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 strategies. 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 risks of lending activities, including changes in the level and trend of loan delinquencies and write-offs that may be impacted by deterioration in the housing and commercial real estate markets and may lead to increased losses and non-performing assets in the Company's loan portfolio, result in the Company's allowance for loan losses not being adequate to cover actual losses, and require the Company to materially increase its reserves; changes in general economic conditions, either nationally or in the Company's market areas; changes in the levels of general interest rates, and the relative differences between short and long term interest rates, deposit interest rates, net interest margin, and funding sources; deposit flows; fluctuations in the demand for loans, the number of unsold homes and other properties, and fluctuations in real estate values in the Company's market areas; adverse changes in the securities markets, including changes in the ability of the issuers of trust preferred CDO securities the Company owns to repay their obligations and the possibility that the Company will recognize additional credit losses from these securities as a result of further OTTI charges; changes as a result of examinations of the Company by the Federal Reserve Board and its bank subsidiary by the Federal Deposit Insurance Corporation, the Washington State Department of Financial Institutions, Division of Banks, or other regulatory authorities, or as a result of agreements with these regulators, including the possibility that any such regulatory authority may, among other things, require the Company to increase its reserve for loan losses, write-down assets, recognize additional OTTI charges on its trust preferred CDO securities; change its regulatory capital position, or affect its ability to borrow funds or maintain or increase deposits, which could adversely affect the Company's liquidity and earnings; the Company's ability to control operating costs and expenses; the use of estimates in determining fair value of certain of the Company's assets, which estimates may prove to be incorrect and result in significant declines in valuation; difficulties in reducing risk associated with the loans on the Company's balance sheet; staffing fluctuations in response to product demand or the implementation of corporate strategies that affect the Company's work force and potential associated charges; computer systems on which the Company depends could fail or experience a security breach, or the implementation of new technologies may not be successful; the Company's ability to retain key members of its senior management team; costs and effects of litigation, including settlements and judgments; the Company's ability to manage loan delinquency rates; increased competitive pressures among financial services companies; changes in consumer spending, borrowing, and savings habits; legislative or regulatory changes that adversely affect the Company's business including changes in regulatory policies and principles, including the interpretation of regulatory capital or other rules; the availability of resources to address changes in laws, rules, or regulations or to respond to regulatory actions; inability of key third-party providers to perform their obligations to the Company; changes in accounting policies and practices, as may be adopted by the financial institution regulatory agencies or the Financial Accounting Standards Board, including additional guidance and interpretation on accounting issues and details of the implementation of new accounting methods; economic impact of war or any terrorist activities; other economic, competitive, governmental, regulatory, and technological factors affecting the Company's operations; pricing, products, and services; time to lease excess space in Company-owned buildings; 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, 2008. Any of the forward-looking statements that the Company makes in this Form 10-Q and in the other public statements may turn out to be wrong because of inaccurate assumptions the Company might make, the factors illustrated above, or other factors that the Company cannot foresee. Because of these and other uncertainties, the Company's actual future results may be materially different from those expressed in any forward-looking statements made by or on the Company's behalf. Therefore, 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 statement.

Comparison of Financial Condition at June 30, 2009 and December 31, 2008

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

                          At June 30,       At December 31,         $ Increase           % Increase
                             2009                 2008              (Decrease)           (Decrease)

Total assets            $       821,391     $         847,233     $        (25,842 )               (3.1 )%
Investment securities
(1)                              65,447                48,879               16,568                 33.9
Interest-bearing
deposits with banks              47,666                29,425               18,241                 62.0
Loans, net                      604,114               658,952              (54,838 )               (8.3 )
Deposits                        488,959               519,239              (30,280 )               (5.8 )
Borrowed funds                  281,421               291,217               (9,796 )               (3.4 )
Total shareholders'
equity                           41,941                29,294               12,647                 43.2

   (1) Includes
mortgage-backed
securities

Total assets decreased $25.8 million or 3.1% to $821.4 million at June 30, 2009, compared to $847.2 million at December 31, 2008. Interest-bearing deposits with the Federal Reserve Bank increased by $18.2 million during the period and investment securities increased $16.6 million due to a pre-tax fair value increase in our trust preferred CDO securities. Partially offsetting these increases was a net decrease of $54.8 million in the loan portfolio, which was primarily the result of loan sales during the first six months of 2009, including the sale of our VISA credit card portfolio, the sale of substantially all of our new one-to four-family loan originations, and the Company's decision to reduce originations of loans for its portfolio as part of the Company's current strategy to shrink the balance sheet. Deposits decreased to $489.0 million from $519.2 million at December 31, 2008, resulting primarily from the $56.5 million reduction in our balance of brokered deposits during the first six months of the year, which was offset by a $10.8 million increase in retail deposits. As a result of its "under-capitalized" status, the Bank is currently prohibited from accepting, renewing or rolling over brokered deposits. Shareholders' equity increased $12.6 million to $41.9 million at June 30, 2009 from $29.3 million at December 31, 2008, primarily as a result of $20.7 million in tax-effected fair value adjustments relating to our trust preferred CDO securities, offset by our net loss of $8.3 million for the six months ended June 30, 2009.

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

                            At June 30, 2009          At December 31, 2008       $ Increase       % Increase
                           Amount        Percent        Amount       Percent     (Decrease)       (Decrease)
Real estate:
One-to four-family
residential              $    52,463          8.5%     $   56,325       8.4%     $    (3,862)         (6.9)%
Five or more family
residential                  141,794       23.0           148,949     22.2            (7,155)        (4.8)
Commercial                   253,981       41.3           253,801     37.7               180           0.1
Total real estate            448,238       72.8           459,075     68.3           (10,837)        (2.4)

Real estate
construction:
One-to four-family
residential                   55,529        9.0            71,424     10.6           (15,895)       (22.3)
Five or more family
residential                      495        0.1               483      0.1                12           2.5
Commercial                    11,004        1.8             9,953      1.5             1,051          10.6
Total real estate
construction                  67,028       10.9            81,860     12.2           (14,832)       (18.1)

Consumer:
Automobile                     8,645        1.4            11,818      1.8            (3,173)      (26.8)
Home equity                   38,143        6.2            42,442      6.3            (4,299)      (10.1)
Credit cards                       -          -            23,192      3.4           (23,192)     (100.0)
Other                          7,384        1.2             8,132      1.2              (748)       (9.2)
Total consumer                54,172        8.8            85,584     12.7           (31,412)      (36.7)

Commercial business           46,395        7.5            45,762      6.8               633          1.4

Total loans                  615,833        100.0%        672,281     100.0%         (56,448)       (8.4)

Less allowance for
loan losses                  (11,719)                     (13,329)                      1,610      (12.1)

Loans, net               $   604,114                  $   658,952               $    (54,838)         (8.3)%

Investments. The following table sets forth the composition of our investment securities at the dates indicated. The available-for-sale investments are presented at fair value, 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 (dollars in thousands):

                             At June 30,      At December 31,    $ Increase       % Increase
                                 2009              2008          (Decrease)       (Decrease)
Available-for-sale:
Trust preferred CDO
securities                      $  36,280           $  14,895     $  21,385            143.6%
Total available-for-sale           36,280              14,895        21,385           143.6

Held-to-maturity:
Municipal obligations               9,376              11,085        (1,709)         (15.4)
Mortgage-backed securities         19,791              22,899        (3,108)         (13.6)
Total held-to-maturity             29,167              33,984        (4,817)         (14.2)

Total Investment Securities        65,447              48,879        16,568            33.9

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

 Total                          $  79,159           $  62,591      $ 16,568             26.5%

Our investment securities portfolio increased by 33.9%, to $65.4 million at June 30, 2009 compared to $48.9 million at December 31, 2008, primarily as a result of an increase in the fair value of our trust preferred CDO securities collateralized by the pooled trust preferred securities issued by 551 FDIC-insured financial institutions and 39 insurance companies. Management adopted the FASB's revised guidance issued on April 9, 2009 changing how the valuation for securities lacking an orderly and liquid market are calculated so they are more representative of fair value under current market conditions. See Note 9 to the Selected Notes to Unaudited Interim Consolidated Financial Statements contained in Part I, Item 1 - "Financial Statements" of this report on Form 10-Q. In connection with adopting these new accounting standards, the Company engaged an independent consulting firm to assist the Company's management in determining the fair value of the Company's trust preferred CDO securities as of June 30, 2009, resulting in a $21.4 million net increase in the fair value of the Company's portfolio of 15 trust preferred CDO securities during the first six months of 2009, notwithstanding the recognition of OTTI credit losses of $10.3 million on such securities during that period as discussed below. Mortgage-backed securities held-to-maturity decreased $3.1 million as a result of routine principal reductions and as a result of maturities and calls, municipal obligations decreased $1.7 million during the six month period ended June 30, 2009.

On a quarterly basis, management evaluates each available-for-sale and held-to-maturity investment security in an unrealized loss position to determine if the impairment is temporary or other-than-temporary. Management has determined seven of the Company's 15 trust preferred securities were other-than-temporarily impaired at June 30, 2009. Accordingly, the Company recognized non-cash, pre-tax OTTI charges of $10.3 million year-to-date, reflecting the credit loss portion of the change in fair value of these securities, as shown in the Consolidated Statements of Operations. The Company intends to, and believes it will more-likely-than-not be able to hold these securities with OTTI to the earlier of their recovery in value or the maturity of the underlying investment security. The Company recorded the change in the non-credit related factors of the change in fair value for these seven securities as a component of shareholders' equity (i.e. accumulated other comprehensive loss).

The valuation of the Company's trust preferred CDO securities and the determination of any OTTI charges with respect to such securities is highly complex and involves a comprehensive process, including quantitative modeling and significant judgment. As with other areas involving the highly subjective determination of amounts by management, there remains the possibility that the Company's and the Bank's regulators will disagree with management's valuation and OTTI analyses with respect to the trust preferred CDO securities and require further write-downs in the values of these securities and the recognition of additional OTTI charges. See

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

                                    At June 30, 2009                 At December 31, 2008              $ 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          29,265              4.75           24,042                3.58               5,223            21.7
Consumer                             225              0.04              488                0.07                (263 )         (53.9 )
Commercial business                2,300              0.37               14                0.00               2,286        16,328.6
Total non-performing loans        31,790              5.16 %         24,544                3.65 %             7,246            29.5

Other non-performing assets
Real estate owned                  8,077                              6,796                                   1,281            18.8
Other repossessed assets              10                                 38                                     (28 )         (73.7 )
Total other non-performing
assets                             8,087                              6,834                                   1,253            18.3

Total non-performing assets   $   39,877                       $     31,378                           $       8,499            27.1 %

Total non-performing assets
as a percentage of
    total assets                    4.85 %                             3.70 %

Loans greater than 30 days
delinquent as
    percentage of total
loans                               5.49 %                             4.00 %

(1) Percent of total loan portfolio

Our non-performing assets have increased to $39.9 million at June 30, 2009 from $31.4 million at December 31, 2008. As of June 30, 2009, we classified $29.3 million in real estate construction loans (representing 43.7% of our total real estate construction portfolio) as non-performing, which consists of $22.3 million in developed one- to four-family residential lots, $2.7 million in one- to four-family residential construction loans with houses in varying stages of completion (i.e., developed lots to completed homes), and $2.0 million in loans for land development in Pierce, Thurston, and King counties of Washington State, as well as a $2.3 million non-residential commercial real estate loan. Of the $31.8 million in total non-performing loans at June 30, 2009, a total of $29.3 million ($27.0 million in real estate construction loans and $2.3 million in commercial business loans) related to balances on loans outstanding to five residential builder relationships, four of which generated the significant level of loan charge-offs in the first quarter of 2009. The cumulative interest not accrued during the first six months of 2009 relating to all non-performing loans totaled $857,000. We seek to reach acceptable payment plans on all of our non-performing loans 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.

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 $31.7 million in total impaired loans, $29.3 million in impaired real estate construction loans and $2.4 million in impaired commercial business 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 $4.3 million specific allowance for these loans.

Other loans not included in the non-performing asset categories as of June 30, 2009 but where known information about possible credit problems of the borrowers causes management to have serious doubts as to the ability of such borrowers to comply with present loan repayment terms totaled $98,000 as of June 30, 2009 (one commercial business loan), compared with $3.3 million as of December 31, 2008 (which became non-performing during the first six months of 2009).

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

                                    At June 30, 2009       At December 31, 2008      $ Increase       % Increase
                                    Amount      Percent      Amount      Percent     (Decrease)       (Decrease)

Non-interest-bearing checking     $    43,447      8.9%    $    40,331      7.8%    $       3,116          7.7%
Interest-bearing checking              40,249     8.2           36,468     7.0              3,781       10.4
Savings accounts                       32,033     6.6           28,197     5.4              3,836       13.6
Money market accounts                 150,785    30.8          145,311    28.0              5,474        3.8
IRA accounts                            5,594     1.1            6,382     1.2               (788)     (12.3)
Brokered certificates of deposit       30,973     6.4           87,442    16.9            (56,469)     (64.6)
Retail certificates of deposit        185,878    38.0          175,108    33.7             10,770         6.2
Total deposits                   $    488,959    100.0%   $    519,239    100.0%   $      (30,280)        (5.8)%

Core deposits                    $    272,108     55.6%   $    256,689     49.4%    $      15,419          6.0%
Non-core deposits                     216,851    44.4          262,550    50.6            (45,699)      (17.4)
Total deposits                   $    488,959    100.0%   $    519,239    100.0%   $      (30,280)        (5.8)%

Our deposits decreased $30.3 million, or 5.8%, to $489.0 million at June 30, 2009 from $519.2 million at December 31, 2008. The decrease was primarily the result of maturing brokered deposits during the first six months of 2009, which were not renewed or replaced. Certificates of deposit at June 30, 2009 included $31.0 million of brokered certificates of deposit, compared to the $87.4 million of brokered certificates of deposit at December 31, 2008. We are increasing our marketing efforts toward generating retail deposits and continue to focus on our local relationship-oriented deposit gathering activities through the Bank's 14 branch network. The result of these efforts was a $26.2 million increase in total retail deposits, with core deposits increasing by $15.4 million during the first half of 2009. These core deposits (i.e. checking, savings, money market and individual retirement accounts) represented 55.6% of total deposits as of June 30, 2009 and are more valuable for us as they are generally less rate sensitive and represent a more stable source of funds.

Borrowings. Borrowed funds decreased $9.8 million, or 3.4%, to $281.4 million at June 30, 2009 from $291.2 million at December 31, 2008. The decrease in borrowed funds was the result of payoffs on maturing term FHLB borrowings.

Capital. Total shareholders' equity increased $12.6 million, or 43.2%, to $41.9 million at June 30, 2009 from $29.3 million at December 31, 2008. The increase in equity during the quarter was primarily attributable to $20.7 million in tax-effected fair value adjustments relating to our trust preferred CDO securities. Partially offsetting that increase was an $8.3 million net loss for the six months ended June 30, 2009, which included the $10.3 million in credit losses realized on seven of our 15 trust preferred CDO securities deemed to involve OTTI, during the same period. As a result of these factors, and the $25.8 million decrease in our total assets, our capital-to-assets ratio under accounting principles generally accepted in the United States increased 165 basis points to 5.11% at June 30, 2009, compared to 3.46% at December 31, 2008.

Comparison of Operating Results for the Three Months Ended June 30, 2009 and 2008

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

                               Three Months Ended June 30,     $ Increase   % Increase
                                   2009             2008       (Decrease)   (Decrease)
Net interest income                $  5,184         $  6,438    $ (1,254)      (19.5)%
Non-interest income                   2,841            2,601         240        9.2
Total revenue                         8,025            9,039      (1,014)     (11.2)
Provision for loan losses             4,000              550       3,450       627.3
Non-interest expense                  7,771            6,900         871        12.6
Impairment loss on securities        (1,808)               -      (1,808)    (100.0)
Net income (loss)                    (3,700)           1,017      (4,717)    (463.8)

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 June 30,       $ Increase     % Increase
                                     2009             2008          (Decrease)     (Decrease)
Interest income:
Loans                              $     9,534      $    11,191    $     (1,657)      (14.8)%
Securities available-for-sale              595            1,276            (681)     (53.4)
Securities held-to-maturity                330              420             (90)     (21.4)
Interest-bearing deposits                   32                6              26      433.3
Federal Home Loan Bank dividends             -               48             (48)    (100.0)
Total interest income                   10,491           12,941          (2,450)     (18.9)

. . .