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 are based on the Company's expectations and are subject to risks and uncertainties that cannot be predicted or quantified and are beyond the Company's control, including the potential that (1) the Company may not be able to continue as a going concern and (2) because of our significantly undercapitalized status, our regulators may initiate additional enforcement actions against us. 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; future actions of Nasdaq and the future listing of the Company's securities; 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 September 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
                           September
                              30,       At December 31,   $ Increase    % Increase
                              2009           2008         (Decrease)    (Decrease)

    Total assets           $  764,154        $  847,233   $  (83,079)       (9.8)%
    Investment securities
    (1)                        51,027            48,879        2,148         4.4
    Interest-bearing
    deposits with banks        41,035            29,425       11,610        39.5
    Loans, net                574,402           658,952      (84,550)     (12.8)
    Deposits                  466,324           519,239      (52,915)     (10.2)
    Borrowed funds            279,337           291,217      (11,880)      (4.1)
    Total shareholders'
    equity                     12,847            29,294      (16,447)     (56.1)

(1) Includes mortgage-backed securities

Total assets decreased $83.1 million or 9.8% to $764.2 million at September 30, 2009, compared to $847.2 million at December 31, 2008. Interest-bearing deposits with the Federal Reserve Bank increased by $11.6 million during the period and investment securities increased $2.1 million due to a pre-tax increase in the fair value of our trust preferred CDO securities. Partially offsetting these increases was a net decrease of $84.6 million in the loan portfolio, which was primarily the result of loan sales, 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 and increase liquidity. Currently, the Bank is prohibited from accepting, renewing, or rolling over brokered deposits as a result of its regulatory capital position. As a result, total deposits decreased to $466.3 million from $519.2 million at December 31, 2008, resulting primarily from a $68.4 million reduction in our balance of brokered deposits from $87.4 million at December 31, 2008 to $19.0 million at September 30, 2009, which was partially offset by a $15.5 million increase in retail deposits. Shareholders' equity decreased $16.5 million to $12.8 million at September 30, 2009 from $29.3 million at December 31, 2008, primarily due to our net loss of $43.3 million for the nine months ended September 30, 2009, partially offset by a lower tax affected unrealized valuation loss of $15.2 million on our trust preferred CDO securities.

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, 2009      At December 31, 2008       $ Increase     % Increase
                                    Amount       Percent       Amount       Percent     (Decrease)     (Decrease)
Real estate:
One-to four-family residential       $  47,841       8.2 %     $  56,325        8.4 %    $  (8,484)       (15.1)%
Five or more family residential        135,023      23.1         148,949       22.2        (13,926)      (9.3)
Commercial                             251,003      43.0         253,801       37.7         (2,798)      (1.1)
Total real estate                      433,867      74.3         459,075       68.3        (25,208)       (5.5)

Real estate construction:
One-to four-family residential          41,956       7.2          71,424       10.6        (29,468)      (41.3)
Five or more family residential            496       0.1             483        0.1             13          2.7
Commercial                              11,484       1.9           9,953        1.5          1,531         15.4
Total real estate construction          53,936       9.2          81,860       12.2        (27,924)      (34.1)

Consumer:
Automobile                               7,491       1.3          11,818        1.8         (4,327)      (36.6)
Home equity                             36,085       6.2          42,442        6.3         (6,357)      (15.0)
Credit cards                                 -         -          23,192        3.4        (23,192)     (100.0)
Other                                    7,401       1.2           8,132        1.2           (731)       (9.0)
Total consumer                          50,977       8.7          85,584       12.7        (34,607)      (40.4)

Commercial business                     45,306       7.8          45,762        6.8           (456)       (1.0)

Total loans                            584,086     100.0 %       672,281      100.0 %      (88,195)      (13.1)

Less allowance for loan losses         (9,684)                  (13,329)                     3,645       (27.3)

Loans, net                            $574,402                  $658,952                  $(84,550)       (12.8)%

Our net loan portfolio decreased $84.6 million, or 12.8%, during the nine months ended September 30, 2009 to $574.4 million, as we significantly reduced new loan originations for portfolio. Lower loan portfolio balances were also impacted by the sale of our $21.6 million VISA credit card portfolio in February 2009, a $27.9 million decrease in our construction loan balances (including $12.5 million in charge-offs of non-accrual construction loan balances) and an $8.5 million decrease in residential real estate loan balances. Additionally, there were regular pay downs on our consumer loan portfolio, and a $6.4 million decline in home equity loan balances as borrowers took advantage of historically low long-term rates by refinancing their existing one-to four-family mortgages and home equity balances into a single mortgage loan, which also contributed to the lower portfolio balances.

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 September 30,   At December 31,    $ Increase      % Increase
                                       2009              2008          (Decrease)      (Decrease)
Available-for-sale:
Trust preferred CDO securities          $  23,396         $  14,895     $   8,501            57.1%
Total available-for-sale                   23,396            14,895         8,501           57.1

Held-to-maturity:
Municipal obligations                       9,377            11,085       (1,708)          (15.4)
Mortgage-backed securities                 18,254            22,899       (4,645)          (20.3)
Total held-to-maturity                     27,631            33,984       (6,353)         (18.7)

Total Investment Securities                51,027            48,879        2,148             4.4

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

 Total                                  $  64,739         $  62,591    $   2,148              3.4%

Our investment securities portfolio increased by 4.4% to $51.0 million at September 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 Notes 3 and 6 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 adopted the use of a range of Level 3 inputs in determining the fair value of the Company's trust preferred CDO securities, resulting in an $8.5 million net increase in the fair value of the Company's portfolio of 15 trust preferred CDO securities during the first nine months of 2009. Mortgage-backed securities held-to-maturity decreased $4.6 million as a result of routine principal reductions, and as a result of maturities and calls, municipal obligations decreased $1.7 million during the nine month period ended September 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 14 of the Company's 15 trust preferred CDO securities were other-than-temporarily impaired at September 30, 2009. Accordingly, the Company recognized cumulative non-cash, pre-tax OTTI charges of $32.3 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 does not intend to sell, nor is it more likely than not that the Company will be required to sell these securities before their recovery in value or the maturity of the underlying investment security. The Company recorded the non-credit related factors of fair value for these 14 securities as a component of shareholders' equity (i.e. accumulated other comprehensive income/(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 Part II, Item 1A, "Risk Factors- - The valuation of the Company's trust preferred CDO securities and the determination of any other-than-temporary impairment with respect to these securities is highly subjective, and our regulators may not agree with our analyses."

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, 2009          At December 31, 2008
                                          Percent of                    Percent of    $ Increase      % Increase
                            Amount       Total Loans       Amount       Total Loans   (Decrease)      (Decrease)
Loans 90 days or more
past due or non-
accrual loans:

Real estate                   $1,604             0.27%    $       -             -%         $1,604           100.0%
Real estate construction      18,155            3.11         24,042          3.58         (5,887)          (24.5)
Consumer                         229            0.04            488          0.07           (259)          (53.1)
Commercial business              872            0.15             14             -             858        6,128.6
Total non-performing
loans                         20,860             3.57%       24,544           3.65%       (3,684)          (15.0)

Other non-performing
assets
Real estate owned             12,890                           6,796                        6,094           89.7
Other repossessed assets           2                              38                         (36)          (94.7)
Total other
non-performing assets         12,892                           6,834                        6,058           88.6


Total non-performing
assets (1)                $   33,752                         $31,378                    $   2,374             7.6%

Total non-performing
assets as a percentage of
total assets (1)                4.42 %                          3.70 %

Loans greater than 30
days delinquent as
percentage of total loans       3.75 %                          4.00 %

(1) Excludes seven trust preferred CDO securities in an amount of $14.4 million (at fair value) as of September 30, 2009 that are being treated by the Company as "non-accrual." Due to the rights granted to the issuers of the debt collateralizing the security that allow the issuers to contractually defer interest payments for up to 20 consecutive quarters, the security is not deemed to be "non-performing" under its original terms. However, if these securities were deemed "non-performing assets," the non-performing assets as a percentage of assets reported for September 30, 2009 would be 6.29%.

Our non-performing assets have increased to $33.8 million or 4.42% of total assets at September 30, 2009 compared to $31.4 million or 3.70% of total assets at December 31, 2008. As of September 30, 2009, we classified $18.2 million in real estate construction loans (representing 33.7% of our total real estate construction portfolio) as non-performing, which consists of $11.5 million in developed one- to four-family residential lots, $2.5 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 $2.2 million non-residential commercial real estate construction loan. The cumulative interest not accrued during the first nine months of 2009 relating to all non-performing loans totaled $1.5 million. We seek to reach acceptable payment plans on all of our non-performing loans while protecting our interests in the existing collateral. However, in the event an acceptable arrangement cannot be reached, we may 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 $19.5 million in total impaired loans, $18.3 million in impaired real estate construction loans, and $1.2 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 $678,000 specific allowance for these loans.

Other loans not included in the non-performing asset categories as of September 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 $19.4 million as of September 30, 2009 ($11.1 million in real estate construction loans, $4.4 million in commercial real estate loans, and $3.9 million in commercial business loans), compared with $3.3 million as of December 31, 2008 (which became non-performing during the first nine months of 2009). For further information regarding non-performing assets, see Note 7 of the Selected Notes to Unaudited Interim Consolidated Financial Statements contained in Part I, Item 1 - "Financial Statements" of this Form 10-Q.

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

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

Non-interest-bearing checking       $  45,107       9.7%      $  40,331       7.8%      $4,776        11.8%
Interest-bearing checking              42,678      9.1           36,468      7.0         6,210       17.0
Savings accounts                       31,601      6.8           28,197      5.4         3,404       12.1
Money market accounts                 131,855     28.3          145,311     28.0       (13,456)     (9.3)
IRA accounts                            5,586      1.2            6,382      1.2          (796)    (12.5)
Brokered certificates of deposit       18,998      4.1           87,442     16.9       (68,444)    (78.3)
Retail certificates of deposit        190,499     40.8          175,108     33.7        15,391        8.8
Total deposits                       $466,324     100.0%       $519,239     100.0%    $(52,915)      (10.2)%

Core deposits                        $256,827      55.1%       $256,689      49.4%    $    138         0.1%
Non-core deposits                     209,497     44.9          262,550     50.6       (53,053)    (20.2)
Total deposits                       $466,324     100.0%       $519,239     100.0%    $(52,915)     (10.2)%

Our deposits decreased $52.9 million, or 10.2%, to $466.3 million at September 30, 2009 from $519.2 million at December 31, 2008. The decrease was primarily the result of maturing brokered deposits during the first nine months of 2009, which in accordance with the formal agreements with our regulators, cannot be renewed or replaced. Certificates of deposit at September 30, 2009 included $19.0 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 focus on generating core deposits inclusive of checking, savings, and money market accounts is valuable, as these products are typically less rate sensitive than certificates of deposits. Since February 20, 2009, the Bank has been restricted from offering deposit rates more than 75 basis points above the average rates of its local market area competitors. Effective January 1, 2010, the Bank intends to utilize the "national rate" as posted on the FDIC website weekly to determine the maximum rate for deposit products the Bank may offer its customers. The national rates historically has been lower than the local market area average rates and therefore place the Company at a competitive disadvantage, which may constrict future deposit growth. Despite the impact of this restriction during 2009, the result of these efforts was a $15.5 million increase in total retail deposits, including $256.8 million of core deposits (i.e. checking, savings, money market, and individual retirement accounts) which represented 55.1% of total deposits as of September 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 $11.9 million, or 4.1%, to $279.3 million at September 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, consistent with our current strategy to deleverage and shrink our balance sheet in order to increase our capital levels.

Capital. Total shareholders' equity decreased $16.5 million, or 56.1%, to $12.8 million at September 30, 2009 from $29.3 million at December 31, 2008. The decrease in equity during the quarter was primarily attributable to a $43.3 million net loss for the nine months ended September 30, 2009, which included the $32.3 million in credit losses realized on 14 of our 15 trust preferred CDO securities deemed to involve OTTI, as well as a $16.7 million valuation allowance established on our deferred tax asset, partially offset by a $15.2 million, tax affected decrease in unrealized fair value losses on the trust preferred CDO securities held by the Company. As a result of these factors, and the $83.1 million decrease in our total assets, our capital-to-assets ratio under accounting principles generally accepted in the United States decreased 178 basis points to 1.68% at September 30, 2009, compared to 3.46% at December 31, 2008.

Comparison of Operating Results for the Three Months Ended September 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 September
                                             30,                $ Increase     % Increase
                                  2009             2008         (Decrease)     (Decrease)
Net interest income             $  5,031            $  6,154      $ (1,123)        (18.2)%
Non-interest income                2,496               2,479            17          0.7
Total revenue                      7,527               8,633        (1,106)       (12.8)
Provision for loan losses          5,700               6,000          (300)        (5.0)
Non-interest expense               7,546               7,022           524          7.5
Impairment loss on securities    (22,052)                  -       (22,052)      (100.0)
. . .