Forward-Looking Statements

This Form 10-Q contains certain "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements may be identified by the use of words such as "believe," "expect," "anticipate," "should," "planned," "estimated," and "potential." These forward-looking statements relate to, among other things, expectations of the business environment in which the Company operates, projections of future performance, perceived opportunities in the market, potential future credit experience, and statements regarding the Company's mission and vision. These forward-looking statements are based upon current management expectations and may, therefore, involve risks and uncertainties. The Company's actual results, performance, or achievements may differ materially from those suggested, expressed, or implied by forward-looking statements as a result of a wide variety or range of factors including, but not limited to: the credit risk of lending activities, including changes in the level and trend of loan delinquencies and write-offs; default risks associated with debt and equity investment securities which may result in OTTI; results of examinations by our banking regulators; interest rate fluctuations; economic conditions in the Company's primary market area; demand for residential, commercial real estate, consumer, and other types of loans; success of new products; competitive conditions between banks and non-bank financial service providers; regulatory and accounting changes; technological factors affecting operations; pricing of products and services; and other risks detailed in the Company's reports filed with the Securities and Exchange Commission, including its Annual Report on Form 10-K for the fiscal year ended December 31, 2007. Accordingly, these factors should be considered in evaluating forward-looking statements, and undue reliance should not be placed on such statements. The Company undertakes no responsibility to update or revise any forward-looking statements.

Comparison of Financial Condition at September 30, 2008 and December 31, 2007

The following table sets forth certain information concerning our consolidated
financial condition at the dates indicated (dollars in thousands):

                        At September 30,       At December 31,         $ Increase          % Increase
                              2008                  2007              (Decrease)           (Decrease)

  Total assets          $         840,649     $         878,864     $       (38,215 )               (4.3 )%
   Investment
securities (1)                    102,509               177,043             (74,534 )              (42.1 )
  Interest-bearing
deposits with banks                    15                    90                 (75 )              (83.3 )
  Loans, net                      650,304               628,921              21,383                  3.4
   Deposits                       464,056               461,487               2,569                  0.6
   Borrowed funds                 308,500               320,454             (11,954 )               (3.7 )
   Total
shareholders' equity               57,508                86,820             (29,312 )              (33.8 )

(1) Includes mortgage-backed securities

Total assets decreased $38.3 million, or 4.3%, to $840.6 million at September 30, 2008 from $878.9 million at December 31, 2007. During the nine months ended September 30, 2008, our investment securities portfolio declined by $74.5 million, primarily the

Loans. The following table sets forth the composition of our loan portfolio by type of loan at the dates indicated (dollars in thousands):

                       At September 30, 2008          At December 31, 2007      $ Increase    % Increase
                         Amount       Percent         Amount        Percent     (Decrease)    (Decrease)
Real estate:
One-to four-family
residential               $65,997          9.9 %    $   76,882         12.1%      $(10,855)      (14.2)%
Five or more family
residential               141,449         21.3         149,080         23.4         (7,631)      (5.1)
Commercial                248,243         37.4          212,901        33.4          35,342      16.6
Total real estate         455,689         68.6         438,863         68.9          16,826       3.8

Real estate
construction:
One-to four-family
residential                79,120         11.9          73,114         11.5           6,006       8.2
Five or more family
residential                   471          0.1           1,839          0.3         (1,368)     (74.4)
Commercial                  5,991          0.9           3,827          0.6           2,164      56.5
Total real estate
construction               85,582         12.9          78,780         12.4           6,802       8.6

Consumer:
Automobile                 13,409          2.0          20,798          3.3         (7,389)     (35.5)
Home equity                42,660          6.4          45,293          7.1         (2,633)      (5.8)
Credit cards               22,793          3.5          23,172          3.6           (379)      (1.6)
Other                       8,123          1.2            7,411         1.2             712       9.6
Total consumer             86,985         13.1           96,674        15.2         (9,689)     (10.0)

Commercial business        35,991          5.4           22,683         3.5          13,308      58.7

Total loans               664,247        100.0 %        637,000       100.0%         27,247       4.3

Less allowance for
loan losses               (13,943)                      (8,079)                     (5,864)      72.6

Loans, net               $650,304                    $  628,921                     $21,383        3.4%

Our net loan portfolio increased $21.4 million, or 3.4%, to $650.3 million at September 30, 2008 from $628.9 million at December 31, 2007. This increase was primarily attributable to growth in our real estate secured loans (including home equity loans), which increased $21.0 million, or 3.7%, to $583.9 million at September 30, 2008 compared to $562.9 million at December 31, 2007. The real estate loan growth included a $35.3 million, or 16.6% increase in nonresidential commercial real estate loans and a $6.8 million, or 8.6% increase in real estate construction loans. These increases were partially offset by a $10.9 million, or 14.2% decline in our one-to four-family mortgage portfolio, due primarily to the sale of $48.2 million in single-family fixed-rate mortgages and a $7.6 million, or 5.1% decline in five or more family real estate loans as a result of a high level of loan repayments for the nine months ended September 30, 2008; and a $2.6 million, or 5.8% decline in home equity loans as a result of tighter underwriting standards and borrowers refinancing their first mortgage on their home and paying off their home equity loans. Additionally, the commercial business loan portfolio increased $13.3 million, or 58.7%. Partially offsetting the increases in loans secured by real estate and commercial business loans was a $7.1 million decrease in consumer loans (excluding home equity loans), including a $7.4 million decline in automobile loan balances primarily attributable to our decision to tighten the underwriting standards for auto loans beginning in 2007 and to discontinue the origination of indirect auto loans on February 1, 2008.

Investments. The following table sets forth the composition of our investment securities at the dates indicated. The available-for-sale investments are presented at net book value after a mark-to-market fair value adjustment, while the held-to-maturity securities are presented at amortized cost. Our investment in the FHLB of Seattle's common stock is presented at cost and for reference purposes only (dollars in thousands):

                           At September 30,   At December 31,     $ Increase     % Increase
                                 2008              2007           (Decrease)     (Decrease)
Available-for-sale:
U. S. Government agencies         $       -   $         5,705        $(5,705)       (100.0)%
Corporate securities                      -             5,023         (5,023)      (100.0)
Trust preferred securities           58,848           102,356        (43,508)       (42.5)
Mortgage-backed securities            7,145            18,203        (11,058)       (60.7)
Total available-for-sale
portfolio                            65,993           131,287        (65,294)       (49.7)

Held-to-maturity:
Municipal obligations                11,790            12,784           (994)        (7.8)
Mortgage-backed securities           24,726            32,972         (8,246)       (25.0)
Total held-to-maturity
portfolio                            36,516            45,756         (9,240)       (20.2)

Total Investment
Securities                          102,509           177,043        (74,534)       (42.1)

Federal Home Loan Bank of
Seattle stock                        13,712            13,712               -           -

 Total                            $ 116,221          $190,755      $ (74,534)        (39.1)%

Our investment securities portfolio decreased by $74.5 million, or 42.1%, to $102.5 million at September 30, 2008 from $177.0 million at December 31, 2007. The decrease in investments was primarily the result of a $42.7 million fair value decline in the Company's portfolio of pooled trust preferred securities issued by FDIC-insured financial institutions and insurance companies and $31.0 million of sales, maturities, and partial calls of investment securities during the nine months ended September 30, 2008. Included in this amount was $6.6 million in principal repayments on mortgage-backed securities. Included in the sales of investment securities during the first nine months of 2008 was $3.7 million of held-to-maturity ("HTM") securities. These HTM securities were sold when they had remaining book values of less than 15% of original purchase price. In accordance with SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, when HTM securities with remaining book values of less than 15% of their original purchase price are sold, they are treated the same as maturities and do not taint the HTM investment portfolio or affect the Company's ability to hold securities in the HTM portfolio in the future.

The Company has evaluated the decline in the fair value of its trust preferred securities, which is directly related to the credit and liquidity crisis being experienced in the financial services industry over the past year. The trust preferred securities market is currently inactive making the valuation of trust preferred securities very difficult. The trust preferred securities are valued by management using unobservable inputs (i.e., Level 3 inputs under SFAS 157) through a discounted cash flow analysis as permitted under SFAS 157 and using the expected cash flows appropriately discounted using present value techniques and Bloomberg screen analytics. The analysis incorporated baseline information from November 2007 when the market was last active (new pooled trust preferred securities were last issued in 2007) and risk premiums were added to reflect current market conditions related to the widening of spreads, liquidity, and credit risk. As a result of the analysis, management recorded the fair value of our trust preferred securities at $58.8 million, or $49.5 million below the net book value of $108.3 million and believes the valuation is appropriate assuming an active market. Please refer to Note 7 - Fair Value for more information.

All of our trust preferred securities remain investment grade, have continued to pay interest as scheduled through September 30, 3008, and are expected to continue paying interest as scheduled. We believe the cash flows of the Company's trust preferred securities, as discounted, appropriately reflect the estimated fair value of the securities. Management has analyzed this portfolio to determine whether the decline is other than temporary and has concluded that only temporary impairment exists. See Note 8 - Other Than Temporary Impairment for more information. Management will continue to evaluate these securities for impairment quarterly. Under U.S. generally accepted accounting principles, the Company has reflected the current period temporary fair value decline in a valuation allowance component of shareholders' equity.

Non-performing Assets. The following table sets forth detailed information concerning our non-performing assets for the periods indicated (dollars in thousands):

                                   At September 30, 2008                At December 31, 2007            $ Increase        % Increase
                                 Amount           Percent (1)        Amount          Percent (1)        (Decrease)        (Decrease)
Loans 90 days or more past
due or non-accrual loans:
Real estate                   $          -                   - %   $        -                   - %    $           -                - %
Real estate construction            31,243                4.70              -                   -             31,243            100.0
Consumer                               242                0.04            497                0.08               (255 )          (51.3 )
Commercial business                    288                0.04              -                   -                288            100.0
Total non-performing loans          31,773                4.78            497                0.08             31,276          6,293.0

Other non-performing assets
Repossessed assets                       -                                 49                                    (49 )         (100.0 )
Real estate owned                      103                                  -                                    103            100.0
Total other non-performing
assets                                 103                                 49                                     54            110.2
Total non-performing assets   $     31,876                         $      546                          $      31,330          5,738.1 %

   Total non-performing
assets as a percentage of
      total assets                    3.79 %                             0.06 %

(1) Percent of total loan portfolio

Our non-performing assets have increased to $31.9 million at September 30, 2008 from $546,000 at December 31, 2007. The increase was primarily the result of cash flow problems experienced by four local residential builders during the second and third calendar quarters of 2008, resulting in their inability to meet the debt service requirements of the loans. As of September 30, 2008, we classified $31.2 million in real estate construction loans (representing 36.5% of our total real estate construction portfolio) associated with four builders as non-performing, which consists of $20.4 million in developed one- to four-family residential lots, $6.9 million in one- to four-family residential construction loans with houses in varying stages of completion (i.e., developed lots to completed homes), and $3.9 million in loans for land development. We classified most of our loans to these four builders (excluding pre-sold homes and rental properties amounting to $4.2 million) as non-performing. The cumulative interest not accrued during the third quarter relating to all non-performing loans totaled $540,000, while the total for the nine months ended September 30, 2008 was $704,000. We intend to work with our builders to reach acceptable payment plans while protecting our interests in the existing collateral. In the event an acceptable arrangement cannot be reached, we may have to acquire these properties through foreclosure or other means and subsequently sell, develop, or liquidate them. Subsequent to September 30, 2008, the Company acquired real estate construction property from one of its construction and land development loan customers, which included homes in various stages of completion and developed lots. See Part II, Item 5 of this Form 10-Q.

Management performs an impairment analysis on a loan when it determines it is probable that all contractual amounts of principal and interest will not be paid as scheduled. The analysis usually occurs when a loan has been negatively classified or placed on non-accrual status. If the current value of the impaired loan is less than the recorded investment in the loan, impairment is recognized by establishing a specific allocation of the allowance for loan losses for the loan or by adjusting an existing allocation. Our analysis of the $31.2 million in non-performing construction loans revealed a specific allocation of the allowance was appropriate. Based on our analysis of these loans, which included the review of either existing or updated appraisals as well as adjustments to those appraisals for deteriorating market conditions, we established a $6.5 million specific allowance for these loans.

Deposits. The following table sets forth the composition of our deposits at the dates indicated (dollars in thousands):

                                At September 30, 2008         At December 31, 2007        $ Increase    % Increase
                                Amount        Percent          Amount       Percent        (Decrease)   (Decrease)

Non-interest-bearing checking     $40,526           8.7 %       $33,924          7.4 %        $6,602         19.5%
Interest-bearing checking          36,930           8.0          41,083          8.9          (4,153)      (10.1)
Savings accounts                   29,056           6.3          28,397          6.1             659         2.3
Money market accounts             135,570          29.1         117,626         25.5          17,944        15.3
IRA accounts                        5,908           1.3           5,713          1.2             195         3.4
Certificates of deposit           216,066          46.6         234,744         50.9         (18,678)       (8.0)
Total deposits                   $464,056         100.0 %      $461,487        100.0 %      $  2,569          0.6%

Core deposits                    $247,990          53.4 %      $226,743         49.1 %       $20,247          9.4%
Non-core deposits                 216,066          46.6         234,744         50.9         (18,678)       (8.0)
Total deposits                   $464,056         100.0 %      $461,487        100.0 %      $  2,569          0.6%

Our deposits increased $2.6 million, or 0.6%, to $464.1 million at September 30, 2008 from $461.5 million at December 31, 2007. Interest-bearing deposits decreased $4.0 million, while non-interest bearing deposits, primarily checking accounts, increased $6.6 million. Our deposit mix at the end of the third quarter included 53.4% of relatively low-cost checking, savings, money market, and individual retirement accounts (i.e., core deposits). Certificates of deposit at September 30, 2008 included $64.7 million of brokered certificates of deposit, an increase of $3.8 million from the $60.9 million of brokered certificates of deposit at December 31, 2007.

Borrowings. Borrowed funds, consisting of Federal Home Loan Bank advances, decreased $12.0 million, or 3.7%, to $308.5 million at September 30, 2008 from $320.5 million at December 31, 2007. The decrease in borrowed funds during the nine months ended September 30, 2008 was primarily attributable to a reduction in short-term liquidity needs. We will continue to utilize borrowings from the FHLB of Seattle for general liquidity needs and also to fund attractive loan and investment opportunities and to enhance earnings in connection with leveraging the Company's capital to increase our net interest income.

Capital. Total shareholders' equity decreased $29.3 million, or 33.8%, to $57.5 million at September 30, 2008 from $86.8 million at December 31, 2007. The decrease in equity during the nine months ended September 30, 2008 was primarily attributable to a $28.2 million unrealized loss, net of taxes, resulting from the mark-to-market fair value adjustment of the available-for-sale securities portfolio. Additionally, we paid out $1.4 million in cash dividends to shareholders, purchased $800,000 of our common stock, and recorded a $489,000 net loss from operations during the first nine months of 2008. Partially offsetting these decreases was $1.5 million in positive equity adjustments related to stock compensation and benefits resulting from our MRP, SOP, and ESOP plans. These changes, and a $38.2 million decline in the balance of our total assets, resulted in our capital-to-assets ratio under accounting principles generally accepted in the United States decreasing 304 basis points to 6.84% at September 30, 2008, compared to 9.88% at December 31, 2007. As of September 30, 2008, the Bank remained categorized "well capitalized" under all regulatory standards.

Comparison of Operating Results for the Three Months Ended September 30, 2008 and 2007

The following table sets forth certain information concerning our results of operations for the periods indicated (dollars in thousands):

                          Three Months Ended September
                                       30,                  $ Increase      % Increase
                                2008            2007        (Decrease)      (Decrease)

Net interest income              $  6,154      $  6,733       $   (579)           (8.6)%
Non-interest income                 2,479         2,412             67            2.8
Total revenue                       8,633         9,145           (512)          (5.6)
Provision for loan losses           6,000           150          5,850        3,900.0
Non-interest expense                7,022         7,349           (327)          (4.4)
Net income (loss)                  (2,950)        1,072         (4,022)        (375.2)

Net Interest Income. The following table sets forth detailed information concerning our net interest income for the periods indicated (dollars in thousands):

                          Three Months Ended September
                                      30,                   $ Increase     % Increase
                               2008            2007         (Decrease)     (Decrease)
Interest income:
Loans                            $10,666       $12,127         $(1,461)         (12.0)%
Securities
available-for-sale                 1,304         2,015            (711)        (35.3)
Securities
held-to-maturity                     398           527            (129)        (24.5)
Interest-bearing deposits              -            28             (28)       (100.0)
Federal Home Loan Bank
stock dividends                       48            21              27         128.6
Total interest income             12,416        14,718          (2,302)        (15.6)

Interest expense:
Deposits                           2,735         4,104          (1,369)        (33.4)
Borrowed funds                     3,527         3,881            (354)         (9.1)
Total interest expense             6,262         7,985          (1,723)        (21.6)
Net interest income              $ 6,154      $  6,733        $   (579)          (8.6)%

Net interest income decreased $579,000, or 8.6%, to $6.2 million for the three months ended September 30, 2008, compared to $6.7 million during the same period in 2007, primarily due to a $540,000 decrease in interest income as a result of unrecognized interest income from non-performing real estate construction loans and a decrease in our investment securities portfolio related to investment sales and principal paydowns. Our net interest margin for the three months ended September 30, 2008 was depressed by 27 basis points as a result of unrecognized interest income from non-performing real estate construction loans, and at 3.06% for the quarter, was 14 basis points lower than the 3.20% for the same period in 2007.

Interest Income. Our interest income decreased $2.3 million, or 15.6%, to $12.4 million for the three months ended September 30, 2008 from $14.7 million for the three months ended September 30, 2007. Interest earned on loans for the three months ended September 30, 2008 and 2007 was $10.7 million and $12.1 million, respectively. The average yield on total loans decreased to 6.39% for the three months ended September 30, 2008 compared to 7.53% for the same period in 2007 reflecting the decrease in short-term interest rates. The decreased yield on our variable-rate loan products was a result of the current lower interest rate environment, and was partially offset by an increase in the average balance of loans, resulting in the decreased interest income on loans. Additionally, during the third quarter of 2008, $31.2 million in construction loans were classified as non-accrual and $540,000 of interest income was not recognized as a result. The average balance of total loans increased by $22.7 million to $665.6 million for the three months ended September 30, 2008 compared to $642.9 million for the same period in 2007. Although a significant portion of the loan portfolio consists of real estate secured loans that do not immediately re-price when interest rates change, construction loans, home equity lines of credit, credit card loans, and some of our commercial business loans do re-price when short-term interest rates change; subject to interest rate floors on most of these loans.

Interest income on investment securities (including mortgage-backed securities) decreased $840,000, or 33.0%, to $1.7 million for the three months ended September 30, 2008 compared to $2.5 million for the three months ended September 30, 2007 as a result of lower average balances. Additionally, the majority of our trust preferred securities adjust to a floating three-month LIBOR rate plus a specified margin every three months. Accordingly, a decrease in the LIBOR rate has also contributed to the decrease in interest income on investments. The average balances of investment securities, including mortgage-backed securities for the three months ended September 30, 2008 and 2007 were $125.9 million and $188.2 million, respectively. The average yield on investment securities was unchanged at 5.41% for the three months ended September 30, 2008 and September 30, 2007.

Interest Expense. Our interest expense decreased $1.7 million, or 21.6%, to $6.3 million for the three months ended September 30, 2008 from $8.0 million for the three months ended September 30, 2007. Declining short-term market interest . . .