end
      of the first quarter and the first week of May, establishing this partial hedge
      will likely result in the partial locking-in of a loss that occurred as a result
      of market movements over the course of those few weeks.




At
      the
      present time, approximately $28 million of the $34 million in recently acquired
      securities have been resold from the portfolio, and we are considering, subject
      to market conditions, additional sales to further reduce the size of our trading
      portfolio.  In the event that future sales are executed, we would expect to
      unwind some of the $42 million in interest rate swaps currently employed to
      partially hedge the portfolio.




In
      June
      of 2002, we issued our first Trust Preferred Security (TPS) in the amount of
      $9
      million and with an interest rate adjustable on a quarterly basis.  At the
      same time, we entered into an interest rate swap with the FHLB in order to
      protect against potential adverse interest rate volatility that could be
      realized from the TPS by fixing the interest rate payable for the first five
      years of the TPS’ life.  The swap is scheduled to mature in June of this
      year, after which time the rate on the TPS will adjust on a quarterly basis
      at
      3.65% over the current three-month LIBOR rate.  As margins on current TPS
      issues have declined to approximately 1.55% to 1.65% over




53


three-month
      LIBOR, it is our intention to call the outstanding $9 million TPS at the
      earliest contractual redemption date, in this case September 2007, and replace
      the issue with a new TPS at a lower margin.








ITEM
                3.
            Quantitative
                and Qualitative Disclosures About Market
                Risk





Market
      risk is defined as the sensitivity of income and capital to changes in interest
      rates, and other relevant market rates or prices.  Our profitability
      is largely dependent on our net interest income.  Consequently, our
      primary exposure to market risk arises from the interest rate risk inherent
      in
      our lending, mortgage banking, deposit, and borrowing
      activities.  Interest rate risk is the risk to earnings and capital
      resulting from adverse movements in interest rates.  To that end, we
      actively monitor and manage our exposure to interest rate risk.





A
      number
      of measures are utilized to monitor and manage interest rate risk, including
      net
      interest income and economic value of equity simulation models, as well as
      traditional “gap” models.  We prepare these models on a monthly basis
      for review by our Asset Liability Committee (ALCO), senior management, and
      Board
      of Directors.  The use of these models requires us to formulate and
      apply assumptions to various balance sheet items.  Assumptions
      regarding interest rate risk are inherent in all financial institutions, and
      may
      include, but are not limited to, prepayment speeds on loans and mortgage-backed
      securities, cash flows and maturities of financial instruments held for purposes
      other than trading, changes in market conditions, loan 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.





54


**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, and is scheduled to mature in June of this year.





In
      the
      second quarter of 2006, we began to utilize interest rate swaps in connection
      with the underwriting of longer-term, fixed-rate commercial real estate
      loans.  This decision was the result of prospective borrowers’ demand
      for longer-term, fixed-rate loans, and the preference of depositors for
      instruments of significantly shorter terms.  Under this program, we
      originate commercial mortgage loans with amortization schedules of up to
      30-years, with an initial 10-year fixed rate.  To hedge the interest
      rate risk exposure presented by ten-year, fixed-rate instruments, we utilize
      interest rate swaps on a loan-by-loan basis to convert each loan’s fixed rate to
      an adjustable rate subject to regular repricing relative to a market index
      rate,
      typically the one-month LIBOR rate.  As this is a relatively new
      program, we do not yet have an expectation of the number of loans that will
      likely be originated and hedged in such a manner.  These interest rate
      swaps will be used solely for the purpose of managing the interest rate risk
      associated with longer-term, fixed-rate assets, and will not be used for any
      speculative purposes.





Finally,
      in the first quarter of this year, we elected early adoption of SFAS No. 157
      and
      159 with respect to the majority of our securities portfolio, the previously
      mentioned TPS, and selected other financial
      instruments.  Consequently, these assets and liabilities are now
      reflected on our statements of condition at their fair values, with any changes
      in market value over the course of a period recognized as income or losses
      in
      the period’s operating results.  To mitigate the earnings volatility
      of the assets marked-to-market we have acquired $42 million in interest rate
      swaps.  Please see the “Subsequent Events” section for a further
      discussion of these derivatives.





**Net
      Interest Income (NII) and Economic Value of Equity (EVE) Simulation Model
      Results**





**March
                31, 2007**
            
            **December
                31, 2006****Percentage
                Change**
            
            **Percentage
                Change****Change
                  in**
                **Interest
                  Rates**(in basis points)
            
            **Net
                  Interest**Income
            **Economic**
                **Value**of
                Equity
            
            **Net
                  Interest**Income
            **Economic**
                **Value**of
                Equity+200
            
            2.72%
            0.81%
            
            2.40%
            (1.07%)+100
            
            n/a
            1.34%
            
            n/a
            0.06%-100
            
            n/a
            (2.06%)
            
            n/a
            (0.88%)-200
            
            (0.82%)
            (6.52%)
            
            0.23%
            (3.76%)





**Net
      Interest Income Simulation**





Our
      income simulation model based on information as of March 31, 2007 indicated
      that
      our net interest income over the following 12 months was projected to increase
      from its “base case”




55


level
      in
      a scenario in which interest rates are assumed to gradually increase by 200
      bps
      over a 12-month period, and fall assuming a gradual 200 bps decline in rates
      over the same timeframe.  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 in either scenario, as an increase in net
      interest income of 2.72% was observed in the rising rate environment, and a
      decline of 0.82% was indicated in the falling rate scenario.





The
      changes indicated by the simulation model represent variances from a “base case”
scenario, which is a projection of net interest income assuming interest rates
      remain unchanged from their current levels over the life of the forecast, and
      that the size of the balance sheet remains stable over the forecast timeframe,
      with no growth or contraction regardless of interest rate
      movements.  The base model will, however, illustrate the future
      effects of rate changes that have already occurred but have not yet flowed
      through to all the assets and liabilities on our balance sheet.  These
      changes can either increase or decrease net interest income, depending on the
      timing and magnitudes of those changes.  Additionally, the tendencies
      for loan and investment prepayments to accelerate in falling interest rate
      scenarios and slow when interest rates rise have been incorporated into the
      model assumptions.  Implicit in these assumptions are additional
      assumptions for increased securities purchases and loan originations at lower
      interest rate levels to offset accelerated prepayments, and conversely, reduced
      securities purchases and loan production when rates increase and prepayments
      slow.





The
      rising and falling rate ramp scenarios then indicate that if the slope of the
      yield curve remains the same, and customer loan and deposit preferences do
      not
      change in response to further movements of the yield curve, then a parallel
      200
      basis point increase or decrease in rates will not significantly change net
      interest income from what is presently expected in the “base
      case.”  In the event the simulation model indicated that the increase
      or decrease in interest rates over the following 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.





Please
      note that the simulation model does not reflect the security sales, purchases,
      and interest rate swap activity that occurred in April and May.





**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




56


liabilities
      to fall, with more prominent effects on longer-term, fixed-rate
      instruments.  Additionally, when interest rates rise, the cash flows
      on our assets are typically expected to decelerate as borrowers are assumed
      to
      become less likely to prepay their loans.  As the cash flows on these
      assets are shifted further into the future, their present values are further
      reduced.  Our EVE simulation model results as of March 31, 2007
      indicated that our liabilities would be expected to exhibit a greater level
      of
      sensitivity to rising rates than assets, with the economic value of assets
      declining by 2.34%, compared to a decline of 2.72% for our
      liabilities.  Given the greater sensitivity of liabilities, the
      reduction in the economic value of liabilities exceeded the impact on
      assets.  Consequently, the economic value of our equity was positively
      impacted in this scenario, rising 0.81%.





The
      opposite occurs when rates decline, as the discount rates used to calculate
      the
      present values of assets and liabilities will decrease, causing the present
      values of both assets and liabilities to rise.  Counteracting this
      effect on assets, however, is the tendency for cash flows from assets to
      accelerate in a falling rate scenario, as borrowers refinance their existing
      loans at lower interest rates.  These loan prepayments prevent the
      economic values of these assets from increasing in a declining rate scenario,
      illustrating an effect referred to as negative convexity.  Taking this
      negative convexity into account, the simulation results indicated a negative
      impact to EVE in the falling rate scenario.  In this case, the
      economic values of both assets and liabilities were positively impacted when
      rates were assumed to fall by 200 bps, assets by 1.70% and liabilities by
      2.69%.  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 6.52%.





The
      Net
      Interest Income and Economic Value of Equity sensitivity analyses do not
      necessarily represent forecasts.  As previously noted, there are
      numerous assumptions inherent in the simulation models as well as in the gap
      report, including the nature and timing of interest levels, the shape of the
      yield curve, loan and deposit growth, prepayments on loans and securities,
      deposit decay rates, pricing decisions on loans and deposits,
      reinvestment/replacement of asset and liability cash flows, customer
      preferences, and competitor and economic influences.





**Gap
      Model**





In
      addition to the above simulation models, an interest “gap” analysis is used to
      measure the matching of our assets and liabilities and exposure to changes
      in
      interest rates.  This model, which represents a traditional view of
      interest rate sensitivity, quantifies the mismatch between assets maturing,
      repricing, or prepaying within a period, and liabilities maturing or repricing
      within the same period.  A gap is considered positive when the amount
      of interest-rate-sensitive assets exceeds the amount of interest-rate-sensitive
      liabilities within a given period.  A gap is considered negative in
      the reverse situation.





**One-Year
      Interest Rate Sensitivity Gap**





**March
                31, 2007**
            
            
            **December
                31, 2006**(Dollars
                in thousands)One-Year
                Repricing/Maturing Assets
            
            $
            669,321
            
            
            $
            673,514One-Year
                Repricing/Maturing Liabilities
            
            
            696,953
            
            
            
            725,636One-Year
                Gap
            
            $
            (27,632
            )
            
            $
            (52,122
            )Total
                Assets
            
            $
            1,056,847
            
            
            $
            1,079,272One-Year
                Interest Rate Gap as a Percentage of Assets
            
            
            (2.6
            %)
            
            
            (4.8
            %)




57


At
      a
      negative, or liability sensitive, 2.6% of assets, our 12-month interest rate
      sensitivity gap as of March 31, 2007 indicated a modest degree of liability
      sensitivity comparable to the 4.8% observed at the 2006
      year-end.  Certain shortcomings are inherent in gap analysis,
      including the failure to recognize differences in the frequencies and magnitudes
      of repricing for different balance sheet instruments.  Additionally,
      some assets and liabilities may have similar maturities or repricing
      characteristics, but they may react differently to changes in interest
      rates.  This illustrates a facet of interest rate exposure referred to
      as “basis risk.”  Assets, such as adjustable-rate mortgage loans, may
      also have features that limit the effect that changes in interest rates have
      on
      the asset in the short-term and/or over the life of the loan, for example a
      limit on the amount by which the interest rate on the loan is allowed to adjust
      each year.  This illustrates another area of interest rate exposure
      referred to as “option risk.”  Due to the limitations of the gap
      analysis, these features are not taken into
      consideration.  Additionally, in the event of a change in interest
      rates, prepayment and early withdrawal penalties could deviate significantly
      from those assumed in the gap calculation.   As a result, we
      utilize the gap report as a complement to our income simulation and economic
      value of equity models.





**Securities**





**ITEM
        3**
  The
        following table sets forth certain information regarding carrying values
        and
        percentage of total carrying values of the Bank’s consolidated portfolio
        of securities classified as available-for-sale and
        held-to-maturity.
  March
                                      31, 20072007
                                  
                                  
                                  2006**Available-for-Sale:**
                                  
                                  Carrying
                                      Value
                                  
                                  
                                  Percent
                                      of Total
                                  
                                  
                                  Carrying
                                      Value
                                  
                                  
                                  Percent
                                      of Total(Dollars
                                      in thousands)US
                                      Government treasury and agency obligations
                                  
                                  $
                                  —
                                  
                                  
                                  
                                  0
                                  %
                                  
                                  $
                                  17,892
                                  
                                  
                                  
                                  16
                                  %Mortgage-backed
                                      securities:Freddie
                                      Mac
                                  
                                  
                                  554
                                  
                                  
                                  
                                  12
                                  %
                                  
                                  
                                  15,527
                                  
                                  
                                  
                                  14
                                  %Ginnie
                                      Mae
                                  
                                  
                                  2,859
                                  
                                  
                                  
                                  62
                                  %
                                  
                                  
                                  40,782
                                  
                                  
                                  
                                  37
                                  %Fannie
                                      Mae
                                  
                                  
                                  1,176
                                  
                                  
                                  
                                  26
                                  %
                                  
                                  
                                  35,863
                                  
                                  
                                  
                                  33
                                  %Total
                                      mortgage-backed securities
                                  
                                  
                                  4,589
                                  
                                  
                                  
                                  100
                                  %
                                  
                                  
                                  92,172
                                  
                                  
                                  
                                  84
                                  %**Total
                                      securities available-for-sale**
                                  
                                  **$**
                                  **4,589**
                                  
                                  
                                  ****
                                  **100**
                                  **%**
                                  
                                  **$**
                                  **110,064**
                                  
                                  
                                  ****
                                  **100**
                                  **%**March
                                      31, 20072007
                                  
                                  
                                  2006**Held-to-Maturity:**
                                  
                                  Carrying
                                      Value
                                  
                                  
                                  Percent
                                      of Total
                                  
                                  
                                  Carrying
                                      Value
                                  
                                  
                                  Percent
                                      of Total(Dollars
                                      in thousands)Municipal
                                      bonds
                                  
                                  $
                                  1,140
                                  
                                  
                                  
                                  22
                                  %
                                  
                                  $
                                  1,170
                                  
                                  
                                  
                                  18
                                  %Mortgage-backed
                                      securities:Freddie
                                      Mac
                                  
                                  
                                  205
                                  
                                  
                                  
                                  4
                                  %
                                  
                                  
                                  345
                                  
                                  
                                  
                                  6
                                  %Fannie
                                      Mae
                                  
                                  
                                  3,863
                                  
                                  
                                  
                                  74
                                  %
                                  
                                  
                                  4,827
                                  
                                  
                                  
                                  76
                                  %Total
                                      mortgage-backed securities
                                  
                                  
                                  4,068
                                  
                                  
                                  
                                  78
                                  %
                                  
                                  
                                  5,172
                                  
                                  
                                  
                                  82
                                  %**Total
                                      securities held-to-maturity**
                                  
                                  **$**
                                  **5,208**
                                  
                                  
                                  ****
                                  **100**
                                  **%**
                                  
                                  **$**
                                  **6,342**
                                  
                                  
                                  ****
                                  **100**
                                  **%****Estimated
                                      market value**
                                  
                                  **$**
                                  **5,176**
                                  
                                  
                                  
                                  
                                  
                                  
                                  **$**
                                  **6,284**
   58
 **ITEM
        3A**
  The
        following table shows the maturity or period to repricing of the Bank’s
        consolidated portfolio of securities available-for-sale and
        held-to-maturity:
   Available-for-sale
                                            at March 31, 2007One
                                            Year or Less
                                        
                                        
                                        Over
                                            One to Three Years
                                        
                                        
                                        Over
                                            Three to Five Years
                                        
                                        
                                        Over
                                            Five to Ten Years
                                        
                                        
                                        Over
                                            Ten to Twenty Years
                                        
                                        
                                        Over
                                            Twenty Years
                                        
                                        
                                        TotalCarrying
                                            Value
                                        
                                        
                                        Weighted
                                            Average Yield
                                        
                                        
                                        Carrying
                                            Value
                                        
                                        
                                        Weighted
                                            Average Yield
                                        
                                        
                                        Carrying
                                            Value
                                        
                                        
                                        Weighted
                                            Average Yield
                                        
                                        
                                        Carrying
                                            Value
                                        
                                        
                                        Weighted
                                            Average Yield
                                        
                                        
                                        Carrying
                                            Value
                                        
                                        
                                        Weighted
                                            Average Yield
                                        
                                        
                                        Carrying
                                            Value
                                        
                                        
                                        Weighted
                                            Average Yield
                                        
                                        
                                        Carrying
                                            Value
                                        
                                        
                                        Weighted
                                            Average Yield**Available-for-Sale:**
                                        
                                        (Dollars
                                            in thousands)Mortgage-backed
                                            securities:Ginnie
                                            Mae
                                        
                                        $
                                        2,860
                                        
                                        
                                        
                                        3.88
                                        %
                                        
                                        $
                                        —
                                        
                                        
                                        
                                        0.00
                                        %
                                        
                                        $
                                        —
                                        
                                        
                                        
                                        0.00
                                        %
                                        
                                        $
                                        —
                                        
                                        
                                        0.00
                                        %
                                        
                                        $
                                        —
                                        
                                        
                                        0.00
                                        %
                                        
                                        $
                                        —
                                        
                                        
                                        0.00
                                        %
                                        
                                        $
                                        2,860
                                        
                                        
                                        
                                        3.88
                                        %Freddie
                                            Mac
                                        
                                        
                                        271
                                        
                                        
                                        
                                        7.13
                                        %
                                        
                                        
                                        283
                                        
                                        
                                        
                                        5.50
                                        %
                                        
                                        
                                        —
                                        
                                        
                                        
                                        0.00
                                        %
                                        
                                        
                                        —
                                        
                                        
                                        0.00
                                        %
                                        
                                        
                                        —
                                        
                                        
                                        
                                        0.00
                                        %
                                        
                                        
                                        —
                                        
                                        
                                        0.00
                                        %
                                        
                                        
                                        554
                                        
                                        
                                        
                                        6.30
                                        %Fannie
                                            Mae
                                        
                                        
                                        198
                                        
                                        
                                        
                                        7.20
                                        %
                                        
                                        
                                        264
                                        
                                        
                                        
                                        5.50
                                        %
                                        
                                        
                                        —
                                        
                                        
                                        
                                        0.00
                                        %
                                        
                                        
                                        —
                                        
                                        
                                        0.00
                                        %
                                        
                                        
                                        713
                                        
                                        
                                        
                                        4.50
                                        %
                                        
                                        
                                        —
                                        
                                        
                                        0.00
                                        %
                                        
                                        
                                        1,175
                                        
                                        
                                        
                                        5.18
                                        %Total
                                            mortgage-backed securities
                                        
                                        
                                        3,329
                                        
                                        
                                        
                                        4.34
                                        %
                                        
                                        
                                        547
                                        
                                        
                                        
                                        5.50
                                        %
                                        
                                        
                                        —
                                        
                                        
                                        
                                        0.00
                                        %
                                        
                                        
                                        —
                                        
                                        
                                        
                                        0.00
                                        %
                                        
                                        
                                        713
                                        
                                        
                                        
                                        4.50
                                        %
                                        
                                        
                                        —
                                        
                                        
                                        0.00
                                        %
                                        
                                        
                                        4,589
                                        
                                        
                                        
                                        4.51
                                        %Total
                                            securities available-for-sale -- Carrying
                                            Value
                                        
                                        $
                                        3,329
                                        
                                        
                                        
                                        4.34
                                        %
                                        
                                        $
                                        547
                                        
                                        
                                        
                                        5.50
                                        %
                                        
                                        $
                                        —
                                        
                                        
                                        
                                        0.00
                                        %
                                        
                                        $
                                        —
                                        
                                        
                                        
                                        0.00
                                        %
                                        
                                        $
                                        713
                                        
                                        
                                        
                                        4.50
                                        %
                                        
                                        $
                                        —
                                        
                                        
                                        
                                        0.00
                                        %
                                        
                                        $
                                        4,589
                                        
                                        
                                        
                                        4.51
                                        %Total
                                            securities available-for-sale -- Amortized
                                            Cost
                                        
                                        $
                                        3,332
                                        
                                        
                                        
                                        4.34
                                        %
                                        
                                        $
                                        540
                                        
                                        
                                        
                                        5.50
                                        %
                                        
                                        $
                                        —
                                        
                                        
                                        
                                        0.00
                                        %
                                        
                                        $
                                        —
                                        
                                        
                                        
                                        0.00
                                        %
                                        
                                        $
                                        732
                                        
                                        
                                        
                                        4.50
                                        %
                                        
                                        $
                                        —
                                        
                                        
                                        
                                        0.00
                                        %
                                        
                                        $
                                        4,604
                                        
                                        
                                        
                                        4.50
                                        %Held-to-Maturity
                                            at March 31, 2007One
                                            Year or Less
                                        
                                        
                                        Over
                                            One to Three Years
                                        
                                        
                                        Over
                                            Three to Five Years
                                        
                                        
                                        Over
                                            Five to Ten Years
                                        
                                        
                                        Over
                                            Ten to Twenty Years
                                        
                                        
                                        Over
                                            Twenty Years
                                        
                                        
                                        TotalCarrying
                                            Value
                                        
                                        
                                        Weighted
                                            Average Yield
                                        
                                        
                                        Carrying
                                            Value
                                        
                                        
                                        Weighted
                                            Average Yield
                                        
                                        
                                        Carrying
                                            Value
                                        
                                        
                                        Weighted
                                            Average Yield
                                        
                                        
                                        Carrying
                                            Value
                                        
                                        
                                        Weighted
                                            Average Yield
                                        
                                        
                                        Carrying
                                            Value
                                        
                                        
                                        Weighted
                                            Average Yield
                                        
                                        
                                        Carrying
                                            Value
                                        
                                        
                                        Weighted
                                            Average Yield
                                        
                                        
                                        Carrying
                                            Value
                                        
                                        
                                        Weighted
                                            Average Yield**Held-to-Maturity:**
                                        
                                        (Dollars
                                            in thousands)Municipal
                                            bonds
                                        
                                        $
                                        —
                                        
                                        
                                        
                                        
                                        
                                        
                                        $
                                        —
                                        
                                        
                                        
                                        
                                        
                                        
                                        $
                                        —
                                        
                                        
                                        
                                        0.00
                                        %
                                        
                                        $
                                        —
                                        
                                        
                                        
                                        0.00
                                        %
                                        
                                        $
                                        220
                                        
                                        
                                        
                                        5.38
                                        %
                                        
                                        $
                                        920
                                        
                                        
                                        
                                        6.31
                                        %
                                        
                                        $
                                        1,140
                                        
                                        
                                        
                                        6.13
                                        %Mortgage-backed
                                            securities:Freddie
                                            Mac
                                        
                                        
                                        205
                                        
                                        
                                        
                                        6.88
                                        %
                                        
                                        
                                        —
                                        
                                        
                                        
                                        0.00
                                        %
                                        
                                        
                                        —
                                        
                                        
                                        
                                        0.00
                                        %
                                        
                                        
                                        —
                                        
                                        
                                        
                                        0.00
                                        %
                                        
                                        
                                        —
                                        
                                        
                                        
                                        0.00
                                        %
                                        
                                        
                                        —
                                        
                                        
                                        
                                        0.00
                                        %
                                        
                                        
                                        205
                                        
                                        
                                        
                                        6.88
                                        %Fannie
                                            Mae
                                        
                                        
                                        1,323
                                        
                                        
                                        
                                        7.24
                                        %
                                        
                                        
                                        1,042
                                        
                                        
                                        
                                        4.25
                                        %
                                        
                                        
                                        —
                                        
                                        
                                        
                                        0.00
                                        %
                                        
                                        
                                        —
                                        
                                        
                                        
                                        0.00
                                        %
                                        
                                        
                                        1,498
                                        
                                        
                                        
                                        4.78
                                        %
                                        
                                        
                                        —
                                        
                                        
                                        
                                        0.00
                                        %
                                        
                                        
                                        3,863
                                        
                                        
                                        
                                        5.48
                                        %Total
                                            mortgage-backed securities
                                        
                                        
                                        1,528
                                        
                                        
                                        
                                        7.19
                                        %
                                        
                                        
                                        1,042
                                        
                                        
                                        
                                        4.25
                                        %
                                        
                                        
                                        —
                                        
                                        
                                        
                                        0.00
                                        %
                                        
                                        
                                        —
                                        
                                        
                                        
                                        0.00
                                        %
                                        
                                        
                                        1,498
                                        
                                        
                                        
                                        4.78
                                        %
                                        
                                        
                                        —
                                        
                                        
                                        
                                        0.00
                                        %
                                        
                                        
                                        4,068
                                        
                                        
                                        
                                        5.55
                                        %Total
                                            securities held-to-maturity -- Carrying
                                            Value
                                        
                                        $
                                        1,528
                                        
                                        
                                        
                                        7.19
                                        %
                                        
                                        $
                                        1,042
                                        
                                        
                                        
                                        4.25
                                        %
                                        
                                        $
                                        —
                                        
                                        
                                        
                                        0.00
                                        %
                                        
                                        $
                                        —
                                        
                                        
                                        
                                        0.00
                                        %
                                        
                                        $
                                        1,718
                                        
                                        
                                        
                                        4.86
                                        %
                                        
                                        $
                                        920
                                        
                                        
                                        
                                        6.31
                                        %
                                        
                                        $
                                        5,208
                                        
                                        
                                        
                                        5.68
                                        %Total
                                            securities held-to-maturity -- Fair Market
                                            Value
                                        
                                        $
                                        1,561
                                        
                                        
                                        
                                        7.19
                                        %
                                        
                                        $
                                        1,020
                                        
                                        
                                        
                                        4.25
                                        %
                                        
                                        $
                                        —
                                        
                                        
                                        
                                        0.00
                                        %
                                        
                                        $
                                        —
                                        
                                        
                                        
                                        0.00
                                        %
                                        
                                        $
                                        1,679
                                        
                                        
                                        
                                        4.86
                                        %
                                        
                                        $
                                        916
                                        
                                        
                                        
                                        6.31
                                        %
                                        
                                        $
                                        5,176
                                        
                                        
                                        
                                        5.70
                                        %
   59


ITEM
                4.
            Controls
                and Procedures





An
      evaluation of the Company’s disclosure controls and procedures (as defined in
      Rules 13a-15(e) of the Securities Exchange Act of 1934 (the “Act”)) was carried
      out under the supervision and with the participation of the Company’s Chief
      Executive Officer, Chief Financial Officer, and other members of the Company’s
      senior management, as of the end of the period covered by this report (the
      “Evaluation Date”).  Based upon this evaluation, the Company’s Chief
      Executive Officer and Chief Financial Officer concluded that, as of the
      Evaluation Date, the Company’s disclosure controls and procedures are effective
      in providing reasonable assurance that the material information required to
      be
      disclosed by the Company in the reports it files or submits under the Act is
      (i)
      accumulated and communicated to the Company’s management (including the
      Company’s Chief Executive Officer and Chief Financial Officer) in a timely
      manner, and (ii) recorded, processed, summarized, and reported within the time
      periods specified in the SEC’s rules and forms.








**PART
                II:**
            **OTHER
                INFORMATION**





ITEM
                1.
            Legal
                Proceedings





At
      March
      31, 2007, the Company was not engaged in any litigation, which in the opinion
      of
      management, after consultation with its legal counsel, would be material to
      the
      Company.





ITEM
                1A.
            Risk
                Factors





For
      information regarding certain Risk Factors, please refer to Part I, Item 1A,
      in
      the Company’s Annual Report on Form 10-K for the year ended December 31,
      2006.





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





None.





ITEM
                3.
            Defaults
                Upon Senior Securities





None.





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





The
      Annual Meeting of Shareholders of First Mutual Bancshares, Inc. was held on
      April 26, 2007.  The results of votes on the matters presented at the
      Meeting are as follows:





60


The
      following individuals were elected as directors for the term noted:




**CLASS  III
                DIRECTORS**
            **VOTES
                FOR**
            **VOTES
                WITHHELD**
            **TERM**Mary
              Case Dunnam
            6,471,614
            79,444
            3
                YearsGeorge
              W. Rowley, Jr.
            6,471,618
            79,440
            3
                YearsJohn
              R. Valaas
            6,446,628
            104,430
            3
                Years




The
      terms
      of the Class I and II directors expire at the Annual Meeting of Shareholders
      for
      2008 and 2009, respectively.





CLASS
      I DIRECTORS, term expires in 2008





Janine
      Florence


F.
      Kemper
      Freeman, Jr.


Robert
      J.
      Herbold


Victor
      E.
      Parker





CLASS
      II DIRECTORS, term expires in 2009





James
      J.
      Doud Jr.


Richard
      S. Sprague


Robert
      C.
      Wallace





ITEM
                5.
            Other
                Information





None.





61


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 8-K
                filed
                withthe
                SEC on July 5, 2006.





(11)
            Statement
                regarding computation of per share earnings.  Reference is made
                to theCompany’s
                Consolidated Statements of Income attached hereto as part of Item
                IFinancial
                Statements, which are incorporated herein by
                reference.





(31.1)
            Certification
                by President and Chief Executive Officer pursuant to Section 302
                of
                theSarbanes-Oxley
                Act of 2002.





(31.2)
            Certification
                by Executive Vice President and Chief Financial Officer pursuant
                to
                Section302
                of the Sarbanes-Oxley Act of 2002.





(32)
            Certification
                by Chief Executive Officer and Chief Financial Officer pursuant
                toSection
                906 of the Sarbanes-Oxley Act of
                2002.





















62


**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:
              May 9, 2007
            FIRST
              MUTUAL BANCSHARES, INC.By:
            /s/ John
              R. ValaasJohn
              R. ValaasPresident
              and Chief Executive Officer By:
              /s/ Roger
                A. ManderyRoger
                A. ManderyExecutive
                  Vice President
                (Principal
                  Financial Officer)











63