CASCADE
FINANCIAL CORPORATION SELECTED FINANCIAL DATA


(Dollars in thousands, except per
share data)


FOR
      THE YEARS ENDEDDECEMBER
      31,2007
              
              
              2006
              
              
              2005
              
              
              2004
              
              
              2003Interest
      income
              
              $
              93,935
              
              
              $
              82,658
              
              
              $
              67,802
              
              
              $
              55,316
              
              
              $
              50,363Interest
      expense
              
              
              50,540
              
              
              
              43,268
              
              
              
              31,276
              
              
              
              22,919
              
              
              
              22,753Net
      interest income
              
              
              43,395
              
              
              
              39,390
              
              
              
              36,526
              
              
              
              32,397
              
              
              
              27,610Provision
      for loan losses
              
              
              1,350
              
              
              
              1,000
              
              
              
              945
              
              
              
              675
              
              
              
              1,275Net
      interest income after provision for loan losses
              
              
              42,045
              
              
              
              38,390
              
              
              
              35,581
              
              
              
              31,722
              
              
              
              26,335Other
      income
              
              
              7,566
              
              
              
              6,026
              
              
              
              6,333
              
              
              
              4,747
              
              
              
              5,306Other
      expense
              
              
              26,682
              
              
              
              24,586
              
              
              
              22,606
              
              
              
              20,317
              
              
              
              17,733Income
      before provision for income taxes
              
              
              22,929
              
              
              
              19,830
              
              
              
              19,308
              
              
              
              16,152
              
              
              
              13,908Net
      income
              
              
              15,546
              
              
              
              13,355
              
              
              
              13,046
              
              
              
              10,785
              
              
              
              9,599Net
      income per common share, basic(1)
              
              
              1.29
              
              
              
              1.11
              
              
              
              1.09
              
              
              
              0.96
              
              
              
              0.94Net
      income per common share, diluted(1)
              
              
              1.27
              
              
              
              1.08
              
              
              
              1.06
              
              
              
              0.93
              
              
              
              0.90Book
      value per common share(1)
              
              
              10.15
              
              
              
              9.53
              
              
              
              8.76
              
              
              
              8.06
              
              
              
              6.21AT
      DECEMBER 31,2007
              
              
              2006
              
              
              2005
              
              
              2004
              
              
              2003Assets
              
              $
              1,417,588
              
              
              $
              1,345,254
              
              
              $
              1,211,784
              
              
              $
              1,088,955
              
              
              $
              885,220Loans,
      net
              
              
              1,092,776
              
              
              
              996,015
              
              
              
              867,049
              
              
              
              794,466
              
              
              
              567,094Cash
      and securities
              
              
              246,548
              
              
              
              282,301
              
              
              
              278,747
              
              
              
              228,644
              
              
              
              290,537Deposits
              
              
              904,896
              
              
              
              855,449
              
              
              
              795,768
              
              
              
              721,908
              
              
              
              564,314Borrowings
              
              
              147,512
              
              
              
              121,485
              
              
              
              66,270
              
              
              
              36,356
              
              
              
              50,123FHLB
      advances
              
              
              231,000
              
              
              
              243,000
              
              
              
              236,000
              
              
              
              228,000
              
              
              
              200,000Stockholders’
      equity
              
              
              122,096
              
              
              
              115,199
              
              
              
              105,193
              
              
              
              96,250
              
              
              
              63,957Nonperforming
      loans
              
              
              1,523
              
              
              
              851
              
              
              
              1,987
              
              
              
              532
              
              
              
              1,921FINANCIAL
      RATIOSFOR
      THE YEARS ENDEDDECEMBER
      31,2007
              
              
              2006
              
              
              2005
              
              
              2004
              
              
              2003Return
      on average assets
              
              
              1.13
              %
              
              
              1.05
              %
              
              
              1.13
              %
              
              
              1.09
              %
              
              
              1.13
              %Return
      on average equity
              
              
              13.23
              
              
              
              12.24
              
              
              
              13.13
              
              
              
              13.22
              
              
              
              15.81Return
      on average tangible equity
              
              
              16.88
              
              
              
              16.08
              
              
              
              17.82
              
              
              
              16.24
              
              
              
              15.81Net
      interest margin
              
              
              3.34
              
              
              
              3.26
              
              
              
              3.35
              
              
              
              3.44
              
              
              
              3.35Efficiency
      ratio
              
              
              52.36
              
              
              
              54.14
              
              
              
              52.75
              
              
              
              54.70
              
              
              
              53.87Dividend
      payout ratio
              
              
              25.98
              
              
              
              28.43
              
              
              
              25.66
              
              
              
              25.81
              
              
              
              18.31Average
      stockholders’ equity to average assets
              
              
              8.58
              
              
              
              8.55
              
              
              
              8.60
              
              
              
              8.25
              
              
              
              7.15Total
      risk-based capital to risk-weighted assets
              
              
              10.80
              
              
              
              11.22
              
              
              
              10.86
              
              
              
              11.18
              
              
              
              13.42Tier
      1 capital to average total assets
              
              
              8.90
              
              
              
              8.99
              
              
              
              8.23
              
              
              
              8.14
              
              
              
              8.49
  (1)Per
common share data is retroactively adjusted to reflect all stock splits and
stock dividends.









This
statement has not been reviewed, or confirmed for accuracy or relevance, by the
Federal Deposit Insurance Corporation.


9


MANAGEMENT
DISCUSSION AND ANALYSIS




The
following discussion is provided for the consolidated operations of Cascade
Financial Corporation (the “Corporation”) as of December 31, 2007. The
Corporation has only one operating subsidiary: Cascade Bank (the “Bank”). The
purpose of this discussion is to focus on significant factors concerning the
Corporation’s financial condition and results of operations, and to provide a
more comprehensive review of the Corporation’s operating results and financial
condition than can be obtained from reading the consolidated financial
statements alone. This discussion should be read with the consolidated financial
statements and the notes thereto.


In
addition to historical information, this report contains certain
"forward-looking statements" within the meaning of the Private Securities
Litigation Reform Act of 1995 ("PSLRA"). This statement is included for the
express purpose of availing the Corporation of the protections of the safe
harbor provisions of the PSLRA. The forward-looking statements contained herein
are subject to factors, risks, and uncertainties that may cause actual results
to differ materially from those projected. The following items are among the
factors that could cause actual results to differ materially from the
forward-looking statements: higher than expected loan delinquency rates; general
economic conditions, including their impact on capital expenditures; business
conditions in the banking industry; recent world events and their impact on
interest rates, businesses, and customers; the regulatory environment; new
legislation; vendor quality and efficiency; employee retention factors;
rapidly-changing technology; competitive factors, including increased
competition with community, regional, and national financial institutions;
fluctuating interest rate environments; and similar matters. Readers are
cautioned not to place undue reliance on these forward-looking statements, which
reflect management's analysis only as of the date of the statement. The
Corporation undertakes no obligation to publicly revise or update these
forward-looking statements to reflect events or circumstances that arise after
the date of this report. Readers should carefully review the risk factors
described in this and other documents the Corporation files from time to time
with the Securities and Exchange Commission.





Critical
Accounting Estimates


Corporations
may apply certain critical accounting estimates requiring management to make
subjective or complex judgments, often as a result of the need to estimate the
effect of matters that are inherently uncertain. The Bank considers its only
material critical accounting estimate to be the allowance for loan losses. We
believe that the accounting estimate related to the allowance for loan losses is
a "critical accounting estimate" because: (1) it is highly susceptible to change
from period to period because it requires management to make assumptions about
future collectability of loans; and (2) the impact of a sudden large loss could
significantly reduce the allowance and would require increased provisions to
replenish the allowance, which would negatively affect earnings.


The
allowance for loan losses is established through a provision for loan losses
charged against earnings. The balance of the allowance for loan losses is
maintained at the amount management believes will be adequate to absorb known
and inherent losses in the loan portfolio. The appropriate balance of the
allowance for loan losses is determined by applying estimated loss factors to
the credit exposure from outstanding loans. Estimated loss factors are based on
subjective measurements including management’s assessment of the internal risk
classifications, changes in the nature of the loan portfolio, industry
concentrations, and the impact of current local, regional and national economic
factors on the quality of the loan portfolio. Changes in these estimates and
assumptions are reasonably possible and may have a material impact on the
Corporation’s consolidated financial statements and results of
operation.


For
additional information regarding the allowance for loan losses, its relation to
the provision for loan losses and risk related to asset quality, see Note 4 in
the Consolidated Financial Statements for the year ended December 31, 2007, and
“Management’s Discussion and Analysis of Financial Condition and Results of
Operation – Provision for Loan Losses.”





Critical
Accounting Policies


The
Corporation’s significant accounting policies are described in Note 1 of the
Notes to Consolidated Financial Statements and are essential to understanding
Management's Discussion and Analysis of Financial Condition and Results of
Operations. The preparation of financial statements in conformity with
accounting principles generally accepted in the United States of America
requires management to make estimates and assumptions which affect the reported
amounts and disclosures. Actual results may differ from these estimates under
different assumptions or conditions. The following policies involve a higher
degree of judgment than do our other significant accounting policies detailed in
Note 1 of the Notes to Consolidated Financial Statements.





Allowance
for Loan Losses


The Bank
reviews historical origination and charge-off relationships, charge-off
experience factors, collection data, delinquency reports, estimates of the value
of the underlying collateral, and other information in order to make the
necessary judgments as to the appropriateness of the provision for loan losses
and the allowance for loan losses. The Bank also uses Qualitative (“Q”) Factors
to analyze the adequacy of the loan loss allowance and determine an unallocated
portion of the allowance.  Factors such as regional/local economic
trends, the health of the real estate market, loan and collateral
concentrations, size of borrowing relationships, trends in loan delinquencies
and charge-offs and changes in asset classifications are now included in the
Bank’s analysis of the allowance for loan losses. Loans losses are charged-off
against the allowance when management confirms the


10


uncollectability
of a loan balance or when the liquidation value of the collateral is less than
the amount of the loan. The Bank believes that the allowance for loan losses is
adequate to cover probable losses inherent in its loan
portfolio.  However, because the allowance for loan losses is based on
estimates, there can be no assurance that the ultimate charge-off amount will
not exceed the estimates.




Investments


The Bank
classifies its investments as held-for-trading, available-for-sale, or
held-to-maturity. Held-for-trading securities are marked to market with the
change in value recognized in the income
statement.  Available-for-sale securities are reported at their fair
value, which is determined by obtaining quoted market prices. Unrealized gains
and losses on available-for-sale securities are included in other comprehensive
income and excluded from earnings. Realized gains and losses and declines in
fair value judged to be other than temporary are included in earnings. The fair
value of financial instruments is discussed in more detail in Note 15 of the
Notes to Consolidated Financial Statements. Held-to-maturity securities are
carried at amortized cost.





Income
Taxes


The Bank
estimates tax expense based on the amount it expects to owe various tax
authorities. Taxes are discussed in more detail in Note 10 of the Notes to
Consolidated Financial Statements. Accrued taxes represent the net estimated
amount due or to be received from taxing authorities. In estimating accrued
taxes, management assesses the relative merits and risks of the appropriate tax
treatment of transactions taking into account statutory, judicial and regulatory
guidance in the context of our tax position.





Fair
Value


Effective
January 1, 2007, we adopted SFAS No. 157, Fair Value Measurements,
which among other things, requires enhanced disclosures about financial
instruments carried at fair value. SFAS No. 157 establishes a hierarchical
disclosure framework associated with the level of pricing observability utilized
in measuring financial instruments at fair value. The degree of judgment
utilized in measuring the fair value of financial instruments generally
correlates to the level of pricing observability. Financial instruments with
readily available active quoted prices or for which fair value can be measured
from actively quoted prices generally will have a higher degree of pricing
observability and a lesser degree of judgment utilized in measuring fair value.
Conversely, financial instruments rarely traded or not quoted will generally
have little or no pricing observability and a higher degree of judgment utilized
in measuring fair value. Pricing observability is impacted by a number of
factors, including the type of financial instrument, whether the financial
instrument is new to the market and not yet established and the characteristics
specific to the transaction. See Note 15 of the Notes to Consolidated
Financial Statements for additional information about the level of pricing
transparency associated with financial instruments carried at fair
value.





FINANCIAL
CONDITION


Total
Assets


The
Corporation’s total assets at December 31, 2007, were $­­­­1.4
billion, compared to $1.3 billion at December 31, 2006, an increase of 5.4%. The
increase in 2007 is due entirely to internal growth. The Corporation’s total
assets at December 31, 2005, were $1.2 billion.





Investment
Securities


Total
securities held decreased by $7.4 million to $232.0 million as of December 31,
2007.  Securities designated as available-for-sale decreased to $94.8
million at December 31, 2007, versus $142.6 million at December 31, 2006.
Securities designated as available-for-sale includes $11.9 million in Federal
Home Loan Bank of Seattle stock at December 31, 2007 and 2006. Securities
designated as held-to-maturity increased to $137.2 million at December 31, 2007,
from $96.8 million a year earlier. The securities in both portfolios consist of
notes issued by Government Sponsored Enterprises (“GSE” e.g. FHLB, FNMA) or
mortgage-backed securities issued by either FNMA or FHLMC or a mortgage conduit.
There were no investment securities that were backed by subprime loans and all
investments received the highest credit rating from at least one of the major
rating agencies.





Loan
Portfolio


Net loans
increased to $1.1 billion at December 31, 2007, a 9.7% increase over $996.0
million at December 31, 2006. Net loans were $867.0 million at December 31,
2005.


Business
banking loans increased from $442.4 million at December 31, 2006, to $468.5
million at December 31, 2007, a 5.9% increase. Growth in this portfolio was the
result of our ability to win new borrowing customers in a very competitive
market. Construction loans (net of loans in process) increased to $381.8 million
from $295.1 million during the year. This portfolio experienced solid growth as
the housing market remained relatively strong during the year. Commercial real
estate loans increased from $119.3 million at December 31, 2006, to $120.4
million at December 31, 2007. The Corporation’s loan focus remains on small
businesses, builders and developers in the Puget Sound Area. Construction
lending is directed toward building single-family housing and land development
for single-family housing. The Bank generally confines its lending to the Puget
Sound Region of Washington State.


Total
single-family residential loans increased from $91.3 million at December 31,
2006, to $98.4 million at December 31, 2007. The Corporation sells the vast
majority of its originations of 30-year fixed-rate loans, its 15-year fixed-rate
loans, and many of its conforming intermediate term hybrid adjustable rate
mortgages (“ARMs”) in the secondary mortgage market.


11


Multifamily
loans outstanding decreased from $34.7 million at December 31, 2006, to $11.4
million at December 31, 2007. The Corporation has de-emphasized this product
line due to intense pricing pressure, so loan payoffs were not replaced with the
same category of loan.


Consumer
loans remained flat at $27.7 million as of December 31, 2007. The Bank’s
consumer loan portfolio is comprised of home equity loans and lines of credit,
installment loans, and credit card loans. Home equity loans generally take the
form of a second mortgage. In terms of direct consumer loans, the Bank has not
emphasized this line of business, concluding that it is at a competitive
disadvantage against the very aggressive pricing of large banks, captive finance
companies and the specialty credit card issuers.





The
chart below indicates the mix of the loan portfolio as of the dates
indicated:




DECEMBER
      31, 2007
              
              
              DECEMBER
      31, 2006
              
              
              DECEMBER
      31, 2005(Dollars
      in thousands)
              
              AMOUNT
              
              
              PERCENT
              
              
              AMOUNT
              
              
              PERCENT
              
              
              AMOUNT
              
              
              PERCENTBusiness
              
              $
              468,453
              
              
              
              42
              %
              
              $
              442,391
              
              
              
              44
              %
              
              $
              394,034
              
              
              
              45
              %Construction
              
              
              381,810
              
              
              
              34
              
              
              
              295,087
              
              
              
              29
              
              
              
              171,964
              
              
              
              20Commercial
      real estate
              
              
              120,421
              
              
              
              11
              
              
              
              119,298
              
              
              
              12
              
              
              
              141,109
              
              
              
              16Core
      commercial loans
              
              
              970,684
              
              
              
              87
              
              
              
              856,776
              
              
              
              85
              
              
              
              707,107
              
              
              
              81Residential
              
              
              98,384
              
              
              
              9
              
              
              
              91,256
              
              
              
              10
              
              
              
              89,422
              
              
              
              10Consumer
              
              
              27,688
              
              
              
              3
              
              
              
              27,686
              
              
              
              2
              
              
              
              32,160
              
              
              
              3Multifamily
              
              
              11,397
              
              
              
              1
              
              
              
              34,719
              
              
              
              3
              
              
              
              52,057
              
              
              
              6Total
      loans
              
              
              1,108,153
              
              
              
              100
              %
              
              
              1,010,437
              
              
              
              100
              %
              
              
              880,746
              
              
              
              100
              %Deferred
      loan fees, net
              
              
              (3,724
              )
              
              
              
              
              
              
              (3,434
              )
              
              
              
              
              
              
              (3,443
              )Allowance
      for losses on loans
              
              
              (11,653
              )
              
              
              
              
              
              
              (10,988
              )
              
              
              
              
              
              
              (10,254
              )Loans,
      net
              
              $
              1,092,776
              
              
              
              
              
              
              $
              996,015
              
              
              
              
              
              
              
              867,049




Allowance
for Loan Losses


Management
provides for possible loan losses by maintaining an allowance. The allowance for
loan losses reflects management’s best estimate of probable losses as of a
particular balance sheet date, but there is no guarantee that management’s
estimate will be sufficient to cover actual loan losses. The allowance for loan
losses is maintained at a level considered adequate based on management’s
assessment of various factors affecting the loan portfolio, including
delinquencies, trends in credit quality, local economic conditions, growth of
the loan portfolio, past loss experience, and the portfolio’s composition.
Increases in the allowance for loan losses made through provisions primarily
reflect loan growth, loan loss risks inherent in lending, and the impact of the
economic climate on the loan portfolio.


Management
determines the amount of the allowance for loan losses by utilizing a loan
grading system to determine risk in the loan portfolio and by considering the
results of credit reviews. The loan portfolio is separated by quality and then
by loan type. Loans of acceptable quality are evaluated as a group, by loan
type, with a specific loss rate assigned to the total loans in each type, but
unallocated to any individual loan. Conversely, each adversely classified loan
is individually analyzed to determine an estimated loss amount. A valuation
allowance is also assigned to these adversely classified loans, but at an
assumed higher reserve rate due to the greater risk of loss. Past due and
impaired loans are actively managed to minimize the potential loss of
principal.


At
December 31, 2007, the allowance for loan losses was $11.7 million (1.05% of
total loans) compared to $11.0 million (1.09% of total loans) at December 31,
2006, and $10.3 million (1.16% of total loans) at December 31, 2005. During
2007, the Corporation added $1.4 million to the allowance compared to $1.0
million in 2006 and $945,000 in 2005.  In 2007, the Bank segregated a
valuation reserve against off-balance sheet commitments, such as loans in
process.  As of December 31, 2007, that valuation reserve account was
$142,000.  Total allowance for loan losses, which includes the
allowance for off-balance sheet commitments, was $11.8 million (1.06% of total
loans) as of December 31, 2007.


Net
loan charge-offs were $543,000 in 2007 (or 0.05% of average loans outstanding)
compared to $266,000 in 2006 (or 0.03% of average loans outstanding). Net
charge-offs were $254,000 (or 0.03% of average loans outstanding) for the year
ended December 31, 2005. The coverage ratio (the allowance for loan losses to
nonperforming loans) was 765% at December 31, 2007, 1,291% at December 31, 2006,
and 516% at December 31, 2005.  Including the allowance for
off-balance sheet commitments, the coverage ratio was 774% at December 31,
2007.





Deposit
Accounts


Deposit
accounts totaled $904.9 million at December 31, 2007, an increase of $49.5
million or 5.8% over $855.4 million at December 31, 2006. Deposits totaled
$795.8 million at December 31, 2005. Checking account balances were $138.2
million as of December 31, 2007, compared to $139.5 million in the prior year.
With the High Performance Checking program, the Bank was able to maintain its
totals even as checking balances declined on a national basis. Money market
deposit account balances grew by 14.8% to $316.0 million with rates competitive
with those offered by money market funds. Certificates of deposit increased 3.3%
to $439.4 million. As business banking activity increases, management’s goal is
to increase its noninterest-bearing or low interest accounts through the growth
of commercial checking accounts.


12


The
market for deposits has remained very competitive. It remains a key objective of
the Bank to increase its demand deposit account balances and other low rate
accounts.





Other
Borrowings


The Bank
uses Federal Home Loan Bank of Seattle (“FHLB”) advances to provide intermediate
and longer term funding, as well as to augment deposits. At December 31, 2007,
the Bank had $231.0 million in FHLB advances compared to $243.0 million as of
December 31, 2006. For 2007, FHLB advances averaged 16.0% of assets compared to
18.6% in 2006. Subject to its Line of Credit with the FHLB, the availability of
collateral, and the parameters of liquidity management, the Bank will continue
to use advances as a funding source.


The
Bank also uses repurchase agreements for funding. At December 31, 2007, the Bank
had executed $120.6 million in repurchase agreements compared to $95.7 million a
year earlier. In 2000, the Corporation issued $10.3 million in trust preferred
securities, which are termed “junior subordinated debentures payable.” These
junior subordinated debentures payable have a fixed rate of 11% and mature on
March 1, 2030, but are callable at a premium beginning March 1, 2010. In
December 2004, the Corporation issued an additional $5.2 million in junior
subordinated debentures payable. These debentures have a fixed rate of 5.82% for
the first 5 years and then float at the three-month LIBOR plus 1.90% for the
remaining 25 years. The debentures are callable at par after 5 years. On March
30, 2006, the Corporation issued an additional $10.3 million in junior
subordinated debentures payable. These debentures have an initial rate of 6.65%
set for 5 years and then convert to a three-month LIBOR plus 1.40% for the
remaining 25 years. The debentures are callable at par after 5 years. Junior
subordinated debentures payable are considered Tier 1 capital by financial
institution regulators.





Capital


Banking
regulations require the Bank to maintain minimum levels of capital. As of
December 31, 2007, the Bank remained a “well-capitalized” institution (the
FDIC’s highest rating), under regulatory guidelines, with a core
capital-to-asset ratio of 9.00% and a risk-based capital-to-asset ratio of
10.91%. The Bank’s regulatory capital ratios are discussed in more detail in
Note 12 of the Notes to Consolidated Financial Statements.


Federal
Reserve guidelines require the Corporation, on a consolidated basis, to maintain
minimum levels of capital as well. At December 31, 2007, the Corporation's total
risk-based capital to risk-weighted assets was 10.80%, compared to 11.22% at
December 31, 2006, and 10.86% at December 31, 2005. The Corporation projects
that earnings retention and existing capital will be sufficient to fund
anticipated asset growth and the existing level of cash dividends, while
maintaining a “well-capitalized” designation under the FDIC and Federal Reserve
guidelines. The Corporation has paid its shareholders a cash dividend on a
quarterly basis since 2002. Average shares outstanding, stock options, net
income per share and book value per share for all periods presented have been
retroactively adjusted to reflect stock splits. For the year, the Corporation
returned $4.1 million in dividends to its shareholders compared to $3.7 million
in 2006. The dividend payout ratio (the ratio of dividends paid to net income)
for 2007 was 26%.


The
Corporation is committed to managing capital for maximum shareholder benefit and
maintaining protection for depositors and creditors. The Corporation manages
various capital levels at both the holding company and subsidiary bank level to
attempt to maintain adequate capital ratios and levels in accordance with
external regulations and capital guidelines established by the Board of
Directors.





RESULTS
OF OPERATIONS


Earnings


Cascade
Financial Corporation earned net income for the year ended December 31, 2007, of
$15.5 million, an increase of 16.4% over the $13.4 million net income in the
year ended December 31, 2006. Earnings per fully diluted share (EPS) were $1.27
in 2007 and $1.08 in 2006. Higher net interest income due to increased earning
assets and an expanded net interest margin contributed to the improved results.
Income was also enhanced by increased checking fees and other service fees, and
fair value gains on items subject to mark to market accounting, which partially
offset the decline in gains on the sale of loans and the decline in other
income. The Corporation earned net income of $13.0 million or $1.06 per fully
diluted share for the fiscal year ended December 31, 2005.





Return
on Average Equity


Return on
average equity for the year ended December 31, 2007, was 13.23% compared to
12.24% for the same period of 2006. Return on average equity for the fiscal year
ending December 31, 2005 was 13.13%.




Return
on Average Tangible Equity


Return on
average tangible equity (average equity less average goodwill) was 16.88%
compared to 16.08% in 2006, and 17.82% in 2005. The June 2004 acquisition of
Issaquah Bancshares, Inc. (“Issaquah”) generated $26.3 million in goodwill and
intangibles as assets and a like amount of capital. Eliminating the average
intangible asset and reducing the capital by the same amount produces average
tangible equity.


Return
on average tangible equity is determined by methods other than those in
accordance with accounting principles generally accepted in the United States of
America (“GAAP”). This measure excludes the average balance of
acquisition-related goodwill and intangibles in determining average tangible
shareholders’ equity. Management believes the presentation of this financial
measure, excluding the impact of these items, provides useful supplemental
information that is essential for a proper understanding of the financial
results of Cascade


13


Financial
Corporation. This disclosure should not be viewed as a substitute for results
determined to be in accordance with GAAP, nor is it necessarily comparable to
non-GAAP performance measures that may be presented by other
companies.





A summary
of tangible equity follows:




(Dollars
      in thousands)
              
              2007
              
              
              2006Net
      income
              
              $
              15,546
              
              
              $
              13,355Average
      equity
              
              $
              117,534
              
              
              $
              109,103Average
      goodwill & intangibles
              
              
              25,439
              
              
              
              26,040Average
      tangible equity
              
              $
              92,095
              
              
              $
              83,063Return
      on average tangible equity
              
              
              16.88
              %
              
              
              16.08
              %
  Net
Interest Income


The
largest component of the Corporation’s earnings is net interest income. Net
interest income is the difference between interest earned on earning assets
(primarily loans, interest-bearing deposits with banks, and investment
securities) and the interest expense associated with interest-bearing
liabilities (deposits and borrowings). Interest earned and interest paid is
affected by general economic conditions, including the demand for loans, cost of
deposits, market rates of interest and government policies. The Corporation’s
operations may be sensitive to changes in interest rates and the resulting
impact on net interest income.


Net
interest income for the year ended December 31, 2007, increased by 10.2%, or
$4.0 million, to $43.4 million from $39.4 million for the year ended December
31, 2006. The improvement in net interest income was primarily due to the growth
in our level of average earning assets of $90.8 million and an 8 basis point
increase in the net interest margin. Net interest income for the fiscal year
ended December 31, 2005 was $36.5 million.


Average
earning assets increased 7.5% to $1.3 billion for the year ended December 31,
2007, from $1.2 billion for the year ended December 31, 2006. Average earning
assets were $1.1 billion for the year ended December 31, 2005.


Net
interest margin is net interest income expressed as a percent of average earning
assets. The net interest margin for the year ended December 31, 2007, was 3.34%,
compared to 3.26% for the year ended December 31, 2006. While the yield on
assets has improved over the last year, liability costs have also increased. The
yield on earning assets increased 39 basis points to 7.24% in 2007. The cost of
interest-bearing liabilities increased 37 basis points to 4.38% for the year as
new liabilities were generally booked at higher rates than the average cost of
existing liabilities.





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 YEARS ENDED DECEMBER 31,2007
              
              
              2006
              
              
              2005(Dollars
      in thousands)
              
              AVERAGE
      BALANCE
              
              INTEREST
                AND
                DIVIDEND
              
              YIELD/
                COST
              
              
              AVERAGE
      BALANCE
              
              INTEREST
                AND
                DIVIDEND
              
              YIELD/
                COST
              
              
              AVERAGE
      BALANCE
              
              INTEREST
                AND
                DIVIDEND
              
              
              YIELD
      /
                COSTASSETSInterest-earning
      assets (1)Residential
      loans
              
              $
              94,608
              
              $
              5,753
              
              6.08
              %
              
              $
              98,476
              
              $
              5,582
              
              5.67
              %
              
              $
              104,789
              
              $
              5,882
              
              
              5.61
              %Multifamily
      loans
              
              
              18,467
              
              
              1,416
              
              7.67
              
              
              
              42,574
              
              
              2,863
              
              6.72
              
              
              
              74,650
              
              
              4,910
              
              
              6.58Commercial
      real estate loans
              
              
              117,952
              
              
              8,259
              
              7.00
              
              
              
              144,094
              
              
              9,821
              
              6.82
              
              
              
              166,736
              
              
              10,957
              
              
              6.57Construction
      loans
              
              
              332,467
              
              
              30,094
              
              9.05
              
              
              
              214,290
              
              
              19,376
              
              9.04
              
              
              
              133,975
              
              
              10,199
              
              
              7.61Consumer
      loans
              
              
              27,575
              
              
              2,128
              
              7.72
              
              
              
              30,064
              
              
              2,304
              
              7.66
              
              
              
              31,352
              
              
              2,210
              
              
              7.05Business
      banking loans
              
              
              455,024
              
              
              33,908
              
              7.45
              
              
              
              426,194
              
              
              31,158
              
              7.31
              
              
              
              343,182
              
              
              23,441
              
              
              6.83Total
      loans
              
              
              1,046,093
              
              
              81,558
              
              7.80
              
              
              
              955,692
              
              
              71,104
              
              7.44
              
              
              
              854,684
              
              
              57,599
              
              
              6.74Securitiesavailable-for-sale
              
              
              102,613
              
              
              4,828
              
              4.71
              
              
              
              148,917
              
              
              6,735
              
              4.52
              
              
              
              134,157
              
              
              5,582
              
              
              4.16Securities
      held-to-maturity
              
              
              88,535
              
              
              4,527
              
              5.11
              
              
              
              96,668
              
              
              4,563
              
              4.72
              
              
              
              93,069
              
              
              4,306
              
              
              4.63Securities
      held-for-trading
              
              
              38,614
              
              
              1,884
              
              4.88
              
              
              
              -
              
              
              -
              
              -
              
              
              
              -
              
              
              -
              
              
              -Daily
      interest-earning deposits
              
              
              21,607
              
              
              1,138
              
              5.27
              
              
              
              5,356
              
              
              256
              
              4.78
              
              
              
              6,912
              
              
              315
              
              
              4.56Total
      securities and interest-earning deposits
              
              
              251,369
              
              
              12,377
              
              4.92
              
              
              
              250,941
              
              
              11,554
              
              4.60
              
              
              
              234,138
              
              
              10,203
              
              
              4.36Total
      interest-earning assets
              
              
              1,297,462
              
              
              93,935
              
              7.24
              
              
              
              1,206,633
              
              
              82,658
              
              6.85
              
              
              
              1,088,822
              
              
              67,802
              
              
              6.23Noninterest-earning
      assetsOffice
      properties andequipment, net
              
              
              13,744
              
              
              
              
              
              
              
              
              12,093
              
              
              
              
              
              
              
              
              12,741Real
      estate, net
              
              
              -
              
              
              
              
              
              
              
              
              -
              
              
              
              
              
              
              
              
              328Other
      noninterest-earning assets
              
              
              59,103
              
              
              
              
              
              
              
              
              56,830
              
              
              
              
              
              
              
              
              53,847Total
      assets
              
              $
              1,370,309
              
              
              
              
              
              
              
              $
              1,275,556
              
              
              
              
              
              
              
              $
              1,155,738


14


FOR
      THE YEARS ENDED DECEMBER 31,2007
            
            
            2006
            
            
            2005(Dollars
      in thousands)
            
            AVERAGE
              BALANCE
            
            
            INTEREST
              AND
              DIVIDEND
            
            YIELD/
              COST
            
            
            AVERAGE
              BALANCE
            
            
            INTEREST
              AND
              DIVIDEND
            
            YIELD/
              COST
            
            
            AVERAGE
              BALANCE
            
            
            INTEREST
              AND
              DIVIDEND
            
            
            YIELD/
              COSTLIABILITIES
      AND EQUITYInterest-bearing
      liabilitiesSavings
      accounts
            
            $
            13,261
            
            
            $
            66
            
            0.50
            %
            
            $
            14,748
            
            
            $
            75
            
            0.51
            %
            
            $
            15,465
            
            
            $
            67
            
            
            0.43
            %Checking
      accounts
            
            
            51,021
            
            
            
            747
            
            1.46
            
            
            
            45,039
            
            
            
            656
            
            1.46
            
            
            
            39,618
            
            
            
            245
            
            
            0.62Money
      market accounts
            
            
            284,843
            
            
            
            12,314
            
            4.32
            
            
            
            229,788
            
            
            
            8,505
            
            3.70
            
            
            
            170,641
            
            
            
            3,255
            
            
            1.91Certificates
      of deposit
            
            
            444,726
            
            
            
            22,093
            
            4.97
            
            
            
            446,437
            
            
            
            19,339
            
            4.33
            
            
            
            467,388
            
            
            
            14,747
            
            
            3.16Total
      interest-bearing deposits
            
            
            793,851
            
            
            
            35,220
            
            4.44
            
            
            
            736,012
            
            
            
            28,575
            
            3.88
            
            
            
            693,112
            
            
            
            18,314
            
            
            2.64Other
      interest-bearing liabilitiesFHLB
      advances
            
            
            226,124
            
            
            
            10,240
            
            4.53
            
            
            
            237,888
            
            
            
            11,194
            
            4.71
            
            
            
            239,896
            
            
            
            11,031
            
            
            4.60Other
      interest-bearing liabilities
            
            
            134,410
            
            
            
            5,080
            
            3.78
            
            
            
            104,085
            
            
            
            3,499
            
            3.36
            
            
            
            39,495
            
            
            
            1,931
            
            
            4.89Total
      interest-bearing liabilities
            
            
            1,154,385
            
            
            
            50,540
            
            4.38
            
            
            
            1,077,985
            
            
            
            43,268
            
            4.01
            
            
            
            972,503
            
            
            
            31,276
            
            
            3.22Other
      liabilities
            
            
            98,390
            
            
            
            
            
            
            
            
            
            88,468
            
            
            
            
            
            
            
            
            
            83,865Total
      liabilities
            
            
            1,252,775
            
            
            
            
            
            
            
            
            
            1,166,453
            
            
            
            
            
            
            
            
            
            1,056,368Stockholders’
      equity
            
            
            117,534
            
            
            
            
            
            
            
            
            
            109,103
            
            
            
            
            
            
            
            
            
            99,370Total
      liabilities and  stockholders’ equity
            
            $
            1,370,309
            
            
            
            
            
            
            
            
            $
            1,275,556
            
            
            
            
            
            
            
            
            $
            1,155,738Net interest income
      (2)
            
            
            
            
            
            $
            43,395
            
            
            
            
            
            
            
            
            $
            39,390
            
            
            
            
            
            
            
            
            $
            36,526Interest rate
      spread(3)
            
            
            
            
            
            
            
            
            2.86
            %
            
            
            
            
            
            
            
            
            2.84
            %
            
            
            
            
            
            
            
            
            
            3.01
            %Net interest margin
      (4)
            
            
            
            
            
            
            
            
            3.34
            %
            
            
            
            
            
            
            
            
            3.26
            %
            
            
            
            
            
            
            
            
            
            3.35
            %Average
      interest-earning assetsto
      average interest-bearingliabilities
            
            
            112.39
            %
            
            
            
            
            
            
            
            
            111.93
            %
            
            
            
            
            
            
            
            
            111.96
            %


(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.




Other
Income


Other
income is derived from sources other than interest and fees on earning assets.
The Corporation’s primary sources of other income are service charge fees on
deposit accounts, other service fees, the accretion of cash surrender value of
bank owned life insurance (“BOLI”), gains on the sale of single-family
residential and other loans, gains on the sale of securities, and rental income,
primarily on space at the building that formerly served as the headquarters of
Issaquah Bank. Other income for the year ended December 31, 2007, was $7.6
million, compared to $6.0 million and $6.3 million for the same periods in 2006
and 2005, respectively. In 2007, the implementation of Statement of Financial
Accounting Standards (“SFAS”) No. 159 resulted in $1.1 million of net fair value
gain.  There were no corresponding gains in 2006 or
2005.  The fair value of financial instruments is discussed in more
detail in Note 15 of the Notes to Consolidated Financial
Statements.





Other
Expense


Other
expense represents costs not associated with deposits and other interest-bearing
liabilities. It includes expenses associated with personnel, premises and
equipment, marketing, and other operations.


Other
expense increased by $2.1 million to $26.7 million for the year ended December
31, 2007, from $24.6 million and $22.6 million for 2006 and 2005, respectively.
Salaries and employee benefits increased overall by $1.1 million to $13.8
million during 2007 compared to the prior year. B&O tax increased $346,000
to $1.4 million and other expenses increased $410,000 to $6.7 million during
2007 compared to the prior year.


A
standard measurement used to calculate the overhead costs of financial
institutions is the efficiency ratio. The efficiency ratio is calculated by
dividing other expense by total revenue, which generally indicates how much an
institution spends to generate a dollar of revenue. The lower the efficiency
ratio, the more efficient the institution. For the years ending December 31,
2007, 2006, and 2005, the Corporation’s efficiency ratio was 52.36%, 54.14%, and
52.75%, respectively. Management continues to look for ways to improve the
efficiency ratio by increasing other income and net interest income while
diligently controlling costs and maintaining high standards of
service.





Liquidity
Management


Liquidity
is a term used to define the Corporation's ability to meet its financial
commitments. The Corporation is required by prudent business practice and its
regulators to maintain adequate levels of liquidity. The main liquidity
requirements are funding customer loan requests and deposit outflows of the
Bank. Primary sources of liquidity are cash and cash equivalents, which include
highly liquid investments. At December 31, 2007, December 31, 2006, and December
31, 2005, cash and cash equivalents totaled $14.5 million, $42.9 million,


15


and $31.1
million, respectively. Another source of liquidity is the Corporation’s
investment portfolio, which consists of investment-grade securities. These
securities are of the highest credit quality and can be sold or used as
collateral to secure borrowings.


The
primary source of borrowings are Federal Home Loan Bank of Seattle
(FHLB-Seattle) advances and repurchase agreements. At December 31, 2007, $264.7
million of additional borrowing capacity remained under the Bank’s existing
credit line from the FHLB-Seattle, which is 35% of the Bank’s assets. The use of
this Line of Credit is subject to the availability of eligible collateral, which
includes residential mortgages, investment grade securities, and commercial real
estate mortgages. At December 31, 2007, the Bank had unencumbered eligible
collateral of approximately $85.5 million to pledge against the line. In
addition, the Bank has the ability to borrow through repurchase agreements.
Under these agreements, borrowings are collateralized with mortgage-backed
securities or other investment securities.


The
Bank has Fed funds borrowing lines with three of its correspondent banks. The
Bank used each of these lines during the year. The Bank also has a Line of
Credit with the Federal Reserve Bank of San Francisco. As of December 31, 2007,
there were no outstanding balances on any of these lines.


Liquidity
management is of critical importance to the Bank in that it significantly relies
upon wholesale sources of funds (e.g. FHLB-Seattle advances). While these
sources have proven to be stable and reliable, an interruption in the
availability of these sources could have an adverse impact on the operations of
the Corporation. Also see the Consolidated Statement of Cash Flows in the
financial statement section of this filing for further information regarding
liquidity.





Interest
Rate Risk Management


Management
considers interest rate risk to be a significant market risk that could have a
material effect on the Corporation’s financial condition and results of
operations.


The
Corporation has taken steps to balance its sensitivity to changes in interest
rates by altering its asset and liability mix. The origination of floating-rate
loans such as business, construction and other prime-based loans is emphasized.
The vast majority of fixed-rate loans have repricing periods with a maximum of
five years. The mix of floating- and fixed-rates assets is designed to mitigate
the impact of rate changes on the Corporation’s net interest income. Virtually
all fixed-rate residential loans are sold into the secondary market. However,
the Bank has sought to add prepayment provisions to its newly originated loans
with 5 year fixed and adjustable rate loans. Many of the Bank’s fixed-rate loans
do not have such provisions for prepayment fees, and as a result, a drop in
rates can precipitate a refinancing of the Bank’s assets.


Interest
rate risk is monitored using several methodologies, principally financial
modeling. The earnings exposure to interest rate changes is evaluated in the
context of certain upward and downward interest rate changes occurring
instantaneously. At December 31, 2007, a 200 basis point increase in rates would
increase forecasted net interest income over a twelve-month period by
approximately 1.8%. A 200 basis point decrease in rates would decrease interest
income by 5.6% according to the model.


The
changes of the fair value of assets and liabilities and the resulting impact on
the fair value of equity are also modeled under different rate scenarios. In the
200 basis point increase scenario, the fair value of equity declines by $1.9
million or 1.2%, a 200 basis point decrease in rates would decrease the fair
value of equity by $34.6 million or 21.3%. Both are within the guideline
established by the Bank’s Asset/Liability Policy.


The
Corporation maintained a trading account for financial instruments during 2007,
however there was no balance as of December 31, 2007. Moreover, the Corporation
is not subject to foreign currency exchange rate risk or commodity price
risk.


The
individual categories of assets and liabilities that are subject to interest
rate sensitivity as of December 31, 2007, are shown in the following
table.




INTEREST REPRICING
      ASSUMPTIONS(Dollars
      in thousands)
            
            <1
      YEAR
            
            
            1-3
              YEARS
            
            
            3-5
              YEARS
            
            
            5-10
              YEARS
            
            
            10
      YEARS
              AND
      UP
            
            
            TOTAL
            
            
            FAIR
      VALUEInterest-Sensitive
      AssetsTotal
      loans
            
            $
            769,203
            
            
            $
            184,515
            
            
            $
            142,227
            
            
            $
            11,988
            
            
            $
            220
            
            
            $
            1,108,153
            
            
            $
            1,126,274Investments
      and  otherinterest-earning assets
            
            
            47,646
            
            
            
            20,426
            
            
            
            36,305
            
            
            
            102,551
            
            
            
            27,711
            
            
            
            234,639
            
            
            
            232,694Interest-Sensitive
      LiabilitiesChecking
      accounts
            
            $
            11,185
            
            
            $
            12,202
            
            
            $
            18,302
            
            
            $
            8,236
            
            
            $
            915
            
            
            $
            50,840
            
            
            $
            50,840Money
      market accounts
            
            
            311,214
            
            
            
            1,462
            
            
            
            2,194
            
            
            
            987
            
            
            
            110
            
            
            
            315,967
            
            
            
            315,967Savings
      accounts
            
            
            2,485
            
            
            
            2,711
            
            
            
            4,067
            
            
            
            1,830
            
            
            
            204
            
            
            
            11,297
            
            
            
            11,297Certificates
      of deposit
            
            
            401,800
            
            
            
            25,080
            
            
            
            3,016
            
            
            
            9,546
            
            
            
            -
            
            
            
            439,442
            
            
            
            442,262Borrowings
            
            
            142,625
            
            
            
            10,000
            
            
            
            35,000
            
            
            
            139,000
            
            
            
            25,000
            
            
            
            351,625
            
            
            
            364,499Junior
      subordinateddebentures payable
            
            
            -
            
            
            
            -
            
            
            
            15,465
            
            
            
            -
            
            
            
            10,310
            
            
            
            25,775
            
            
            
            26,887





Off-Balance
Sheet Arrangements: Credit Commitments


Commitments
to extend credit are agreements to lend to a customer as long as there is no
violation of any condition established in the contract. Commitments generally
have fixed expiration dates or other termination clauses and may require payment
of a fee. Since many of the commitments are expected to expire without being
drawn upon, the total commitment amounts do not necessarily represent future
cash requirements.


16


The
Bank underwrites its standby letters of credit using its policies and procedures
applicable to loans in general. Standby letters of credit are made on an
unsecured and secured basis. The Bank had not incurred any losses on its
commitments in 2007 or 2006.





A summary
of the notional amount of the Bank’s financial instruments with off-balance
sheet risk at December 31, 2007 follows:




(Dollars
      in thousands)
              
              TOTALCommitments
      to extend credit
              
              $
              308,753Standby
      letters of credit and financial guarantees written
              
              
              5,171Unused
      commitments on bankcards
              
              
              12,840Total
              
              $
              326,764
  Contractual
Obligations and Commitments


The
following table sets forth the Corporation’s long-term contractual
obligations:




PAYMENTS
      DUE PER PERIOD(Dollars
      in thousands)
              
              <1
      YEAR
              
              
              1-3
      YEARS
              
              
              3-5
      YEARS
              
              
              THEREAFTER
              
              
              TOTALCertificates
      of deposit
              
              $
              401,800
              
              
              $
              25,080
              
              
              $
              3,016
              
              
              $
              9,546
              
              
              $
              439,442Federal
      Home Loan Bank advances
              
              
              2,000
              
              
              
              10,000
              
              
              
              50,000
              
              
              
              169,000
              
              
              
              231,000Operating
      lease obligations
              
              
              813
              
              
              
              1,541
              
              
              
              1,463
              
              
              
              7,445
              
              
              
              11,262Junior
      subordinated debentures payable
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              26,887
              
              
              
              26,887Total
              
              $
              404,613
              
              
              $
              36,621
              
              
              $
              54,479
              
              
              $
              212,878
              
              
              $
              708,591
  At
December 31, 2007, the Corporation’s long-term contractual obligations related
to debt totaled $257.9 million. See additional discussion under Notes 7 and 8 to
the Consolidated Financial Statements for the year ended December 31,
2007.


The
Corporation also has operating leases comprised of leases for office
space.





Summation
of Factors That May Affect Financial Condition and Future Results


Credit risk: The most
significant risk that may impact Cascade Financial Corporation would be
deterioration in the quality of the loan portfolio. The Corporation’s loan
growth has been focused on commercial lending. While it has not been the
Corporation’s experience, historically for the banking industry, commercial
loans have higher levels of losses than residential loans. The Corporation’s
ability to meet its profitability and growth goals would be severely compromised
with a large number of impaired credits. In addition, the Corporation and its
subsidiary, Cascade Bank, could face regulatory restrictions on its
activities.


Interest
rate risk:While the Corporation actively manages its exposure to changes
in interest rates, volatile interest rates and/or changes in the shape of the
yield curve could have a meaningful impact on the Corporation’s net income. Many
of the assets and liabilities of the Corporation have embedded options, which
add another layer of complexity in its interest rate risk management
practices.


Liquidity:
Disruptions in the capital markets could have a major impact on the
Corporation’s net income and balance sheet. As a user of Federal Home Loan Bank
advances, repurchase agreements and brokered CDs, interruption or truncation of
these sources of funds could force the Corporation to liquidate assets at an
inauspicious time or curtail lending activity, which could adversely affect
customer relationships.


Recently issued accounting
pronouncements: In December 2004, the FASB issued No. 123(R), Share-Based Payment, which is
a revision of No. 123, Accounting for Stock-Based
Compensation. Statement 123(R) supersedes the Accounting Principles Board
(“APB”) Opinion No. 25, which the Corporation had used to report stock options
granted to employees and directors. Statement 123(R) requires all share-based
payments to employees, including stock options, be recognized in the income
statement based on their fair values.





Available
Information


A copy of
the Corporation’s annual report on Form 10-K, quarterly reports on Form 10-Q,
current reports on Form 8-K, and all amendments to such reports filed pursuant
to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, are available
free of charge on or through our website located at www.cascadebank.com as soon
as reasonably practicable after filing with the United States Securities and
Exchange Commission. These reports are also available to shareholders, at no
charge, upon written request to the Secretary of Cascade Financial Corporation
at 2828 Colby Avenue, Everett, Washington 98201.


17


Report of Independent Registered Public Accounting
Firm





The Board
of Directors Cascade
Financial Corporation:





We have
audited the accompanying consolidated balance sheets of Cascade Financial
Corporation and Subsidiaries (the Corporation) as of December 31, 2007 and 2006,
and the related consolidated statements of income, stockholders' equity and
comprehensive income, and cash flows for each of the years in the three-year
period ended December 31, 2007. We also have audited the Corporation’s internal
control over financial reporting as of December 31, 2007, based on criteria
established in Internal Control - Integrated Framework issued by the Committee
of Sponsoring Organizations of the Treadway Commission (COSO). The Corporation’s
management is responsible for these financial statements, for maintaining
effective internal control over financial reporting, and for its assessment of
the effectiveness of internal control over financial reporting included in the
accompanying Report of Management on Internal Control over Financial Reporting.
Our responsibility is to express an opinion on these financial statements and an
opinion on the effectiveness of the Corporation's internal control over
financial reporting based on our audits.





We
conducted our audits in accordance with auditing standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audits to obtain reasonable assurance about whether the
financial statements are free of material misstatement and whether effective
internal control over financial reporting was maintained in all material
respects. Our audits of the financial statements included examining, on a test
basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement
presentation.  Our audit of internal control over financial reporting
included obtaining an understanding of internal control over financial
reporting, assessing the risk that a material weakness exists, and testing and
evaluating the design and operating effectiveness of internal control based on
the assessed risks.  Our audits also included performing such other
procedures as we considered necessary in the circumstances. We believe that our
audits provide a reasonable basis for our opinions.





A
company's internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles. A company's internal control over
financial reporting includes those policies and procedures that (1) pertain to
the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the company; (2)
provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the company's
assets that could have a material effect on the financial
statements.





Because
of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.





In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the consolidated financial position of Cascade
Financial Corporation and Subsidiaries as of December 31, 2007 and 2006, and the
results of their operations and their cash flows for each of the years in the
three-year period ended December 31, 2007, in conformity with accounting
principles generally accepted in the United States of America. Also in our
opinion, Cascade Financial Corporation maintained, in all material respects,
effective internal control over financial reporting as of December 31, 2007,
based on criteria established in Internal Control - Integrated Framework issued
by the Committee of Sponsoring Organizations of the Treadway Commission
(COSO).





As
discussed in Note 7 to the consolidated financial statements, effective January
1, 2007, the Corporation adopted Statement of Financial Accounting Standards No.
159, The Fair Value Option for
Financial Assets and Financial Liabilities and No. 157, Fair Value
Measurements.







Everett,
Washington


March 12,
2008


18


CASCADE
FINANCIAL CORPORATION AND SUBSIDIARIES


Consolidated
Balance Sheets


December
31, 2007, and 2006




DECEMBER
      31,(Dollars
      in thousands, except share amounts)
            
            2007
            
            
            2006ASSETSCash
      on hand and in banks
            
            $
            12,911
            
            
            $
            23,707Interest-bearing
      deposits in other financial institutions
            
            
            1,619
            
            
            
            19,172Securities
      available-for-sale, fair value
            
            
            82,860
            
            
            
            130,656Securities
      held-to-maturity, amortized cost
            
            
            137,238
            
            
            
            96,846Federal
      Home Loan Bank (FHLB) stock
            
            
            11,920
            
            
            
            11,920Loans,
      net
            
            
            1,092,776
            
            
            
            996,015Goodwill
            
            
            24,585
            
            
            
            25,195Core
      deposit intangible, net
            
            
            634
            
            
            
            775Premises
      and equipment, net
            
            
            14,160
            
            
            
            12,003Cash
      surrender value of bank owned life insurance (BOLI)
            
            
            22,658
            
            
            
            17,974Accrued
      interest receivable and other assets
            
            
            16,227
            
            
            
            10,991Total
      assets
            
            $
            1,417,588
            
            
            $
            1,345,254LIABILITIES
      AND STOCKHOLDERS’ EQUITYLiabilities:Deposits
            
            $
            904,896
            
            
            $
            855,449FHLB
      advances
            
            
            231,000
            
            
            
            243,000Securities
      sold under agreements to repurchase
            
            
            120,625
            
            
            
            95,710Junior
      subordinated debentures payable
            
            
            15,465
            
            
            
            25,775Junior
      subordinated debentures payable, fair value
            
            
            11,422
            
            
            
            —Advance
      payments by borrowers for taxes and insurance
            
            
            502
            
            
            
            703Dividends
      payable
            
            
            1,082
            
            
            
            967Accrued
      interest payable, expenses, and other liabilities
            
            
            10,500
            
            
            
            8,451Total
      liabilities
            
            
            1,295,492
            
            
            
            1,230,055Stockholders’
      equity:Preferred
      stock, $.01 par value. Authorized 500,000 shares; no shares issued or
      outstandingCommon
      stock, $.01 par value. Authorized 25,000,000 shares; issued and
      outstanding 12,023,685 shares at December 31, 2007,
              and
      12,093,699 shares at December 31, 2006
            
            
            120
            
            
            
            121Additional
      paid-in capital
            
            
            40,322
            
            
            
            39,430Retained
      earnings, substantially restricted
            
            
            82,169
            
            
            
            77,952Accumulated
      other comprehensive loss
            
            
            (515
            )
            
            
            (2,304
            )Total
      stockholders’ equity
            
            
            122,096
            
            
            
            115,199Total
      liabilities and stockholders’ equity
            
            $
            1,417,588
            
            
            $
            1,345,254




(See accompanying notes to
consolidated financial statements.)


19


CASCADE
FINANCIAL CORPORATION AND SUBSIDIARIES


Consolidated
Statements of Income


Years
ended December 31, 2007, 2006, and 2005





YEARS
      ENDEDDECEMBER
      31,(Dollars
      in thousands, except share amounts)
            
            2007
            
            
            2006
            
            
            2005Interest
      income:Loans
            
            $
            81,558
            
            
            $
            71,104
            
            
            $
            57,599Securities
      held-for-trading
            
            
            1,884
            
            
            
            —
            
            
            
            —Securities
      available-for-sale
            
            
            4,756
            
            
            
            6,723
            
            
            
            5,534Securities
      held-to-maturity
            
            
            4,527
            
            
            
            4,563
            
            
            
            4,306FHLB
      dividends
            
            
            72
            
            
            
            12
            
            
            
            48Interest-bearing
      deposits
            
            
            1,138
            
            
            
            256
            
            
            
            315Total
      interest income
            
            
            93,935
            
            
            
            82,658
            
            
            
            67,802Interest
      expense:Deposits
            
            
            35,220
            
            
            
            28,576
            
            
            
            18,314FHLB
      advances
            
            
            10,240
            
            
            
            11,193
            
            
            
            11,031Securities
      sold under agreements to repurchase
            
            
            2,960
            
            
            
            1,619
            
            
            
            733Junior
      subordinated debentures payable
            
            
            2,120
            
            
            
            1,880
            
            
            
            1,198Total
      interest expense
            
            
            50,540
            
            
            
            43,268
            
            
            
            31,276Net
      interest income
            
            
            43,395
            
            
            
            39,390
            
            
            
            36,526Provision
      for loan losses
            
            
            1,350
            
            
            
            1,000
            
            
            
            945Net
      interest income after provision for loan losses
            
            
            42,045
            
            
            
            38,390
            
            
            
            35,581Other
      income:Gain
      on sale of loans
            
            
            199
            
            
            
            483
            
            
            
            865(Loss)
      gain on sale of securities available-for-sale, net
            
            
            (435
            )
            
            
            —
            
            
            
            67Net
      gain on fair value of financial instruments
            
            
            1,081
            
            
            
            —
            
            
            
            —Net
      gain on FHLB advances
            
            
            569
            
            
            
            —
            
            
            
            —(Loss)
      gain on sale of REO, net
            
            
            —
            
            
            
            (27
            )
            
            
            33Checking
      service fees
            
            
            3,820
            
            
            
            3,311
            
            
            
            3,124Other
      service fees
            
            
            1,059
            
            
            
            1,156
            
            
            
            916BOLI
            
            
            803
            
            
            
            769
            
            
            
            764Other
            
            
            470
            
            
            
            334
            
            
            
            564Total
      other income
            
            
            7,566
            
            
            
            6,026
            
            
            
            6,333Other
      expenses:Salaries
      and employee benefits
            
            
            13,817
            
            
            
            12,691
            
            
            
            12,114Occupancy
            
            
            3,576
            
            
            
            3,450
            
            
            
            3,323Marketing
            
            
            1,182
            
            
            
            1,094
            
            
            
            810B&O
      tax
            
            
            1,373
            
            
            
            1,027
            
            
            
            713Other
            
            
            6,734
            
            
            
            6,324
            
            
            
            5,646Total
      other expenses
            
            
            26,682
            
            
            
            24,586
            
            
            
            22,606Income
      before provision for income taxes
            
            
            22,929
            
            
            
            19,830
            
            
            
            19,308Provision
      for income taxes
            
            
            7,383
            
            
            
            6,475
            
            
            
            6,262Net
      income
            
            $
            15,546
            
            
            $
            13,355
            
            
            $
            13,046Net
      income per common share, basic
            
            $
            1.29
            
            
            $
            1.11
            
            
            $
            1.09Weighted
      average number of shares outstanding, basic
            
            
            12,047,792
            
            
            
            12,060,191
            
            
            
            11,977,824Net
      income per share, diluted
            
            $
            1.27
            
            
            $
            1.08
            
            
            $
            1.06Weighted
      average number of shares outstanding, diluted
            
            
            12,284,854
            
            
            
            12,363,198
            
            
            
            12,319,873


(See accompanying notes to
consolidated financial statements.)


20


CASCADE
FINANCIAL CORPORATION AND SUBSIDIARIES


Consolidated
Statements of Stockholders’ Equity and Comprehensive Income


Years
ended December 31, 2007, 2006, and 2005




Consolidated
      Statement of Stockholders’ Equity(Dollars
      in thousands, except share amounts)
                
                SHARES
                
                
                COMMON STOCK
                
                
                ADDITIONAL
                  PAID-IN CAPITAL
                
                
                RETAINED
                  EARNINGS
                
                
                ACCUMULATED
                  OTHER COMPREHENSIVE
                  INCOME
                  (LOSS), NET
                
                
                TOTAL
                  STOCK-HOLDERS’
                  EQUITYBalances
      at December 31, 2004
                
                
                9,559,822
                
                
                $
                96
                
                
                $
                37,326
                
                
                $
                59,975
                
                
                $
                (1,147
                )
                
                $
                96,250Cash
      dividends
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                (3,260
                )
                
                
                —
                
                
                
                (3,260
                )Options
      exercised, including related tax benefit
                
                
                81,019
                
                
                
                —
                
                
                
                803
                
                
                
                —
                
                
                
                —
                
                
                
                803Net
      income
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                13,046
                
                
                
                —
                
                
                
                13,046Shares
      repurchased
                
                
                (40,953
                )
                
                
                —
                
                
                
                (42
                )
                
                
                (816
                )
                
                
                —
                
                
                
                (858
                )Other
      comprehensive loss, net of tax (benefit)
                  of
      $(457)
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                (850
                )
                
                
                (850
                )Issaquah
      merger
                
                
                3,899
                
                
                
                —
                
                
                
                62
                
                
                
                —
                
                
                
                —
                
                
                
                62Balances
      at December 31, 2005
                
                
                9,603,787
                
                
                
                96
                
                
                
                38,149
                
                
                
                68,945
                
                
                
                (1,997
                )
                
                
                105,193Stock
      split (5-for-4)
                
                
                2,410,282
                
                
                
                24
                
                
                
                (33
                )
                
                
                —
                
                
                
                —
                
                
                
                (9
                )Cash
      dividends
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                (3,706
                )
                
                
                —
                
                
                
                (3,706
                )Options
      exercised, including related tax benefit
                
                
                122,920
                
                
                
                1
                
                
                
                1,058
                
                
                
                —
                
                
                
                —
                
                
                
                1,059Stock
      compensation expense net of tax benefit
                
                
                —
                
                
                
                —
                
                
                
                287
                
                
                
                —
                
                
                
                —
                
                
                
                287Net
      income
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                13,355
                
                
                
                —
                
                
                
                13,355Shares
      repurchased
                
                
                (43,290
                )
                
                
                —
                
                
                
                (31
                )
                
                
                (642
                )
                
                
                —
                
                
                
                (673
                )Other
      comprehensive loss, net of tax (benefit)
                  of
      $(165)
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                (307
                )
                
                
                (307
                )Balances
      at December 31, 2006
                
                
                12,093,699
                
                
                
                121
                
                
                
                39,430
                
                
                
                77,952
                
                
                
                (2,304
                )
                
                
                115,199Adoption
      of fair value option
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                (4,532
                )
                
                
                —
                
                
                
                (4,532
                )Cash
      dividends
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                (4,094
                )
                
                
                —
                
                
                
                (4,094
                )Options
      exercised, including related tax benefit
                
                
                108,818
                
                
                
                —
                
                
                
                813
                
                
                
                —
                
                
                
                —
                
                
                
                813Stock
      compensation expense net of tax benefit
                
                
                —
                
                
                
                —
                
                
                
                213
                
                
                
                —
                
                
                
                —
                
                
                
                213Net
      income
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                15,546
                
                
                
                —
                
                
                
                15,546Shares
      repurchased
                
                
                (178,832
                )
                
                
                (1
                )
                
                
                (134
                )
                
                
                (2,703
                )
                
                
                —
                
                
                
                (2,838
                )Other
      comprehensive income,net of tax
                  provision
      of $963
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                1,789
                
                
                
                1,789Balances
      at December 31, 2007
                
                
                12,023,685
                
                
                $
                120
                
                
                $
                40,322
                
                
                $
                82,169
                
                
                $
                (515
                )
                
                $
                122,096


Consolidated
      Statement of Comprehensive IncomeYEARS
      ENDED DECEMBER 31,2007
            
            
            2006
            
            
            2005Net
      income
            
            $
            15,546
            
            
            $
            13,355
            
            
            $
            13,046Unrealized
      gain (loss) on securities available-for-sale, netof tax provision
      (benefit) of $953, $(165) and $(499)
            
            
            1,771
            
            
            
            (307
            )
            
            
            (927
            )Unrealized
      (loss) on swaps available-for-sale, net of taxprovision (benefit) of $0, $0
      and $(77)
            
            
            —
            
            
            
            —
            
            
            
            (146
            )Reclassification
      adjustment for gains on securitiesincluded in net income, net of
      tax provision of$10, $0 and $23
            
            
            18
            
            
            
            —
            
            
            
            44Reclassification
      adjustment for gains on swaps includedin net income, net of tax
      provision of $0, $0 and $96
            
            
            —
            
            
            
            —
            
            
            
            179Comprehensive
      income
            
            $
            17,335
            
            
            $
            13,048
            
            
            $
            12,196





(See
accompanying notes to consolidated financial statements.)


21


CASCADE
FINANCIAL CORPORATION AND SUBSIDIARIES


Consolidated
Statements of Cash Flows


Years
ended December 31, 2007, 2006, and 2005




YEARS
      ENDEDDECEMBER
      31,(Dollars
      in thousands)
              
              2007
              
              
              2006
              
              
              2005Cash
      flows from operating activities:Net
      income
              
              $
              15,546
              
              
              $
              13,355
              
              
              $
              13,046Adjustments
      to reconcile net income to net cash provided by (used in) operating
      activities:Depreciation
      and amortization of premises and equipment
              
              
              1,875
              
              
              
              1,917
              
              
              
              1,874Provision
      for losses on loans
              
              
              1,350
              
              
              
              1,000
              
              
              
              945Increase
      in cash surrender value of bank owned life insurance
              
              
              (684
              )
              
              
              (661
              )
              
              
              (663
              )Amortization
      of retained servicing rights
              
              
              44
              
              
              
              6
              
              
              
              30Amortization
      of core deposit intangible
              
              
              141
              
              
              
              141
              
              
              
              141Deferred
      income taxes
              
              
              1,982
              
              
              
              178
              
              
              
              (150
              )Deferred
      loan fees, net
              
              
              290
              
              
              
              (9
              )
              
              
              748Gain
      on sale of loans
              
              
              (199
              )
              
              
              (483
              )
              
              
              (865
              )Stock-based
      compensation
              
              
              213
              
              
              
              287
              
              
              
              —Excess
      tax benefits from stock-based compensation
              
              
              (231
              )
              
              
              (314
              )
              
              
              (301
              )Purchase
      of securities held-for-trading
              
              
              (46,413
              )
              
              
              —
              
              
              
              —Proceeds
      from sales/calls on securities held-for-trading
              
              
              112,162
              
              
              
              —
              
              
              
              —Net
      (loss) gain on sales of securities available-for-sale
              
              
              435
              
              
              
              —
              
              
              
              (67
              )Net
      gain on FHLB advances
              
              
              (569
              )
              
              
              —
              
              
              
              —Loss
      on sales of premises and equipment
              
              
              —
              
              
              
              —
              
              
              
              —Net
      loss (gain) on sale of real estate owned, investment propertyand
      other repossessed assets
              
              
              —
              
              
              
              27
              
              
              
              (33
              )Federal
      Home Loan Bank stock dividend received
              
              
              —
              
              
              
              —
              
              
              
              (48
              )Net
      change in accrued interest receivable and other assets
              
              
              (1,313
              )
              
              
              (562
              )
              
              
              (156
              )Net
      change in accrued interest payable, expensesand other
      liabilities
              
              
              (733
              )
              
              
              1,764
              
              
              
              2,392Net
      cash provided by operating activities
              
              
              83,896
              
              
              
              16,646
              
              
              
              16,893Cash
      flows from investing activities:Loans
      originated, net of principal repayments
              
              
              (91,242
              )
              
              
              (133,462
              )
              
              
              (71,352
              )Purchases
      of securities held-to-maturity
              
              
              (64,034
              )
              
              
              (3,434
              )
              
              
              (10,054
              )Proceeds
      from sales/calls on securities held-to-maturity
              
              
              5,000
              
              
              
              —
              
              
              
              —Principal
      repayments on securities held-to-maturity
              
              
              2,658
              
              
              
              2,020
              
              
              
              6,271Purchases
      of securities available-for-sale
              
              
              (76,198
              )
              
              
              (5,716
              )
              
              
              (58,289
              )Proceeds
      from sales of securities available-for-sale
              
              
              66,220
              
              
              
              —
              
              
              
              6,488Principal
      repayments on securities available-for-sale
              
              
              5,677
              
              
              
              15,184
              
              
              
              22,318Purchases
      of premises and equipment
              
              
              (4,047
              )
              
              
              (1,846
              )
              
              
              (1,345
              )Proceeds
      from sales/retirements of premises and equipment and REO
              
              
              15
              
              
              
              269
              
              
              
              25Proceeds
      from loan participations sold
              
              
              (6,818
              )
              
              
              3,988
              
              
              
              (1,747
              )Purchase
      CRA investment
              
              
              (1,890
              )
              
              
              —
              
              
              
              —Purchase
      of bank owned life insurance
              
              
              (4,000
              )
              
              
              —
              
              
              
              —Net
      cash used in investing activities
              
              
              (168,659
              )
              
              
              (122,997
              )
              
              
              (107,685
              )Subtotal,
      carried forward
              
              $
              (84,763
              )
              
              $
              (106,351
              )
              
              $
              (90,792
              )
  (See
accompanying notes to consolidated financial statements.)


22


CASCADE
FINANCIAL CORPORATION AND SUBSIDIARIES


Consolidated
Statements of Cash Flows,Continued


Years
ended December 31, 2007, 2006, and 2005




YEARS
      ENDEDDECEMBER
      31,(Dollars
      in thousands)
              
              2007
              
              
              2006
              
              
              2005Subtotal,
      brought forward
              
              $
              (84,763
              )
              
              $
              (106,351
              )
              
              $
              (90,792
              )Cash
      flows from financing activities:Proceeds
      from issuance of common stock
              
              
              582
              
              
              
              736
              
              
              
              564Dividends
      paid
              
              
              (3,978
              )
              
              
              (3,603
              )
              
              
              (3,163
              )Repurchase
      of common stock
              
              
              (2,838
              )
              
              
              (673
              )
              
              
              (858
              )Excess
      tax benefits from stock-based compensation
              
              
              231
              
              
              
              314
              
              
              
              301Net
      increase in deposits
              
              
              49,134
              
              
              
              59,681
              
              
              
              73,860Net
      increase (decrease) in Federal Home Loan Bank advances
              
              
              (11,431
              )
              
              
              7,000
              
              
              
              8,000Net
      increase (decrease) in securities sold under agreements to
      repurchase
              
              
              24,915
              
              
              
              44,652
              
              
              
              30,156Net
      increase (decrease) in advance payments by borrowers for taxes and
      insurance
              
              
              (201
              )
              
              
              14
              
              
              
              12Proceeds
      from junior subordinated debentures payable
              
              
              —
              
              
              
              10,000
              
              
              
              —Net
      cash provided by financing activities
              
              
              56,414
              
              
              
              118,121
              
              
              
              108,872Net
      increase (decrease) in cash and cash equivalents
              
              
              (28,349
              )
              
              
              11,770
              
              
              
              18,080Cash
      and cash equivalents at beginning of period
              
              
              42,879
              
              
              
              31,109
              
              
              
              13,029Cash
      and cash equivalents at end of period
              
              $
              14,530
              
              
              $
              42,879
              
              
              $
              31,109Supplemental
      disclosures of cash flow information –Cash
      paid during the period for:Interest
              
              $
              51,457
              
              
              $
              40,241
              
              
              $
              30,642Income
      taxes
              
              
              5,600
              
              
              
              6,700
              
              
              
              4,716Supplemental
      schedule of non-cash investing activities:Mark-to-market
      on securities available-for-sale
              
              
              (2,752
              )
              
              
              472
              
              
              
              1,308Retirement
      of common stock in retained earnings
              
              
              171
              
              
              
              142
              
              
              
              60Dividends
      declared
              
              
              4,094
              
              
              
              3,706
              
              
              
              3,260Cumulative
      adjustment to equity for SFAS No.159
              
              
              (3,162
              )
              
              
              —
              
              
              
              —
  (See
accompanying notes to consolidated financial statements below.)














Notes
to Consolidated Financial Statements


(Dollars in
thousands, except share amounts)





(1)
Summary of Significant Accounting Policies


The
accounting and financial reporting policies of Cascade Financial Corporation
(the “Corporation”) and its sole subsidiary, Cascade Bank (“the Bank”) conform
to accounting principles generally accepted in the United States of America and
to general practice within the financial institutions industry, where
applicable. In preparing the consolidated financial statements, management makes
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of income and expense. Actual
results could differ from those estimates. A material estimate that is
particularly susceptible to significant change relates to the determination of
the allowance for losses on loans and the valuation of real estate acquired in
connection with foreclosures or in satisfaction of loans. In connection with the
determination of the estimated losses on loans and foreclosed assets
held-for-sale, management obtains independent appraisals for significant
properties.


The
following is a description of the more significant policies that the Corporation
follows in preparing and presenting its consolidated financial
statements.


23


CASCADE
FINANCIAL CORPORATION AND SUBSIDIARIES


Notes
to Consolidated Financial Statements


(Dollars in
thousands, except share amounts)





(a)
Basis of Presentation


The
consolidated financial statements include the accounts of the Corporation and
the Bank. All significant intercompany balances and transactions have been
eliminated in the consolidation. In January 2003, the Financial Accounting
Standards Board (FASB) issued Interpretation No. 46 (FIN 46), Consolidation of Variable Interest
Entities and, in December 2003, issued Revised Interpretation No. 46 (FIN
46R), Consolidation of
Variable Interest Entities, which replaced FIN 46. Historically, issuer
trusts that issued trust preferred securities (junior subordinated debentures
payable) have been consolidated by their parent companies and trust preferred
securities have been treated as eligible for Tier 1 capital treatment by bank
holding companies under Federal Reserve Board (FRB) rules and regulations
relating to minority interests in equity accounts of consolidated
subsidiaries.As
a result of the adoption of FIN 46R, we deconsolidated the Trust and all periods
in the consolidated financial statements have been restated to reflect this
change.


In
a Supervisory Letter dated July 2, 2003, the FRB stated that trust preferred
securities continue to qualify as Tier 1 capital until notice is given to the
contrary. The FRB will review the regulatory implications of any accounting
treatment changes and will provide further guidance if necessary or
warranted.





(b)
Cash Equivalents


The
Corporation considers all interest-bearing deposits and short-term highly liquid
investment securities with an original maturity of three months or less to be
cash equivalents.




(c)
Interest-Bearing Deposits with Financial Institutions


Interest-bearing
deposits with other financial institutions are carried at cost and include
interest-bearing deposits at the Federal Home Loan Bank. At times throughout the
year, the Bank has balances that exceed FDIC insurance limits.




(d)
Federal Home Loan Bank (FHLB) Stock


As a
member of the FHLB system, the Bank is required to maintain a minimum level of
investment in FHLB stock based on specified percentages of its outstanding FHLB
advances. The Bank's investment in FHLB stock is carried at par value ($100 per
share), which reasonably approximates its fair value. The Bank may request
redemption at par value of any stock in excess of the amount the Bank is
required to hold. Stock redemptions are at the discretion of the FHLB. During
2002, the FHLB revised its capital structure from the issuance of one class of
stock to two, B (1) and B (2) stock. Class B (1) stock can be sold back to the
FHLB at cost, but is restricted as to purchase, sale and redemption. Class B (2)
is not a required investment for institutions and is not restricted to purchase
and sale, but has the same redemption restrictions as Class B (1) stock.
Included in the balance sheet as of December 31, 2007, and 2006, the Bank has
$11.9 million and $0 of Class B (1) and B (2) stock.





(e)
Transfer of Financial Assets


Transfers
of financial assets are accounted for as sales when control over the assets has
been surrendered. Control over transferred assets is deemed to be surrendered
when (1) the assets have been isolated from the Bank, (2) the transferee obtains
the right (free of conditions that constrain it from taking advantage of that
right) to pledge or exchange the transferred assets, and (3) the Bank does not
maintain effective control over the transferred assets through an agreement to
repurchase them before their maturity.





(f)
Mortgage Servicing Rights


Servicing
assets are recognized when rights are acquired through the sale of mortgage
loans or when the Bank originates and sells mortgage loans and retains the
servicing. Loans serviced for others are not included in the accompanying
consolidated balance sheets. In 2006, the Bank sold $34.1 million of commercial
real estate and multifamily loans and retained the servicing. In the two
previous years, the Bank had not retained the servicing on any loans sold.
Capitalized servicing rights are reported in other assets. Mortgage loans
serviced for others include whole loans sold. Loans being serviced totaled $32.0
million and $39.0 million at December 31, 2007, and 2006,
respectively.


Servicing
fee income is recorded for fees earned for servicing loans. The fees are based
on a contractual percentage of the outstanding principal or a fixed amount per
loan and are recorded as income when earned. The amortization of mortgage
servicing rights is netted against loan servicing fee income.





(g)
Marketing Costs


The Bank
expenses most marketing costs as they are incurred but some marketing costs are
capitalized and amortized over the useful life of the expenditure. Marketing
expense was $1.2 million, $1.1 million, and $810 for the years ended December
31, 2007, 2006, and 2005, respectively.


24


CASCADE
FINANCIAL CORPORATION AND SUBSIDIARIES


Notes
to Consolidated Financial Statements


(Dollars
in thousands, except share amounts)





(h)
Comprehensive Income


Comprehensive
income is comprised of net income and other comprehensive income. Other
comprehensive income includes items previously recorded directly to equity, such
as unrealized gains and losses on securities available-for-


sale and
certain derivative instruments. Comprehensive income is presented with the
consolidated statement of stockholders equity.





(i)
Earnings per Share (EPS) Data


The
Corporation displays basic and diluted EPS in the consolidated statement of
income. Basic EPS is computed by dividing net income by the weighted average
number of shares outstanding during the year. Diluted EPS is computed by
dividing net income by diluted weighted average shares outstanding, which
includes common stock equivalent shares outstanding using the treasury stock
method, unless such shares are anti-dilutive. Common stock equivalents include
stock options.




(j)
Goodwill and Other Intangible Assets


Net
assets of companies acquired in purchase transactions are recorded at fair value
at the date of acquisition. Identified intangibles are amortized on an
accelerated basis over the period benefited. Goodwill is not amortized but is
reviewed for potential impairment on a quarterly basis at the reporting unit
level. The impairment test is performed in two phases. The first step of the
goodwill impairment test compares the fair value of the reporting unit with its
carrying amount, including goodwill. If the fair value of the reporting unit
exceeds its carrying amount, goodwill of the reporting unit is considered not
impaired; however, if the carrying amount of the reporting unit exceeds its fair
value, an additional procedure must be performed. That additional procedure
compares the implied fair value of the reporting unit’s goodwill (as defined in
SFAS No. 142, Goodwill and
Other Intangible Assets, (“SFAS 142”)) with the carrying amount of that
goodwill. An impairment loss is recorded to the extent that the carrying amount
of goodwill exceeds its implied fair value. The excess cost over fair value of
net assets acquired consists mainly of goodwill and core deposit premiums. Core
deposit intangibles are amortized on a straight-line basis over 8 years.
Intangibles are evaluated periodically, and at least annually, for
impairment.




Goodwill
and other intangible assets consisted of the following at December 31, 2007 and
2006:





GROSS
      CARRYING AMOUNTIntangible
      assets carrying value
            
            2007
            
            
            2006Goodwill
            
            $
            24,585
            
            
            $
            25,195Core
      deposit intangible, net
            
            
            634
            
            
            
            775Total
            
            $
            25,219
            
            
            $
            25,970







Amortization
of intangible assets and mortgage servicing rights for 2007 and 2006, was as
follows:





YEARS
      ENDED DECEMBER 31Intangible
      assets amortization and impairment
            
            2007
            
            
            2006Core
      deposit intangible
            
            $
            141
            
            
            $
            141Mortgage
      servicing rights
            
            
            44
            
            
            
            6Total
            
            $
            185
            
            
            $
            147





Estimated
existing intangible asset amortization for the next five years is as
follows:





Estimated
      amortization expenseFor
      year ended 12/31/08
            
            $
            180For
      year ended 12/31/09
            
            
            169For
      year ended 12/31/10
            
            
            161For
      year ended 12/31/11
            
            
            155For
      year ended 12/31/12
            
            
            80


25


CASCADE
FINANCIAL CORPORATION AND SUBSIDIARIES


Notes
to Consolidated Financial Statements


(Dollars
in thousands, except share amounts)





(k)
Loans


Almost
all of the Corporation's loans are located in Washington State, primarily in the
Puget Sound Region. At December 31, 2007, the Corporation's loans were
classified as one-to-four-family residences (9%), multifamily residences (1%),
real estate construction (34%), business assets (42%), consumer assets (3%), and
non-owner occupied commercial real estate properties (11%). Accordingly, the
ultimate collectability of the Corporation's loan portfolio is susceptible to
changes in the economic and real estate market conditions in the Puget Sound
Region.


Business
banking loans comprise 42% of the total loan portfolio. Most of the business
banking loans are secured with collateral such as commercial property, business
inventories, accounts receivable, equipment and personal property of the
borrowers and/or guarantors. At December 31, 2007, $25.3 million in commercial
and industrial loans were unsecured. Home equity loans and Lines of Credit
account for the majority of the consumer loan portfolio.


Real
estate loans originated by the Corporation are generally secured by no less than
80% of the lesser of the appraised value or purchase price of the underlying
property. The Corporation currently requires first mortgage, residential
customers to obtain private mortgage insurance on all loans above an 80%
loan-to-value ratio.


Loans
that management has the intent and ability to hold for the foreseeable future or
until maturity or pay-off generally are reported at their outstanding unpaid
principal balances adjusted for charge-offs, the allowance for loan losses, and
any deferred fees or costs on originated loans. Interest income is accrued on
the unpaid principal balance.




Interest
Income


Interest
is accrued only if deemed collectible. Accrual of interest income is generally
discontinued when a loan becomes 90 days past due and accrued interest amounts
are reversed. Once interest has been paid to date or management considers the
loan to be fully collectible, it is returned to accrual status. However, the
Bank had three loans that were 90 days or more past due and still accruing,
totaling $11.6 million at December 31, 2007. These loans are secured by real
estate and supported by current appraised values.


Loan
origination fees and certain direct origination costs are deferred and amortized
as an adjustment of the loan’s yield over the contractual life of the loan using
the interest method. In the event loans are sold, the remaining net deferred
loan origination fees or costs are recognized as a component of the gains or
losses on the sale of loans. When portfolio loans pay off before their
contractual maturity, the remaining deferred fees or costs are recognized as
interest income or expense.


Loan
commitment fees are deferred until loans are funded, at which time they are
amortized into interest income using the effective interest method. If the
commitment period expires, the fees are recognized as service
charges.




Impairment
of Loans and Allowance for Loan Losses


The
allowance for loan losses is established as losses are estimated to have
occurred through a provision for loan losses charged to earnings. Loan losses
are charged against the allowance when management believes the uncollectability
of a loan balance is confirmed. Subsequent recoveries, if any, are credited to
the allowance.


The
allowance for loan losses is evaluated on a regular basis by management and is
based upon management’s periodic review of the collectability of the loans in
light of historical experience, the nature and volume of the loan portfolio,
adverse situations that may affect the borrower’s ability to repay, estimated
value of any underlying collateral and prevailing economic conditions. This
evaluation is inherently subjective as it requires estimates that are
susceptible to significant revision as more information becomes
available.


The
allowance consists of specific, general and unallocated components. The specific
component relates to loans that are classified as either doubtful or
substandard.  For such loans that are also classified as impaired, an
allowance is established when the discounted cash flows (or collateral value or
observable market price) of the impaired loan is lower than the carrying value
of that loan. The general component covers nonclassified loans and is based on
historical loss experience adjusted for qualitative factors. An unallocated
component is maintained to cover uncertainties that could affect management’s
estimate of probable losses. The unallocated component of the allowance reflects
the margin of imprecision inherent in the underlying assumptions used in the
methodologies for estimating specific and general losses in the
portfolio.


A
loan is considered impaired when, based on current information and events, it is
probable that the Corporation will be unable to collect the scheduled payments
of principal or interest when due according to the contractual terms of the loan
agreement. Factors considered by management in determining impairment include
payment status, collateral value, and the probability of collecting scheduled
principal and interest payments when due. Loans that experience


insignificant
payment delays and payment shortfalls generally are not classified as impaired.
Management determines the significance of payment delays and payment shortfalls
on a case-by-case basis, taking into consideration all of the


circumstances
surrounding the loan and the borrower, including the length of the delay, the
reasons for the delay, the borrower’s prior payment record, and the amount of
the shortfall in relation to the principal and interest owed. Impairment is
measured on a loan-by-loan basis for commercial and construction loans by either
the present value of expected future cash flows discounted at the loan’s
effective interest rate, the loan’s obtainable market price, or the fair value
of the collateral if the loan is collateral dependent.


26


CASCADE
FINANCIAL CORPORATION AND SUBSIDIARIES


Notes
to Consolidated Financial Statements


(Dollars
in thousands, except share amounts)





Large
groups of smaller balance homogeneous loans are collectively evaluated for
impairment. Accordingly, the Corporation does not separately identify individual
consumer and residential loans for impairment disclosures, unless such loans are
the subject of a restructuring agreement.


Management
believes the allowance for losses on loans is adequate. While management uses
available information to recognize losses on these assets, future additions to
the allowances will be necessary based on


changes
in economic conditions, particularly in the Western Washington Region. In
addition, various regulatory agencies, as an integral part of their examination
process, periodically review the Corporation’s allowances for losses on loans.
Such agencies may require the Corporation to recognize additions to the
allowances, or change valuations, based on their judgments about information
available to them at the time of their examinations.





(l)
Sales of Loans


Any loan
that management determines will not be held-to-maturity is classified as
held-for-sale at the time of origination. Loans originated and designated as
held-for-sale are intended for sale in the secondary market and are carried at
the lower of cost or estimated fair value in the aggregate. Gains or losses on
the sale of such loans are based on the specific identification method. Net
unrealized losses, if any, are recognized through a valuation allowance by
charges to income. The Bank held $129 in loans held for sale at December 31,
2007, and $311 in loans held for sale at December 31, 2006. Loans are sold
without recourse on a best efforts, servicing released basis. In December 2006,
the Bank sold $34.1 million in commercial and multifamily loans in which the
servicing was retained.





(m)
Securities


Debt and
equity securities, including mortgage-backed securities (“MBS”), may be
classified as held-for-trading, available-for-sale, or held-to-maturity.
Securities classified as held-for-trading are carried at fair value with
unrealized gains and losses reported in earnings. Securities available-for-sale
are carried at fair value, with unrealized gains and losses reported as a
component of other comprehensive income. Investment securities held-to-maturity
are carried at amortized cost or principal balance, adjusted for amortization of
premiums and accretion of discounts. Amortization of premiums and accretion of
discounts are calculated using a method that approximates the level yield
method. The Corporation has the ability, and it is management’s intention, to
hold held-to-maturity securities until maturity. Investments with fair values
that are less than the amortized cost are considered impaired. Impairment may
result from either a decline in the financial condition of the issuing entity
or, in the case of fixed interest rate investments, from rising interest rates.
At each financial statement date, management assesses each investment to
determine if impaired investments are temporarily impaired or if the impairment
is other-than-temporary based upon the positive and negative evidence available.
Evidence evaluated includes, but is not limited to, industry analyst reports,
credit market conditions, interest rate trends, and the intent and ability of
the Corporation to retain its investment in the issuer for a period of time
sufficient to allow for any anticipated recovery of fair value. If negative
evidence outweighs positive evidence that the carrying amount is recoverable
within a reasonable period of time, the impairment is deemed to be
other-than-temporary and the security is written down in earnings as a realized
loss in the period in which such determination is made. Gains and losses on the
sale of securities are recorded on the settlement date and are determined based
on the specific identification method.





(n)
Real Estate Owned


Real
estate owned includes real estate acquired in settlement of loans. Real estate
owned is recorded at the lower of cost or fair value, based upon the most recent
appraisal, less estimated costs to sell. Development, improvement and direct
holding costs related to the property are capitalized. Any loss recorded at the
time a foreclosure occurs is classified as a charge-off against the allowance
for loan losses. Losses that result from the ongoing periodic valuation of these
properties are charged to operations in the period in which they are identified.
There was no real estate owned at December 31, 2007 or December 31,
2006.





(o)
Premises and Equipment


Land is
carried at cost. Buildings and equipment are stated at cost less accumulated
depreciation. Straight-line depreciation is provided over the estimated useful
lives of the respective assets. Leasehold improvements are amortized over the
estimated useful lives of the improvements, or terms of the related leases,
whichever is shorter.  27


CASCADE
FINANCIAL CORPORATION AND SUBSIDIARIES


Notes
to Consolidated Financial Statements


(Dollars in
thousands, except share amounts)





(p)
Income Taxes


We
account for income taxes in accordance with SFAS No. 109 Accounting for Income Taxes
(“SFAS No. 109”), under the liability method which requires recognition of
deferred tax assets and liabilities for the expected future income tax
consequences of transactions that have been included in the Consolidated
Financial Statements. Under this method, deferred tax assets and liabilities are
determined based on the difference between the financial statement and tax basis
of assets and liabilities using enacted tax rates in effect for the year in
which the differences are expected to reverse. When circumstances warrant, we
assess the likelihood that our net deferred tax assets will more-likely-than-not
be recovered from future projected taxable income.





(q)
Stock-Based Compensation


The
Corporation previously accounted for its stock option plan in accordance with
the provisions of APB Opinion No. 25, Accounting for Stock Issued to
Employees. Effective January 1, 2006, the Corporation adopted SFAS No.
123 (revised 2004), Share-Based Payment, (“SFAS
No. 123(R)”) using the modified prospective method. Statement 123(R) requires
all share-based payments to employees, including grants of employee stock
options, to be recognized in the income statement based on their fair values.
See Note 14 to the Consolidated Financial Statements for a further discussion on
stock-based compensation.





(r)
Interest Rate Swap Agreements


For
asset/liability management purposes, the Corporation has used interest rate swap
agreements to hedge various exposures or to modify interest rate characteristics
of various instruments. Interest rate swaps are contracts in which a series of
interest rate flows are exchanged over a prescribed period. The notional amount
on which the interest payments are based is not exchanged. Such derivatives are
linked to specific assets or liabilities, and have high correlation between the
contract and the underlying item being hedged, both at inception and throughout
the hedge period.  The Corporation had no interest rate swap
agreements at December 31, 2007.


Interest
rate swap agreements are utilized to convert a portion of variable-rate debt to
a fixed-rate (cash flow hedge), or to convert a portion of fixed-rate assets to
a variable-rate (fair value hedge).


Under
SFAS No. 133, as amended, the gain or loss on a swap designated and qualifying
as a fair value hedging instrument, as well as the offsetting gain or loss on
the hedged item attributable to the risk being hedged, is recognized currently
in earnings in the same accounting period. The effective portion of the gain or
loss on a swap designated and


qualifying
as a cash flow hedging instrument is reported as a component of other
comprehensive income. The ineffective portion of the gain or loss on the swap
instrument, if any, is recognized in current earnings.


Interest
rate derivative financial instruments receive hedge accounting treatment only if
they are designated as a hedge and are expected to be, and are, effective in
substantially reducing interest rate risk arising from the assets and
liabilities. Those swaps that do not meet the hedging criteria discussed below
would be recorded at fair value with changes in fair value recorded in current
income. Swaps must meet specific effectiveness tests (e.g., over time the change
in their fair values due to the designated hedge risk must be within 80 to 125
percent of the opposite change in the fair values of the hedged assets or
liabilities). If periodic assessment indicates derivatives no longer provide an
effective hedge, the derivatives contracts would be closed out and settled or
marked-to-market through income.


Beginning
January 1, 2001, in accordance with SFAS No. 133, hedges of variable-rate debt
are accounted for as cash flow hedges, with changes in fair value recorded in
derivative assets or liabilities and other comprehensive income. The net
settlement (upon close out or termination) that offsets changes in the value of
the hedged debt is deferred and amortized into net interest income over the life
of the hedged debt. Hedges of fixed-rate assets are accounted for as fair value
hedges, with changes in fair value recorded in derivative assets or liabilities
and interest income. The net settlement (upon close out or termination) that
offsets changes in the value of the assets adjusts the basis of the assets and
is deferred and amortized to interest income over the life of the assets. That
portion, if any, of the net settlement amount that did not offset changes in the
value of the hedged asset or liability is recognized immediately in noninterest
income.


Cash
flows resulting from the derivative financial instruments that are accounted for
as hedges of assets and liabilities are classified in the cash flow statement in
the same category as the cash flows of the items being hedged.


Derivative
financial instruments are recognized as assets and liabilities on the
consolidated balance sheet and measured at fair value.





(s)  Off-Balance
Sheet Credit Related Financial Instruments


In the
ordinary course of business, the Corporation enters into commitments to extend
credit, including commitments under lines of credit, bank cards, letters of
credit, and standby letters of credit and guarantees. Such financial instruments
are recorded when they are funded.





(t)  Bank
Owned Life Insurance (BOLI)


The
carrying amount of BOLI approximates its fair value, net of any surrender
charges. Fair value of BOLI is estimated using the cash surrender
value.  28


CASCADE
FINANCIAL CORPORATION AND SUBSIDIARIES


Notes
to Consolidated Financial Statements


(Dollars
in thousands, except share amounts)





(u)
Reclassifications


Certain
balances have been reclassified to conform to the 2007
presentation.





(v)
Recent Accounting Pronouncements


In
September 2006, the FASB issued SFAS No. 158, Employers' Accounting for Defined
Benefit Pension and Other Post-retirement Plans— An Amendment of FASB Statements No. 87,
88, 106, and 132(R). This Statement improves financial reporting by
requiring an employer to recognize the overfunded or underfunded status of a
defined benefit post-retirement plan as an asset or liability in its statement
of financial position and to recognize changes in that funded status in the year
in which the changes occur through comprehensive income of a business entity or
changes in unrestricted net assets of a not-for-profit organization. This
Statement also improves financial reporting by requiring an employer to measure
the funded status of a plan as of the date of its year-end statement of
financial position, with limited exceptions. An employer with publicly traded
equity securities is required to initially recognize the funded status of a
defined benefit post-retirement plan and to provide the required disclosures as
of the end of the fiscal year ending after December 15, 2006. The requirement to
measure plan assets and benefit obligations as of the date of the employer's
fiscal year-end statement of financial position is effective for fiscal years
ending after December 15, 2008. SFAS No. 158 is not expected to have a material
impact on the Corporation.


In
November 2007, the SEC issued Staff Accounting Bulletin
No. 109, Written Loan
Commitments Recorded at Fair Value through Earnings (“SAB 109”). SAB 109
provides guidance on the accounting for written loan commitments recorded at
fair value under GAAP. Specifically, the SAB revises the Staff’s views on
incorporating expected net future cash flows related to loan servicing
activities in the fair value measurement of a written loan commitment.  SAB
109, which supersedes SAB 105, Application of
Accounting Principles to Loan Commitments, requires the
expected net future cash flows related to the associated servicing of the
loan be included in the measurement of all written loan commitments that are
accounted for at fair value through earnings. SAB 109 is effective on January 1,
2008 for the Corporation. Adoption of SAB 109 is not expected to have a material
impact on the Corporation’s financial statements.


In
December 2007, FASB issued SFAS No. 141 (revised), Business Combinations. SFAS
No. 141R establishes principles and requirements for how an acquirer
recognizes and measures in its financial statements the identifiable assets
acquired, the liabilities assumed, any noncontrolling interest in the acquiree
and the goodwill acquired. SFAS No. 141R also establishes disclosure
requirements to enable the evaluation of the nature and financial effects of the
business combination. This statement applies prospectively to business
combinations for which the acquisition date is on or after January 1, 2009.
Accordingly, we will apply SFAS 141(R) to business combinations occurring
on or after January 1, 2009.


In
December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in
Consolidated Financial Statements, an amendment of ARB
No. 51.  SFAS 160 establishes accounting and
reporting standards that require that the ownership interests in subsidiaries
held by parties other than the parent be clearly identified, labeled, and
presented in the consolidated statement of financial position within equity, but
separate from the parent’s equity; the amount of consolidated net income
attributable to the parent and to the noncontrolling interest be clearly
identified and presented on the face of the consolidated statement of income;
and changes in a parent’s ownership interest while the parent retains its
controlling financial interest in its subsidiary be accounted for consistently.
SFAS 160 also requires that any retained noncontrolling equity investment
in the former subsidiary be initially measured at fair value when a subsidiary
is deconsolidated. SFAS 160 also sets forth the disclosure requirements to
identify and distinguish between the interests of the parent and the interests
of the noncontrolling owners. SFAS 160 applies to all entities that prepare
consolidated financial statements, except not-for-profit organizations, but will
affect only those entities that have an outstanding noncontrolling interest in
one or more subsidiaries or that deconsolidate a subsidiary. SFAS 160 is
effective for fiscal years, and interim periods within those fiscal years,
beginning on or after December 15, 2008. Earlier adoption is prohibited.
SFAS 160 must be applied prospectively as of the beginning of the fiscal
year in which SFAS 160 is initially applied, except for the presentation
and disclosure requirements. The presentation and disclosure requirements are
applied retrospectively for all periods presented.  We do not have a
noncontrolling interest in one or more subsidiaries. Accordingly, we do not
anticipate that the initial application of SFAS 160 will have an impact on
our financial statements.





(2)
Restricted Assets


Federal
Reserve Board regulations require that the Bank maintain certain minimum reserve
balances as either cash on hand, in the vault or on deposit with the Federal
Reserve Bank. The minimum reserve balance as of December 31,


2006 was
approximately $5.6 million. The reserve required to be held at the Federal
Reserve as of December 31, 2007 was $0 due to a reclassification of
deposits.


29


CASCADE
FINANCIAL CORPORATION AND SUBSIDIARIES


Notes
to Consolidated Financial Statements


(Dollars in
thousands, except share amounts)





(3)
Securities


A summary
of securities at December 31, 2007, and December 31, 2006, follows:




DECEMBER
      31, 2007AMORTIZED
              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
              VALUESecurities
      available-for-saleMBS
            
            $
            26,286
            
            
            $
            2
            
            
            $
            5
            
            
            $
            (71
            )
            
            $
            (795
            )
            
            $
            25,427Agency
      notes
            
            
            57,366
            
            
            
            67
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            57,433Total
            
            $
            83,652
            
            
            $
            69
            
            
            $
            5
            
            
            $
            (71
            )
            
            $
            (795
            )
            
            $
            82,860





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
              VALUESecurities
      held-to-maturityMBS
            
            $
            22,556
            
            
            $
            28
            
            
            $
            —
            
            
            $
            —
            
            
            $
            (643
            )
            
            $
            21,941Agency
      notes
            
            
            113,907
            
            
            
            67
            
            
            
            —
            
            
            
            (246
            )
            
            
            (149
            )
            
            
            113,579Corporate/other
            
            
            775
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            775Total
            
            $
            137,238
            
            
            $
            95
            
            
            $
            —
            
            
            $
            (246
            )
            
            $
            (792
            )
            
            $
            136,295





DECEMBER
      31, 2006AMORTIZED
              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
              VALUESecurities
      available-for-saleMBS
            
            $
            38,428
            
            
            $
            47
            
            
            $
            3
            
            
            $
            (18
            )
            
            $
            (713
            )
            
            $
            37,747Agency
      notes
            
            
            95,772
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            (2,863
            )
            
            
            92,909Total
            
            $
            134,200
            
            
            $
            47
            
            
            $
            3
            
            
            $
            (18
            )
            
            $
            (3,576
            )
            
            $
            130,656





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
              VALUESecurities
      held-to-maturityMBS
            
            $
            25,218
            
            
            $
            7
            
            
            $
            —
            
            
            $
            (14
            )
            
            $
            (873
            )
            
            $
            24,338Agency
      notes
            
            
            70,853
            
            
            
            —
            
            
            
            —
            
            
            
            (24
            )
            
            
            (2,406
            )
            
            
            68,423Corporate/other
            
            
            775
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            775Total
            
            $
            96,846
            
            
            $
            7
            
            
            $
            —
            
            
            $
            (38
            )
            
            $
            (3,279
            )
            
            $
            93,536







At
December 31, 2007, the Bank had 11 securities with a gross unrealized loss
totaling $795 in our available-for-sale portfolio with a fair value of $21.0
million that had an unrealized loss for greater than one year and 14
held-to-maturity securities with a gross unrealized loss totaling $792 with a
fair value of $50.0 million that have had an unrealized loss for more than one
year. The only impairment on available-for-sale securities was in the MBS
category, which accounted for 100% of the total impairment. As of December 31,
2007, the Bank had 12 available-for-sale and 17 held-to-maturity securities
included in the temporarily impaired report, compared to 16 available-for-sale
and 13 held-to-maturity with unrealized gains. The temporary impairment was less
than 3% of the total book value of investments. Temporarily impaired securities
are a result of an increase in interest rates and are expected to regain their
value as the securities near maturity and/or market rates decline;
other-than-temporarily impaired securities are a result of contractual failure
by the issuer and are not expected to rebound and are considered not
collectable. At December 31, 2007, the Bank had no securities with
other-than-temporary impairments.


Certain
investment securities shown above currently have fair values less than amortized
cost and therefore contain unrealized losses. The Corporation has evaluated
these securities and has determined that the decline in value is temporary and
is related to the change in market interest rates since purchase. All are rated
AAA for credit quality by at least one major


rating
agency.


30


CASCADE FINANCIAL CORPORATION AND
SUBSIDIARIES


Notes
to Consolidated Financial Statements


(Dollars in
thousands, except share amounts)





The
decline in value is not related to any company or industry specific event. The
Corporation anticipates full recovery of amortized cost with respect to these
securities at maturity or sooner in the event of a more favorable market
interest rate environment.


As
of December 31, 2007, and 2006, the Corporation was required to maintain 81,050
and 79,050 shares, respectively, of $100 par value FHLB stock.


Accrued
interest receivable on securities and interest-bearing deposits was $2.2 million
and $2.3 million at


December
31, 2007, and 2006, respectively.





Proceeds
from the sales of securities available-for-sale and gross realized gains and
losses are summarized as follows for the year ended December 31, 2007, 2006, and
2005:




PROCEEDS
              
              
              GAINS
              
              
              LOSSESYear
      ended December 31, 2007
              
              $
              66,220
              
              
              $
              55
              
              
              $
              (490
              )Year
      ended December 31, 2006
              
              
              —
              
              
              
              —
              
              
              
              —Year
      ended December 31, 2005
              
              
              6,488
              
              
              
              68
              
              
              
              (1
              )
  The
following table shows the contractual or expected maturities of the
Corporation’s securities available-for-sale at December 31, 2007:




WITHIN
      ONE
                YEAR
              
              
              ONE
      TO
                FIVE YEARS
              
              
              OVER
      FIVE TO
                TEN YEARS
              
              
              OVER
      TEN
                YEARS
              
              
              TOTALAmortized
      CostMBS
              
              $
              —
              
              
              $
              11,075
              
              
              $
              13,248
              
              
              $
              1,963
              
              
              $
              26,286Agency
      notes
              
              
              4,999
              
              
              
              20,999
              
              
              
              31,313
              
              
              
              55
              
              
              
              57,366Total
      amortized cost
              
              $
              4,999
              
              
              $
              32,074
              
              
              $
              44,561
              
              
              $
              2,018
              
              
              $
              83,652Fair
      ValueMBS
              
              $
              —
              
              
              $
              10,891
              
              
              $
              12,746
              
              
              $
              1,790
              
              
              $
              25,427Agency
      notes
              
              
              5,006
              
              
              
              21,012
              
              
              
              31,360
              
              
              
              55
              
              
              
              57,433Total
      fair value
              
              $
              5,006
              
              
              $
              31,903
              
              
              $
              44,106
              
              
              $
              1,845
              
              
              $
              82,860
  The
following table shows the contractual or expected maturities of the
Corporation’s securities held-to-maturity at December 31, 2007:




WITHIN
      ONE
                  YEAR
                
                
                ONE
      TO
                  FIVE YEARS
                
                
                OVER
      FIVE TO
                  TEN YEARS
                
                
                OVER
      TEN
                  YEARS
                
                
                TOTALAmortized
      CostMBS
                
                $
                —
                
                
                $
                —
                
                
                $
                —
                
                
                $
                22,556
                
                
                $
                22,556Agency
      notes
                
                
                —
                
                
                
                12,905
                
                
                
                32,948
                
                
                
                68,054
                
                
                
                113,907Corporate/other
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                775
                
                
                
                775Total
      amortized cost
                
                $
                —
                
                
                $
                12,905
                
                
                $
                32,948
                
                
                $
                91,385
                
                
                $
                137,238Fair
      ValueMBS
                
                $
                —
                
                
                $
                —
                
                
                $
                —
                
                
                $
                21,941
                
                
                $
                21,941Agency
      notes
                
                
                —
                
                
                
                12,905
                
                
                
                32,904
                
                
                
                67,770
                
                
                
                113,579Corporate/other
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                775
                
                
                
                775Total
      fair value
                
                $
                —
                
                
                $
                12,905
                
                
                $
                32,904
                
                
                $
                90,486
                
                
                $
                136,295
  Securities
are classified based upon contractual maturity dates. Actual maturities may
differ from contractual maturities because the borrowers have the right to
prepay their obligations. The fair value of securities pledged as collateral to
secure public deposits were $36.0 million at December 31, 2007, and $54.2
million at December 31, 2006. The fair value of securities pledged to the FHLB
at December 31, 2007 was $29.1 million and $41.0 million at December 31, 2006.
The fair value of securities pledged to fund repurchase agreements were $139.7
million at December 31, 2007, and $109.1 million at December 31,
2006.


31


CASCADE
FINANCIAL CORPORATION AND SUBSIDIARIES


Notes
to Consolidated Financial Statements


(Dollars in
thousands, except share amounts)





(4)
Loans and Allowance for Loan Losses


A summary
of loans at December 31, 2007 and 2006, follows:




DECEMBER
      31,
              
              
              DECEMBER
      31,2007
              
              
              2006Residential
              
              $
              98,384
              
              
              $
              91,256Multifamily
              
              
              11,397
              
              
              
              34,719Commercial
      real estate
              
              
              120,421
              
              
              
              119,298Construction(1)
              
              
              381,810
              
              
              
              295,087Business
      banking
              
              
              468,453
              
              
              
              442,391Consumer
              
              
              27,688
              
              
              
              27,686Total
      loans
              
              
              1,108,153
              
              
              
              1,010,437Deferred
      loan fees, net
              
              
              (3,724
              )
              
              
              (3,434
              )Allowance
      for loan losses
              
              
              (11,653
              )
              
              
              (10,988
              )Net
      loans
              
              $
              1,092,776
              
              
              $
              996,015Loans
      serviced for others
              
              $
              31,965
              
              
              $
              39,032
  (1)
Construction loans are net of loans in process.





Accrued
interest on loans was $5.9 million and $5.3 million at December 31, 2007, and
December 31, 2006, respectively. Loans to officers and directors totaled $301 at
December 31, 2007, $311 at December 31, 2006, and $300 at December 31, 2005.
Repayments totaling $10, $6, and $39 were received and additional advances of
$0, $17, and $17 were made for the years ended December 31, 2007, 2006, and
2005, respectively. Additionally, in 2006, $2.3 million in loans were excluded
since the director previously included was no longer affiliated with the
Bank.


At
December 31, 2007, the composition of the loan portfolio was as
follows:




FIXED
              
              
              VARIABLE
              
              
              ADJUSTABLERATE
              
              
              RATE(1)
              
              
              RATETerm
      to maturityLess
      than one year
              
              $
              50,909
              
              
              $
              295,398
              
              
              $
              5,3591-3
      years
              
              
              55,379
              
              
              
              102,387
              
              
              
              8,1553-5
      years
              
              
              58,783
              
              
              
              5,357
              
              
              
              30,5315-10
      years
              
              
              118,199
              
              
              
              16,337
              
              
              
              207,11010-20
      years
              
              
              5,056
              
              
              
              3,888
              
              
              
              27,186Over
      20 years
              
              
              3,744
              
              
              
              11,842
              
              
              
              102,533Total
              
              $
              292,070
              
              
              $
              435,209
              
              
              $
              380,874





(1)
            Variable
      includes all Prime, LIBOR, or Treasury indexed loans with a repricing
      frequency of three months or less.





Nonaccrual
loans totaled $1.5 million, $851, and $2.0 million, respectively, at December
31, 2007, December 31, 2006, and December 31, 2005. If interest on these loans
had been recognized, such income would have been $111, $27, and $82
respectively, for the periods ended December 31, 2007, 2006, and 2005. The
Corporation has no commitments to extend additional credit on loans that are
nonaccrual. At December 31, 2007, 2006, and 2005, loans totaling $29.1 million,
$9.4 million, and $17.5 million, were adversely classified loans. Of the
adversely classified loans, $451, $223, and $1.5 million were under foreclosure
at December 31, 2007, 2006, and 2005, respectively. The average balances of
adversely classified loans for the years ended December 31, 2007 and December
31, 2006, respectively, were $9.2 million and $13.8 million and the Corporation
recognized $561 and $759 of related interest income on such loans during the
time they were adversely classified.


At
December 31, 2007, 2006, and 2005, impaired loans totaled $1.5 million, $859,
and $2.0 million, respectively. The average balances during the years ended
December 31, 2007, 2006 and 2005 were $973, $796, and $1.2 million,
respectively. The allowance for loan losses related to these loans was
approximately $361, $401, and $801 at December 31, 2007, 2006, and 2005,
respectively. Interest collected on these loans in cash and included in income
was not considered significant for 2007, 2006, and 2005. If interest on these
loans had been accrued, the additional amount of such income would not have been
significant for 2007, 2006, and 2005. At December 31, 2007, there were no
commitments to lend additional funds to borrowers whose loans were classified as
impaired.


The
Bank had three loans that were 90 days or more past due and still accruing,
totaling $11.6 million at December 31, 2007. These loans are secured by real
estate and supported by current appraised values. There were no loans 90 days or
more past due at December 31, 2006.


At
December 31, 2007, the Corporation had outstanding commitments to grant loans of
$13.1 million with fixed interest rates and $32.0 million with adjustable
rates.


32


CASCADE
FINANCIAL CORPORATION AND SUBSIDIARIES


Notes
to Consolidated Financial Statements


(Dollars in
thousands, except share amounts)





The
Corporation had non-mandatory forward commitments totaling $0 and $364 to sell
loans into the secondary market at December 31, 2007, and December 31, 2006,
respectively.


Commitments
to extend credit are agreements to lend to a customer as long as there is no
violation of any condition


established
in the contract. Commitments generally have fixed expiration dates or other
termination clauses and may require payment of a fee. Since many of the
commitments are expected to expire without being drawn upon, the
total


commitment
amounts do not necessarily represent future cash requirements. While
approximately 100% of commercial letters of credit are utilized, a significant
portion of such utilization is on an immediate payment basis. The


Bank
evaluates each customer's creditworthiness on a case-by-case basis. The amount
of collateral obtained, if it is deemed necessary by the Bank upon extension of
credit, is based on management's credit evaluation of the borrower. Collateral
held varies but may include accounts receivable, inventory, property, plant and
equipment, and income-producing commercial properties.


Unfunded
commitments under commercial Lines of Credit, revolving credit lines and loans
in process are commitments for possible future extensions of credit to existing
customers.


Standby
letters of credit and financial guarantees written are conditional commitments
issued by the Bank to guarantee the performance of a customer to a third party.
Those guarantees are primarily issued to support public and private borrowing
arrangements, bond financing, and similar transactions. The Bank underwrites its
standby letters of credit using its policies and procedures applicable to loans
in general. Standby letters of credit are made on an unsecured and secured
basis. The Bank has not been required to perform on any financial guarantees
during the past two years. The Bank did not incur any significant losses on its
commitments in 2007 or 2006.





At
December 31, 2007, and 2006, the following financial instruments with
off-balance sheet risk were outstanding:





2007
              
              
              2006Commitments
      to grant loans
              
              $
              45,118
              
              
              $
              21,412Unfunded
      commitments under lines of credit/loans in process
              
              
              265,118
              
              
              
              196,902Standby
      letters of credit and financial guarantees written
              
              
              5,171
              
              
              
              4,924Unused
      commitments on bankcards
              
              
              12,840
              
              
              
              12,751Total
              
              $
              328,247
              
              
              $
              235,989
  A summary
of the allowance for losses on loans follows:




YEARS
      ENDED DECEMBER 31,2007
              
              
              2006
              
              
              2005Balances
      at beginning of year
              
              $
              10,988
              
              
              $
              10,254
              
              
              $
              9,563Off-balance
      sheet commitments
              
              
              (142
              )
              
              
              —
              
              
              
              —Provision
      for loss
              
              
              1,350
              
              
              
              1,000
              
              
              
              945Recoveries
              
              
              135
              
              
              
              148
              
              
              
              266Charge-offs
              
              
              (414
              )
              
              
              (520
              )Balances
      at end of year
              
              $
              11,653
              
              
              $
              10,988
              
              
              $
              10,254


(5)
Premises and Equipment


A summary
of premises and equipment follows:




ESTIMATED
              
              DECEMBER
      31,
              
              
              DECEMBER
      31,USEFUL LIVES
              
              2007
              
              
              2006Land
              
              
              $
              4,277
              
              
              $
              2,577Buildings
              40
      years
              
              
              11,394
              
              
              
              10,936Leasehold
      improvements
              Lease
      term
              
              
              2,498
              
              
              
              2,229Furniture
      and equipment
              2-10
      years
              
              
              14,066
              
              
              
              14,67932,235
              
              
              
              30,421Accumulated
      depreciation and amortization
              
              
              
              (18,075
              )
              
              
              (18,418
              )Total
              
              
              $
              14,160
              
              
              $
              12,003
  Total
depreciation and amortization expenses were $1.9 million for each of the years
ended December 31, 2007, 2006, and 2005, respectively.  33
 CASCADE
FINANCIAL CORPORATION AND SUBSIDIARIES


Notes
to Consolidated Financial Statements


(Dollars
in thousands, except share amounts)




The Bank
leases space for various branches. These leases run for a period ranging from 20
months to 12 years and allow for established rent increases each year. Generally
these leases require the Bank to pay all taxes, maintenance and utility costs,
as well as maintain certain types of insurance. The annual lease commitments at
December 31, 2007, are as follows:




Years ending December
      31,
            2008
            $
            8132009
            
            7882010
            
            7532011
            
            7382012
            
            725Thereafter
            
            7,445Total
            $
            11,262





Rental
expenses charged to operations were approximately $763, $693, and $642 for the
years ended December 31, 2007, 2006, and 2005, respectively.





(6)
Deposits


Deposits
at December 31, 2007, and 2006, are summarized as follows:




DECEMBER
      31,
              
              
              DECEMBER
      31,2007
              
              
              2006Noninterest-bearing
      checking accounts
              
              $
              87,350
              
              
              $
              87,456Interest-bearing
      checking accounts
              
              
              50,840
              
              
              
              52,051Money
      market deposit accounts
              
              
              315,967
              
              
              
              275,286Savings
      accounts
              
              
              11,297
              
              
              
              15,158Certificates
      of deposit
              
              
              439,442
              
              
              
              425,498Total
              
              $
              904,896
              
              
              $
              855,449





Time
deposit accounts in amounts of $100 thousand or more totaled $271.5 million and
$257.0 million at December 31, 2007, and December 31, 2006, respectively.Deposits held by
executive officers and directors totaled $4.2 million at December 31, 2007, and
$3.5 million at December 31, 2006. Included in these totals were $2.6 million
and $2.0 million held in business accounts on which six directors have signing
authority, at December 31, 2007, and December 31 2006,
respectively.




WEIGHTED
      AVERAGE
              INTEREST
      RATE
              ON DEPOSITS
            
            
            DEPOSIT
      ACCOUNTS
              WITH
      BALANCES
              IN
      EXCESS OF
              $100 THOUSAND
            
            ACCRUED
      INTEREST
              PAYABLE
      ON
              DEPOSITSDecember
      31, 2007
            
            3.78
            %
            
            $
            606,579
            
            $
            4,285December
      31, 2006
            
            3.86
            
            
            
            552,522
            
            
            5,176


A summary
of interest expense on deposits follows:




YEARS
      ENDED DECEMBER 31,2007
              
              
              2006
              
              
              2005Checking
      and money market accounts
              
              $
              13,061
              
              
              $
              9,160
              
              
              $
              3,500Savings
      accounts and time deposits
              
              
              22,159
              
              
              
              19,416
              
              
              
              14,814Total
              
              $
              35,220
              
              
              $
              28,576
              
              
              $
              18,314
  Maturities
of time deposits at December 31, 2007, are as follows:




Years
      ending December 31,
              2008
              $
              401,8002009
              
              20,9002010
              
              4,1802011
              
              8682012
              
              2,148Thereafter
              
              9,546Total
              $
              439,442


(7)
Junior Subordinated Debentures Payable (Trust Preferred Securities)


On March
1, 2000, $10.3 million of 11% junior subordinated debentures payable due March
1, 2030, were issued by a wholly owned business Trust whose common equity is
100% owned by Cascade Financial Corporation, Cascade Capital Trust I. The Trust
exists for the exclusive purposes of issuing and selling the junior subordinated
debentures


34


CASCADE
FINANCIAL CORPORATION AND SUBSIDIARIES


Notes
to Consolidated Financial Statements


(Dollars in
thousands, except share amounts)





payable,
using the proceeds from the sale of the capital securities to acquire junior
subordinated debentures payable, issued by Cascade Financial Corporation, and
engaging in only those other activities necessary, advisable or incidental to
the above. The Corporation used the proceeds for general corporate purposes
including stock


repurchases
and investment in its subsidiary bank.


The junior subordinated debentures
payable will mature on March 1, 2030 unless redeemed prior to such date if
certain conditions are met.


In
October 2003, the Corporation entered into an interest rate swap agreement with
a third party as a hedge of the interest rate on the Corporation’s junior
subordinated debentures payable. Under the terms of the agreement, the
Corporation received an 11% fixed-rate and paid a floating-rate of USD-six-month
LIBOR-BBA plus 520 basis points. The swap was terminated in December 2006 at a
loss of $150.


On
December 15, 2004, the Corporation issued $5.2 million in junior subordinated
debentures payable, as Cascade Capital Trust II. These debentures have a fixed
coupon of 5.82% for the first 5 years and then float at the three-month LIBOR
plus 1.90% for the remaining 25 years. The debentures are callable at par after
5 years. These debentures are considered Tier 1 capital by financial institution
regulators.


On
March 30, 2006, the Corporation issued an additional $10.3 million in junior
subordinated debentures payable, as Cascade Capital Trust III. These debentures
have a fixed coupon of 6.50% for the first 5 years and then float, if not
called, at the three-month LIBOR plus 1.40% for the remaining 25 years. These
debentures are also considered Tier 1 capital for regulatory
purposes.


The
junior subordinated debentures payable issued under Cascade Capital Trusts II
and III incorporate the same structure, for the same purposes as Cascade Capital
Trust I.


Effective
January 1, 2007, the Corporation elected early adoption of SFAS No. 159, The Fair Value Option for Financial
Assets and Financial Liabilities,and SFAS No. 157, Fair Value Measurements, both
of which were issued in February 2007. The Corporation applied fair value
accounting to Cascade Capital Trust I. Upon adoption of SFAS No. 159 and No.
157, the Corporation determined a fair value for Cascade Capital Trust I of
approximately 117 or $11.17 million for the $10.0 million in trust preferred
securities (junior subordinated debentures). This resulted in charging off the
unamortized issuance costs to retained earnings of $654 as required under SFAS
No. 159. The $1.17 million fair value premium is the result of the 11% coupon
and the 5.5% call premium. This fair value premium should be effectively written
down to the $550 premium to call the security on March 1, 2010, which is
embedded in its fair value. The fair value option was not selected for variable
rate junior subordinated debentures totaling $15.0 million.See
Note 15 of the Notes to Consolidated Financial Statements for additional
information on SFAS No. 157.





(8)
FHLB Advances


FHLB
advances are summarized as follows:


DECEMBER 31,
              
              
              DECEMBER 31,2007
              
              
              2006MATURITY DATE
              AMOUNT
              
              
              WEIGHTED
                AVERAGE
                INTEREST
                RATE
              
              
              AMOUNT
              
              
              WEIGHTED
                AVERAGE
                INTEREST
                RATEAt December 31,
              2007
              
              $
              —
              
              
              $
              —
              
              
              $
              32,000
              
              
              
              5.87
              %2008
              
              
              2,000
              
              
              
              3.51
              
              
              
              2,000
              
              
              
              3.512009
              
              
              10,000
              
              
              
              3.62
              
              
              
              39,000
              
              
              
              5.002010
              
              
              —
              
              
              
              —
              
              
              
              45,000
              
              
              
              5.832011
              
              
              10,000
              
              
              
              3.88
              
              
              
              10,000
              
              
              
              3.882012
              
              
              40,000
              
              
              
              4.33
              
              
              
              —
              
              
              
              —Thereafter(1)
              
              
              169,000
              
              
              
              4.32
              
              
              
              115,000
              
              
              
              4.04$
              231,000
              
              
              
              4.27
              %
              
              $
              243,000
              
              
              
              4.76
              %


(1)
            Includes
      $30,000 tied to the three-month
LIBOR.





YEARS
      ENDED DECEMBER 31,2007
              
              
              2006Maximum
      amount of outstanding FHLB advances at any month-end
              
              $
              264,790
              
              
              
              256,000Average
      amount of outstanding FHLB advances during the year
              
              
              226,124
              
              
              
              237,888
  The Bank
had $199.0 million in fixed-rate advances as of December 31, 2007, and the FHLB
has the option to convert these advances to variable-rate advances after a
specified period.


At
December 31, 2007, the Bank had an unused Line of Credit from the FHLB-Seattle
of $264.7 million subject to the availability of eligible collateral. The Bank’s
credit line with the FHLB-Seattle is 35% of total assets, or up to approximately
$495.7 million, and is subject to certain collateral requirements.


FHLB
advances are collateralized by otherwise unencumbered permanent residential
mortgages, investment grade securities, and other eligible real estate
mortgages. Federal statute requires all members of the FHLB to maintain
collateral on FHLB borrowings and advances equivalent to the amount borrowed on
a daily basis.


35


CASCADE
FINANCIAL CORPORATION AND SUBSIDIARIES


Notes
to Consolidated Financial Statements


(Dollars in
thousands, except share amounts)





(9)
Securities Sold Under Agreements to Repurchase and Lines of Credit


The
Corporation enters into sales of securities under agreements to repurchase
(reverse repurchase agreements) that are treated as financing arrangements.
Accordingly, the obligations to repurchase securities sold are reflected as a
liability in the consolidated balance sheets, and the securities underlying the
agreements remain in the asset accounts. The securities underlying the
agreements are under the Corporation’s control and are held by nationally known
government security dealers who are recognized as primary dealers by the Federal
Reserve Board, or other investment banking firms approved by the Corporation’s
Board of Directors.


Securities
sold under agreements to repurchase the same securities consist of agency notes
and/or mortgage-backed securities summarized as follows:


UNDERLYING SECURITIESBALANCE
                OUTSTANDING
              
              
              WEIGHTED
                AVERAGE
                INTEREST
                RATE
              
              
              BOOK
      VALUE,
                INCLUDING
                ACCRUED
                INTEREST
              
              
              MARKET
                VALUEDecember
      31, 2007
              
              $
              120,625
              
              
              3.30
              %
              
              $
              140,523
              
              
              $
              139,722December
      31, 2006
              
              
              95,710
              
              
              1.42
              
              
              
              113,026
              
              
              
              109,145
  Financial
data pertaining to repurchase agreements follows:


YEARS
      ENDED DECEMBER 31,2007
              
              
              2006Maximum
      amount of outstanding agreements at any month-end
              
              $
              120,625
              
              
              $
              96,007Average
      amount of outstanding agreements during the year
              
              
              107,516
              
              
              
              81,284
  The
Corporation used $120.0 million of repurchase agreements that adjust to a spread
under three-month LIBOR for periods ranging from six months to one year and then
adjust to a fixed rate for the remainder of the agreement unless the lender
terminates the agreement.


The
Bank has Fed funds borrowing lines with three of its correspondent banks. One
line is for $15.0 million and


matures
July 1, 2008. The other two facilities are for $10.0 million each; one matures
June 30, 2008, and the other has no maturity date. Interest rates for these
lines are quoted at the time of borrowing and are subject to certain collateral
requirements. The Bank used each of these lines during the year. The Bank also
has the ability to borrow from the Federal Reserve Bank of San Francisco based
on the amount of collateral pledged. As of December 31, 2007, there were no
outstanding balances on any of these lines.




(10)
Income Taxes


Income
tax expense (benefits) includes the following components:


YEARS
      ENDEDDECEMBER
      31,2007
              
              2006
              
              2005Current
              $
              5,401
              
              $
              6,297
              
              $
              6,412Deferred
              
              1,982
              
              
              178
              
              
              (150
              )Total
              $
              7,383
              
              $
              6,475
              
              $
              6,262
  As
required by SFAS No. 109, we continually review the likelihood that
deferred tax assets will be realized in future tax periods under the
“more-likely-than-not” criteria. In making this judgment, SFAS No. 109
requires that all available evidence, both positive and negative, should be
considered to determine whether, based on the weight of that evidence, a
valuation allowance is required. As of December 31, 2007, we had
$4.8 million of deferred tax assets and net deferred tax assets (after
deferred tax liabilities) of $1.6 million related to the U.S. tax jurisdictions
whose recoverability is dependent upon future profitability.


In the future, our effective tax rate
could be adversely affected by several factors, many of which are outside of our
control. Our effective tax rate is affected by the proportion of revenues and
income before taxes in the various domestic and international jurisdictions in
which we operate. Further, we are subject to changing tax laws, regulations and
interpretations in multiple jurisdictions in which we operate, as well as the
requirements, pronouncements and rulings of certain tax, regulatory and
accounting organizations. We estimate our annual effective tax rate each quarter
based on a combination of actual and forecasted results of subsequent quarters.
Consequently, significant changes in our actual quarterly or forecasted results
may impact the effective tax rate for the current or future
periods.


For
the year ended December 31, 2007, the Corporation's effective tax rate was 32.2%
compared to 32.7% and 32.4% for the years ended December 31, 2006 and 2005.
Decreased tax benefits related to interest on tax exempt loans and increases in
cash surrender value of bank owned life insurance comprised the significant
portion of the differences in the effective tax rates between the two
years.  36


CASCADE
FINANCIAL CORPORATION AND SUBSIDIARIES


Notes
to Consolidated Financial Statements


(Dollars
in thousands, except share amounts)





Income tax expense differs from that
computed by applying the U.S. federal income tax rate of 35% to pretax income
for the years ended December 31st as a
result of the following:




2007
              
              
              2006
              
              
              2005Computed
      “expected” tax expense
              
              $
              8,025
              
              
              $
              6,941
              
              
              $
              6,758Bank
      owned life insurance (BOLI)
              
              
              (239
              )
              
              
              (231
              )
              
              
              (232
              )Tax
      exempt interest
              
              
              (218
              )
              
              
              (341
              )
              
              
              (284
              )Nondeductible
      option cost
              
              
              68
              
              
              
              101
              
              
              
              —Other,
      net
              
              
              (253
              )
              
              
              5
              
              
              
              20Total
              
              $
              7,383
              
              
              $
              6,475
              
              
              $
              6,262
  Under
certain provisions of the Internal Revenue Code, the Corporation was allowed a
statutory bad debt deduction


(based
upon a percentage of taxable income before such deduction) for additions to tax
bad debt reserves established for the purpose of absorbing losses on loans or
property acquired through foreclosure. This amount represents allocations of
income to bad debt deductions for tax reporting purposes only. Reduction of
amounts so allocated for


purposes
other than tax bad debt losses will create income for tax reporting purposes
only, which will be subject to the then-current corporate income tax
rate.





The
following table presents major components of the net deferred tax asset
(liability) resulting from differences between financial reporting and tax bases
at December 31, 2007, and December 31, 2006:


DECEMBER
      31,
              
              
              DECEMBER
      31,2007
              
              
              2006Deferred
      tax assets:Securities
      available-for-sale
              
              $
              277
              
              
              $
              1,240Junior
      subordinated debentures
              
              
              607
              
              
              
              —Premises
      and equipment
              
              
              274
              
              
              
              —Loans
              
              
              3,640
              
              
              
              3,316Gross
      deferred tax assets
              
              
              4,798
              
              
              
              4,556Deferred
      tax liabilities:Deferred
      loan fees
              
              
              (1,184
              )
              
              
              (1,660
              )Core
      deposit intangible
              
              
              (222
              )
              
              
              (267
              )Premises
      and equipment
              
              
              —
              
              
              
              (203
              )FHLB
      stock
              
              
              (1,732
              )
              
              
              (1,732
              )Other
              
              
              (86
              )
              
              
              (139
              )Gross
      deferred tax liabilities
              
              
              (3,224
              )
              
              
              (4,001
              )Net
      deferred tax asset
              
              $
              1,574
              
              
              $
              555
  A
valuation allowance for deferred tax assets was not considered necessary at
December 31, 2007 or 2006. Management believes the Corporation will fully
realize its total deferred income tax assets as of December 31, 2007, and 2006,
based upon its total deferred income tax liabilities, previous taxes paid and
its current and expected future levels of taxable income.


The
Corporation adopted the provisions of FASB Interpretation No. 48, Accounting for Uncertainty in Income
Taxes, on January 1, 2007. The Corporation had no unrecognized tax
benefits which would require an adjustment to the January 1, 2007 beginning
balance of retained earnings. The Corporation had no unrecognized tax benefits
at January 1, 2007 and at December 31, 2007.


The
Corporation recognizes interest accrued and penalties related to unrecognized
tax benefits in tax expense. During the years ended December 31, 2007 and 2006,
the Corporation recognized no interest and penalties.


The
Corporation and its subsidiaries files income tax returns in the U.S. Federal
jurisdiction. With few exceptions, the Corporation is no longer subject to U.S.
Federal or state/local income tax examinations by tax authorities for years
before 2003.


37


CASCADE
FINANCIAL CORPORATION AND SUBSIDIARIES


Notes
to Consolidated Financial Statements


(Dollars
in thousands, except share amounts)





(11)
Earnings per Share


The
following table presents EPS information:




YEARS
      ENDED DECEMBER 31,2007
              
              
              2006
              
              
              2005Net
      income
              
              $
              15,546
              
              
              $
              13,355
              
              
              $
              13,046Common
      shares outstanding (basic)
              
              
              12,047,792
              
              
              
              12,060,191
              
              
              
              11,977,824Effect
      of dilutive stock options
              
              
              237,062
              
              
              
              303,007
              
              
              
              342,049Common
      shares outstanding (diluted)
              
              
              12,284,854
              
              
              
              12,363,198
              
              
              
              12,319,873EPS,
      basic
              
              $
              1.29
              
              
              $
              1.11
              
              
              $
              1.09EPS,
      diluted
              
              
              1.27
              
              
              
              1.08
              
              
              
              1.06
  For
purposes of calculating basic and diluted earnings per share, the numerator of
net income is the same. There were outstanding options to purchase 174,810,
196,554, and 143,939 shares of common stock at December 31, 2007,


December
31, 2006, and December 31, 2005, respectively, that are considered non-dilutive
and have been excluded from the above calculation. Non-dilutive options have an
exercise price that is greater than the current market price of the
stock.





(12)
Stockholders’ Equity


(a)
Restrictions on Dividends


Current
regulations allow the Bank to pay dividends on its stock if its regulatory
capital would not thereby be reduced below the amount required for the statutory
capital requirements set by the Federal Deposit Insurance Corporation
(FDIC).




(b)
Regulatory Capital


The
Corporation (on a consolidated basis) and the Bank are subject to various
regulatory capital requirements administered by the federal banking agencies.
Failure to meet minimum capital requirements can initiate certain mandatory and
possibly additional discretionary actions by regulators that, if undertaken,
could have a direct material effect on the Corporation's and Bank's financial
statements. Under capital adequacy guidelines and the regulatory framework for
prompt corrective action, the Corporation and the Bank must meet specific
capital guidelines that involve quantitative measures of their assets,
liabilities and certain off-balance-sheet items as calculated under regulatory
accounting practices. The capital amounts and classification are also subject to
qualitative judgments by the regulators about components, risk weightings, and
other factors. Prompt corrective action provisions are not applicable to bank
holding companies.


Quantitative
measures established by regulation to ensure capital adequacy require the
Corporation and the Bank to maintain minimum amounts and ratios (set forth in
the following table) of total and Tier 1 capital (as defined in the regulations)
to risk-weighted assets (as defined) and of Tier 1 capital (as defined) to
average assets (as defined). Management believes, as of December 31, 2007, and
2006, that the Corporation and the Bank met all capital adequacy requirements to
which they are subject. To be categorized as well-capitalized, an institution
must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage
ratios as set forth in the following tables.


At
December 31, 2007, banking regulations required institutions to have a minimum
total risk-based capital to risk-weighted assets ratio of 8% and a Tier 1 (core)
capital to adjusted total assets ratio of 4%.


At
December 31, 2007, the Bank was in compliance with the regulatory requirements
for well-capitalized institutions.


As of
December 31, 2007, the most recent notification from the FDIC categorized the
Bank as well-capitalized under the regulatory framework for prompt corrective
action. There are no conditions or events since the notification that management
believes have changed the Bank's category.




ACTUAL
              
              
              MINIMUMREQUIREMENTSFOR
      CAPITALADEQUACY
              
              
              WELL-CAPITALIZEDREQUIREMENTSCASCADE BANK
              
              AMOUNT
              
              
              RATIO
              
              
              AMOUNT
              
              
              RATIO
              
              
              AMOUNT
              
              
              RATIODecember
      31, 2007:Total
      risk-based capital to risk-weighted assets (1)
              
              $
              135,345
              
              
              10.91
              %
              
              $
              99,248
              
              
              8.00
              %
              
              $
              124,059
              
              
              10.00
              %Tier
      I (core) capital to risk-weighted assets
              
              
              123,550
              
              
              9.96
              
              
              
              49,624
              
              
              4.00
              
              
              
              74,436
              
              
              6.00Tier
      I (core) capital to average total assets
              
              
              123,550
              
              
              9.00
              
              
              
              54,901
              
              
              4.00
              
              
              
              68,626
              
              
              5.00December
      31, 2006:Total
      risk-based capital to risk-weighted assets (1)
              
              $
              127,132
              
              
              11.20
              %
              
              $
              90,816
              
              
              8.00
              %
              
              $
              113,521
              
              
              10.00
              %Tier
      I (core) capital to risk-weighted assets
              
              
              116,144
              
              
              10.23
              
              
              
              45,408
              
              
              4.00
              
              
              
              68,112
              
              
              6.00Tier
      I (core) capital to average total assets
              
              
              116,144
              
              
              8.96
              
              
              
              51,850
              
              
              4.00
              
              
              
              64,813
              
              
              5.00


38


CASCADE
FINANCIAL CORPORATION AND SUBSIDIARIES
 Notes
to Consolidated Financial Statements
 (Dollars
in thousands, except share amounts)
 The
Corporation, as a bank holding company regulated by the Federal Reserve, is also
subject to capital requirements that are similar to those for Cascade
Bank.


ACTUAL
              
              
              MINIMUMREQUIREMENTSFOR
      CAPITALADEQUACY
              
              
              WELL-CAPITALIZED
                REQUIREMENTSCASCADE FINANCIAL CORP
              
              AMOUNT
              
              
              RATIO
              
              
              AMOUNT
              
              
              RATIO
              
              
              AMOUNT
              
              
              RATIODecember
      31, 2007:Total
      risk-based capital to risk-weighted assets (1)
              
              $
              134,174
              
              
              10.80
              %
              
              
              99,361
              
              
              8.00
              %
              
              $
              124,201
              
              
              10.00
              %Tier
      I (core) capital to risk-weighted assets
              
              
              122,379
              
              
              9.85
              
              
              
              49,681
              
              
              4.00
              
              
              
              74,521
              
              
              6.00Tier
      I (core) capital to average total assets
              
              
              122,379
              
              
              8.9
              
              
              
              55,032
              
              
              4.00
              
              
              
              68,790
              
              
              5.00December
      31, 2006:Total
      risk-based capital to risk-weighted assets (1)
              
              $
              127,504
              
              
              11.22
              %
              
              $
              90,935
              
              
              8.00
              %
              
              
              113,668
              
              
              10.00
              %Tier
      I (core) capital to risk-weighted assets
              
              
              116,516
              
              
              10.25
              
              
              
              45,467
              
              
              4.00
              
              
              
              68,201
              
              
              6.00Tier
      I (core) capital to average total assets
              
              
              116,516
              
              
              8.99
              
              
              
              51,850
              
              
              4.00
              
              
              $
              64,813
              
              
              5.00
  (1)  The
FDIC and the Federal Reserve require institutions to maintain Tier I capital of
not less than one-half of total capital.




(13)
Mortgage Servicing Rights


A summary
of capitalized mortgage servicing rights, included in other assets, at December
31, 2007, and December 31, 2006, follows:




DECEMBER
      31,
              
              
              DECEMBER
      31,2007
              
              
              2006Balance
      at beginning of year
              
              $
              174
              
              
              $
              10Additions
              
              
              —
              
              
              
              170Amortization
              
              
              (44
              )
              
              
              (6
              )Balance
      at end of year
              
              $
              130
              
              
              $
              174
  The
fair value of servicing rights was determined using a discount rate of 12% and a
prepayment speed of 400%.





(14)
Employee Benefit Plans


(a)
Savings Plan


The
Corporation maintains a savings plan under section 401(k) of the Internal
Revenue Code, covering substantially


all
full-time employees. Under the plan, employee contributions are matched by the
Corporation at a rate of 50% of the first $12 contributed. Such matching becomes
vested over a period of five years of credited service. Employees may make
investments in various stock, fixed income or money market plans, or may
purchase stock in the Corporation.


The
Corporation contributed $336, $313, and $287 to the plan for the years ended
December 31, 2007, 2006, and 2005, respectively.




(b)
Employee Stock Purchase Plan


The
Corporation maintains an employee stock purchase plan, under the terms of which
213,212 shares of common stock have been authorized for issuance. The plan
allows employees of the Corporation with three months of service the opportunity
to purchase common stock through accumulated salary deductions during each
offering period. On the first day of each six-month offering period (January 1
and July 1 of each year), eligible employees who elect to participate are
granted options to purchase a limited number of shares and unless the
participant withdraws from the plan, the option is effectively exercised on the
last day of each offering period. The aggregate number of shares to be purchased
in any given offering is determined by dividing the accumulated salary deduction
for the period by the lower of 85% of the market price of a common share at the
beginning or end of an offering period.





(c)
Stock Options


The
shareholders of the Corporation approved two stock option plans to promote the
best interest of the Corporation and its shareholders by providing an incentive
to employees and directors. The plans permit the grant of incentive stock
options and non-qualified stock options.


Options
are granted to certain employees and directors at prices equal to the market
value of the stock on the dates the options were 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. The maximum number of
options that may be issued under the plan is 937,500 (as adjusted for stock
splits and dividends). The Corporation had 597,566 and 592,200 shares available
for grant at December 31, 2007, and 2006, respectively.  39


CASCADE
FINANCIAL CORPORATION AND SUBSIDIARIES


Notes
to Consolidated Financial Statements


(Dollars
in thousands, except share amounts)





Accounting
for Stock Options


On
January 1, 2006, the Corporation adopted SFAS No.123(R), applying the
modified prospective method. SFAS No. 123(R) requires all equity-based
payments to employees, including grants of employee stock options, to be
recognized in the Consolidated Statements of Income at the fair value of the
award over the requisite service period. Under the modified prospective method,
the Corporation is required to record equity-based compensation expense for all
awards granted after the date of adoption and for the unvested portion of
previously granted awards outstanding as of the date of adoption.


Net
compensation cost charged against income for stock option expense was $213 for
2007, and $287 for 2006. The total income tax benefit recognized in the income
statement for stock based compensation arrangements was $231 for 2007, and $314
for 2006.


The
fair values of the options granted to the Corporation’s employees were estimated
on the date of grant using the Black-Scholes valuation model. The application of
this valuation model involves assumptions that are judgmental and sensitive in
the determination of compensation expense.


The
following table provides the range of assumptions used for stock options
granted:





YEARS
      ENDED DECEMBER 31,2007
            
            
            2006
            
            
            2005Risk-free
      interest rate
            
            
            4.75
            %
            
            
            4.50
            %
            
            
            3.00
            %Expected
      life in years
            
            
            5
            
            
            
            5
            
            
            
            8Expected
      volatility
            
            
            24
            %
            
            
            24
            %
            
            
            24
            %Dividend
      yield
            
            
            2.00
            %
            
            
            2.03
            %
            
            
            2.02
            %




Historical
information was the primary basis for the selection of the expected volatility,
expected dividend yield and the expected lives of the options. The Corporation
has collected a long history of option activity and feels 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.


A summary
of option activity as of, and for the year ended, December 31, 2007 is as
follows:




OPTIONS
              
              
              WEIGHTED-
                AVERAGE
                EXERCISE
                PRICE
      PER
                SHARE
              
              
              WEIGHTED-
                AVERAGE
                REMAINING
                CONTRACTUAL
                TERM
                (IN
      YEARS)
              
              
              AGGREGATE
                INTRINSIC
                VALUEOutstanding
      as of December 31, 2006
              
              
              703,606
              
              
              $
              9.26
              
              
              
              5.76
              
              
              $
              5,511,642Granted
              
              
              4,000
              
              
              
              16.21Exercised
              
              
              (102,295
              )
              
              
              5.63Forfeited/Cancelled
              
              
              (9,744
              )
              
              
              13.02Outstanding
      as of December 31, 2007
              
              
              595,567
              
              
              $
              9.87
              
              
              
              5.13
              
              
              $
              2,580,240Exercisable
      as of December 31, 2007
              
              
              384,696
              
              
              $
              7.76
              
              
              
              4.07
              
              
              $
              2,361,610
  All
amounts have been adjusted retroactively to reflect the 5-for-4 stock split paid
in May 2006.


All
options granted have limited rights that enable a holder upon a change in
control of the Corporation to elect to receive cash equal to the difference
between the exercise price of the option and the fair market value of the common
stock on the date of exercise. At December 31, 2007, and December 31, 2006,
384,696 and 383,916 shares, respectively, were fully exercisable.


The
weighted average fair values of options granted under the Corporation's stock
option plan were $4.04, $3.77, and $3.86, respectively for the years ended
December 31, 2007, December 31, 2006, and December 31, 2005. The total intrinsic
value of options exercised were $1.1 million, $1.3 million and $1.1 million,
respectively, during the years ended December 31, 2007, 2006, and 2005. Total
unrecognized compensation cost related to stock options was $210 as of December
31, 2007, and $466 as of December 31, 2006. That cost is expected to be
recognized over a weighted average period of 1.3 years. Cash received from
options exercised under all share-based payment arrangements were $576, $670,
and $443 for the years ended December 31, 2007, 2006 and 2005,
respectively.


As a result of adopting SFAS No.
123(R), the Corporation’s income before income taxes for the years ended
December 31, 2007, and 2006, was $213 and $287 lower, respectively, than if it
had continued to account for share-based compensation under Opinion No. 25. This
option expense is included in salaries and employee benefits
expenses.


Prior
to the adoption of SFAS No. 123(R), the Corporation presented all tax benefits
of deductions resulting from the exercise of stock options as operating cash
flows in the Statement of Cash Flows. SFAS No. 123(R) requires the cash flow
resulting from the tax benefits resulting from tax deductions in excess of the
compensation cost recognized CASCADE


40


FINANCIAL CORPORATION AND
SUBSIDIARIES


Notes
to Consolidated Financial Statements


(Dollars
in thousands, except share amounts)





for those
options (excess tax benefits) to be classified as financing cash flows. The $231
excess tax benefit classified as a financing cash inflow would have been
classified as an operating cash inflow if the Corporation had not adopted SFAS
No. 123(R).


The
following table illustrates the effect on net income and earnings per share for
the years ended December 31, 2005, if the Corporation had applied the fair
value recognition provisions of SFAS No. 123(R) to stock-based employee
compensation:


YEAR
      ENDED DECEMBER 31,2005Net
      Income, as reported
              
              $
              13,046Add:
      Stock-based employee compensation expense included in reported net income,
      net of related tax effects
              
              
              -Deduct:
      Total stock-based employee compensation expense determined under fair
      value based method for all awards, net of related tax
    effects
              
              
              167Pro
      forma net income
              
              $
              12,879
   DECEMBER
      31,2005Net
      income per common share - Basic
              
              $
              1.09As
      reportedPro
      forma
              
              
              1.07Net
      income per common share - DilutedAs
      reported
              
              $
              1.06Pro
      forma
              
              
              1.05
  Deferred
Compensation Plan


In
December 2004, the Board adopted the Cascade Bank Deferred Compensation Plan.
The purpose of this Plan is to provide specified benefits to a select group of
management or highly compensated employees who contribute materially to the
continued growth, development and business success of the Bank.  The
Plan was inactive in 2007 and has been replaced with a new plan effective
February 1, 2008.


On
January 16, 2008 the Cascade Bank Non-Qualified Deferred Compensation Plan was
adopted. During 2007, one of the major projects of the Compensation Committee
was to develop and recommend a plan to the Board of Directors that would provide
specified benefits to a select group of management and highly compensated
employees. Participants may contribute up to 50 percent of salary and 100
percent of their bonus to the Plan. In addition, the Compensation Committee has
the authority to authorize an employer contribution to the Plan for these same
employees. The contribution will be based upon the performance of the Bank as
well as the individual performance of each employee. The Non-Qualified Deferred
Compensation Plan will also be available to Directors. Each Director may
contribute up to 100 percent of their director compensation to the Plan. No
Corporation contributions will be made for Directors.





Employment
Agreement


The Bank
entered into an employment agreement with Carol K. Nelson dated November 27,
2007, which replaced a previous agreement dated July 12, 2005. This agreement
replaced a prior agreement dated March 26, 2002 and extended on January 27,
2004. The current agreement may be terminated upon 90 days written
notice.





(15)
Fair Value of Financial Instruments


The fair
value estimates presented below are subjective in nature, involve uncertainties
and matters of significant judgment and, therefore, are not necessarily
indicative of the amounts the Corporation could realize in a current market
exchange. The Corporation has not included certain material items in its
disclosure, such as the value of the long-term relationships with the
Corporation’s lending and deposit customers, since this is an intangible and not
a financial instrument. Additionally, the estimates do not include any tax
ramifications. There may be inherent


weaknesses
in any calculation technique, and changes in the underlying assumptions used,
including discount rates and estimates of future cash flows, that could
materially affect the results. For all of these reasons, the aggregation of the
fair value calculations presented herein do not represent, and should not be
construed to represent, the underlying value of the
Corporation.


41


CASCADE
FINANCIAL CORPORATION AND SUBSIDIARIES


Notes
to Consolidated Financial Statements


(Dollars
in thousands, except share amounts)





The
following table presents a summary of the fair value of the Corporation’s
financial instruments:




DECEMBER 31,
              
              
              DECEMBER 31,2007
              
              
              2006CARRYING
                VALUE
              
              
              ESTIMATED
                FAIR VALUE
              
              
              CARRYING
                VALUE
              
              
              ESTIMATED
                FAIR VALUEFinancial
      assets:Cash
      and cashequivalents
              
              $
              14,530
              
              
              $
              14,530
              
              
              $
              42,879
              
              
              $
              42,879Securities
      available-for-sale
              
              
              82,860
              
              
              
              82,860
              
              
              
              130,656
              
              
              
              130,656Securities
      held-to-maturity
              
              
              137,238
              
              
              
              136,295
              
              
              
              96,846
              
              
              
              93,536FHLB
      stock
              
              
              11,920
              
              
              
              11,920
              
              
              
              11,920
              
              
              
              11,920Loans,
      net
              
              
              1,092,776
              
              
              
              1,110,897
              
              
              
              996,015
              
              
              
              1,002,554Financial
      liabilities:Deposit
      accounts(1)
              
              $
              904,896
              
              
              $
              895,449
              
              
              $
              855,449
              
              
              $
              854,795Borrowings
              
              
              351,625
              
              
              
              364,499
              
              
              
              338,710
              
              
              
              338,859Junior
      subordinated debentures payable
              
              
              15,465
              
              
              
              14,649
              
              
              
              25,775
              
              
              
              27,465Junior
      subordinated debentures payable, at fair value
              
              
              11,422
              
              
              
              11,422
              
              
              
              —
              
              
              
              —Mark-to-market
      on swaps
              
              
              —
              
              
              
              —
              
              
              
              312
              
              
              
              312


(1)
            Net
      of ($312) mark-to-market on swap for
2006.





Fair
Value Accounting


SFAS No.
159 generally permits the measurement of selected eligible financial
instruments at fair value at specified election dates. Upon adoption of SFAS No.
159, the Corporation selected fair value measurement for certain
available-for-sale and held-to-maturity investment securities, FHLB advances and
Cascade Capital Trust I (junior subordinated debentures), which had fair values
of approximately $68.1 million, $46.7 million and $12.1 million, respectively,
on January 1, 2007. The Corporation also selected fair value measurement for an
interest rate swap on a certificate of deposit with a notional value of $10.0
million and a fair value loss of $312 on January 1, 2007. SFAS No. 157
defines fair value, establishes a framework for measuring fair value under GAAP,
and expands disclosures about fair value measurement.


Fair
values determined by Level 1 inputs utilize quoted prices (unadjusted) in active
markets for identical assets or liabilities that the Corporation has the ability
to access. Fair values determined by Level 2 inputs utilize inputs other than
quoted prices included in Level 1 that are observable for the asset or
liability, either directly or indirectly. Level 2 inputs include quoted prices
for similar assets and liabilities in active markets, and inputs other than
quoted prices that are observable for the asset or liability, such as interest
rates and yield curves that are observable at commonly quoted intervals. Level 3
inputs are unobservable inputs for the asset or liability, and include
situations where there is little, if any, market activity for the asset or
liability.


Upon
adoption of SFAS No. 157, there was no cumulative effect adjustment to beginning
retained earnings and no impact on the financial statements, other than in
conjunction with the adoption of SFAS No. 159, in the year ended December 31,
2007.


At
December 31, 2007, the Corporation had $11.9 million in junior subordinated
debenture measured at fair value on a recurring basis.


The
junior subordinated debentures are valued using discounted cash flows to the
next available redemption date on the date of valuation based on recent
issuances or quotations from brokers for comparable bank holding companies and
are considered a Level 2 input method.


42


CASCADE
FINANCIAL CORPORATION AND SUBSIDIARIES


Notes
to Consolidated Financial Statements


(Dollars
in thousands, except share amounts)


Initial
      Fair Value Adjustment on Adoption of SFAS 159JANUARY
      1, 2007(Dollars
      in thousands)
            
            AMORTIZED
      COST
            
            
            FAIR
      MARKET VALUATION ADJUSTMENT
            
            
            BASIS
      AT FMV
            
            
            RELATED
      DEFERRED TAXES
            
            
            CUMULATIVE
      EFFECT OF ADOPTIONAssetsSecurities
      available-for-sale (AFS) reclassified to fair value
            
            $
            54,721
            
            
            $
            (2,056
            )
            
            $
            52,665
            
            
            $
            720
            
            
            $
            (1,336
            )Securities
      held-to-maturity (HTM) reclassified to fair value
            
            
            15,984
            
            
            
            (554
            )
            
            
            15,430
            
            
            
            194
            
            
            
            (360
            )Deferred
      origination costs on junior subordinated
              debentures
            
            
            654
            
            
            
            (654
            )
            
            
            -
            
            
            
            227
            
            
            
            (427
            )$
            71,359
            
            
            $
            (3,264
            )
            
            $
            68,095
            
            
            $
            1,141
            
            
            $
            (2,123
            )LiabilitiesFHLB
      advances
            
            $
            45,000
            
            
            $
            1,654
            
            
            $
            46,654
            
            
            $
            (579
            )
            
            $
            1,075Junior
      subordinated debentures payable
            
            
            10,310
            
            
            
            1,740
            
            
            
            12,050
            
            
            
            (609
            )
            
            
            1,131Interest
      rate swap on CD
            
            
            -
            
            
            
            312
            
            
            
            312
            
            
            
            (109
            )
            
            
            203$
            55,310
            
            
            $
            3,706
            
            
            $
            59,016
            
            
            $
            (1,297
            )
            
            $
            2,409Total
      adjustment
            
            
            
            
            
            
            
            
            
            
            
            
            
            $
            2,438
            
            
            $
            (4,532
            )Less
      transfer from other comprehensive loss to
              retained
      earnings
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (738
            )
            
            $
            1,370Cumulative
      adjustment of deferred tax asset and
              equity
      on adoption of  SFAS 159
            
            
            
            
            
            
            
            
            
            
            
            
            
            $
            1,700
            
            
            $
            (3,162
            )





Following
the initial election, changes in the value of financial instruments recorded at
fair value are recognized as gains or losses in subsequent financial reporting
periods. As a result of the adoption of SFAS No. 159 and changes in the fair
value measurement of the financial assets and liabilities noted above, the
Corporation recorded a cumulative net gain of $1.1 million ($703 after tax)
for the year ended December 31, 2007.




Fair
      Value Gains (Losses)($
      IN 000S)
                PAR
      VALUE
              
              
              
              TOTAL
                NET
      INCOME10,000
              
              Interest
      rate swap
              
              $
              5745,000
              
              FHLB
      advances
              
              
              (70
              )70,000
              
              Investment
      securities HFT
              
              
              51810,000
              
              Junior
      subordinated debentures
              
              
              576Total
              
              $
              1,081Adjusted
      for taxes
              
              $
              703


Cash
and Cash Equivalents


The
carrying amount represents fair value.




Securities
including mortgage backed securities and FHLB stock


Fair
values are based on quoted market prices or dealer quotations when available or
through the use of alternate approaches, such as matrix or model pricing, when
market quotes are not readily available.




Loans


Fair
values are estimated using current market interest rates to discount future cash
flows for each of the six different loan types. Interest rates used to discount
the cash flows are based on U.S. Treasury yields or other market interest rates
with appropriate spreads for each segment. The spread over the Treasury yields
or other market rates is used to account for liquidity, credit quality and
higher servicing costs. Prepayment rates are based on expected future prepayment
rates, or, where appropriate and available, market prepayment
rates.




Deposit
Accounts


The fair
value of deposits with no stated maturity, such as checking accounts, money
market deposit accounts and savings accounts, equals the amount payable on
demand. The fair value of certificates of deposits is calculated based on the
discounted value of contractual cash flows. The discount rate is equal to the
rate currently offered on similar products.




Borrowings
(FHLB advances and securities sold under agreements to repurchase)


The fair
value is calculated based on the discounted cash flow method, adjusted for
market interest rates and terms to maturity.


43


CASCADE
FINANCIAL CORPORATION AND SUBSIDIARIES


Notes
to Consolidated Financial Statements


(Dollars
in thousands, except share amounts)





Junior
Subordinated Debentures Payable (Trust Preferred Securities)


The fair
value is calculated based on the amounts required to settle the contracts,
adjusted for market interest rates and terms to maturity.




Swaps


The fair
value is calculated based on the discounted cash flow method, adjusted for
changes in swap spreads to the underlying treasury securities.





(16)
On-Balance Sheet Derivative Instruments and Hedging Activities


Derivative
Financial Instruments


The
Corporation had derivative financial instruments in the form of interest rate
swap agreements, which derive their value from underlying interest rates. These
transactions involved both credit and market risk. Direct credit exposure is
limited to the net difference between the calculated amounts to be received and
paid, and any change in fair value of the contract in which the counterparty
would owe the Corporation if the contract were terminated. Such difference,
which represents the fair value of the derivative instruments, is reflected on
the Corporation's balance sheet as derivative assets and derivative liabilities.
The Corporation controls the credit risk of its financial contracts through
credit approvals, limits and monitoring procedures, and does not expect any
counterparties to fail to meet their obligations.


Off-balance-sheet
financial instruments - commitments to extend credit, standby letters of credit
and financial guarantees represent the principal categories of off-balance
instruments (Note 4). The fair value of these commitments is not considered
material because they are for a short period of time and subject to customary
credit terms.




Risk
Management Policies - Hedging Instruments


The
primary focus of the Corporation’s asset/liability management program is to
monitor the sensitivity of the Corporation’s net income and fair value of equity
under varying interest rate scenarios to take steps to control its risks (see
Management Discussion and Analysis – Interest Rate Risk
Management).




Interest
Rate Risk Management - Fair Value Hedging Instruments


The
Corporation holds fixed and variable-rate assets and liabilities. Fixed-rates
may expose the Corporation to variability in their fair value due to changes in
the level of interest rates. The Corporation may utilize interest
rate


swaps as
an asset/liability management strategy to hedge the change in value of the
assets due to changes in interest rate assumptions.


An
interest rate swap agreement used to hedge junior subordinated debentures
payable (trust preferred securities), with a notional amount of $10.0 million
was terminated in December 2006 at a loss of $150.


The
information pertaining to a terminated interest rate swap agreement used to
hedge certificates of deposit is as follows:




DECEMBER
      31,2006Notional
      amount
            
            $
            10,000Weighted
      average pay rate
            
            
            5.14
            %Fixed
      receive rate
            
            
            5.00
            %Maturity
      in years
            
            
            7.4Unrealized
      (loss) relating to interest rate swap
            
            $
            (312
            )





This
agreement provides for the Corporation to make payments at a variable-rate
determined by a three-month LIBOR in exchange for receiving payments at a fixed
rate. The unrealized (loss) relating to the interest rate swap of $(312) was
marked to market as an adjustment to equity with the implementation of SFAS No.
159 effective January 1, 2007. The swap was terminated in April 2007 at a net
loss of $4.


Risk
management results for the year ended December 31, 2006, related to the balance
sheet hedging of certificates of deposit indicate that the hedge was 100%
effective and that there was no component of the derivative instrument’s gain or
loss during which was excluded from the assessment of hedge
effectiveness.


The
Corporation enters into rate lock commitments to extend credit to borrowers for
generally a 30-day or 60-day period for the origination of loans.


On
March 13, 2002, the Financial Accounting Standards Board determined that loan
commitments related to the origination or acquisition of mortgage loans that
will be held-for-sale must be accounted for as derivative instruments.
Accordingly, the Corporation adopted such accounting on July 1, 2002, and such
commitments, along with any related fees received from potential borrowers, are
recorded at fair value in derivative assets or liabilities, with changes in fair
value recorded in the net gain or loss on sale of mortgage loans. Since the
Corporation originates its saleable loans on a “best effort” basis and delivers
those loans to the purchaser within 10 days at the committed price, there will
generally be no gain or loss recorded on those commitments.


The
Corporation had non-mandatory forward commitments totaling $0 and $364 to sell
loans into the secondary market at December 31, 2007, and December 31, 2006,
respectively.


44


CASCADE
FINANCIAL CORPORATION AND SUBSIDIARIES


Notes
to Consolidated Financial Statements


(Dollars
in thousands, except share amounts)





(17)
Contingencies


The
Corporation is a defendant in various legal proceedings arising in connection
with its business. It is the opinion of management that the financial position
and the results of operations of the Corporation will not be materially
adversely


affected
by the final outcome of these legal proceedings and that adequate provision has
been made in the accompanying consolidated financial statements.


At
periodic intervals, the Washington State Department of Financial Institutions
and the Federal Deposit Insurance Corporation routinely examine the
Corporation’s financial statements as part of their legally prescribed oversight
of the banking industry. Based on these examinations, the regulators can direct
that the Corporation’s financial statements be adjusted in accordance with their
findings.





(18)
Condensed Financial Information of Cascade Financial Corporation


Following
are the condensed financial statements of Cascade Financial Corporation (parent
only) for the period indicated:


BALANCE
      SHEET
              
              DECEMBER 31, 2007
              
              
              DECEMBER 31, 2006Assets:Cash
              
              $
              267
              
              
              $
              829Investment
      in subsidiary
              
              
              148,267
              
              
              
              139,827Other
      assets
              
              
              2,011
              
              
              
              1,765$
              150,545
              
              
              $
              142,421Liabilities
      and stockholders’ equity:Other
      liabilities
              
              $
              1,562
              
              
              $
              1,447Junior
      subordinated debentures payable
              
              
              26,887
              
              
              
              25,775Stockholders’
      equity
              
              
              122,096
              
              
              
              115,199$
              150,545
              
              
              $
              142,421
   INCOME
      STATEMENT
              
              FOR
      THE YEARS ENDED DECEMBER 31,2007
              
              
              2006
              
              
              2005Equity
      in undistributed net income of the subsidiary
              
              $
              16,745
              
              
              $
              14,836
              
              
              $
              13,992Interest
      income – junior subordinated debentures payable
              
              
              64
              
              
              
              58
              
              
              
              46Net
      gain on fair value of junior subordinated debentures
    payable
              
              
              576
              
              
              
              —
              
              
              
              —Operating
      expenses
              
              
              (364
              )
              
              
              (460
              )
              
              
              (299
              )Interest
      expense – junior subordinated debentures payable
              
              
              (2,120
              )
              
              
              (1,880
              )
              
              
              (1,198
              )Income
      before benefit from income taxes
              
              
              14,901
              
              
              
              12,554
              
              
              
              12,541Benefit
      from income taxes
              
              
              645
              
              
              
              801
              
              
              
              505Net
      income
              
              $
              15,546
              
              
              $
              13,355
              
              
              $
              13,046


45


CASCADE
FINANCIAL CORPORATION AND SUBSIDIARIES


Notes
to Consolidated Financial Statements


(Dollars
in thousands, except share amounts)




STATEMENT
      OF CASH FLOWS
              
              FOR
      THE YEARS ENDED DECEMBER 31,2007
              
              
              2006
              
              
              2005Cash
      flows from operating activities:Net
      income
              
              $
              15,546
              
              
              $
              13,355
              
              
              $
              13,046Adjustments
      to reconcile net income to net cash(used in) operating
      activities:Equity
      in net income of subsidiaries
              
              
              (16,745
              )
              
              
              (14,836
              )
              
              
              (13,992
              )Increase
      (decrease) in other assets
              
              
              (31
              )
              
              
              936
              
              
              
              195(Decrease)
      increase in other liabilities
              
              
              (629
              )
              
              
              (287
              )
              
              
              134Net
      cash used in operating activities
              
              
              (1,859
              )
              
              
              (832
              )
              
              
              (617
              )Cash
      flows from investing activities:Dividends
      received from subsidiaries
              
              
              7,300
              
              
              
              4,250
              
              
              
              4,000Investment
      in subsidiary
              
              
              —
              
              
              
              (10,000
              )
              
              
              —Net
      cash provided (used) by investing activities
              
              
              7,300
              
              
              
              (5,750
              )
              
              
              4,000Cash
      flows from financing activities:Repurchase
      of common stock
              
              
              (2,838
              )
              
              
              (673
              )
              
              
              (858
              )Proceeds
      from exercise of stock options
              
              
              813
              
              
              
              1,050
              
              
              
              865Dividends
      paid
              
              
              (3,978
              )
              
              
              (3,603
              )
              
              
              (3,163
              )Proceeds
      from junior subordinated debentures payable
              
              
              —
              
              
              
              10,000
              
              
              
              —Net
      cash (used) provided by financing activities
              
              
              (6,003
              )
              
              
              6,774
              
              
              
              (3,156
              )Net
      increase (decrease) in cash and cash equivalents
              
              
              (562
              )
              
              
              192
              
              
              
              227Cash
      and cash equivalents:Beginning
      of year
              
              
              829
              
              
              
              637
              
              
              
              410End
      of year
              
              $
              267
              
              
              $
              829
              
              
              $
              637
  (19)
Lines of Business


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.





(20) Selected
Quarterly Financial Data(Unaudited)




QUARTER ENDEDMAR
      31,
            
            
            JUNE
      30,
            
            
            SEPT
      30,
            
            
            DEC
      31,2007
            
            
            2007
            
            
            2007
            
            
            2007Interest
      income
            
            $
            22,631
            
            
            $
            23,789
            
            
            $
            23,378
            
            
            $
            24,137Interest
      expense
            
            
            12,354
            
            
            
            12,798
            
            
            
            12,568
            
            
            
            12,820Net
      interest income
            
            
            10,277
            
            
            
            10,991
            
            
            
            10,810
            
            
            
            11,317Provision
      for loan losses
            
            
            250
            
            
            
            250
            
            
            
            350
            
            
            
            500Other
      income
            
            
            2,051
            
            
            
            1,834
            
            
            
            1,942
            
            
            
            1,739Other
      expense
            
            
            6,423
            
            
            
            6,548
            
            
            
            6,724
            
            
            
            6,987Income
      before provision for income taxes
            
            
            5,655
            
            
            
            6,027
            
            
            
            5,678
            
            
            
            5,569Provision
      for income taxes
            
            
            1,890
            
            
            
            2,044
            
            
            
            1,892
            
            
            
            1,557Net
      income
            
            $
            3,765
            
            
            $
            3,983
            
            
            $
            3,786
            
            
            $
            4,012Earnings
      per share, basic
            
            $
            0.31
            
            
            $
            0.33
            
            
            $
            0.32
            
            
            $
            0.33Earnings
      per share, diluted
            
            
            0.30
            
            
            
            0.32
            
            
            
            0.31
            
            
            
            0.33




46


CASCADE
FINANCIAL CORPORATION AND SUBSIDIARIES


Notes
to Consolidated Financial Statements


(Dollars
in thousands, except share amounts)





(20) Selected
Quarterly Financial Data(Unaudited)
(continued)


QUARTER ENDEDMAR
      31,
              
              
              JUNE
      30,
              
              
              SEPT
      30,
              
              
              DEC
      31,2006
              
              
              2006
              
              
              2006
              
              
              2006Interest
      income
              
              $
              18,787
              
              
              $
              20,249
              
              
              $
              21,396
              
              
              $
              22,226Interest
      expense
              
              
              9,267
              
              
              
              10,561
              
              
              
              11,440
              
              
              
              12,000Net
      interest income
              
              
              9,520
              
              
              
              9,688
              
              
              
              9,956
              
              
              
              10,226Provision
      for loan losses
              
              
              250
              
              
              
              300
              
              
              
              300
              
              
              
              150Other
      income
              
              
              1,325
              
              
              
              1,573
              
              
              
              1,616
              
              
              
              1,512Other
      expense
              
              
              5,875
              
              
              
              6,036
              
              
              
              6,349
              
              
              
              6,326Income
      before provision for income taxes
              
              
              4,720
              
              
              
              4,925
              
              
              
              4,923
              
              
              
              5,262Provision
      for income taxes
              
              
              1,548
              
              
              
              1,598
              
              
              
              1,609
              
              
              
              1,720Net
      income
              
              $
              3,172
              
              
              $
              3,327
              
              
              $
              3,314
              
              
              $
              3,542Earnings
      per share, basic
              
              $
              0.26
              
              
              $
              0.28
              
              
              $
              0.27
              
              
              $
              0.29Earnings
      per share, diluted
              
              
              0.26
              
              
              
              0.27
              
              
              
              0.27
              
              
              
              0.29QUARTER ENDEDMAR
      31,
              
              
              JUNE
      30,
              
              
              SEPT
      30,
              
              
              DEC
      31,2005
              
              
              2005
              
              
              2005
              
              
              2005Interest
      income
              
              $
              15,600
              
              
              $
              16,666
              
              
              $
              17,391
              
              
              $
              18,145Interest
      expense
              
              
              6,826
              
              
              
              7,515
              
              
              
              8,055
              
              
              
              8,880Net
      interest income
              
              
              8,774
              
              
              
              9,151
              
              
              
              9,336
              
              
              
              9,265Provision
      for loan losses
              
              
              245
              
              
              
              250
              
              
              
              250
              
              
              
              200Other
      income
              
              
              1,600
              
              
              
              1,667
              
              
              
              1,564
              
              
              
              1,502Other
      expense
              
              
              5,553
              
              
              
              5,776
              
              
              
              5,672
              
              
              
              5,605Income
      before provision for income taxes
              
              
              4,576
              
              
              
              4,792
              
              
              
              4,978
              
              
              
              4,962Provision
      for income taxes
              
              
              1,505
              
              
              
              1,577
              
              
              
              1,634
              
              
              
              1,546Net
      income
              
              $
              3,071
              
              
              $
              3,215
              
              
              $
              3,344
              
              
              $
              3,416Earnings
      per share, basic
              
              $
              0.26
              
              
              $
              0.27
              
              
              $
              0.28
              
              
              $
              0.29Earnings
      per share, diluted
              
              
              0.25
              
              
              
              0.26
              
              
              
              0.27
              
              
              
              0.28


47





ANNUAL
SHAREHOLDERS’ MEETING


The
Annual Shareholders’ meeting will be held at the Everett Golf & Country
Club, 1500 52nd Street
SE, Everett, Washington, on Tuesday, April 22, 2008 at 6:30 p.m. Pacific
time.


48