General

Our results of operations depend primarily on revenue generated as a result of our net interest income and non-interest income. Net interest income is the difference between the interest income we earn on our interest-earning assets (consisting primarily of loans and investment securities) and the interest we pay on our interest-bearing liabilities (consisting primarily of customer savings and money market accounts, time deposits and borrowed funds). Non-interest income consists primarily of service charges on deposit and loan accounts, gains on the sale of loans and investments, loan servicing fees, real estate lease income, and investment and insurance commissions. Our results of operations are also affected by our provisions for loan losses and non-interest expenses. Non-interest expenses consist primarily of compensation and benefits, occupancy, office operations and supplies, equipment, data processing, marketing, and, when applicable, deposit insurance premiums. Our results of operations are also affected significantly by general and local economic and competitive conditions, changes in market interest rates, changes in the fair value and impairment of investments securities, governmental policies and actions of regulatory authorities.

Business Strategy

As a financial service provider, we serve more than 25,000 households in our primary market area of Tacoma-Pierce County and the neighboring City of Federal Way in Washington State. We principally focus on growing and expanding customer relationships in this geographical market area and provide our services primarily through 14 full-service retail locations, 20 automated teller machines, and our Call Center. In addition, we offer customers 24-hour access through our internet banking services and automated voice response telephone banking system. Our strategy of delivering services through the combined availability of branches, the internet, and our call center provides customers with personalized options on how they want to access our services.

Our traditional banking services consist of attracting retail checking, money market, and certificates of deposit from the general public and businesses; which we invest primarily in commercial real estate loans, multi-family real estate loans, real estate construction and land loans, one- to four-family real estate loans, a variety of consumer loans (e.g., credit cards, home equity, automobile), and commercial business loans. We are a member of the Federal Home Loan Bank of Seattle and use borrowed funds and brokered deposits as a funding source to supplement customer deposits for funding loans and investments and to assist us in managing liquidity and our interest rate risk.

We also focus on building and deepening customer relationships by offering financial planning and investment services, as well as property and casualty insurance products to our customers and the local community. We provide financial planning and non-insured investment products and conduct business under the name of Rainier Pacific Financial Services. We offer property and casualty and life insurance products and conduct business under the name of Rainier Pacific Insurance Services.

We plan to continue growing our market share of local insured deposits and reduce our reliance on the use of brokered deposits over the next several years. In the current operating environment, we anticipate moderating the growth of the loan portfolio by de-emphasizing real estate and land construction, auto, and unsecured consumer loan originations and implementing more stringent underwriting criteria for commercial, multi-family, and commercial business loans. We are also evaluating various strategic options and are seeking the assistance of investment banking services to evaluate and potentially pursue the prospects of private equity investment or other capital raising alternatives. While we continue to act upon both tactical and strategic alternatives to raise capital and restructure our balance sheet, we cannot assure you that in the current financial environment these efforts will be successful and will result in sufficient capital preservation or infusion prior to any actions that the Company=s and the Bank=s regulators may take.

Operating Strategy

Our mission is to build profitable relationships by providing valuable financial solutions for our customers. Service quality, broad product selection, and convenient access are all primary attributes of our brand and business strategy. We focus on providing exceptional service and quality products and services, as well as convenient access to generate a high level of customer satisfaction. We are committed to providing a network of branch offices and proprietary automated teller machines that enable our customers to access our services within 15 minutes from essentially anywhere in Pierce County and the City of Federal Way.

Our operating strategy is focused on continuing to build the value of our Company by profitably offering a broad array of financial products and services to residents and businesses located in our primary geographical market area of operation. We plan to grow existing retail customer relationships, by gaining an increased proportion of their deposit, investment, and insurance services, and increasing small business banking relationships that offer the greatest potential for future profits.

We have established strategic objectives that guide our actions. Our primary strategic objectives are: (1) being a full-service financial solutions provider delivering a high degree of value to our customers and community; and (2) actively managing Rainier Pacific Financial Group to produce a financially stable organization that grows its market value over time.

Critical Accounting Estimates

Allowance for loan losses. Management recognizes that loan losses occur over the life of a loan, and that the allowance for loan losses must be maintained at a level sufficient to absorb probable losses inherent in the loan portfolio. Management's determination of the allowance is based on a number of factors, including the level of non-performing loans, loan loss experience, credit concentrations, a review of the quality of the loan portfolio, underwriting practices, collateral values and economic conditions. The allowance is increased by the provision for loan losses, which is charged against current period operating results and decreased by the amount of actual loan charge-offs, net of recoveries.

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 company management to make assumptions about future losses on loans; and (2) the impact of a sudden large loss could significantly reduce the allowance and potentially require increased provisions to replenish the allowance, which would negatively affect earnings.

Our methodology for assessing the appropriateness of the allowance consists of two key elements: a formula element and a specific element.

We review the consumer and residential loan portfolios as pools of loans since no single loan is individually significant. The formula element is calculated by applying a loss percentage factor to the various loan types based on past due ratios, historical loss experience, regulatory and internal credit grading and classification systems, and changes in underwriting practices that could affect the collectibility of the portfolio. Additionally, we consider economic and other factors, including loan volumes and concentrations, seasoning of the loan portfolio, and local employment data. These factors may be adjusted for events that are significant in management's judgment as of the evaluation date.

We determine the specific element through the evaluation of specific commercial real estate and commercial business loans on an individual basis once a loan is deemed impaired. A loan is considered impaired when, based on current information, management determines it is probable that the Company will be unable to collect all amounts due according to the terms of the loan agreement. Impairment is measured by the difference between the recorded investment in the loan (including accrued interest and net deferred loan fees or costs) and the estimated present value of total expected future cash flows, discounted at the loan's effective rate, or the fair value of

Our asset liability management committee (primarily consisting of senior management) reviews and analyzes the loan portfolio, charge-offs, and allowance on a quarterly basis. Management then discusses the development and calculation of this critical accounting estimate with the loan and investment committee of our board of directors. The audit committee of our board of directors also reviews the Company's disclosures including this critical accounting estimate.

We reviewed and evaluated the loan portfolio and the adequacy of the allowance at December 31, 2008 and believe that the allowance is adequate for the risk inherent in the loan portfolio considering the current economic environment. In 2008, the total loan portfolio, including loans held-for-sale, increased 5.5% to $672.3 million at December 31, 2008 from $637.0 million at December 31, 2007. The recent weakness in one- to four-family home sales, slowdown in the economic environment, and portfolio growth during the last few years in our real estate construction and land, multi-family, and commercial real estate loans has increased our exposure to loan losses. In September 2002, the Bank started making one- to four-family real estate construction and land loans. As of December 31, 2008, real estate construction and land loans were 12.2% of the loan portfolio and totaled $81.9 million, an increase of $3.1 million, or 3.9%, from $78.8 million in fiscal 2007. This was, however, $65.7 million higher compared to $16.2 million for the year ended December 31, 2004. In addition, the loan portfolio has experienced substantial growth especially in multi-family and commercial real estate loans. At December 31, 2008, the multi-family and commercial real estate portfolios totaled $402.8 million, up from $362.0 million, $358.9 million and $325.2 million at December 31, 2007, 2006 and 2005, respectively. In the December 31, 2008 allowance for loan loss review, we determined that the allowance was adequate at 1.98% of total loans, or $13.3 million compared to 1.27% of total loans or $8.1 million at December 31, 2007. The increase in the allowance was primarily a result of the deteriorating financial and economic markets, weakness in housing markets, financial stress being experienced by home builders/developers and higher losses in the loan portfolio, especially from one- to four-family real estate construction and land loans.

The Bank recorded net charge-offs of $1.8 million, $804,000, $914,000, $1.1 million and $2.0 million during the years ended December 31, 2008, 2007, 2006, 2005 and 2004, respectively. Consumer loans (including home equity) totaled $85.6 million, $96.7 million, $106.1 million, $102.6 million and $116.8 million or 12.7%, 15.2%, 16.6%, 17.6% and 23.2% of the loan portfolio at December 31, 2008, 2007, 2006, 2005 and 2004, respectively. Consumer loans, including home equity loans, have historically accounted for essentially all of the Bank's charge-offs. In 2008, the Bank recorded net charge-offs of $978,000 in consumer loans, $686,000 in one- to four-family residential construction loans, and $59,000 in commercial business loans.

The provision for loan losses has fluctuated based upon the growth of the loan portfolio, the changing characteristics and composition of the portfolio, the level of charge-offs, and the economic environment. The provision for loan losses was $7.0 million, $600,000, $600,000, $750,000 and $2.7 million for the years ended December 31, 2008, 2007, 2006, 2005 and 2004, respectively. The substantial increase in the provision for loan losses was due to deterioration in the credit quality of our one- to four-family construction and land development loans. The weakness in the local housing market has placed substantial stress on our local builders/developers which has reduced the quality of our construction and land loan portfolio.

Fair Value - Trust Preferred CDO Securities. Effective January 1, 2008, the Company began determining the fair market value of our financial instruments based on the fair value hierarchy established in SFAS No. 157, Fair Value Measurements ("SFAS 157"), which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.

? Level 1 - Quoted prices in active markets for identical assets or liabilities; including items such as U.S. Treasury and other U.S. Government and agency securities actively traded in over-the-counter markets.

? Level 2 - Observable inputs other than Level 1 including quoted prices for similar assets or liabilities, quoted prices in less active markets, or other observable inputs that can be corroborated by observable market data. This category generally includes items such as certain U.S. Government and agency securities; certain CDO securities; and corporate debt securities.

? Level 3 - Observable inputs supported by little or no market activity for financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation. This category generally includes certain CDO securities and certain private equity investments.

We carry our available-for-sale ("AFS") securities at fair value and perform recurring valuations on our AFS securities. We use observable inputs (i.e., Level 2 inputs under SFAS 157) to value our agency mortgage-backed securities, if any, and use unobservable inputs (i.e., Level 3 inputs under SFAS 157) to value our trust preferred CDO securities.

In October 2008, the FASB issued FSP 157-3, Determining the Fair Value of a Financial Asset in a Market That is Not Active ("FSP 157-3"). FSP 157-3 clarifies the application of SFAS 157 in an inactive market. FSP 157-3 addresses application issues such as how management's internal assumptions should be considered in measuring fair value when relevant observable data do not exist, how observable market information in a market that is not active should be considered when measuring fair value, and how the use of market quotes should be considered in assessing the relevance of observable and unobservable data available to measure fair value. FSP 157-3 was effective upon issuance. The Company's adoption of FSP 157-3 impacted how the trust preferred CDO securities shown on the statement of financial condition were valued at September 30, 2008 and December 31, 2008.

The following table presents the fair value of our AFS securities under the associated fair value hierarchy as established by SFAS 157 and FSP 157-3 as of December 31, 2008 (dollars in thousands):

                           Quoted Prices in             Significant             Significant
                          Active Markets for               Other               Unobservable          Assets at
                           Identical Assets          Observable Inputs            Inputs               Fair
                              (Level 1)                  (Level 2)               (Level 3)             Value

Available-for-sale
securities              $                    -     $                    -     $        14,895     $        14,895

We believe that the estimate of fair value of our trust preferred securities is a "critical accounting estimate" because (1) it is highly susceptible to change from period to period as a result of the volatile financial markets and because it requires the Company to make significant assumptions about the fair value of a substantial asset; and (2) the impact of a large decline in the fair value of this asset can and has resulted in a significant decline in earnings, shareholders' equity, and regulatory capital which will adversely affect the Company going forward.

Between December 16, 2002 and January 12, 2006, the Company invested in 15 separate holdings of investment grade A-rated mezzanine tranches of trust preferred CDO securities. The securities were issued and are referred to as Preferred Term Securities Limited ("PreTSL"). The underlying collateral for the PreTSL is pooled trust preferred securities issued by banks and insurance companies geographically dispersed across the United States. The Company holds PreTSL IV, and VI through XIX.

Prior to September 30, 2008, the Company determined the fair value of the trust preferred CDO securities using a valuation technique based on Level 3 inputs that did not require adjustment. The Level 3 inputs included

Beginning September 30, 2008, the Company determined based on market activity that the market for the trust preferred CDO securities that the Company holds and for similar collateralized debt obligation securities (such as higher-rated tranches within the same collateralized debt obligation security) were inactive. That determination was made considering that there are few observable transactions for the trust preferred CDO securities or similar collateralized debt obligation securities and the observable prices for those transactions have varied substantially over time. Consequently, the Company has considered those observable inputs, and has determined our trust preferred CDO securities should remain classified within Level 3 of the fair value hierarchy.

At September 30, 2008, the Company used an income approach valuation technique (using discounted cash flows and present value techniques) that maximizes the use of relevant observable inputs and minimized the use of unobservable inputs which was considered more representative of fair value then relying on the estimation of market value technique used prior to September 30, 2008, which had few observable inputs and relied primarily on data in an inactive market. The Company used the discount rate adjustment technique described in Appendix B of SFAS 157 to determine fair value at September 30, 2008.

At December 31, 2008, the Company reviewed a variety of alternative pricing information including pricing provided by independent investment banking/brokerage and financial consulting sources, along with internally prepared valuations. The range of values for the trust preferred CDO securities as of December 31, 2008 was $0.12 to $0.49 per $1.00 of par value, and reflect the current illiquid and inactive market for these types of securities. Based on its analysis, the Company currently believes that a weighted average price of approximately $0.14 per $1.00 of par value is representative of the fair value of the entire $108.0 million (par value) in the trust preferred CDO securities portfolio.

At December 31, 2008, the Company valued the trust preferred CDO securities using values provided by an independent investment banking/brokerage firm. The estimates of fair value are predominately based on a review of the securities and any recent sales activity of the same or similar securities, and are considered to be representative of the price at which the security could be sold in the current inactive and illiquid market. The general methodology includes the following:

? a review of any market activity in the securities or similar securities, and considers the sale price, including distressed sales, as a starting indication of the securities' value; ? a review of the defaults and deferrals by the underlying issuers for each of the securities;
? a review of any rating agency research reports and rating indications; ? a review of the expected cash flows for relative value and to determine if any payments will be missed; and
? a review of the underlying collateral and credits, and for overlap of issuers.

The Company has reflected the change in value of 12 trust preferred CDO securities as an unrealized loss of $71.5 million (pre-tax), or $47.2 million net of income tax benefit, as a component of shareholders' equity (i.e., accumulated other comprehensive loss) and recorded a $21.7 million in impairment charges (pre-tax), or $14.1 million net of income tax benefit on the three trust preferred CDO securities considered to involve OTTI.

The following table reconciles the changes in the fair value of our AFS securities classified as Level 3 (i.e., trust preferred securities) (dollars in thousands):

                                                                       Securities
                                                                  Available-for- Sale
                                                                       (Level 3)

Beginning Balance at December 31, 2007                           $                   --
  Transfers into Level 3                                                        102,356
  Total realized and unrealized gains (losses)                                  (86,818 )
  Purchases                                                                          --

  Paydowns and maturities                                                          (643 )
Ending Balance at December 31, 2008                              $               14,895

The amount of total gains (losses) for the year ended
December 31, 2008 included in earnings attributable to
the change in unrealized gains (losses) relating to assets
still held at December 31, 2008                                  $               21,706

Fair Value Loans. The Company does not record impaired loans at fair value on a recurring basis. From time to time, non-recurring fair value adjustments to collateral dependent loans are recorded to reflect partial write-downs based on observable market price or current appraised value of collateral. As of December 31, 2008, management evaluated $28.0 million of impaired loans, which consisted of $24.8 million in construction loans and $3.2 million in commercial business loans. The $21.6 million fair market value of impaired loans reported in the table below represents the $28.0 million in impaired loan balances, net of a $6.4 million specific allowance. We also do not record real estate owned (acquired through a lending relationship) at fair value on a recurring basis. All real estate owned properties are recorded at amounts which are equal to or less than the fair market value of the properties based on current independent appraisals reduced by estimated selling costs upon transfer of the loans to real estate owned. From time to time, non-recurring fair value adjustments to real estate owned are recorded to reflect partial write downs based on an observable market price or current appraised value of collateral. The following table presents the fair value of our impaired loans and real estate owned under the associated fair value hierarchy as established by SFAS 157 as of December 31, 2008 (dollars in thousands):

                                        Quoted Prices
                                          in Active
                                         Markets for           Significant          Significant
                                          Identical          Other Observable       Unobservable
                                           Assets                Inputs                Inputs         Assets at Fair
                                          (Level 1)             (Level 2)            (Level 3)             Value

Impaired loans                         $             -     $                 -     $       21,551     $        21,551
Real estate owned                                    -                       -              6,796               6,796
Total                                  $             -     $                 -     $       28,347     $        28,347

Critical Accounting Policies

The Company's significant accounting principles are described in Note 1 of the Notes to Consolidated Financial Statements included in Item 8 of this report 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 included in Item 8 of this report.

Investments. The Company classifies its investments as either available-for-sale or held-to-maturity. Available-for-sale securities are reported at their fair value, which is generally determined by obtaining quoted market prices for securities in active markets and by using an income valuation technique (using discounted cash flows and present value techniques) or market prices for our trust preferred securities which are in an inactive market. 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 17 of the Notes to Consolidated Financial Statements included in Item 8 of this report.

Long-Lived Assets and Intangibles. The Company periodically assesses the impairment of its long-lived assets and intangibles using judgment as to the effects of external factors, including market conditions. Judgment is also required in projecting future operating results. If actual external conditions and future operating results differ from the Company's judgments, impairment charges may be necessary to reduce the carrying value of these assets to the appropriate market value.

. . .