UNITED STATES SECURITIES AND EXCHANGE COMMISSION


Washington,
D.C. 20549





FORM
10-Q





þ
            QUARTERLY
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934 FOR THE QUARTERLY PERIOD ENDED September 30,
      2008




OR




 ̈
            TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934 FOR TRANSITION PERIOD FROM
      ______________TO_________________




Commission
file number0-25286





CASCADE FINANCIAL
CORPORATION


(Exact
name of registrant as specified in its charter)





Washington
            
            91-1661954(State
      or other jurisdiction of incorporation or organization)
            
            (IRS
      Employer Identification No.)2828
      Colby AvenueEverett,
      Washington
            
            98201(Address
      of principal executive offices)
            
            (Zip
      Code)(425)
      339-5500(Registrant's
      telephone number, including area
code)





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 twelve 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 ninety days. Yes þ     No
 ̈




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




Large
Accelerated Filer  ̈    Accelerated
Filer þ    Non-Accelerated
Filer  ̈    Smaller
Reporting Company  ̈




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




Indicate
the number of shares outstanding of each of the issuer’s classes of common
stock, as of the latest practicable date.




Class
            Outstanding as of October 31,
      2008Common
      Stock ($.01 par value)
            12,071,032




1





CASCADE
FINANCIAL CORPORATION





FORM
10-Q


For the Quarter Ended September 30,
2008








INDEX





PAGEPART I — Financial
    Information:Item 1
            —
      Financial Statements:—
      Condensed Consolidated Balance Sheets
            3—
      Condensed Consolidated Statements of Operations
            4—
      Consolidated Statements of Comprehensive (Loss) Income
            5—
      Condensed Consolidated Statements of Cash Flows
            6—
      Notes to Condensed Consolidated Financial Statements
            8Item 2
            —
      Management’s Discussion and Analysis of Financial Condition and Results of
      Operations
            13Item 3
            —
      Quantitative and Qualitative Disclosures about Market Risk
            25Item 4
            —
      Controls and Procedures
            26PART II — Other
Information:Item 1
            —
      Legal Proceedings
            27Item 1A
            —
      Risk Factors
            27Item 2
            —
      Unregistered Sales of Equity Securities and Use of
Proceeds
            28Item 3
            —
      Defaults Upon Senior Securities
            28Item 4
            —
      Submission of Matters to a Vote of Security Holders
            28Item 5
            —
      Other Information
            28Item 6
            —
      Exhibits
            28Signatures
            29




2


PART I –– FINANCIAL
INFORMATION





Item
1 – Financial Statements





CASCADE
FINANCIAL CORPORATION AND SUBSIDIARY


CONDENSED
CONSOLIDATED BALANCE SHEETS


(unaudited)


(Dollars
      in thousands except share and per share amounts)
            
            September
      30,
            
            
            December
      31,2008
            
            
            2007ASSETSCash
      on hand and in banks
            
            $
            12,822
            
            
            $
            12,911Interest-earning
      deposits in other institutions
            
            
            611
            
            
            
            1,619Securities
      available-for-sale, fair value
            
            
            102,313
            
            
            
            82,860Federal
      Home Loan Bank (FHLB) Stock
            
            
            11,920
            
            
            
            11,920Securities
      held-to-maturity, amortized cost
            
            
            140,615
            
            
            
            137,238Loans,
      net
            
            
            1,195,267
            
            
            
            1,092,776Goodwill
            
            
            24,585
            
            
            
            24,585Core
      deposit intangible, net
            
            
            529
            
            
            
            634Premises
      and equipment, net
            
            
            15,676
            
            
            
            14,160Cash
      surrender value of bank-owned life insurance (BOLI)
            
            
            23,388
            
            
            
            22,658Deferred
      tax asset
            
            
            8,437
            
            
            
            1,574REO
      and other repossessed assets
            
            
            1,446
            
            
            
            -Accrued
      interest receivable and other assets
            
            
            14,173
            
            
            
            14,653TOTAL
      ASSETS
            
            $
            1,551,782
            
            
            $
            1,417,588LIABILITIES AND STOCKHOLDERS’
      EQUITYLiabilities:Deposits
            
            $
            992,505
            
            
            $
            904,896FHLB
      advances
            
            
            255,000
            
            
            
            231,000Securities
      sold under agreements to repurchase
            
            
            120,983
            
            
            
            120,625Federal
      Reserve Borrowing
            
            
            30,000
            
            
            
            -Junior
      subordinated debentures payable
            
            
            15,465
            
            
            
            15,465Junior
      subordinated debentures payable, at fair value
            
            
            10,535
            
            
            
            11,422Advance
      payments by borrowers for taxes and insurance
            
            
            885
            
            
            
            502Dividends
      payable
            
            
            -
            
            
            
            1,082Accrued
      interest payable, expenses and other liabilities
            
            
            7,309
            
            
            
            10,500TOTAL
      LIABILITIES
            
            
            1,432,682
            
            
            
            1,295,492Stockholders’ Equity:Preferred
      stock, $.01 par value, Authorized 500,000 shares;no
      shares issued or outstanding
            
            
            -
            
            
            
            -Common
      stock, $.01 par value, Authorized 25,000,000 shares;issued
      and outstanding 12,071,032 shares at September 30,2008,
      and 12,023,685 shares at December 31, 2007
            
            
            120
            
            
            
            120Additional
      paid-in capital
            
            
            40,737
            
            
            
            40,322Retained
      earnings, substantially restricted
            
            
            79,753
            
            
            
            82,169Accumulated
      other comprehensive loss, net of tax
            
            
            (1,510
            )
            
            
            (515
            )TOTAL
      STOCKHOLDERS’ EQUITY
            
            
            119,100
            
            
            
            122,096TOTAL
      LIABILITIES AND STOCKHOLDERS’ EQUITY
            
            $
            1,551,782
            
            
            $
            1,417,588





See notes
to condensed consolidated financial statements





3


CASCADE
FINANCIAL CORPORATION AND SUBSIDIARY


CONDENSED
CONSOLIDATED STATEMENTS OF OPERATIONS


(unaudited)





(Dollars
      in thousands except
            
            Three
      months ended
            
            
            Nine
      months endedshare
      and per share amounts)
            
            September
      30,
            
            
            September
      30,2008
            
            
            2007
            
            
            2008
            
            
            2007Interest
      income:Loans
            
            $
            20,611
            
            
            $
            20,345
            
            
            $
            58,957
            
            
            $
            60,456Securities
      held-for-trading
            
            
            -
            
            
            
            386
            
            
            
            -
            
            
            
            1,738Securities
      available-for-sale
            
            
            1,574
            
            
            
            1,408
            
            
            
            4,780
            
            
            
            3,396FHLB
      dividends
            
            
            42
            
            
            
            18
            
            
            
            113
            
            
            
            48Securities
      held-to-maturity
            
            
            2,102
            
            
            
            1,054
            
            
            
            6,178
            
            
            
            3,089Interest-earning
      deposits
            
            
            16
            
            
            
            167
            
            
            
            124
            
            
            
            1,072Total
      interest income
            
            
            24,345
            
            
            
            23,378
            
            
            
            70,152
            
            
            
            69,799Interest
      expense:Deposits
            
            
            6,430
            
            
            
            8,821
            
            
            
            20,986
            
            
            
            26,395FHLB
      advances and other borrowings
            
            
            4,548
            
            
            
            3,217
            
            
            
            12,819
            
            
            
            9,736Junior
      subordinated debentures
            
            
            530
            
            
            
            530
            
            
            
            1,590
            
            
            
            1,590Total
      interest expense
            
            
            11,508
            
            
            
            12,568
            
            
            
            35,395
            
            
            
            37,721Net
      interest income
            
            
            12,837
            
            
            
            10,810
            
            
            
            34,757
            
            
            
            32,078Provision
      for loan losses
            
            
            1,250
            
            
            
            350
            
            
            
            4,840
            
            
            
            850Net
      interest income after provision for loan losses
            
            
            11,587
            
            
            
            10,460
            
            
            
            29,917
            
            
            
            31,228Other
      income:Checking
      fees
            
            
            1,328
            
            
            
            1,005
            
            
            
            3,640
            
            
            
            2,839Service
      fees
            
            
            280
            
            
            
            265
            
            
            
            825
            
            
            
            794BOLI
            
            
            271
            
            
            
            203
            
            
            
            790
            
            
            
            598Net
      (loss) gain on sales/calls of securities
            
            
            (87
            )
            
            
            28
            
            
            
            396
            
            
            
            (431
            )Gain
      on sale of loans
            
            
            36
            
            
            
            46
            
            
            
            119
            
            
            
            167Net
      gain on fair value of financial instruments
            
            
            389
            
            
            
            281
            
            
            
            887
            
            
            
            934Net
      gain on FHLB advances
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            569Other
            
            
            106
            
            
            
            114
            
            
            
            337
            
            
            
            357Total
      other income
            
            
            2,323
            
            
            
            1,942
            
            
            
            6,994
            
            
            
            5,827Other
      expenses:Compensation
      and employee benefits
            
            
            3,789
            
            
            
            3,551
            
            
            
            11,039
            
            
            
            10,246Occupancy
            
            
            955
            
            
            
            903
            
            
            
            2,935
            
            
            
            2,603Marketing
            
            
            228
            
            
            
            316
            
            
            
            790
            
            
            
            909Other
            
            
            2,190
            
            
            
            1,954
            
            
            
            6,583
            
            
            
            5,937Other
      than temporary impairment (OTTI) on investments
            
            
            17,338
            
            
            
            -
            
            
            
            17,338
            
            
            
            -Total
      other expenses
            
            
            24,500
            
            
            
            6,724
            
            
            
            38,685
            
            
            
            19,695(Loss)
      income before (benefit) provision for federal income taxes
            
            
            (10,590
            )
            
            
            5,678
            
            
            
            (1,774
            )
            
            
            17,360(Benefit)
      provision for federal income taxes
            
            
            (3,971
            )
            
            
            1,892
            
            
            
            (1,402
            )
            
            
            5,826Net
      (loss) income
            
            $
            (6,619
            )
            
            $
            3,786
            
            
            $
            (372
            )
            
            $
            11,534Net
      (loss) income per common share, basic
            
            $
            (0.55
            )
            
            $
            0.32
            
            
            $
            (0.03
            )
            
            $
            0.96Weighted
      average number of shares outstanding, basic
            
            
            12,059,480
            
            
            
            12,009,440
            
            
            
            12,047,700
            
            
            
            12,055,024Net
      (loss) income per share, diluted
            
            $
            (0.55
            )
            
            $
            0.31
            
            
            $
            (0.03
            )
            
            $
            0.94Weighted
      average number of shares outstanding, diluted
            
            
            12,140,168
            
            
            
            12,233,781
            
            
            
            12,168,009
            
            
            
            12,307,001Dividends
      declared per share
            
            $
            0.09
            
            
            $
            0.09
            
            
            $
            0.27
            
            
            $
            0.25





See notes
to condensed consolidated financial statements





4


CASCADE
FINANCIAL CORPORATION AND SUBSIDIARY


CONSOLIDATED
STATEMENTS OF COMPREHENSIVE (LOSS) INCOME


(unaudited)








Three
      months ended
            
            
            Nine
      months Ended(Dollars
      in thousands)
            
            September
      30,
            
            
            September
      30,2008
            
            
            2007
            
            
            2008
            
            
            2007Net
      (loss) income
            
            $
            (6,619
            )
            
            $
            3,786
            
            
            $
            (372
            )
            
            $
            11,534Increase
      in unrealized gain (loss) on securitiesavailable-for-sale,
      net of tax expense (benefit)of
      $551 and $351 for the three monthsended
      September 30, 2008, and 2007, respectively,and
      $(635) and $947 for the nine months endedSeptember
      30, 2008, and 2007, respectively.
            
            
            1,024
            
            
            
            651
            
            
            
            (1,180
            )
            
            
            1,759Less
      reclassification adjustment for loss on securitiesincluded
      in net (loss) income, net of tax (benefit)expense
      of $(30) and $2 for the three months endedSeptember
      30, 2008, and 2007, respectively, and$100
      and $10 for the nine months endedSeptember
      30, 2008, and 2007, respectively.
            
            
            (57
            )
            
            
            4
            
            
            
            185
            
            
            
            19Comprehensive
      (loss) income
            
            $
            (5,652
            )
            
            $
            4,441
            
            
            $
            (1,367
            )
            
            $
            13,312







See notes
to condensed consolidated financial statements




5


CASCADE
FINANCIAL CORPORATION AND SUBSIDIARY


CONDENSED
CONSOLIDATED STATEMENTS OF CASH FLOWS


(unaudited)


Nine
      Months Ended

              September
      30,(Dollars
      in thousands)
            
            2008
            
            
            2007Cash
      flows from operating activities:Net
      (loss) income
            
            $
            (372
            )
            
            $
            11,534Adjustments
      to reconcile net income to net cash provided by (used in) operatingactivities:Depreciation
      and amortization of premises and equipment
            
            
            1,562
            
            
            
            1,362Provision
      for losses on loans
            
            
            4,840
            
            
            
            850Increase
      in cash surrender value of bank-owned life insurance
            
            
            (730
            )
            
            
            (509
            )Amortization
      of retained servicing rights
            
            
            30
            
            
            
            32Amortization
      of core deposit intangible
            
            
            105
            
            
            
            106Deferred
      federal income taxes
            
            
            (6,327
            )
            
            
            (1,141
            )Deferred
      loan fees, net of amortization
            
            
            (475
            )
            
            
            262Gain
      on sale of loans
            
            
            119
            
            
            
            167Stock-based
      compensation
            
            
            156
            
            
            
            168Excess
      tax benefit from stock-based payments
            
            
            (30
            )
            
            
            (265
            )Net
      change in fair value of financial instruments
            
            
            (887
            )
            
            
            (934
            )Loss
      on sales/calls of securities available-for-sale
            
            
            (284
            )
            
            
            -Loss
      on calls of securities held-to-maturity
            
            
            (112
            )
            
            
            -Net
      increase in accrued interest receivable and other assets
            
            
            (1,295
            )
            
            
            (1,074
            )Net
      decrease in accrued interest payable, expenses and other
      liabilities
            
            
            (3,155
            )
            
            
            (29
            )Impairment
      on securities available-for-sale (OTTI)
            
            
            17,338
            
            
            
            -Net
      cash provided by operating activities
            
            
            10,483
            
            
            
            10,529Cash
      flows from investing activities:Loans
      originated, net of principal repayments
            
            
            (102,556
            )
            
            
            (62,855
            )Net
      purchases of securities held-for-trading
            
            
            -
            
            
            
            48,761Net
      purchases of securities available-for-sale
            
            
            (123,896
            )
            
            
            (61,198
            )Proceeds
      from sales/calls of securities available-for-sale
            
            
            83,684
            
            
            
            22,132Principal
      repayments on securities available-for-sale
            
            
            2,174
            
            
            
            5,343Net
      purchases of securities held-to-maturity
            
            
            (81,866
            )
            
            
            (5,000
            )Proceeds
      from calls of securities held-to-maturity
            
            
            77,050
            
            
            
            -Principal
      repayments on securities held-to-maturity
            
            
            1,551
            
            
            
            2,173Purchases
      of premises and equipment
            
            
            (3,077
            )
            
            
            (3,595
            )Proceeds
      from sales/retirements of premises and equipment
            
            
            -
            
            
            
            14Net
      decrease in loan participations sold
            
            
            (4,453
            )
            
            
            (2,573
            )Investment
      in Community Reinvestment Act (CRA) – low income housing
            
            
            323
            
            
            
            -Net
      cash used in investing activities
            
            
            (151,066
            )
            
            
            (56,798
            )Subtotal,
      carried forward
            
            $
            (140,583
            )
            
            $
            (46,269
            )




See notes
to condensed consolidated financial statements





6


CASCADE
FINANCIAL CORPORATION AND SUBSIDIARY


CONDENSED
CONSOLIDATED STATEMENTS OF CASH FLOWS


(unaudited)


Nine
      Months EndedSeptember
      30,(Dollars
      in thousands)
            
            2008
            
            
            2007Subtotal,
      brought forward
            
            $
            (140,583
            )
            
            $
            (46,269
            )Cash
      flows from financing activities:Proceeds
      from issuance of common stock
            
            
            356
            
            
            
            572Dividends
      paid
            
            
            (3,250
            )
            
            
            (2,896
            )Repurchase
      of common stock
            
            
            -
            
            
            
            (2,830
            )Excess
      tax benefits from stock-based payments
            
            
            30
            
            
            
            265Net
      increase in deposits
            
            
            87,609
            
            
            
            50,962Net
      increase (decrease) in FHLB advances
            
            
            24,000
            
            
            
            (46,000
            )Net
      increase in securities sold under agreements to repurchase
            
            
            358
            
            
            
            24,908Proceeds
      from Federal Reserve borrowing
            
            
            30,000
            
            
            
            -Net
      decrease in advance payments by borrowers for taxes and
      insurance
            
            
            383
            
            
            
            35Net
      cash provided by financing activities
            
            
            139,486
            
            
            
            25,016Net
      decrease in cash and cash equivalents
            
            
            (1,097
            )
            
            
            (21,253
            )Cash
      and cash equivalents at beginning of period
            
            
            14,530
            
            
            
            42,879Cash
      and cash equivalents at end of period
            
            $
            13,433
            
            
            $
            21,626Supplemental
      disclosures of cash flow information—cash paid during the period
      for:Interest
            
            $
            37,018
            
            
            $
            37,683Federal
      income taxes
            
            
            -
            
            
            
            5,600Supplemental
      schedule of non-cash investing activities:Change
      in unrealized loss on securities available-for-sale
            
            
            1,530
            
            
            
            (598
            )Net
      change in real estate owned, investment property and other repossessed
      assets
            
            
            1,446
            
            
            
            -Retirement
      of common stock in retained earnings
            
            
            -
            
            
            
            171Dividends
      declared
            
            
            2,168
            
            
            
            3,013Cumulative
      adjustment of equity on adoption of SFAS No. 159
            
            
            -
            
            
            
            (3,389
            )





See notes
to condensed consolidated financial statements





7


CASCADE
FINANCIAL CORPORATION AND SUBSIDIARY


NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


September
30, 2008


(unaudited)





1.
            Presentation
      of Financial Information





The
accompanying financial information is unaudited and has been prepared from the
consolidated financial statements of Cascade Financial Corporation (the
“Corporation”), and its subsidiary, Cascade Bank (the “Bank” or “Cascade”). All
significant intercompany balances have been eliminated in the consolidation. In
the opinion of management, the financial information reflects all adjustments
(consisting of normal recurring adjustments) necessary for a fair presentation
of the financial condition, results of operations, and cash flows of the
Corporation pursuant to the requirements of the SEC for interim reporting.
Operating results for the nine months ended September 30, 2008, are not
necessarily indicative of the results that may be expected for the year ending
December 31, 2008.





Certain
information and footnote disclosures included in the Corporation’s financial
statements for the year ended December 31, 2007, have been condensed or omitted
from this report. Accordingly, these statements should be read in conjunction
with the financial statements and notes thereto included in the Corporation’s
December 31, 2007 Annual Report on Form 10-K.





2.
            Commitments
      and Contingencies





In the
normal course of business there are various commitments to fund loans to meet
the financing needs of our customers. Management does not anticipate any
material loss as a result of these commitments.





Periodically
there have been various claims and lawsuits against the Corporation or the Bank,
such as claims to enforce liens, claims involving the origination of real
property loans and other issues incidental to the Corporation’s and the Bank’s
business. In the opinion of management, no material loss is expected from any
such pending lawsuits.





3.
            Recently
      Issued Accounting Standards





In
October 2008, the FASB issued FASB Staff Position (FSP) FAS No. 157-3,
Determining the Fair Value of
a Financial Asset When the Market for That Asset Is Not Active. The FSP
clarifies the application of FAS No. 157, Fair Value Measurements, when
the market for a financial asset is not active. The FSP was effective upon
issuance, including reporting for prior periods for which financial statements
have not been issued. The adoption of the FSP for reporting as of
September 30, 2008, did not have a material impact on our consolidated
financial statements.





4.  Other
than temporary impairment (OTTI) on investments





On September 7, 2008, the U.S.
Treasury, the Federal Reserve and the Federal Housing Finance Agency (FHFA)
announced that FHFA was placing Fannie Mae and Freddie Mac under conservatorship
and would eliminate dividends on Fannie Mae and Freddie Mac common and preferred
stock.  At June 30, 2008, Cascade Financial Corporation owned
preferred shares issued by Fannie Mae ($10.2 million book value with a 8.25%
coupon rate) and Freddie Mac ($8.4 million with a 5.57% coupon rate) with a
combined adjusted book


8


value of
approximately $18.6 million.  With an amortized cost basis for the
securities of $18.6 million, Cascade recorded a pre-tax OTTI charge of $17.3
million, resulting in a charge net of taxes of $11.3 million to third quarter
2008 earnings.





5.           Stockholders’
Equity





a)
            Earnings
      per Share





The
following table presents the computation of basic and diluted net (loss) income
per share for the periods indicated:





Three
      Months Ended
            
            
            Nine
      Months Ended(dollars
      in thousands,
            
            September
      30,
            
            
            September
      30,except
      share and per share amounts)
            
            2008
            
            
            2007
            
            
            2008
            
            
            2007Numerator:Net
      (loss) income
            
            $
            (6,619
            )
            
            $
            3,786
            
            
            $
            (372
            )
            
            $
            11,534Denominator:Denominator
      for basic net income per share-Weighted
      average shares
            
            
            12,059,480
            
            
            
            12,009,440
            
            
            
            12,047,700
            
            
            
            12,055,024Effect
      of dilutive securities:Stock
      options
            
            
            80,688
            
            
            
            224,341
            
            
            
            120,309
            
            
            
            251,977Denominator
      for diluted net income per share-Weighted
      average shares and assumedconversion
      of dilutive stock options
            
            
            12,140,168
            
            
            
            12,233,781
            
            
            
            12,168,009
            
            
            
            12,307,001Basic
      net (loss) income per share
            
            $
            (0.55
            )
            
            $
            0.32
            
            
            $
            (0.03
            )
            
            $
            0.96Diluted
      net (loss) income per share
            
            $
            (0.55
            )
            
            $
            0.31
            
            
            $
            (0.03
            )
            
            $
            0.94





For the
quarters ended September 30, 2008, and 2007, there were anti-dilutive options to
purchase shares of 421,016 and 180,653 respectively, excluded from the above
calculation. For the nine month periods ended September 30, 2008, and 2007,
there were anti-dilutive options to purchase shares of 305,697 and 174,806
respectively, excluded from the above calculation.





b)
            Dividends





On October 2, 2008, the Corporation
announced its twenty-fifth consecutive quarterly cash dividend payment. The
dividend was $0.045 per share and was paid on October 29, 2008, to shareholders
of record as of October 15, 2008.





c)
            Stock-based
      Compensation





Compensation
expense related to stock-based compensation was $156,000 for the nine months
ended September 30, 2008, and $168,000 for the nine months ended September 30,
2007.


9


Changes in total options
outstanding for the nine months ended September 30, 2008, are as
follows:


Options
            
            
            Weighted-
              Average
              Exercise
              Price
      per Share
            
            
            Weighted-
              Average
              Remaining
              Contractual
              Term
              (in
      years)
            
            
            Aggregate
              Intrinsic
              ValueOutstanding
      on December 31, 2007
            
            
            595,567
            
            
            $
            9.87
            
            
            
            5.13
            
            
            $
            2,580,240Granted
            
            
            96,382
            
            
            
            12.63Exercised
            
            
            (12,890
            )
            
            
            6.93Forfeited/Canceled
            
            
            (4,375
            )
            
            
            15.12Outstanding
      on March 31, 2008
            
            
            674,684
            
            
            $
            10.29
            
            
            
            5.69
            
            
            $
            2,006,654Granted
            
            
            1,000
            
            
            
            10.90Exercised
            
            
            -Forfeited/Canceled
            
            
            -Outstanding
      on June 30, 2008
            
            
            675,684
            
            
            $
            10.29
            
            
            
            5.45
            
            
            $
            370,714Granted
            
            
            -
            
            
            
            -Exercised
            
            
            (12,787
            )
            
            
            5.32Forfeited/Canceled
            
            
            (6,014
            )
            
            
            6.93Outstanding
      on September 30, 2008
            
            
            656,883
            
            
            $
            10.41
            
            
            
            5.32
            
            
            $
            555,221Exercisable
      on September 30, 2008
            
            
            441,658
            
            
            $
            8.70
            
            
            
            3.97
            
            
            $
            555,221





The
unrecognized share-based compensation cost on unvested options at September 30,
2008, was $278,505, which will be recognized over the estimated average life of
the options of approximately five years.





Options
are granted to certain employees and directors at prices equal to the market
value of the stock at the close of trading on the dates the options are granted.
The options granted have a term of 10 years from the grant date. Incentive stock
options granted to employees vest over a five-year period. Non-qualified options
granted to directors vest over a four-year period. Compensation expense is
recorded as if each vesting portion of the award is a separate award. We have
estimated the fair value of all stock option awards as of the date of the grant
by applying a Black-Scholes pricing valuation model. The application of this
valuation model involves assumptions that are judgmental and sensitive in the
determination of compensation expense. Key assumptions used in determining the
fair value of options granted during the nine months ended September 30, 2008,
were as follows:





Expected
      price volatility
            24
            %Risk-free
      interest rate
            2.46
            %Dividend
      yield on underlying stock
            2.90
            %Weighted-average
      expected life in years
            5.69





The total
options authorized at September 30, 2008, were 1,161,443. Options granted for
the nine months ended September 30, 2008, were 97,382 with a fair value of $2.61
per option. The total intrinsic value of options exercised during the nine
months ended September 30, 2008, was $132,515. The total intrinsic value of
options exercised during the nine months ended September 30, 2007, was
$1,126,944.





Historical
information is the primary basis for the selection of the expected volatility,
projected dividend yield and expected lives of the options. The Bank uses
historical information for its key assumptions. The Bank has collected a long
history of option activity and believes that this historical information
presents the best basis for future projections. The risk-free interest rate was
selected based upon U.S. Treasury issues with a term equal to the expected life
of the option being valued at the time of the grant.


10


SFAS No.
123(R) requires the recognition of stock-based compensation for the number of
awards that are expected to vest. As a result, for most awards, recognized stock
compensation expense was reduced by estimated forfeitures primarily based on
historical forfeiture rates of 6.19%. Estimated forfeitures will be continually
evaluated in subsequent periods and may change based on new facts and
circumstances.





(d)        Emergency
Economic Stabilization Act of 2008 and Troubled Asset Relief
Program




In
response to the financial crises affecting the banking system and financial
markets, the Emergency Economic Stabilization Act of 2008 (the “Act”) was signed
into law on October 3, 2008.  In conjunction with the Act and the
Troubled Asset Relief Program (“TARP”), the U.S. Treasury Department recently
announced a voluntary Capital Purchase Program to assist financial institutions
and increase lending to United States businesses and
consumers.  Pursuant to the program, the Treasury will purchase up to
$250 billion of senior preferred stock and warrants to purchase common stock
from qualifying institutions.  An eligible institution must apply by
November 14, 2008.





On
November 3, 2008, Cascade received preliminary approval to participate in the
U.S. Treasury Department’s Capital Purchase Program.  As a participant,
Cascade plans to issue approximately $39 million in senior preferred stock, with
related warrants to purchase up to $6 million in common stock, to the U.S.
Treasury.  The anticipated sale of the preferred stock and warrants is
expected to close in approximately 30 days from the announcement date and is
contingent upon completion of standard closing documents and subsequent
registration with the Securities and Exchange Commission.  The preferred
stock will pay a 5% dividend for the first five years, after which the rate will
increase to 9% if the preferred shares are not redeemed by the Company. 
The terms and conditions of the transaction and the preferred stock will conform
to those provided by the U.S. Treasury.  A summary of the Capital Purchase
Program can be found on the Treasury’s web site at www.ustreas.gov/initiatives/eesa. 
The additional capital will enhance our capacity to support the communities we
serve through expanded lending activities and economic development.  This
capital will also add flexibility in considering strategic opportunities that
likely will be available to us as the financial services industry continues to
consolidate.





6.
            Non-Qualified
      Deferred Compensation Plan





The
Company has adopted the Cascade Bank Non-Qualified Deferred Compensation Plan
(the “Plan”) dated February 1, 2008.  The Plan is an unfunded,
non-qualified deferred compensation plan designed to provide a select group of
non-employee directors, management and highly compensated employees of Cascade
Bank, and its affiliates, an opportunity to defer a portion of their salary and
bonus. Cascade Bank may also, in its sole discretion, make contributions to
accounts on behalf of any and all eligible persons. For the quarter ended
September 30, 2008, eligible participants contributed $31,000 to the Plan. There
have been no contributions made by the Bank as of September 30,
2008.


11


7.
            Fair
      Value Measurements





SFAS
No. 157, Fair Value
Measurements, defines fair value, establishes a framework for measuring
fair value, establishes a three-level valuation hierarchy for disclosure of fair
value measurement and enhances disclosure requirements for fair value
measurements. The valuation hierarchy is based upon the transparency of inputs
to the valuation of an asset or liability as of the measurement date. The three
levels are defined as follows:





•  Level 1
      - Inputs to the valuation methodology are quoted prices (unadjusted) for
      identical assets or liabilities in active markets.•  Level 2
      - Inputs to the valuation methodology include quoted prices for similar
      assets and liabilities in active markets, and inputs that are observable
      for the asset or liability, either
              directly or indirectly,
      for substantially the full term of the financial instrument.•  Level 3
      - Inputs to the valuation methodology are unobservable and significant to
      the fair value measurement.





Determination of fair market
values:





Junior
subordinated debentures payable are priced using discounted cash flows to the
next available redemption date on the date of valuation based on recent
issuances or quotations for comparable bank holding companies and are considered
a Level 3 input method.





Fair
value adjustments to impaired collateral dependent loans are sometimes recorded
to reflect partial write-downs based on the current appraised value of the
collateral or internally developed models which contain management’s
assumptions.





Fair
value adjustments to real estate owned (REO) and other repossessed assets are
recorded at the lower of carrying amount of the loan or fair value less selling
costs.  Any write-downs based on the asset’s fair value at the date of
acquisition are charged to the allowance for loan losses.  After
foreclosure, management periodically performs valuations such that the real
estate is carried at the lower of its new cost basis or fair value, net of
estimated costs to sell.





The
following table presents the balances of liabilities measured at fair value on a
recurring basis at September 30, 2008, and the total gains from these fair value
adjustments for the nine months ended September 30, 2008.


(Dollars
      in thousands)
            
            Fair
      Value at September 30, 2008
            
            
            Nine
      Months Ended
              September
      30, 2008Description
            
            Level 1
            
            
            Level 2
            
            
            Level
      3
            
            
            Total
            
            
            Total
      GainsJunior
      subordinated debentures payable
            
            $
            -
            
            
            $
            -
            
            
            $
            10,535
            
            
            $
            10,535
            
            
            $
            887Total
            
            $
            -
            
            
            $
            -
            
            
            $
            10,535
            
            
            $
            10,535
            
            
            $
            887





The
change in fair market value of the junior subordinated debentures payable is
recorded as a component of non-operating income.





The
following table presents the balance of assets measured at fair value on a
nonrecurring basis at September 30, 2008, and the total losses resulting from
these fair value adjustments for the nine months ended September 30,
2008.


12


(Dollars
      in thousands)
            
            Fair
      Value at September 30, 2008
            
            
            Nine
      Months Ended
              September
      30, 2008Description
            
            Level 1
            
            
            Level 2
            
            
            Level 3
            
            
            Total
            
            
            Total LossesImpaired
      loans
            
            $
            -
            
            
            $
            -
            
            
            $
            23,605
            
            
            $
            23,605
            
            
            $
            1,613REO
      and other repossessed assets
            
            $
            -
            
            
            $
            -
            
            
            $
            1,446
            
            
            $
            1,446
            
            
            $
            -Total
            
            $
            -
            
            
            $
            -
            
            
            $
            25,051
            
            
            $
            25,051
            
            
            $
            1,613







Item
2 – Management’s Discussion and Analysis of Financial Condition and Results of
Operations





The
following discussion is intended to assist in understanding the financial
condition and results of the Corporation. The information contained in this
section should be read with the unaudited condensed consolidated financial
statements and accompanying notes included in this Quarterly Report, and the
December 31, 2007 audited consolidated financial statements and accompanying
notes included in our recent Annual Report on Form 10-K.





Forward-Looking
Statements


Certain
of the statements contained herein that are not historical facts are
forward-looking statements within the meaning of the Private Securities Reform
Act.  The Corporation’s actual results may differ materially from
those included in the forward-looking statements.  Forward-looking
statements are typically identified by words or phrases such as “believe,”
“expect,” “intend,” “may increase,” “may fluctuate,” and similar expressions or
future or conditional verbs such as “will,” “should,” “would,” and
“could.”  These forward-looking statements involve risks and
uncertainties including, but not limited to, economic conditions, portfolio
growth, the credit performance of the portfolios, including bankruptcies, and
seasonal factors; changes in general economic conditions including the
performance of financial markets, prevailing inflation and interest rates,
realized gains from sales of investments, gains from asset sales, and losses on
commercial lending activities; results of various investment activities; the
effects of competitors’ pricing policies, of changes in laws and regulations on
competition and of demographic changes on target market populations’ savings and
financial planning needs; industry changes in information technology systems on
which we are highly dependent; failure of acquisitions to produce revenue
enhancements or cost savings at levels or within the time frames originally
anticipated or unforeseen integration difficulties; the adoption of the
Corporation of an FFIEC policy that provides guidance on the reporting of
delinquent consumer loans and the timing of associated credit charge-offs for
financial institution subsidiaries; and the resolution of legal proceedings and
related matters.  In addition, the banking industry in general is
subject to various monetary and fiscal policies and regulations, which include
those determined by the Federal Reserve Board, the Federal Deposit Insurance
Corporation, and state regulators, whose policies and regulations could affect
the Corporation’s results.  These statements are representative only
on the date hereof, and the Corporation undertakes no obligation to update any
forward-looking statements made.





Cascade
Financial Corporation is a bank holding company incorporated in the state of
Washington. The Corporation’s sole operating subsidiary is Cascade Bank; a
Washington State chartered commercial bank. The Corporation and the Bank are
headquartered in Everett, Washington. The Bank offers loan, deposit, and other
financial services through its twenty-one branches located in Snohomish, King
and Skagit Counties (Washington).


13


Selected
Financial Data





The
following table sets forth certain selected financial data concerning the
Corporation for the periods indicated:


At
      or for the three months ended
              September
      30,
            
            
            At
      or for the nine months ended
              September
      30,2008
            
            
            2007
            
            
            2008
            
            
            2007Return
      on average assets
            
            
            -1.69
            %
            
            
            1.12
            %
            
            
            -0.03
            %
            
            
            1.13
            %Return
      on average stockholders’ equity
            
            
            -20.58
            
            
            
            12.75
            
            
            
            -0.39
            
            
            
            13.27Average
      stockholders’ equity to average assets
            
            
            8.22
            
            
            
            8.77
            
            
            
            8.32
            
            
            
            8.55Other
      expenses to average assets
            
            
            6.30
            
            
            
            2.00
            
            
            
            3.40
            
            
            
            1.93Efficiency
      ratio(1)
            
            
            47.24
            
            
            
            52.73
            
            
            
            51.13
            
            
            
            51.96Average
      interest-bearing assets to average interest-bearing
      liabilities
            
            
            109.24
            
            
            
            112.91
            
            
            
            110.56
            
            
            
            112.21(1) Excludes
      after-tax charge of $11.3 million for OTTI on investments in Fannie Mae
      and Freddie Mac preferred stock.








CHANGES
IN FINANCIAL CONDITION





Total
assets increased 9.2% or $134.2 million to $1.55 billion at September 30, 2008,
compared to $1.42 billion at December 31, 2007. Net loans, e.g. net of deferred
loan fees and the allowance for loan losses, increased 10.1% or $102.5 million
to $1.20 billion at September 30, 2008, from $1.09 billion at December 31,
2007.





Total investment
securities increased $22.9 million to $254.9 million at September 30, 2008,
compared to $232.0 million at December 31, 2007. The investment portfolio is
concentrated in securities issued by Government Sponsored Enterprises (GSEs,
e.g. FNMA or FHLMC) as well as mortgage-backed pass-through securities and
collateralized mortgage obligations backed by pools of single family residential
mortgages (known collectively as MBS). All investment purchases during the nine
months ended September 30, 2008, were rated AAA or AA in terms of credit quality
by Moody’s and/or Standard & Poors. All MBS and GSE debt securities in the
portfolio as of September 30, 2008, were also rated AAA.





(Dollars
      in thousands)
            
            SEPTEMBER
      30, 2008Securities
    available-for-sale
            
            Amortized
              Cost
            
            
            Gross
              Unrealized
              Gains
              Less
      Than
              1
      Year
            
            
            Gross
              Unrealized
              Gains
              More
      Than
              1
      Year
            
            
            Gross
              Unrealized
              (Losses)
              Less
      Than
              1
      Year
            
            
            Gross
              Unrealized
              (Losses)
              More
      Than
              1
      Year
            
            
            Fair
      ValueMBS
            
            $
            32,183
            
            
            $
            -
            
            
            $
            -
            
            
            $
            (227
            )
            
            $
            (928
            )
            
            $
            31,028GSE
      notes
            
            
            71,158
            
            
            
            -
            
            
            
            -
            
            
            
            (1,167
            )
            
            
            -
            
            
            
            69,991Corporate/other
            
            
            1,294
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            1,294Total
            
            $
            104,635
            
            
            $
            -
            
            
            $
            -
            
            
            $
            (1,394
            )
            
            $
            (928
            )
            
            $
            102,313Securities held-to-maturity
            
            Amortized
              Cost
            
            
            Gross
              Unrealized
              Gains
              Less
      Than
              1
      Year
            
            
            Gross
              Unrealized
              Gains
              More
      Than
              1
      Year
            
            
            Gross
              Unrealized
              (Losses)
              Less
      Than
              1
      Year
            
            
            Gross
              Unrealized
              (Losses)
              More
      Than
              1
      Year
            
            
            Fair
              ValueMBS
            
            $
            21,011
            
            
            $
            13
            
            
            $
            9
            
            
            $
            (585
            )
            
            $
            (228
            )
            
            $
            20,220GSE
      notes
            
            
            118,829
            
            
            
            8
            
            
            
            -
            
            
            
            (2,403
            )
            
            
            -
            
            
            
            116,434Corporate/other
            
            
            775
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            775Total
            
            $
            140,615
            
            
            $
            21
            
            
            $
            9
            
            
            $
            (2,988
            )
            
            $
            (228
            )
            
            $
            137,429




14


(Dollars
      in thousands)
            
            DECEMBER
      31, 2007Securities
    available-for-sale
            
            Amortized
              Cost
            
            
            Gross
              Unrealized
              Gains
              Less
      Than
              1
      Year
            
            
            Gross
              Unrealized
              Gains
              More
      Than
              1
      Year
            
            
            Gross
              Unrealized
              (Losses)
              Less
      Than
              1
      Year
            
            
            Gross
              Unrealized
              (Losses)
              More
      Than
              1
      Year
            
            
            Fair
              ValueMBS
            
            $
            26,286
            
            
            $
            2
            
            
            $
            5
            
            
            $
            (71
            )
            
            $
            (795
            )
            
            $
            25,427GSE
      notes
            
            
            57,366
            
            
            
            67
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            57,433Total
            
            $
            83,652
            
            
            $
            69
            
            
            $
            5
            
            
            $
            (71
            )
            
            $
            (795
            )
            
            $
            82,860Securities held-to-maturity
            
            Amortized
              Cost
            
            
            Gross
              Unrealized
              Gains
              Less
      Than
              1
      Year
            
            
            Gross
              Unrealized
              Gains
              More
      Than
              1
      Year
            
            
            Gross
              Unrealized
              (Losses)
              Less
      Than
              1
      Year
            
            
            Gross
              Unrealized
              (Losses)
              More
      Than
              1
      Year
            
            
            Fair
              ValueMBS
            
            $
            22,556
            
            
            $
            28
            
            
            $
            -
            
            
            $
            -
            
            
            $
            (643
            )
            
            $
            21,941GSE
      notes
            
            
            113,907
            
            
            
            67
            
            
            
            -
            
            
            
            (246
            )
            
            
            (149
            )
            
            
            113,579Corporate/other
            
            
            775
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            775Total
            
            $
            137,238
            
            
            $
            95
            
            
            $
            -
            
            
            $
            (246
            )
            
            $
            (792
            )
            
            $
            136,295





As of
September 30, 2008, the Bank held eight securities in our available-for-sale
portfolio and two in our held-to-maturity portfolio that have had an unrealized
loss for more than one year. The losses on the available-for-sale securities
have increased since December 31, 2007, due to a widening of credit spreads. The
loss in the held-to-maturity portfolio decreased $564,000 during the nine months
ended September 30, 2008, to $228,000. We have the ability to hold the
investments for the period of time management believes to be sufficient for a
market price recovery. We hold no securities that are backed by sub-prime loans
or collateralized debt obligations.





On
September 9, 2008, Cascade reported that as of June 30, 2008, the Bank owned
preferred shares issued by Fannie Mae ($10.2 million book value) and Freddie Mac
($8.4 million book value) with a combined adjusted book value of approximately
$18.6 million.  As of September 30, 2008, the fair market value of
these securities was $1.3 million.  With an amortized cost basis for
the securities of $18.6 million, Cascade recorded a pre-tax OTTI charge of $17.3
million, resulting in a charge net of taxes of $11.3 million to third quarter
2008 earnings.





At
September 30, 2008, the Bank held FHLB of Seattle stock of $11.9 million. On
August 4, 2008, the FHLB declared a $0.35 per share cash dividend payable on
August 22, 2008. The dividend payment was $41,721.





Loan
Portfolio





Virtually
all of the Bank’s loans are to businesses or individuals in the Puget Sound
area. Business loans are made to small and medium sized businesses within that
area for a wide array of purposes. Included in the business loan total are loans
secured by real estate, the majority of which the borrower is the primary tenant
of the property. Real estate construction loans are extended to builders and
developers of residential and commercial real estate. Commercial real estate
loans fund small, non-owner occupied buildings.





Residential
loans, held in the Bank’s portfolio, are generally adjustable rate loans secured
by single family residences. The Bank also originates longer term fixed rate
residential loans, but sells most of those loans into the secondary market on a
best efforts, servicing released basis. Home equity loans are primarily second
mortgages on the borrower’s primary residence. Consumer loans are
non-residential, e.g. automobiles, credit cards or boats.


15


Net loans
increased by $102.5 million to $1.20 billion as of September 30, 2008, compared
to $1.09 billion at December 31, 2007. Loans more closely associated with a
commercial bank, e.g. business, real estate construction, and commercial real
estate loans, grew $25.9 million to $996.6 million as of September 30, 2008,
compared to $970.7 million as of December 31, 2007.





Multifamily
loans increased $63.1 million to $74.5 million. The majority of this increase is
due to completed construction loans totaling $38.3 million that were transferred
to the multifamily category during the period. Home equity and consumer loans
increased $2.0 million to $29.7 million and residential loans increased by $13.9
million to $112.3 million.





The
following summary reflects the Bank’s loan portfolio as of the dates
indicated:





(Dollars
      in thousands)
            September
      30, 2008
            
            %
      of Portfolio
            
            
            December
      31, 2007
            
            %
      of PortfolioBusiness
            $
            473,213
            
            
            39.0
            %
            
            $
            468,453
            
            
            42.3
            %Real
      estate construction(1)
            
            403,569
            
            
            33.3
            
            
            
            381,810
            
            
            34.4Commercial
      real estate
            
            119,787
            
            
            9.9
            
            
            
            120,421
            
            
            10.9Home
      equity/consumer
            
            29,659
            
            
            2.4
            
            
            
            27,688
            
            
            2.5Residential(2)
            
            112,283
            
            
            9.3
            
            
            
            98,384
            
            
            8.9Multifamily
      real estate
            
            74,535
            
            
            6.1
            
            
            
            11,397
            
            
            1.0Total
      loans
            $
            1,213,046
            
            
            100.0
            %
            
            $
            1,108,153
            
            
            100.0
            %Deferred
      loan fees
            
            (3,248
            )
            
            
            
            
            
            (3,724
            )Allowance
      for loan losses
            
            (14,531
            )
            
            
            
            
            
            (11,653
            )Loans,
      net
            $
            1,195,267
            
            
            
            
            
            $
            1,092,776





(1)
            Real
      estate construction loans are net of loans in
  process.


(2)
            Loans
      held-for-sale are included in residential loans, and at less than 1% of
      total loans, are not considered
material.





Deposits,
Other Borrowings, and Stockholders’ Equity





Checking account deposits
increased as the Bank continued to focus its sales activities on deposit
generation in general and checking/transaction accounts in particular. Total
checking account balances increased by $35.1 million between December 31, 2007
and September 30, 2008.





Total
deposits increased by $87.6 million from $904.9 million at December 31, 2007, to
$992.5 million at September 30, 2008. Savings and money market accounts (MMDA)
decreased $60.7 million as municipalities reduced balances to meet their cash
flow requirements and consolidated balances in the State Investment Pool. CD’s
increased $113.2 million to $552.7 million. An increase in brokered CD’s
accounted for most of that growth.





The
following table reflects the Bank’s deposit mix as of the dates
indicated:





(Dollars
      in thousands)
            
            September
      30, 2008
            
            
            %
      of Deposits
            
            
            December
      31, 2008
            
            
            %
      of DepositsChecking
      accounts
            
            $
            173,257
            
            
            
            17.4
            %
            
            $
            138,190
            
            
            
            15.3
            %Savings
      & MMDA
            
            
            266,560
            
            
            
            26.9
            
            
            
            327,264
            
            
            
            36.2CD’s
            
            
            552,688
            
            
            
            55.7
            
            
            
            439,442
            
            
            
            48.5Total
            
            $
            992,505
            
            
            
            100.0
            %
            
            $
            904,896
            
            
            
            100.0
            %


16


FHLB
advances increased by $24.0 million from $231.0 million at December 31, 2007, to
$255.0 million at September 30, 2008, as advances offered lower costs than some
deposits. Securities sold under agreements to repurchase were $120.6 million at
December 31, 2007, and $121.0 at September 30, 2008. Cascade participates in the
Federal Reserve’s term auction facility (TAF) but had no balance as of September
30, 2008. The Bank had $30.0 million outstanding from the Federal Reserve
discount window as of September 30, 2008.  The Bank uses structured
advances and repurchase agreements to lower our cost of funds.





Total
stockholders’ equity decreased $3.0 million from $122.1 million at December 31,
2007, to $119.1 million at September 30, 2008. The decrease in equity was due to
the net loss for that period. The loss was due to OTTI charge on investments in
Fannie Mae and Freddie Mac preferred securities. During the nine months ended
September 30, 2008, no Cascade common stock was repurchased under the Board
approved stock repurchase plan. Accumulated other comprehensive loss increased
by $995,000 due to an increase in the fair value loss on available-for-sale
securities.





Asset
Quality




Non-performing
assets (non-performing loans, real estate owned and other repossessed property)
totaled $17.1 million and $1.5 million at September 30, 2008, and December 31,
2007, respectively. Non-performing loans (NPLs) consist of loans which are on
non-accrual, loans that are ninety days past due, and loans that management
otherwise has serious reservations about the collectibility of all principal and
interest owed. NPLs increased to $15.7 million at September 30, 2008, compared
to $1.5 million at December 31, 2007, but decreased from $32.0 million at June
30, 2008. Of the $15.7 million, $15.2 million were real estate construction and
land loans, including $10.7 million for three developed lot loans and one land
acquisition and development loan and $4.5 million in another lending
relationship for single family construction. The remaining non-performing loans
included two business loans totaling $228,000, one residential loan totaling
$155,000 and one installment loan totaling $59,000. There was $1.4 million of
real estate owned (REO) at September 30, 2008 and $0 at December 31, 2007. The
REO consisted of three completed new houses. There were no other repossessed
assets as of September 30, 2008, and December 31, 2007.





Management
remains concerned about the residential housing slowdown and the effect it has
had on credit quality. Inventories of homes and lots continue to increase in
Snohomish, King and Pierce counties during 2008. The trends toward slowing of
the overall economy only increases our concerns. Management has increased
monitoring of construction and land acquisition loans and has reduced
originations in these portfolios.





At
September 30, 2008, the Bank’s allowance for loan losses was $14.5 million
compared to $11.7 million at December 31, 2007. Additionally, at September 30,
2008, $107,000 was recorded in a general valuation allowance allocated to
off-balances sheet commitments, e.g. lines of credit and construction loans in
process. This reserve is recorded as an “other liability” on the Corporation’s
balance sheet. During the quarter ended September 30, 2008, this account was
reduced by $6,000 to $107,000 compared to $142,000 at December 31, 2007. Total
allowance for loan losses, which includes the allowance for off-balance sheet
commitments, was 1.21% of total loans outstanding at September 30, 2008,
compared to 1.06% at


17
 December
31, 2007. Total allowance for loan losses was 93% of non-performing loans at
September 30, 2008, compared to 774% at December 31, 2007. As a result of FASB
Statement No. 114, Accounting
by Creditors for Impairment of a Loan, Management has performed extensive
impairment analyses on the nonperforming loans, including obtaining and
evaluating updated appraisals, to determine the adequacy of the allowance for
loan losses, as well as recording appropriate charge-offs.





The
allowance for loan losses is maintained at a level sufficient to provide for
losses based on management’s evaluation of known and inherent risks in the
portfolio. This evaluation includes analysis of the financial condition of the
borrower, the value of the collateral securing selected loans, consideration of
potential loss experience and management’s projection of trends affecting credit
quality. The increase in the dollar amount of the allowance and the percentage
of the allowance is primarily attributable to an increase in loans and a general
slowdown in the housing market and the general economy. Management believes that
the allowance for loan losses represents Management’s best estimate of the
probable credit losses inherent in the loan portfolio and is adequate to provide
for losses that may be incurred on non-performing loans.





During
the quarter ended September 30, 2008, loan charge-offs equaled $1.04
millionwhile
recoveries were $1.00 million resulting in net charge-offs of $43,000 or 0 basis
points of total loans. Of the loans charged-off, $696,000 came from the partial
write-off of a land acquisition and development loan, $116,000 came from a
partial write-off of a construction loan and $94,000 came from a write-off of a
business loan. The balance of the write downs came from consumer and deposit
related charge-offs, e.g. overdrafts. For the first nine months of 2008, net
charge-offs were $2.0 million or 16 basis points of total loans.





The
following table provides summary information concerning asset quality as of and
for the quarters ended September 30, 2008, and December 31, 2007,
respectively:





September
      30, 2008
            
            
            December
      31, 2007Non-performing
      loans to total assets
            
            
            1.01
            %
            
            
            0.11
            %Non-performing
      loans to total loans outstanding
            
            
            1.29
            
            
            
            0.14Non-performing
      assets to total assets
            
            
            1.10
            
            
            
            0.11Total
      allowance for loan losses to non-performing loans(1)
            
            
            93
            
            
            
            774Total
      allowance for loan losses to total loans(1)
            
            
            1.21
            
            
            
            1.06Net
      charge-offs to total loans
            
            
            0.00
            
            
            
            0.01(1)
      Total allowance for loan losses includes off-balance sheet loan
      commitments of $107,000 at September 30, 2008, and $142,000 at December
      31, 2007.





During
the third quarter, approximately $11.6 million of nonperforming loans were
reduced through the assumption, by a qualified purchaser, of two loans secured
by residential real estate developments located in Snohomish County. These
transactions allowed Cascade to recapture approximately $1.0 million in interest
income and recover $1.0 million of previously charged-off
loans.


18


Average
Balances and an Analysis of Average Rates Earned and Paid





The
following table shows average balances and interest income or interest expense,
with the resulting average yield or rate by category or average earning asset or
interest-bearing liability.


For
      the Quarter Ended September 30,2008
            
            
            2007(Dollars
      in thousands)
            
            Average
              Balance
            
            
            Interest
              or
              Dividend
            
            
            Yield/
              Cost
            
            
            Average
              Balance
            
            
            Interest
              or
              Dividend
            
            
            Yield/
              CostASSETSInterest-earning assets (1)Residential loans
            
            $
            107,464
            
            
            $
            1,589
            
            
            
            5.91
            %
            
            $
            90,920
            
            
            $
            1,394
            
            
            
            6.08
            %Multifamily loans
            
            
            72,658
            
            
            
            1,223
            
            
            
            6.68
            
            
            
            11,849
            
            
            
            228
            
            
            
            7.63Commercial real estate
      loans
            
            
            116,273
            
            
            
            1,962
            
            
            
            6.69
            
            
            
            115,629
            
            
            
            2,011
            
            
            
            6.90Construction loans
            
            
            375,480
            
            
            
            7,091
            
            
            
            7.49
            
            
            
            333,518
            
            
            
            7,677
            
            
            
            9.13Consumer loans
            
            
            29,148
            
            
            
            480
            
            
            
            6.54
            
            
            
            27,192
            
            
            
            531
            
            
            
            7.75Business banking
    loans
            
            
            478,869
            
            
            
            8,266
            
            
            
            6.85
            
            
            
            450,379
            
            
            
            8,504
            
            
            
            7.49Total loans
      (accruing)
            
            
            1,179,892
            
            
            
            20,611
            
            
            
            6.93
            
            
            
            1,029,487
            
            
            
            20,345
            
            
            
            7.84Securities
      available-for-sale
            
            
            119,456
            
            
            
            1,616
            
            
            
            5.37
            
            
            
            115,786
            
            
            
            1,426
            
            
            
            4.89Securities
      held-to-maturity
            
            
            140,545
            
            
            
            2,102
            
            
            
            5.93
            
            
            
            83,764
            
            
            
            1,054
            
            
            
            5.07Securities
      held-for-trading
            
            
            -
            
            
            
            -
            
            
            
            0.00
            
            
            
            30,941
            
            
            
            386
            
            
            
            4.73Daily interest-earning
      deposits
            
            
            12,633
            
            
            
            16
            
            
            
            0.51
            
            
            
            12,832
            
            
            
            167
            
            
            
            5.15Total securities and
      interest-earning deposits
            
            
            272,634
            
            
            
            3,734
            
            
            
            5.43
            
            
            
            243,323
            
            
            
            3,033
            
            
            
            4.95Total interest-earning
      assets
            
            
            1,452,526
            
            
            
            24,345
            
            
            
            6.67
            
            
            
            1,272,810
            
            
            
            23,378
            
            
            
            7.30Noninterest-earning assetsOffice properties and equipment,
      net
            
            
            15,799
            
            
            
            
            
            
            
            
            
            
            
            14,090Other noninterest-earning
      assets
            
            
            88,446
            
            
            
            
            
            
            
            
            
            
            
            57,289Total assets
            
            
            1,556,771
            
            
            
            
            
            
            
            
            
            
            
            1,344,189LIABILITIES
      AND EQUITYInterest-bearing
liabilitiesSavings accounts
            
            $
            10,944
            
            
            $
            14
            
            
            
            0.50
            %
            
            $
            13,232
            
            
            $
            17
            
            
            
            0.50
            %Checking accounts
            
            
            79,686
            
            
            
            349
            
            
            
            1.74
            
            
            
            52,615
            
            
            
            194
            
            
            
            1.46Money market
    accounts
            
            
            299,411
            
            
            
            1,617
            
            
            
            2.14
            
            
            
            273,915
            
            
            
            3,040
            
            
            
            4.40Certificates of
      deposit
            
            
            507,610
            
            
            
            4,450
            
            
            
            3.48
            
            
            
            441,099
            
            
            
            5,570
            
            
            
            5.01Total interest-bearing
      deposits
            
            
            897,651
            
            
            
            6,430
            
            
            
            2.84
            
            
            
            780,861
            
            
            
            8,821
            
            
            
            4.48Other interest-bearing
      liabilitiesFHLB advances
            
            
            253,927
            
            
            
            2,746
            
            
            
            4.29
            
            
            
            201,641
            
            
            
            2,261
            
            
            
            4.45Securities sold under agreements
      to repurchase
            
            
            120,935
            
            
            
            1,618
            
            
            
            5.31
            
            
            
            117,478
            
            
            
            956
            
            
            
            3.23Junior subordinated debentures
      payable
            
            
            26,356
            
            
            
            530
            
            
            
            7.98
            
            
            
            27,255
            
            
            
            530
            
            
            
            7.71Other borrowings
            
            
            30,829
            
            
            
            184
            
            
            
            2.36
            
            
            
            -
            
            
            
            -
            
            
            
            0.00Total interest-bearing
      liabilities
            
            
            1,329,698
            
            
            
            11,508
            
            
            
            3.44
            
            
            
            1,127,235
            
            
            
            12,568
            
            
            
            4.44Other liabilities
            
            
            99,137
            
            
            
            
            
            
            
            
            
            
            
            99,093Total
    liabilities
            
            
            1,428,835
            
            
            
            
            
            
            
            
            
            
            
            1,226,328Stockholders’
    equity
            
            
            127,936
            
            
            
            
            
            
            
            
            
            
            
            117,861Total liabilities and
      stockholders’ equity
            
            
            1,556,771
            
            
            
            
            
            
            
            
            
            
            
            1,344,189Net
      interest income (2)
            
            
            
            
            
            $
            12,837
            
            
            
            
            
            
            
            
            
            
            $
            10,810Interest
      rate spread (3)
            
            
            
            
            
            
            
            
            
            
            3.23
            
            
            
            
            
            
            
            
            
            
            
            2.86Net
      interest margin (4)
            
            
            
            
            
            
            3.52
            
            
            
            
            
            
            
            
            
            
            
            3.38Average
      interest-earning assets to average
              interest-bearing
      liabilities
            
            
            109.24
            %
            
            
            
            
            
            
            
            
            
            
            112.91
            %





(1)  Does
not include interest on loans 90 days or more past due.


(2)  Interest
and dividends on total interest-earning assets less interest on total
interest-bearing liabilities.


(3)  Total
interest-earning assets yield less total interest-bearing liabilities
cost.


(4)  Net
interest income as an annualized percentage of total interest-earning
assets.


19


Rate/Volume
Analysis





The
following table sets forth the effects of changing rates and volumes on net
interest income of the Corporation. Information is provided with respect to (i)
effects on interest income attributable to changes in volume (changes in volume
multiplied by prior rate); (ii) effects on interest income attributable to
changes in rate (changes in rate multiplied by prior volume); and (iii) changes
in rate/volume mix (change in rate multiplied by change in volume).





(Dollars
      in thousands)
            
            Quarter
      Ended September 30,2008 Compared to Quarter Ended
              September
      30, 2007
              Increase
      (Decrease) Due toRate
            
            
            Volume
            
            
            Mix
            
            NetInterest-earning
      assetsResidential
      loans
            
            $
            (38
            )
            
            $
            251
            
            
            $
            (18
            )
            $
            195Multifamily
      loans
            
            
            (28
            )
            
            
            1,160
            
            
            
            (137
            )
            
            995Commercial
      real estate
            
            
            (59
            )
            
            
            11
            
            
            
            (1
            )
            
            (49
            )Construction
      loans
            
            
            (1,368
            )
            
            
            958
            
            
            
            (177
            )
            
            (587
            )Consumer
      loans
            
            
            (82
            )
            
            
            37
            
            
            
            (6
            )
            
            (51
            )Business
      banking loans
            
            
            (723
            )
            
            
            534
            
            
            
            (48
            )
            
            (237
            )Total
      loans
            
            
            (2,298
            )
            
            
            2,951
            
            
            
            (387
            )
            
            266Securities
      held-for-trading
            
            
            -
            
            
            
            (366
            )
            
            
            (3
            )
            
            (369
            )Securities
      available-for-sale
            
            
            139
            
            
            
            45
            
            
            
            6
            
            
            190Securities
      held-to-maturity
            
            
            180
            
            
            
            720
            
            
            
            131
            
            
            1,031Daily
      interest-earning deposits
            
            
            (149
            )
            
            
            (3
            )
            
            
            1
            
            
            (151
            )Total
      net change in income on interest-earning assets
            
            $
            (2,128
            )
            
            $
            3,347
            
            
            $
            (252
            )
            $
            967Interest-bearing
      liabilitiesInterest-bearing
      depositsSavings
accounts
            
            $
            -
            
            
            $
            (3
            )
            
            $
            -
            
            $
            (3
            )Checking
    accounts
            
            
            35
            
            
            
            99
            
            
            
            20
            
            
            154Money market
      accounts
            
            
            (1,548
            )
            
            
            281
            
            
            
            (156
            )
            
            (1,423
            )Certificates of
      Deposit
            
            
            (1,688
            )
            
            
            833
            
            
            
            (264
            )
            
            (1,119
            )FHLB advances
            
            
            (81
            )
            
            
            580
            
            
            
            (14
            )
            
            485Securities sold under agreements
      to repurchase
            
            
            610
            
            
            
            28
            
            
            
            23
            
            
            661Junior subordinated debentures
      payable
            
            
            18
            
            
            
            (17
            )
            
            
            (1
            )
            
            -Other borrowings
            
            
            -
            
            
            
            -
            
            
            
            184
            
            
            184Total
      net change in expenses on interest-bearing liabilities
            
            $
            (2,654
            )
            
            $
            1,801
            
            
            $
            (208
            )
            $
            (1,061
            )Net
      increase in net interest income
            
            
            
            
            
            
            
            
            
            
            
            
            $
            2,028








RESULTS
OF OPERATIONS





Comparison
of the Three and Nine Months Ended September 30, 2008 and 2007





General





Following
an after-tax charge of $11.3 million for OTTI on investments in Fannie Mae and
Freddie Mac preferred securities, after the U.S. government placed these
companies under Conservatorship, Cascade reported a net loss of $6.6 million or
$0.55 per diluted share for the three months ended September 30, 2008, compared
to net income of $3.8 million or $0.31 per diluted share during the comparable
period in 2007. Third quarter net income was $4.7 million excluding the OTTI
charge. Net interest income before provision for loan losses increased $2.0
million to $12.8 million for the quarter ended September 30, 2008, compared to
$10.8 million for the quarter ended September 30, 2007. Total other income
increased $381,000


20
 to $2.3
million for the quarter ended September 30, 2008, as compared to the quarter
ended September 30, 2007. Increases in checking fees and service fees accounted
for $338,000 of the increase. Total other expenses were $24.5 million for the
quarter ended September 30, 2008. The OTTI charge on Fannie Mae and Freddie Mac
preferred securities accounted for $17.3 million of the
expense.





Cascade
reported a loss of $372,000, or $0.03 per diluted share on a fully-reported GAAP
basis, compared to earnings of $11.5 million, or $0.94 per diluted share, in the
first nine months of 2007.





Net
Interest Income





Net
interest income, before provision for loan losses, increased 18.5% or $2.0
million to $12.8 million for the three months ended September 30, 2008, compared
to $10.8 million for the three months ended September 30, 2007. Average
interest-earning assets increased $179.7 million or 14.2% to $1.45 billion for
the three months ended September 30, 2008, compared to the same period in 2007.
Average total loans increased $172.2 million to $1.20 billion and average
investment securities increased $44.5 million to $275.0 million for the three
months ended September 30, 2008, compared to the same quarter of the prior
year.





At
      or for the
            
            
            At
      or for thethree
      months ended
            
            
            nine
      months endedSeptember
      30,
            
            
            September
      30,(Dollars in
      millions)
            
            2008
            
            
            2007
            
            
            2008
            
            
            2007Average
      interest-earning
      assets
            
            $
            1,452,526
            
            
            $
            1,272,810
            
            
            $
            1,430,815
            
            
            $
            1,286,453Average
      interest-bearing liabilities
            
            
            1,329,698
            
            
            
            1,127,235
            
            
            
            1,294,138
            
            
            
            1,146,488Yield
      on interest-earning
      assets
            
            
            6.67
            %
            
            
            7.30
            %
            
            
            6.55
            %
            
            
            7.25
            %Cost of
      interest-bearing liabilities
            
            
            3.44
            
            
            
            4.44
            
            
            
            3.65
            
            
            
            4.40Net
      interest spread
            
            
            3.23
            
            
            
            2.86
            
            
            
            2.90
            
            
            
            2.85Net
      interest margin
            
            
            3.52
            
            
            
            3.38
            
            
            
            3.24
            
            
            
            3.33





The net
interest margin increased 14 basis points to 3.52% for the three months ended
September 30, 2008, compared to the same quarter the prior year. The yield on
interest-earning assets decreased 63 basis points to 6.67% for the three months
ended September 30, 2008, compared to 7.30% for the three months ended September
30, 2007. The increase in interest income, yield on interest-earning assets and
net interest margin were partially due to the recapture of approximately $1.0
million in additional interest income on nonperforming loans that were paid-off
during the quarter. The cost of interest-bearing liabilities decreased 100 basis
points to 3.44% for the three months ended September 30, 2008, compared to 4.44%
for the same period in 2007, primarily due to decreased costs for deposits as
deposit rates reflected the aggressive lowering of short term rates by the
Federal Reserve beginning in September 2007.





Provision
for Loan Losses





Cascade’s
provision for loan losses was $1.3 million for the three months and $4.8 million
for the nine months ended September 30, 2008. The provision for loan losses was
$350,000 and $850,000 for the same periods in 2007, respectively. The increase
in the provision was due to growth in the loan portfolio and a continued
slowdown in the real estate


21
 market.
The provision for loan losses is based on the size, composition and growth of
the portfolio, and management’s evaluation of known and inherent risks in the
portfolio, as well as Cascade’s loss experience.





Other
Income





Total
other income increased $381,000 or 21.1% to $2.3 million for the three months
ended September 30, 2008, as compared to $1.9 million for the three months ended
September 30, 2007. Total other income was $7.0 million and $5.8 million for the
nine months ended September 30, 2008, and September 30, 2007, respectively. For
the three months ended September 30, 2008, checking fees increased to $1.3
million compared to $1.0 million for the same period in the prior year due to
growth in the number of accounts and increased activity fees. Loss on sale of
securities was $87,000 for the three months ended September 30, 2008, compared
to a gain of $28,000 for the same quarter in the prior year. Bank-owned life
insurance income increased $68,000 as the Bank purchased an additional $5.0
million of insurance in December 2007.





Other
Expense





Total
other expenses including a $17.3 million OTTI charge were $24.5 million for the
three months and $38.7 million for the nine months ended September 30, 2008,
compared to $6.7 million for the three months and $19.7 million for the nine
months ended September 30, 2007. Excluding the OTTI charge other expenses would
have been $7.2 million and $21.3 million for the three and nine months ended
September 30, 2008.





Compensation
and employee benefit expenses increased $238,000 to $3.8 million during the
three months ended September 30, 2008, compared to the same quarter last year.
Compensation and employee benefit expense was $11.0 million for the nine months
ended September 30, 2008 and $10.2 million for the same period in 2007. The
increased compensation and personnel expense was primarily due to increased
staffing levels from the opening of our Shoreline and Burlington branches. The
remaining other expense categories (occupancy, marketing and other) totaled $3.4
million for the three months and $10.3 million for the nine months ended
September 30, 2008, and $3.2 million for the three months and $9.4 for the nine
months ended September 30, 2007.





Cascade
had a benefit for income taxes of $4.0 million compared to a provision of $1.9
million for the quarter ended September 30, 2008 and 2007.  The tax
rate for the third quarter of 2008 was 37% compared to a tax rate of 33% the
prior year.





Segment
Results





The
Corporation and the Bank are managed by a legal entity and not by lines of
business. The Bank’s operations include commercial banking services, such as
lending activities, business services, deposit products and other services. The
performance of the Bank as a whole is reviewed by the Board of Directors and
Management Committee.





The
Management Committee, which is the senior decision making group of the Bank, is
comprised of seven members including the President/CEO. Segment information is
not necessary to be presented in the notes to the consolidated financial
statements because operating decisions are made based on the performance of the
Corporation as a whole.


22


Liquidity
and Sources of Funds





The Bank
monitors its liquidity position to assure that it will have adequate resources
to meet its customers’ needs. Potential uses of funds are new loans; the
disbursement of construction loans in process; draws on unused business lines of
credit and unused consumer lines of credit; the purchase of investment
securities; deposit withdrawals; and repayment of FHLB advances. In terms of
commitments, as of September 30, 2008, Cascade had $80.2 million of construction
loans in process, $98.3million
in unused business lines of credit and future business commitments, $37.9
million in unused consumer lines of credit including credit cards, and $16.9 million in
other undisbursed commitments. Recent history indicates construction lines will
be funded at 71% of commitments
at any point in time. The Bank’s business customers use approximately 50% of their credit
lines at any given time. About 44% of the home
equity lines of credit are drawn upon at any point. Cash flows from operations
contribute to liquidity as well as proceeds from maturities of securities and
customer deposits. As indicated on the Corporation’s Condensed Consolidated
Statement of Cash Flows, net cash from operating activities contributed $10.5
million to liquidity for the nine months ended September 30, 2008, and for the
nine months ended September 30, 2007.





Funding
needs are met through existing liquidity balances, deposit growth, FHLB advances
and other borrowings including the Federal Reserve Bank, as well as the
repayment of existing loans and the sale of loans. Cascade maintains balances in
FHLB deposits, which equaled $600,000 as of September 30, 2008, and $7.4 million
at September 30, 2007.





Subject
to the availability of eligible collateral and certain requirements, the Bank’s
credit line with the FHLB-Seattle is 35% of total eligible assets or up to
approximately $542.7 million at
current asset levels as of September 30, 2008. At September 30, 2008, the Bank
had $255.0
million in advances and an unused line of credit from the FHLB-Seattle of
approximately $287.7million subject to the ability to pledge eligible collateral. The Bank
also uses reverse repurchase agreements (securities sold under agreements to
repurchase) to provide a flexible source of funding. At September 30, 2008, the
Bank had $121.0 million in reverse repurchase agreements outstanding. Securities
that could be pledged to secure additional funding at the FHLB-Seattle, the
repurchase market or sold for liquidity were $35.2 million at the
end of the quarter and $11.0 million as of December 31, 2007. Commercial real
estate loans totaling $367.9 million and
home equity and second lien residential loans totaling $35.4million
are being used as a source of collateral at the FHLB. The Bank also has a total
of $35.0
million in Fed funds lines with three correspondent banks.  Cascade did not draw on
these lines during the quarter. The Bank also has a $78.2 million line
of credit (based upon pledged collateral) at the Federal Reserve Bank of San
Francisco.As of
September 30, 2008, there was an outstanding balance of $30.0 million in
short-term borrowings with the Federal Reserve discount
window.





The
recent turmoil in the credit markets did not have a direct impact on the Bank’s
liquidity management practices. Access to the FHLB, the brokered deposit market,
the Federal Reserve, and our correspondent banks remains open.


23


Capital
Resources





The
Corporation’s main source of capital is typically the retention of its net
income that is not paid in dividends. The Corporation also receives capital
through the exercise of stock options granted to employees and directors. The
Corporation permits employees and directors to tender shares of Cascade’s stock,
which they have held for a minimum of six months, to exercise
options.





The Board
of Directors authorized a stock repurchase program of up to 300,000 shares of
the Corporation’s stock at its May 2008 meeting. The repurchase program does not
obligate the Corporation to acquire any specific number of shares. The main
focus of the program is to attempt to offset the dilution created by the
exercise of stock options and other stock grants; see Part II – Other
Information, Item 2 – Unregistered Sales of Equity Securities and Use of
Proceeds.





On March
30, 2006, Cascade Capital Trust III issued $10 million in par value junior
subordinated debentures payable (Trust Preferred Securities). These securities
have a fixed rate of 6.65% for the first 5 years and then float at 3-month LIBOR
plus 1.40% for the remaining 25 years. Cascade Capital Trust III is a statutory
business trust created for the exclusive purposes of issuing and selling capital
securities and utilizing sale proceeds to acquire junior subordinated debt
issued by Cascade Financial Corporation. Accordingly, the junior subordinated
debentures are the sole assets of the Trust, and payments under the junior
subordinated debentures will be the sole revenues of the Trust. All of the
common securities of the Trust are owned by the Corporation.





On
December 15, 2004, Cascade Capital Trust II issued $5 million in par value
junior subordinated debentures payable. These securities have a fixed rate of
5.82% for the first 5 years and then float at 3-month LIBOR plus 1.90% for the
remaining 25 years. The structure of Cascade Capital Trust II is identical to
Cascade Capital Trust III.





On March
1, 2000, Cascade Capital Trust I issued $10 million par value junior
subordinated debentures payable. These securities have a fixed rate of 11% and
mature on March 1, 2030, but are callable at a premium beginning March 1, 2010
and semi-annually thereafter. The structure of Cascade Capital Trust I is
identical to Cascade Capital Trust III. In keeping with the adoption of FIN 46R,
the Corporation’s balance sheet has replaced the title of “trust preferred
securities” with “junior subordinated debentures payable,” although there have
been no changes in terms of the underlying obligations. The Trust has been
deconsolidated upon adoption of FIN 46R at December 31, 2003, and did not have a
significant impact on the Corporation’s financial condition or results of
operations.





Capital
Requirements





Cascade
is subject to regulatory capital requirements at both the Bank and holding
company level. Cascade Bank is in full compliance with all capital requirements
established by the FDIC and the Washington State Department of Financial
Institutions. The Bank’s regulatory capital requirements are expressed as a
percentage of assets. To be adequately capitalized, the Bank must hold adjusted
capital levels equal to 4% of its assets and 8% of its risk-weighted assets. As
of September 30, 2008, for the purposes of this calculation, the


24
 Bank’s
average total assets and total risk-weighted assets were $1.53 billion and $1.30
billion respectively. The related excess capital amounts as of September 30,
2008, are presented in the following table:





(Dollars
      in thousands)
            Adequately
      Capitalized
            
            
            Well
      CapitalizedCore
    capital
            Amount
            
            Percentage
            
            
            Amount
            
            PercentageCascade’s
      Tier 1 (Core) capital
            $
            119,840
            
            
            7.83
            %
            
            $
            119,840
            
            
            7.83
            %Minimum
      requirement
            
            61,213
            
            
            4.00
            
            
            
            91,819
            
            
            6.00Excess
            $
            58,627
            
            
            3.83
            %
            
            $
            28,021
            
            
            1.83
            %Risk-based
      capital
            Amount
            
            Percentage
            
            
            Amount
            
            PercentageCascade’s
      Risk-based capital
            $
            134,478
            
            
            10.36
            %
            
            $
            134,478
            
            
            10.36
            %Minimum
      requirement(1)
            
            103,855
            
            
            8.00
            
            
            
            129,819
            
            
            10.00Excess
            $
            30,623
            
            
            2.36
            %
            
            $
            4,659
            
            
            0.36
            %(1)Based on risk-weighted assets.





The
Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”)
provides the FDIC with broad powers to take “prompt corrective action” to
resolve problems of insured depository institutions. The actions the FDIC can
take depend upon whether the institution in question is “well capitalized,”
“adequately capitalized,” “undercapitalized,” “significantly undercapitalized”
or “critically undercapitalized.” Under FDIC guidelines, Cascade Bank is a “well
capitalized” institution as of September 30, 2008, which requires a core capital
to assets ratio of at least 6% and a risk-based capital to assets ratio of at
least 10%.





The
Corporation, as a bank holding company regulated by the Federal Reserve, is
subject to capital requirements that are similar to those for Cascade Bank. As
of September 30, 2008, the Corporation is “well capitalized” under Federal
Reserve guidelines with a Tier 1 ratio of 7.87% and a risk-based ratio of
10.40%.





Item
3 – Quantitative and Qualitative Disclosures about Market Risk





ASSET/LIABILITY
MANAGEMENT





The Bank,
like other financial institutions, is subject to fluctuations in interest rates
because its interest-bearing liabilities reprice on different terms than its
interest-earning assets. Management actively monitors the inherent interest rate
risk for the potential impact of changes in rates on the
Bank.





The Bank
uses a simulation model as its primary tool to measure its interest rate risk. A
major focus of the Bank’s asset/liability management process is to preserve and
enhance net interest income. Cascade’s Board of Directors has enacted policies
that establish targets for the maximum negative impact that changes in interest
rates may have on the Bank’s net interest income, the fair value of equity and
adjusted capital/asset ratios under certain interest rate shock scenarios. Key
assumptions are made to evaluate the change to Cascade’s income and capital to
changes in interest rates. These assumptions, while deemed reasonable by
Management, are inherently uncertain. As a result, the estimated effects of
changes in interest rates from the simulation model will be different than
actual experience.


25


Using
standard interest rate shock (an instantaneous uniform change in interest rates
at all maturities) methodology, as of September 30, 2008, the Bank is within all
the guidelines established by the Board for the changes in net interest income,
fair value of equity, and adjusted capital/asset ratios. As of September 30,
2008, the Bank’s fair value of equity decreases 4.1% in the up 200 basis point
scenario and 15.9% in the down 200 basis point scenario, within the established
guideline of a maximum 30% decline. Using the same methodology, the adjusted
capital/asset ratio is 9.0% in the up 200 basis point scenario and 7.6% in the
down 200 basis point scenario, both above the 5% minimum established guideline.
The net interest income decreases 1.7% in the up 200 basis point scenario and
8.4% in the down 200 basis point scenario, both within the guideline of a 10%
decline.





The Bank
has sought to manage its interest rate exposure through the structure of its
balance sheet. To limit its interest rate risk, the Bank has sought to sell
virtually all 15 and 30 year fixed rate residential loans, it also sells many of
its hybrid ARM residential loans. The table below summarizes the Bank’s loan
portfolio by rate type at September 30, 2008.





Type
            
            Percentage
      of
              PortfolioVariable
            
            37
            %Adjustable
            
            38
            %Fixed
            
            25
            %





The Bank
extends the maturity of its liabilities by offering long-term deposit products
to customers, and by obtaining longer term FHLB advances. As of September 30,
2008, the entire portfolio of $249.0 million in long-term advances had original
maturities greater than one year. In addition, the Bank had a short-term advance
of $6.0 million at September 30, 2008. This portfolio consists entirely of
advances with put provisions that allow the FHLB to convert the advance to a
LIBOR based, adjustable rate borrowing under certain rate conditions and on
specific dates.





In
addition to writing embedded options in some of its liabilities, the Bank
invests in mortgage backed securities and callable GSE securities. The Bank
receives higher yields in return by writing call options. The Bank models this
optionality in measuring, monitoring, and managing its interest rate exposure.
As of September 30, 2008, the Bank did not use any interest rate swaps,
including caps, floors or collars.





Item
4 - Controls and Procedures





EVALUATION
OF DISCLOSURE CONTROLS AND PROCEDURES





An
evaluation of the Registrant's disclosure controls and procedures (as defined in
section 13(a) - 14(c) of the Securities Exchange Act of 1934 (the "Act")) was
carried out under the supervision and with the participation of the Registrant's
Chief Executive Officer, Chief Financial Officer, and several other members of
the registrant's senior management as of September 30, 2008. The Registrant's
Chief Executive Officer and Chief Financial Officer concluded that the
Registrant's disclosure controls and procedures as then in effect were effective
in ensuring that the information required to be disclosed by the Registrant in
the reports it files or submits under the Act is (i) accumulated and
communicated to the


26
 Registrant's
management (including the 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.





CHANGES
IN INTERNAL CONTROLS





In the
quarter ended September 30, 2008, the Registrant did not make any significant
changes in, nor take any corrective actions regarding, its internal controls, or
other factors that have materially affected or are reasonably likely to
materially affect these controls.





PART II––OTHER
INFORMATION





Item
1.  Legal Proceedings




The
Corporation and the Bank are involved in litigation and have negotiations in
progress resulting from activities arising from normal operations. In the
opinion of management, none of these matters are likely to have a materially
adverse effect on the Corporation’s financial position.





Item
1A.  Risk Factors





There have been no material changes in
the risk factors previously disclosed in Part 1, Item 1A. – Risk Factors of our
Annual Report on Form 10-K for the year ended December 31, 2007, except that the
following risk factor is added to those previously contained in the Form
10-K:





Downturns
in the Western Washington real estate market could hurt our
business.





Our
business activities and credit exposure are concentrated primarily in Snohomish,
King and Pierce Counties of Washington State .  While
we do not have any sub-prime loans, our construction and land loan portfolios,
our commercial and multifamily loan portfolios and certain of our other loans
have been affected by the downturn in the residential real estate
market.  Substantial portions of our loan portfolio consists of loans
secured by real estate located in Western Washington.  During 2008,
evidence of this downturn became more apparent in the markets we
serve.  If real estate values continue to decline the collateral for
our loans will provide less security.  As a result, our ability to
recover on defaulted loans by selling the underlying real estate will be
diminished, and we would be more likely to suffer losses on defaulted
loans.  The events and conditions described in this risk factor could
therefore have a material adverse effect on our business, results of operations
and financial condition.


27


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




Issuer
      Purchases of Equity Securities2008 PLAN
            
            
            Total
      Number
            
            
            Maximumof Shares
      Purchased
            
            
            Number
      of
              Shares
      thatPeriod
            
            Total
              Number
            
            
            Average
              Price
            
            
            as
      Part of Publicly
            
            
            May
      Yet be PurchasedBeginning
            Ending
            
            of Shares
      Purchased
            
            
            Paid
      per
              Share
            
            
            Announced
              Plan
            
            
            Under
      the
              Plan
      (1)July
      1, 2008
            July
      31, 2008
            
            
            -
            
            
            $
            -
            
            
            
            -
            
            
            
            300,000August
      1, 2008
            August
      31, 2008
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            300,000September
      1, 2008
            September
      30, 2008
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            300,000Total
            
            
            
            -
            
            
            $
            -
            
            
            
            -
            
            
            
            300,000During
      the period presented there were no shares purchased.1) In
      May 2008, the Corporation announced a new stock repurchase plan to
      purchase up to 300,000 shares of the Corporation’s stock. The Plan
      will expire on May 31, 2009.







Item
3.  Defaults upon Senior Securities




Not applicable




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




Not applicable




Item
5.  Other information




Not applicable




Item
6.  Exhibits




(a)  Exhibits




31.1
            Certifications
      of the Chief Executive Officer pursuant to Section 302 of the
      Sarbanes-Oxley Act


31.2
            Certifications
      of the Chief Financial Officer pursuant to Section 302 of the
      Sarbanes-Oxley Act


32           Certification
pursuant to Section 906 of the Sarbanes-Oxley Act







(b)
            Reports
      on Form 8-K




On July
22, 2008, the Corporation filed a Form 8-K reporting an attached press release
announcing earnings information for the quarter ended June 30, 2008, under Items
2.02 and 9.01 of Form 8-K.




On
September 9, 2008, the Corporation filed a Form 8-K announcing the potential
loss on the Company’s investment in Fannie Mae and Freddie Mac preferred stock,
under Items 8.01 of Form 8-K.




On
October 21, 2008, the Corporation filed a Form 8-K reporting an attached press
release announcing earnings for the quarter ended September 30, 2009, under
Items 2.02 and 9.01 of Form 8-K.


28




(b)
            Reports
      on Form 8-K (continued)




On
November 3, 2008, the Corporation filed a Form 8-K reporting an attached press
release announcing it has received preliminary approval from the U.S. Treasury
Department to participate in its Capital Purchase Program under the Emergency
Economic Stabilization Act of 2008, under Items 8.01 and 9.01 of form
8-K.







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.








CASCADE
      FINANCIAL CORPORATIONNovember
      7, 2008
            /s/
      Lars H. JohnsonBy:     Lars
      H. Johnson,
              Executive Vice
      President
              (Chief Financial
      Officer)







29