TIMBERLAND BANCORP INC - Annual Report: 2002 (Form 10-K)

        The Bank originates both fixed-rate loans and adjustable-rate loans. Generally, 15- and 30-year fixed-rate loans are originated to meet the requirements for sale in the secondary market to the FHLMC, however, from time to time, a portion of these fixed-rate loans originated by the Bank may be retained in the Bank's loan portfolio to meet the Bank's asset/liability management objectives. The Bank uses an automated underwriting program, which preliminarily qualifies a loan as conforming to FHLMC underwriting standards when the loan is originated. At September 30, 2002, $33.6 million, or 29.7%, of the Bank's one- to- four family loan portfolio consisted of fixed rate one- to- four family mortgage loans.

        The Bank also offers adjustable rate mortgage ("ARM") loans at rates and terms competitive with market conditions. All of the Bank's ARM loans are retained in its loan portfolio and not with a view toward sale in the secondary market.

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        The Bank offers several ARM products which adjust annually after an initial period ranging from one to five years subject to a limitation on the annual increase of 2% and an overall limitation of 6%. These ARM products have utilized the weekly average yield on one year U.S. Treasury securities adjusted to a constant maturity of one year plus a margin of 3.00% to 4.00%. ARM loans held in the Bank's portfolio do not permit negative amortization of principal and carry no prepayment restrictions. Borrower demand for ARM loans versus fixed-rate mortgage loans is a function of the level of interest rates, the expectations of changes in the level of interest rates and the difference between the initial interest rates and fees charged for each type of loan. The relative amount of fixed-rate mortgage loans and ARM loans that can be originated at any time is largely determined by the demand for each in a competitive environment. At September 30, 2002, $79.5 million, or 70.3%, of the Bank's one- to- four family loan portfolio consisted of ARM loans.

       A portion of the Bank's ARM loans are "non-conforming" because they do not satisfy acreage limits, or various other requirements imposed by the FHLMC. Some of these loans are also originated to meet the needs of borrowers who cannot otherwise satisfy the FHLMC credit requirements because of personal and financial reasons (i.e., divorce, bankruptcy, length of time employed, etc.), and other aspects, which do not conform to the FHLMC's guidelines. Many of these borrowers have higher debt to income ratios, or the loans are secured by unique properties in rural markets for which there are no comparable sales of comparable properties to support value according to secondary market requirements. These loans are known as non-conforming loans and the Bank may require additional collateral or lower loan-to-value ratios prior to the origination of the loan. The Bank believes that these loans satisfy a need in its local market area. As a result, subject to market conditions, the Bank intends to continue to originate such loans.

        The retention of ARM loans in the Bank's loan portfolio helps reduce the Bank's exposure to changes in interest rates. There are, however, unquantifiable credit risks resulting from the potential of increased interest to be paid by the customer due to increases in interest rates. It is possible that, during periods of rising interest rates, the risk of default on ARM loans may increase as a result of repricing and the increased costs to the borrower. Furthermore, because the ARM loans originated by the Bank generally provide, as a marketing incentive, for initial rates of interest below the rates which would apply were the adjustment index used for pricing initially, these loans are subject to increased risks of default or delinquency. The Bank attempts to reduce the potential for delinquencies and defaults on ARM loans by qualifying the borrower based on the borrower's ability to repay the ARM loan assuming that the maximum interest rate that could be charged at the first adjustment period remains constant during the loan term. Another consideration is that although ARM loans allow the Bank to increase the sensitivity of its asset base due to changes in the interest rates, the extent of this interest sensitivity is limited by the periodic and lifetime interest rate adjustment limits. Because of these considerations, the Bank has no assurance that yields on ARM loans will be sufficient to offset increases in the Bank's cost of funds.

        While fixed-rate, single-family residential mortgage loans are normally originated with 15 to 30 year terms, such loans typically remain outstanding for substantially shorter periods. This is because borrowers often prepay their loans in full upon sale of the property pledged as security or upon refinancing the original loan. In addition, substantially all mortgage loans in the Bank's loan portfolio contain due-on-sale clauses providing that the Bank may declare the unpaid amount due and payable upon the sale of the property securing the loan. Typically, the Bank enforces these due-on-sale clauses to the extent permitted by law and as business judgment dictates. Thus, average loan maturity is a function of, among other factors, the level of purchase and sale activity in the real estate market, prevailing interest rates and the interest rates payable on outstanding loans.

        The Bank requires fire and extended coverage casualty insurance (and loans originated since 1994, if appropriate, generally requires flood insurance) be maintained on all of its real estate secured loans. 

        The Bank's lending policies generally limit the maximum loan-to-value ratio on mortgage loans secured by owner-occupied properties to 95% of the lesser of the appraised value or the purchase price. However, the Bank usually obtains private mortgage insurance ("PMI") on the portion of the principal amount that exceeds 80% of the appraised value of the security property. The maximum loan-to-value ratio on mortgage loans secured by non-owner-occupied properties is generally 80% (90% for loans originated for sale in the secondary market to the FHLMC).

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         Construction and Land Development Lending. Prompted by unfavorable economic conditions in its primary market area in 1980, the Bank sought to establish a market niche and, as a result, began originating construction loans. In recent periods, construction lending activities have been primarily in the Pierce County, King County, Thurston County, and Kitsap County markets. Competition from other financial institutions has increased in recent periods and the Bank expects that its margins on construction loans may be reduced in the future. 

        The Bank currently originates three types of residential construction loans: (i) speculative construction loans, (ii) custom construction loans and (iii) owner/builder loans. The Bank initiated its construction lending with the origination of speculative construction loans. As a result, the Bank began to establish contacts with the building community and increased the origination of custom construction and land development loans in rural market areas. The Bank believes that its in-house computer system has enabled it to establish processing and disbursement procedures to meet the needs of these borrowers. To a lesser extent, the Bank also originates construction loans for the development of multi-family and commercial properties. Subject to market conditions, the Bank intends to continue to emphasize its residential construction lending activities. 

        At September 30, 2002, the composition of the Bank's construction and land development loan portfolio was as follows:

        Unlike speculative construction loans, custom construction loans are made to home builders who, at the time of construction, have a signed contract with a home buyer who has a commitment for permanent financing for the finished home with the Bank or another lender. Custom construction loans are generally originated for a term of 12 months, with fixed interest rates ranging from 7.9% to 9.0% and with loan-to-value ratios of 80% of the appraised

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estimated value of the completed property or sales price, whichever is less. During this 12 month period, the borrower is required to make monthly payments of accrued interest on the outstanding loan balance.

        Owner/builder construction loans are originated to the home owner rather than the home builder as a single loan that automatically converts to a permanent loan at the completion of construction. The construction phase of a owner/builder construction loan generally lasts six to nine months with fixed interest rates ranging from 8.25% to 9.5%, and with loan-to-value ratios of 80% (or up to 95% with PMI) of the appraised estimated value of the completed property or cost, whichever is less. During this 12 month period, the borrower is required to make monthly payments of accrued interest on the outstanding loan balance. At the completion of construction, the loan converts automatically to either a fixed-rate mortgage loan, which conforms to secondary market standards, or an ARM loan for retention in the Bank's portfolio. At September 30, 2002, custom and owner/builder construction loans totaled $31.0 million, or 38.7%, of the total construction loan portfolio. At September 30, 2002, the largest outstanding custom construction loan had an outstanding balance of $650,000 and was performing according to its terms.

        The Bank originates loans to local real estate developers with whom it has established relationships for the purpose of developing residential subdivisions (i.e., installing roads, sewers, water and other utilities) (generally with ten to 50 lots). At September 30, 2002, subdivision development loans totaled $10.7 million, or 13.4% of construction and land development loans receivable. Land development loans are secured by a lien on the property and made for a period of two to five years with fixed or variable interest rates, and are made with loan-to-value ratios generally not exceeding 75%. Monthly interest payments are required during the term of the loan. Land development loans are structured so that the Bank is repaid in full upon the sale by the borrower of approximately 80% of the subdivision lots. Substantially all of the Bank's land development loans are secured by property located in its primary market area. In addition, in the case of a corporate borrower, the Bank also generally obtains personal guarantees from corporate principals and reviews their personal financial statements. At September 30, 2002, the largest land development loan had an outstanding loan balance of $1.8 million (including $882,000 of undisbursed loans in process balance), and was not performing according to its terms. See "--Lending Activities -- Nonperforming Assets and Delinquencies."

        Land development loans secured by land under development involve greater risks than one- to- four family residential mortgage loans because such loans are advanced upon the predicted future value of the developed property. If the estimate of such future value proves to be inaccurate, in the event of default and foreclosure the Bank may be confronted with a property the value of which is insufficient to assure full repayment. The Bank attempts to minimize this risk by generally limiting the maximum loan-to-value ratio on land loans to 75% of the estimated developed value of the secured property.

        The Bank also provides construction financing for multi-family and commercial properties. At September 30, 2002, such construction loans amounted to $11.2 million. These loans are secured by motels, apartment buildings, condominiums, office buildings and retail rental space located in the Bank's primary market area and currently range in amount from $250,000 to $4.2 million. At September 30, 2002, the largest outstanding commercial real estate construction loan had a balance of $3.5 million (including $2.5 million of undisbursed loans in process balance), and was performing according to terms. At September 30, 2002, the largest outstanding multi-family construction loan had a balance of $4.2 million (including $217,000 of undisbursed loans in process balance), and was performing according to terms. Periodically, the Bank purchases (without recourse to the seller other than for fraud) from other lenders participation interests in multi-family and commercial construction loans.  The Bank underwrites such participation interests according to its own standards. At September 30, 2002, the largest construction participation interest had an outstanding balance of $2.9 million, which represented a 67% interest in a construction loan secured by a multi-family property located in Clark County, Washington. At September 30, 2002, this loan was performing according to its terms.

        All construction loans must be approved by the Bank's Loan Committee or the Bank's Board of Directors. See "-- Lending Activities -- Loan Solicitation and Processing." Prior to preliminary approval of any construction loan application, an independent fee appraiser inspects the site and the Bank reviews the existing or proposed improvements, identifies the market for the proposed project and analyzes the pro forma data and assumptions on the project. In the case of a speculative or custom construction loan, the Bank reviews the experience and expertise of the builder. After preliminary approval has been given, the application is processed, which includes obtaining credit reports, financial

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statements and tax returns on the borrowers and guarantors, an independent appraisal of the project, and any other expert reports necessary to evaluate the proposed project. In the event of cost overruns, the Bank generally requires that the borrower increase the funds available for construction by depositing its own funds into a loans in process account.

        Loan disbursements during the construction period are made to the builder based on a line item budget. Periodic on-site inspections are made by qualified inspectors to document the reasonableness of the draw request. For most builders, the Bank disburses loan funds by providing vouchers to suppliers, which when used by the builder to purchase supplies are submitted by the supplier to the Bank for payment.

        The Bank regularly monitors the construction loan disbursements using an internal computer program. Property inspections are performed by qualified inspectors. The Bank believes that its internal monitoring system helps reduce many of the risks inherent in its construction lending.

        The Bank originates construction loan applications through customer referrals, contacts in the business community and occasionally real estate brokers seeking financing for their clients.

        Construction lending affords the Bank the opportunity to achieve higher interest rates and fees with shorter terms to maturity than does its single-family permanent mortgage lending. Construction lending, however, is generally considered to involve a higher degree of risk than single-family permanent mortgage lending because of the inherent difficulty in estimating both a property's value at completion of the project and the estimated cost of the project. The nature of these loans is such that they are generally more difficult to evaluate and monitor. If the estimate of construction cost proves to be inaccurate, the Bank may be required to advance funds beyond the amount originally committed to permit completion of the project. If the estimate of value upon completion proves to be inaccurate, the Bank may be confronted with a project whose value is insufficient to assure full repayment. Projects may also be jeopardized by disagreements between borrowers and builders and by the failure of builders to pay subcontractors. Loans to builders to construct homes for which no purchaser has been identified carry more risk because the payoff for the loan depends on the builder's ability to sell the property prior to the time that the construction loan is due. The Bank has sought to address these risks by adhering to strict underwriting policies, disbursement procedures, and monitoring practices. In addition, because the Bank's construction lending is primarily secured by properties in its primary market area, changes in the local and state economies and real estate markets could adversely affect the Bank's construction loan portfolio.

        Real Estate Contracts. The Bank purchases real estate contracts and deeds of trust from individuals who have privately sold their homes or property. These contracts are generally secured by one- to- four family properties, building lots and undeveloped land and range in principal amount from $10,000 to $200,000, but typically are in amounts between $20,000 and $40,000. Properties securing real estate contracts purchased by the Bank are generally located within its primary market area. Prior to purchasing the real estate contract, the Bank reviews the contract and analyzes and assesses the collateral for the loan, the down payment made by the borrower and the credit history on the loan. As of September 30, 2002, the Bank had outstanding $1.0 million of real estate contracts.

        Multi-Family Lending. At September 30, 2002, the Bank had $24.1 million, or 6.7% of the Bank's total loan portfolio, secured by multi-family dwelling units (more than four units) located primarily in the Bank's primary market area. At September 30, 2002, approximately 42.7% of the Bank's multi-family loans represent participation interests in loans, secured by properties generally located in the Bank's primary market area, purchased from other lenders. Such participation interests are purchased without recourse to the seller other than for fraud. The Bank underwrites such participation interests according to its own standards.

        Multi-family loans are generally originated with variable rates of interest ranging from 3.00% to 3.50% over the one-year constant maturity U.S. Treasury Bill Index or a matched term FHLB advance, with principal and interest payments fully amortizing over terms of up to 30 years. Multi-family loans currently range in principal balance from $40,000 to $6.1 million. At September 30, 2002, the largest multi-family loan had an outstanding principal balance of $6.1 million and was secured by an apartment building located in the Bank's primary market area. At September 30, 2002, this loan was performing according to its terms.

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        The maximum loan-to-value ratio for multi-family loans is generally 75%. The Bank requires its multi-family loan borrowers to submit financial statements and rent rolls on the subject property annually. The Bank also inspects the subject property annually. The Bank generally imposes a minimum debt coverage ratio of approximately 1.10 for loans secured by multi-family properties.

        Multi-family mortgage lending affords the Bank an opportunity to receive interest at rates higher than those generally available from one- to- four family residential lending. However, loans secured by such properties usually are greater in amount, more difficult to evaluate and monitor and, therefore, involve a greater degree of risk than one- to- four family residential mortgage loans. Because payments on loans secured by multi-family properties are often dependent on the successful operation and management of the properties, repayment of such loans may be affected by adverse conditions in the real estate market or the economy. The Bank seeks to minimize these risks by strictly scrutinizing the financial condition of the borrower, the quality of the collateral and the management of the property securing the loan. If the borrower is a corporation, the Bank also generally obtains personal guarantees from corporate principals based on a review of personal financial statements.

        Commercial Real Estate Lending. Commercial real estate loans totaled $97.6 million, or 27.0% of total loans receivable at September 30, 2002, and consisted of 259 loans. The Bank originates commercial real estate loans generally at variable interest rates and secured by properties, such as restaurants, motels, office buildings and retail/wholesale facilities, located in its primary market area. The principal balance of a commercial real estate loan currently ranges between $16,000 and $5.0 million. At September 30, 2002, the largest commercial real estate loan had an outstanding principal balance of $5.0 million, and was secured by a commercial property located in Olympia, Washington. At September 30, 2002, four commercial real estate loans totaling $688,000 were not performing according to terms. See "-- Lending Activities -- Nonperforming Assets and Delinquencies."

        The Bank requires appraisals of all properties securing commercial real estate loans. Appraisals are performed by an independent appraiser designated by the Bank, all of which are reviewed by management. The Bank considers the quality and location of the real estate, the credit of the borrower, the cash flow of the project and the quality of management involved with the property. The Bank generally imposes a minimum debt coverage ratio of approximately 1.10 for originated loans secured by income producing commercial properties. Loan-to-value ratios on commercial real estate loans are generally limited to 75%. The Bank generally obtains loan guarantees from financially capable parties based on a review of personal financial statements.

        Commercial real estate lending affords the Bank an opportunity to receive interest at rates higher than those generally available from one- to- four family residential lending. However, loans secured by such properties usually are greater in amount, more difficult to evaluate and monitor and, therefore, involve a greater degree of risk than one- to- four family residential mortgage loans. Because payments on loans secured by commercial properties often depend upon the successful operation and management of the properties, repayment of such loans may be affected by adverse conditions in the real estate market or the economy. The Bank seeks to minimize these risks by generally limiting the maximum loan-to-value ratio to 75% and strictly scrutinizing the financial condition of the borrower, the quality of the collateral and the management of the property securing the loan.

        Land Lending. The Bank originates loans for the acquisition of land upon which the purchaser can then build or make improvements necessary to build or to sell as improved lots. At September 30, 2002, land loans totaled $15.5 million, or 4.3% of the Bank's total loan portfolio. Land loans originated by the Bank are generally fixed-rate loans and have maturities of five to ten years. Land loans currently range in principal amount from $5,000 to $600,000. The largest land loan had an outstanding balance of $600,000 at September 30, 2002 and was performing according to its terms. At September 30, 2002, seven land loans totaling $251,000 were not performing according to terms. See "-- Lending Activities - Nonperforming Assets and Delinquencies."

        Loans secured by undeveloped land or improved lots involve greater risks than one- to- four family residential mortgage loans because such loans are more difficult to evaluate. If the estimate of value proves to be inaccurate, in the event of default and foreclosure the Bank may be confronted with a property the value of which is insufficient to assure

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full repayment. The Bank attempts to minimize this risk by generally limiting the maximum loan-to-value ratio on land loans to 75%.

        Consumer Lending. Consumer lending has traditionally been a small part of the Bank's business. Consumer loans generally have shorter terms to maturity and higher interest rates than mortgage loans. Consumer loans include home equity lines of credit, Title I home improvement loans, second mortgage loans, savings account loans, automobile loans, boat loans, motorcycle loans, recreational vehicle loans and unsecured loans. Consumer loans are made with both fixed and variable interest rates and with varying terms. At September 30, 2002, consumer loans amounted to $21.8 million, or 6.0% of the total loan portfolio.

        At September 30, 2002, the largest component of the consumer loan portfolio consisted of second mortgage loans and home equity lines of credit, which totaled $13.7 million, or 3.8%, of the total loan portfolio. Home equity lines of credit and second mortgage loans are made for purposes such as the improvement of residential properties, debt consolidation and education expenses, among others. The majority of these loans are made to existing customers and are secured by a first or second mortgage on residential property. The Bank occasionally solicits these loans. The loan-to-value ratio is typically 80% or less, when taking into account both the first and second mortgage loans. Second mortgage loans typically carry fixed interest rates with a fixed payment over a term between five and 20 years. Home equity lines of credit are generally for a one year term and the interest rate is tied to the 26 week Treasury Bill or the prime rate.

        In July 1997, the Bank began issuing VISA credit cards to its existing customers. At September 30, 2002, credit card loans amounted to $1.8 million. The Bank does not engage in direct mailings of pre-approved credit cards.

        Consumer loans entail greater risk than do residential mortgage loans, particularly in the case of consumer loans that are unsecured or secured by rapidly depreciating assets such as automobiles. In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation. The remaining deficiency often does not warrant further substantial collection efforts against the borrower beyond obtaining a deficiency judgment. In addition, consumer loan collections are dependent on the borrower's continuing financial stability, and are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. Furthermore, the application of various federal and state laws, including federal and state bankruptcy and insolvency laws, may limit the amount that can be recovered on such loans. The Bank believes that these risks are not as prevalent in the case of the Bank's consumer loan portfolio because a large percentage of the portfolio consists of second mortgage loans and home equity lines of credit that are underwritten in a manner such that they result in credit risk that is substantially similar to one- to- four family residential mortgage loans. Nevertheless, second mortgage loans and home equity lines of credit have greater credit risk than one- to- four family residential mortgage loans because they are secured by mortgages subordinated to the existing first mortgage on the property, which may or may not be held by the Bank. At September 30, 2002, there were $49,000 of consumer loans delinquent in excess of 90 days.

        Commercial Business Lending. Commercial business loans totaled $9.4 million, or 2.6% of total loans receivable at September 30, 2002, and consisted of 85 loans. In July 1998, the Bank established a business banking division staffed by three experienced commercial bankers to increase the Bank's origination of commercial business loans. Currently, the division is staffed by seven commercial lenders. Commercial business loans are generally secured by business equipment or other property and are made at variable rates of interest equal to a negotiated margin above the prime rate. The Bank also generally obtains personal guarantees from financially capable parties based on a review of personal financial statements.

        Commercial business lending generally involves greater risk than residential mortgage lending and involves risks that are different from those associated with residential and commercial real estate lending. Real estate lending is generally considered to be collateral based lending with loan amounts based on predetermined loan to collateral values and liquidation of the underlying real estate collateral is viewed as the primary source of repayment in the event of borrower default. Although commercial business loans are often collateralized by equipment, inventory, accounts receivable or other business assets, the liquidation of collateral in the event of a borrower default is often an insufficient

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source of repayment because accounts receivable may be uncollectible and inventories and equipment may be obsolete or of limited use, among other things. Accordingly, the repayment of a commercial business loan depends primarily on the creditworthiness of the borrower (and any guarantors), while liquidation of collateral is a secondary and often insufficient source of repayment.

        Loan Maturity. The following table sets forth certain information at September 30, 2002 regarding the dollar amount of loans maturing in the Bank's portfolio based on their contractual terms to maturity, but does not include scheduled payments or potential prepayments. Demand loans, loans having no stated schedule of repayments and no stated maturity, and overdrafts are reported as due in one year or less.

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        The following table sets forth the dollar amount of all loans due after September 30, 2002, which have fixed interest rates and have floating or adjustable interest rates.

        Scheduled contractual principal repayments of loans do not reflect the actual life of such assets. The average life of loans is substantially less than their contractual terms because of prepayments. In addition, due-on-sale clauses on loans generally give the Bank the right to declare loans immediately due and payable in the event, among other things, that the borrower sells the real property subject to the mortgage and the loan is not repaid. The average life of mortgage loans tends to increase, however, when current mortgage loan market rates are substantially higher than rates on existing mortgage loans and, conversely, decrease when rates on existing mortgage loans are substantially higher than current mortgage loan market rates.

        Loan Solicitation and Processing. Loan originations are obtained from a variety of sources, including walk-in customers, and referrals from builders and realtors. Upon receipt of a loan application from a prospective borrower, a credit report and other data are obtained to verify specific information relating to the loan applicant's employment, income and credit standing. An appraisal of the real estate offered as collateral generally is undertaken by an appraiser retained by the Bank and certified by the State of Washington.

        Mortgage loan applications are initiated by loan officers and are required to be approved by the Bank's Loan Committee, which consists of the Bank's President, Executive Vice President and two other senior management officers. Certain consumer loans up to and including $25,000 may be approved by individual loan officers and the Bank's consumer lending department manager may approve loans up to and including $50,000. All other loans (except commercial business loans) up to and including $500,000 may be approved by any two members of the Bank's Loan Committee. Commercial business loans up to and including $250,000 may also be approved by the Bank's Business Banking Division manager. Loans in excess of $500,000, as well as loans of any size granted to a single borrower whose aggregate lending relationship exceeds $500,000, and commercial business loans in excess of $250,000, must be approved by the Bank's Board of Directors.

        Loan Originations, Purchases and Sales. During the years ended September 30, 2002 and 2001, the Bank's total gross loan originations were $203.6 million and $156.0 million, respectively. Periodically, the Bank purchases participation interests in construction and land development loans and multi-family loans, secured by properties located in the Bank's primary market area, from other lenders. Such purchases are underwritten to the Bank's underwriting guidelines and are without recourse to the seller other than for fraud. See "-- Lending Activities -- Construction and Land Development Lending" and "-- Lending Activities -- Multi-Family Lending."

        Consistent with its asset/liability management strategy, the Bank's policy has been to retain in its portfolio all of the ARM loans and generally originates fixed rate loans with a view toward sale in the secondary market to the FHLMC; however, from time to time, a portion of fixed-rate loans may be retained in the Bank's portfolio to meet its

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asset-liability objectives. Loans sold in the secondary market are generally sold on a servicing retained basis. At September 30, 2002, the Bank's loan servicing portfolio totaled $140.4 million.

        The following table shows total loans originated, purchased, sold and repaid during the periods indicated.

        Loan Origination Fees. The Bank, in some instances, receives loan origination fees. Loan fees are a percentage of the principal amount of the loan which are charged to the borrower for funding the loan. The amount of fees charged by the Bank is generally 1.0% to 2.0%. Current accounting standards require fees received and certain loan origination costs for originating loans to be deferred and amortized into interest income over the contractual life of the loan. Net deferred fees or costs associated with loans that are prepaid are recognized as income at the time of prepayment. Deferred origination loan fees totaled $3.2 million at September 30, 2002.

        Nonperforming Assets and Delinquencies. The Bank assesses late fees or penalty charges on delinquent loans of approximately 5% of the monthly loan payment amount. Substantially all fixed-rate and ARM loan payments are due on the first day of the month; however, the borrower is given a 15 day grace period to make the loan payment. When a mortgage loan borrower fails to make a required payment when due, the Bank institutes collection procedures. A notice is mailed to the borrower 16 days after the date the payment is due. Attempts to contact the borrower by telephone

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generally begin on or before the 30th day of delinquency. If a satisfactory response is not obtained, continuous follow-up contacts are attempted until the loan has been brought current. Before the 90th day of delinquency, attempts to interview the borrower, preferably in person, are made to establish (i) the cause of the delinquency, (ii) whether the cause is temporary, (iii) the attitude of the borrower toward the debt, and (iv) a mutually satisfactory arrangement for curing the default.

        If the borrower is chronically delinquent and all reasonable means of obtaining payment on time have been exhausted, foreclosure is initiated according to the terms of the security instrument and applicable law. Interest income on loans is reduced by the full amount of accrued and uncollected interest.

        When a consumer loan borrower or commercial business borrower fails to make a required payment on a loan by the payment due date, the Bank institutes similar collection procedures as for its mortgage loan borrowers.

        The Bank's Board of Directors is informed monthly as to the status of all loans that are delinquent by more than 30 days, the status on all loans currently in foreclosure, and the status of all foreclosed and repossessed property owned by the Bank.

        The following table sets forth information with respect to the Bank's nonperforming assets at the dates indicated.

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        Additional interest income which would have been recorded for the year ended September 30, 2002 had nonaccruing loans been current in accordance with their original terms amounted to approximately $253,000. No interest income was recorded on nonaccrual loans for the year ended September 30, 2002.

        Real Estate Owned. Real estate acquired by the Bank as a result of foreclosure or by deed-in-lieu of foreclosure is classified as real estate owned until sold. When property is acquired it is recorded at the lower of its cost, which is the unpaid principal balance of the related loan plus foreclosure costs, or fair market value. Subsequent to foreclosure, the property is carried at the lower of the foreclosed amount or fair value, less estimated selling costs. At September 30, 2002, the Bank had $680,000 in real estate owned consisting primarily of six one- to- four family properties, and five land parcels.

        Restructured Loans. Under accounting principles generally accepted in the United States of America, the Bank is required to account for certain loan modifications or restructuring as a "troubled debt restructuring." In general, the modification or restructuring of a debt constitutes a troubled debt restructuring if the Bank for economic or legal reasons related to the borrower's financial difficulties grants a concession to the borrowers that the Bank would not otherwise consider. Debt restructuring or loan modifications for a borrower does not necessarily always constitute troubled debt restructuring, however, and troubled debt restructuring do not necessarily result in non-accrual loans. The Bank had no restructured loans at September 30, 2002.

        Asset Classification. Applicable regulations require that each insured institution review and classify its assets on a regular basis. In addition, in connection with examinations of insured institutions, regulatory examiners have authority to identify problem assets and, if appropriate, require them to be classified. There are three classifications for problem assets: substandard, doubtful and loss. Substandard assets have one or more defined weaknesses and are characterized by the distinct possibility that the insured institution will sustain some loss if the deficiencies are not corrected. Doubtful assets have the weaknesses of substandard assets with the additional characteristic that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions and values questionable, and there is a high possibility of loss. An asset classified as loss is considered uncollectible and of such little value that continuance as an asset of the institution is not warranted. When an insured institution classifies problem assets as either substandard or doubtful, it is required to establish general allowances for loan losses in an amount deemed prudent by management. These allowances represent loss allowances which have been established to recognize the inherent risk associated with lending activities and the risks associated with particular problem assets. When an insured institution classifies problem assets as loss, it charges off the balance of the asset against the allowance for loan losses. Assets which do not currently expose the insured institution to sufficient risk to warrant classification in one of the aforementioned categories but possess weaknesses are required to be designated as special mention. The Bank's determination as to the classification of its assets and the amount of its valuation allowances is subject to review by the FDIC and the Division which can order the establishment of additional loss allowances.

        The aggregate amounts of the Bank's classified assets (as determined by the Bank), and of the Bank's allowances for loan losses at the dates indicated, were as follows:

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        The Bank's classified assets increased by $5.2 million at September 30, 2002, primarily as a result of a $6.8 million increase in loans classified as special mention and a $1.6 million decrease in loans classified as substandard.

        Special mention loan are defined as those credits deemed by management to have some potential weakness that deserve management's close attention. If left uncorrected these potential weaknesses may result in the deterioration of the payment prospects of the loan. Assets in this category are not adversely classified and currently do not expose the Bank to sufficient risk to warrant a substandard classification. Five relationships encompass more than 88% of the loans classified as special mention. They include a $3.5 million loan on a 142-unit motel in Pierce County, a $2.5 million loan secured by a mobile home development in Portland, Oregon, a $2.0 million loan secured by an Alzheimer's/assisted living facility in Kitsap County, and three loans to an established contractor in King County totaling $1.8 million. Each of these loans is current and paying in accordance with the required loan terms.

        Substandard loans are classified as those loans that are inadequately protected by the current net worth, and paying capacity of the obligor, or of the collateral pledged. Assets classified as substandard have a well-defined weakness, or weaknesses that jeopardize the repayment of the debt. If the weakness, or weaknesses are not corrected there is the distinct possibility that some loss will be sustained. The aggregate amount of loans classified as substandard at September 30, 2002 decreased by $1.56 million to $7.97 million from the amount reported at September 30, 2001. At September 30, 2002, 58 loans were classified as substandard compared to 64 at September 30, 2001. The largest loan currently classified substandard is a $1.8 million land development loan (including $882,000 of undisbursed loans in process balance) that was delayed due to an encroachment on the land securing the Bank's loan. The encroachment has been removed and the Bank's borrower is expecting an award from the party that caused the encroachment. The loan is currently not performing in accordance with the required loan terms.

        Allowance for Loan Losses. The allowance for loan losses is maintained to cover losses inherent in the loan portfolio. The Bank has established a systematic methodology for the determination of provisions for loan losses that takes into consideration the need for an overall general valuation allowance. The Bank's methodology for assessing the adequacy of its allowance for loan losses is based on its historic loss experience for various loan segments; adjusted for changes in economic conditions, delinquency rates, and other factors. Using these loss estimate factors, management develops a range of probable loss for each loan category. Certain individual loans for which full collectibility may not be assured are evaluated individually with loss exposure based on estimated discounted cash flows or collateral values. The total estimated range of loss based on these two components of the analysis is compared to the loan loss allowance balance. Based on this review, management will adjust the allowance as necessary to maintain directional consistency with trends in the loan portfolio.

        In originating loans, the Bank recognizes that losses will be experienced and that the risk of loss will vary with, among other things, the type of loan being made, the creditworthiness of the borrower over the term of the loan, general economic conditions and, in the case of a secured loan, the quality of the security for the loan. The Bank increases its allowance for loan losses by charging provisions for loan losses against the Bank's income.

        Management reviews the adequacy of the allowance at least quarterly based on management's assessment of current economic conditions, past loss and collection experience, and risk characteristics of the loan portfolio. A provision for losses is charged against income monthly to maintain the allowances.

        At September 30, 2002, the Bank had an allowance for loan losses of $3.6 million. Management believes that the amount maintained in the allowance is adequate to absorb losses inherent in the portfolio. Although management believes that it uses the best information available to make such determinations, future adjustments to the allowance for loan losses may be necessary and results of operations could be significantly and adversely affected if circumstances differ substantially from the assumptions used in making the determinations.

        While the Bank believes it has established its existing allowance for loan losses in accordance with accounting principles generally accepted in the United States of America, there can be no assurance that regulators, in reviewing the Bank's loan portfolio, will not request the Bank to increase significantly its allowance for loan losses. In addition,

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because future events affecting borrowers and collateral cannot be predicted with certainty, there can be no assurance that the existing allowance for loan losses is adequate or that substantial increases will not be necessary should the quality of any loans deteriorate as a result of the factors discussed above. Any material increase in the allowance for loan losses may adversely affect the Bank's financial condition and results of operations.

        The following table sets forth an analysis of the Bank's allowance for possible loan losses for the periods indicated.

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        The following table sets forth the breakdown of the allowance for loan losses by loan category at the dates indicated.

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Investment Activities

        At September 30, 2002, the Company's investment portfolio totaled $41.6 million, consisting of $23.7 million of securities available for sale and $17.9 million of mortgage-backed securities available for sale. This compares with a total portfolio of $29.4 million at September 30, 2001, comprised of $10.2 million of securities available for sale and $19.2 million of mortgage-backed securities available for sale. The composition of the portfolios by type of security, at each respective date is presented in the table, which follows.

        The investment policies of the Company are established and monitored by the Board of Directors. The policies are designed primarily to provide and maintain liquidity, to generate a favorable return on investments without incurring undue interest rate and credit risk, and to compliment the Bank's lending activities. These policies dictate the criteria for classifying securities as either available for sale or held to maturity. The policies permit investment in various types of liquid assets permissible under applicable regulations, which includes U.S. Treasury obligations, securities of various federal agencies, certain certificates of deposit of insured banks, banker's acceptances, federal funds, and mortgage-backed securities. The Company's investment policy also permits investment in equity securities in certain financial service companies.

        The following table sets forth the investment securities portfolio and carrying values at the dates indicated.

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        General. Deposits and loan repayments are the major sources of the Bank's funds for lending and other investment purposes. Scheduled loan repayments are a relatively stable source of funds, while deposit inflows and outflows and loan prepayments are influenced significantly by general interest rates and money market conditions. Borrowings through the FHLB-Seattle may be used to compensate for reductions in the availability of funds from other sources.

        Deposit Accounts. Substantially all of the Bank's depositors are residents of Washington. Deposits are attracted from within the Bank's market area through the offering of a broad selection of deposit instruments, including money market deposit accounts, checking accounts, regular savings accounts and certificates of deposit. Deposit account terms vary, according to the minimum balance required, the time periods the funds must remain on deposit and the interest rate, among other factors. In determining the terms of its deposit accounts, the Bank considers current market interest rates, profitability to the Bank, matching deposit and loan products and its customer preferences and concerns. In recent periods, the Bank has used deposit interest rate promotions in connection with the opening of new branch offices.

        At September 30, 2002 the Bank had $36.2 million of jumbo certificates of deposit of $100,000 or more, which includes $8.6 million in public unit funds. The Bank does not solicit brokered deposits and believes that its jumbo certificates of deposit, which represented 12.4% of total deposits at September 30, 2002, present similar interest rate risk compared to its other deposit products.

        The following table sets forth information concerning the Bank's deposits at September 30, 2002.

        The following table indicates the amount of the Bank's jumbo certificates of deposit by time remaining until maturity as of September 30, 2002. Jumbo certificates of deposit have principal balances of $100,000 or more and the rates paid on such accounts are generally negotiable.

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        Time Deposits by Maturities. The following table sets forth the amount and maturities of time deposits at September 30, 2001.

        Deposit Activities. The following table sets forth the savings activities of the Bank for the periods indicated.

        Borrowings. Savings deposits are the primary source of funds for the Bank's lending and investment activities and for general business purposes. The Bank has the ability to use advances from the FHLB-Seattle to supplement its supply of lendable funds and to meet deposit withdrawal requirements. The FHLB-Seattle functions as a central reserve bank providing credit for member financial institutions. As a member of the FHLB-Seattle, the Bank is required to own capital stock in the FHLB-Seattle and is authorized to apply for advances on the security of such stock and certain of its mortgage loans and other assets (principally securities which are obligations of, or guaranteed by, the U.S. Government)

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provided certain creditworthiness standards have been met. Advances are made pursuant to several different credit programs. Each credit program has its own interest rate and range of maturities. Depending on the program, limitations on the amount of advances are based on the financial condition of the member institution and the adequacy of collateral pledged to secure the credit. At September 30, 2002, the Bank maintained an uncommitted credit facility with the FHLB-Seattle that provided for immediately available advances up to an aggregate amount of 35% of the Bank's total assets, under which $61.8 million was outstanding.

        The following table sets forth certain information regarding short-term borrowings by the Bank at the end of and during the periods indicated using monthly average balance:

General

        As a state-chartered, federally insured savings bank, the Bank is subject to extensive regulation. Lending activities and other investments must comply with various statutory and regulatory requirements, including prescribed minimum capital standards. The Bank is regularly examined by the FDIC and the Division and files periodic reports concerning the Bank's activities and financial condition with its regulators. The Bank's relationship with depositors and borrowers also is regulated to a great extent by both federal and state law, especially in such matters as the ownership of savings accounts and the form and content of mortgage documents.

        Federal and state banking laws and regulations govern all areas of the operation of the Bank, including reserves, loans, mortgages, capital, issuance of securities, payment of dividends and establishment of branches. Federal and state bank regulatory agencies also have the general authority to limit the dividends paid by insured banks and bank holding companies if such payments should be deemed to constitute an unsafe and unsound practice. The respective primary federal regulators of the Company and the Bank have authority to impose penalties, initiate civil and administrative actions and take other steps intended to prevent banks from engaging in unsafe or unsound practices.

State Regulation and Supervision

        As a state-chartered savings bank, the Bank is subject to applicable provisions of Washington law and regulations of the Division adopted thereunder. State law and regulations govern the Bank's ability to take deposits and pay interest thereon, to make loans on or invest in residential and other real estate, to make consumer loans, to invest in

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securities, to offer various banking services to its customers, and to establish branch offices. Under state law, savings banks in Washington also generally have all of the powers that federal savings banks have under federal laws and regulations. The Bank is subject to periodic examination and reporting requirements by and of the Division.

Deposit Insurance

        The FDIC is an independent federal agency that insures the deposits, up to prescribed statutory limits, of depository institutions. The FDIC currently maintains two separate insurance funds: the Bank Insurance Fund ("BIF") and the SAIF. The Bank's accounts are insured by the SAIF to the maximum extent permitted by law. As insurer of the Bank's deposits, the FDIC has examination, supervisory and enforcement authority over the Bank.

        The FDIC has established a risk-based system for setting deposit insurance assessments. Under the risk-based assessment system, an institution's insurance assessment varies according to the level of capital the institution holds, the balance of insured deposits during the preceding two quarters, and the degree to which it is the subject of supervisory concern. In addition, regardless of the potential risk to the insurance fund, federal law requires the ratio of reserves to insured deposits at $1.25 per $100. Both funds currently meet this reserve ratio. Since 1997, the assessment rate for both SAIF and BIF deposits ranged from zero to 0.27% of covered deposits. As a well capitalized bank, the Bank qualified for the lowest rate on its deposits for calendar 2002.

        In addition to deposit insurance assessments, the FDIC is authorized to collect assessments against insured deposits to be paid to the Financing Corporation ("FICO") to service FICO debt incurred in the 1980s to help fund the thrift industry cleanup. The FICO assessment rate is adjusted quarterly.

        Prior to 2000, the FICO assessment rate for BIF-insured deposits was one-fifth the rate applicable to deposits insured by the SAIF. Beginning in 2000, SAIF- and BIF-insured deposits were assessed at the same rate by FICO. As a result, BIF FICO assessments will be higher than in previous periods while SAIF FICO assessments will be lower. For the fourth quarter of 2002, the annualized rate was 1.70 cents per $100 of insured deposits.

        The FDIC may terminate the deposit insurance of any insured depository institution if it determines after a hearing that the institution has engaged or is engaging in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, order or any condition imposed by an agreement with the FDIC. It also may suspend deposit insurance temporarily during the hearing process for the permanent termination of insurance, if the institution has no tangible capital. If insurance of accounts is terminated, the accounts at the institution at the time of termination, less subsequent withdrawals, shall continue to be insured for a period of six months to two years, as determined by the FDIC. Management is not aware of any existing circumstances that could result in termination of the deposit insurance of the Bank.

Prompt Corrective Action

        The FDIC is required to take certain supervisory actions against undercapitalized savings institutions, the severity of which depends upon the institution's degree of undercapitalization. Generally, an institution that has a ratio of total capital to risk-weighted assets of less than 8%, a ratio of Tier I (core) capital to risk-weighted assets of less than 4%, or a ratio of core capital to total assets of less than 4% (3% or less for institutions with the highest examination rating) is considered to be undercapitalized. An institution that has a total risk-based capital ratio less than 6%, a Tier I capital ratio of less than 3% or a leverage ratio that is less than 3% is considered to be significantly undercapitalized and an institution that has a tangible capital to assets ratio equal to or less than 2% is deemed to be critically undercapitalized. Subject to a narrow exception, the FDIC is required to appoint a receiver or conservator for a savings institution that is critically undercapitalized. FDIC regulations also require that a capital restoration plan be filed with the FDIC within 45 days of the date a savings institution receives notice that it is undercapitalized, significantly undercapitalized or critically undercapitalized. Compliance with the plan must be guaranteed by any parent holding company in an amount of up to the lesser of 5% of the institution's assets or the amount which would bring the institution into compliance with all capital standards. In addition, numerous mandatory supervisory actions become immediately applicable to an undercapitalized institution, including, but not limited to, increased monitoring by regulators and

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restrictions on growth, capital distributions and expansion. The FDIC also could take any one of a number of discretionary supervisory actions, including the issuance of a capital directive and the replacement of senior executive officers and directors.

        At September 30, 2002, the Bank was categorized as "well capitalized" under the prompt corrective action regulations of the FDIC.

Standards for Safety and Soundness

        The federal banking regulatory agencies have prescribed, by regulation, guidelines for all insured depository institutions relating to: internal controls, information systems and internal audit systems; loan documentation; credit underwriting; interest rate risk exposure; asset growth; asset quality; earnings and compensation, fees and benefits. The guidelines set forth the safety and soundness standards that the federal banking agencies use to identify and address problems at insured depository institutions before capital becomes impaired. If the FDIC determines that the Bank fails to meet any standard prescribed by the guidelines, the agency may require the Bank to submit to the agency an acceptable plan to achieve compliance with the standard. FDIC regulations establish deadlines for the submission and review of such safety and soundness compliance plans.

Capital Requirements

        FDIC regulations recognize two types or tiers of capital: core ("Tier 1") capital and supplementary ("Tier 2") capital. Tier 1 capital generally includes common stockholders' equity and noncumulative perpetual preferred stock, less most intangible assets. Tier 2 capital, which is limited to 100 percent of Tier 1 capital, includes such items as qualifying general loan loss reserves, cumulative perpetual preferred stock, mandatory convertible debt, term subordinated debt and limited life preferred stock; however, the amount of term subordinated debt and intermediate term preferred stock (original maturity of at least five years but less than 20 years) that may be included in Tier 2 capital is limited to 50 percent of Tier 1 capital.

        The FDIC currently measures an institution's capital using a leverage limit together with certain risk-based ratios. The FDIC's minimum leverage capital requirement specifies a minimum ratio of Tier 1 capital to average total assets. Most banks are required to maintain a minimum leverage ratio of at least 4% to 5% of total assets.  At September 30, 2002, the Bank had a Tier 1 leverage capital ratio of 15.6%.  The FDIC retains the right to require a particular institution to maintain a higher capital level based on an institution's particular risk profile.

        FDIC regulations also establish a measure of capital adequacy based on ratios of qualifying capital to risk-weighted assets. Assets are placed in one of four categories and given a percentage weight -- 0%, 20%, 50% or 100% -- based on the relative risk of that category. In addition, certain off-balance-sheet items are converted to balance-sheet credit equivalent amounts, and each amount is then assigned to one of the four categories. Under the guidelines, the ratio of total capital (Tier 1 capital plus Tier 2 capital) to risk-weighted assets must be at least 8%, and the ratio of Tier 1 capital to risk-weighted assets must be at least 4%. In evaluating the adequacy of a bank's capital, the FDIC may also consider other factors that may affect a bank's financial condition. Such factors may include interest rate risk exposure, liquidity, funding and market risks, the quality and level of earnings, concentration of credit risk, risks arising from nontraditional activities, loan and investment quality, the effectiveness of loan and investment policies, and management's ability to monitor and control financial operating risks.

        The Division requires that net worth equal at least 5% of total assets. Intangible assets must be deducted from net worth and assets when computing compliance with this requirement. At September 30, 2002, the Bank had a net worth of 15.2% of total assets.

        FDIC capital requirements are designated as the minimum acceptable standards for banks whose overall financial condition is fundamentally sound, which are well-managed and have no material or significant financial weaknesses. The FDIC capital regulations state that, where the FDIC determines that the financial history or condition, including off-balance sheet risk, managerial resources and/or the future earnings prospects of a bank are not adequate

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and/or a bank has a significant volume of assets classified substandard, doubtful or loss or otherwise criticized, the FDIC may determine that the minimum adequate amount of capital for that bank is greater than the minimum standards established in the regulation.

        The Bank's management believes that, under the current regulations, the Bank will continue to meet its minimum capital requirements in the foreseeable future. However, events beyond the control of the Bank, such as a downturn in the economy in areas where the Bank has most of its loans, could adversely affect future earnings and, consequently, the ability of the Bank to meet its capital requirements.

        The table below sets forth the Bank's capital position relative to its FDIC capital requirements at September 30, 2002. The definitions of the terms used in the table are those provided in the capital regulations issued by the FDIC.

Activities and Investments of Insured State-Chartered Banks

        Federal law generally limits the activities and equity investments of FDIC-insured, state-chartered banks to those that are permissible for national banks. Under regulations dealing with equity investments, an insured state bank generally may not directly or indirectly acquire or retain any equity investment of a type, or in an amount, that is not permissible for a national bank. An insured state bank is not prohibited from, among other things, (i) acquiring or retaining a majority interest in a subsidiary, (ii) investing as a limited partner in a partnership the sole purpose of which is direct or indirect investment in the acquisition, rehabilitation or new construction of a qualified housing project, provided that such limited partnership investments may not exceed 2% of the bank's total assets, (iii) acquiring up to 10% of the voting stock of a company that solely provides or reinsures directors', trustees' and officers' liability insurance

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coverage or bankers' blanket bond group insurance coverage for insured depository institutions, and (iv) acquiring or retaining the voting shares of a depository institution if certain requirements are met.

        Federal law provides that an insured state-chartered bank may not, directly, or indirectly through a subsidiary, engage as "principal" in any activity that is not permissible for a national bank unless the FDIC has determined that such activities would pose no risk to the insurance fund of which it is a member and the bank is in compliance with applicable regulatory capital requirements. Any insured state-chartered bank directly or indirectly engaged in any activity that is not permitted for a national bank or for which the FDIC has granted and exception must cease the impermissible activity.

Environmental Issues Associated With Real Estate Lending

        The Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA"), a federal statute, generally imposes strict liability on, among other things, all prior and present "owners and operators" of hazardous waste sites. However, the U.S. Congress created a safe harbor provision for secured creditors by providing that the term "owner and operator" excludes a person who, without participating in the management of the site, holds indicia of ownership primarily to protect its security interest in the site. Since the enactment of the CERCLA, this "secured creditor exemption" has been the subject of judicial interpretations which have left open the possibility that lenders could be liable for cleanup costs on contaminated property that they hold as collateral for a loan.

        In response to the uncertainty created by judicial interpretations, in April 1992, the United States Environmental Protection Agency ("EPA"), an agency within the Executive Branch of the government, promulgated a regulation clarifying when and how secured creditors could be liable for cleanup costs under the CERCLA. Generally, the regulation protected a secured creditor that acquired full title to collateral property through foreclosure as long as the creditor did not participate in the property's management before foreclosure and undertook certain due diligence efforts to divest itself of the property. However, in February 1994, the U.S. Court of Appeals for the District of Columbia Circuit held that the EPA lacked authority to promulgate such regulation on the grounds that Congress meant for decisions on liability under the CERCLA to be made by the courts and not the Executive Branch. In January 1995, the U.S. Supreme Court denied to review the U.S. Court of Appeal's decision. In light of this adverse court ruling, in October 1995 the EPA issued a statement entitled "Policy on CERCLA Enforcement Against Lenders and Government Entities that Acquire Property Involuntarily" explaining that as an enforcement policy, the EPA intended to apply as guidance the provisions of the EPA lender liability rule promulgated in 1992.

        To the extent that legal uncertainty exists in this area, all creditors, including the Bank, that have made loans secured by properties with potential hazardous waste contamination (such as petroleum contamination) could be subject to liability for cleanup costs, which costs often substantially exceed the value of the collateral property.

Federal Reserve System

        The Federal Reserve Board requires under Regulation D that all depository institutions, including savings banks, maintain reserves on transaction accounts or non-personal time deposits. These reserves may be in the form of cash or non-interest-bearing deposits with the regional Federal Reserve Bank. Negotiable order of withdrawal accounts and other types of accounts that permit payments or transfers to third parties fall within the definition of transaction accounts and are subject to Regulation D reserve requirements, as are any non-personal time deposits at a savings bank. Under Regulation D, a bank must maintain reserves against net transaction accounts in the amount of 3% on amounts of $37.3 million or less, plus 10% on amounts in excess of $37.3 million. In addition, a bank may designate and exempt $5.0 million of certain reservable liabilities from these reserve requirements. These amounts and percentages are subject to adjustment by the Federal Reserve. The reserve requirement on non-personal time deposits with original maturities of less than 1.5 years is 0%. As of September 30, 2002, the Bank's deposit with the Federal Reserve Bank and vault cash exceeded its reserve requirements.

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Affiliate Transactions

        The Company and the Bank are legal entities separate and distinct. Various legal limitations restrict the Bank from lending or otherwise supplying funds to the Company (an "affiliate"), generally limiting such transactions with the affiliate to 10% of the bank's capital and surplus and limiting all such transactions to 20% of the bank's capital and surplus. Such transactions, including extensions of credit, sales of securities or assets and provision of services, also must be on terms and conditions consistent with safe and sound banking practices, including credit standards, that are substantially the same or at least as favorable to the bank as those prevailing at the time for transactions with unaffiliated companies.

        Federally insured banks are subject, with certain exceptions, to certain restrictions on extensions of credit to their parent holding companies or other affiliates, on investments in the stock or other securities of affiliates and on the taking of such stock or securities as collateral from any borrower. In addition, such banks are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit or the providing of any property or service.

Community Reinvestment Act

        Banks are also subject to the provisions of the Community Reinvestment Act of 1977 ("CRA"), which requires the appropriate federal bank regulatory agency, in connection with its regular examination of a bank, to assess the bank's record in meeting the credit needs of the community serviced by the bank, including low and moderate income neighborhoods. The regulatory agency's assessment of the bank's record is made available to the public. Further, such assessment is required of any bank which has applied, among other things, to establish a new branch office that will accept deposits, relocate an existing office or merge or consolidate with, or acquire the assets or assume the liabilities of, a federally regulated financial institution. The Bank received a "satisfactory" rating during its most recent CRA examination.

Dividends

        Dividends from the Bank constitute the major source of funds for dividends which may be paid by the Company. The amount of dividends payable by the Bank to the Company depends upon the Bank's earnings and capital position, and is limited by federal and state laws, regulations and policies. According to Washington law, the Bank may not declare or pay a cash dividend on its capital stock if it would cause its net worth to be reduced below (i) the amount required for liquidation accounts or (ii) the net worth requirements, if any, imposed by the Director of the Division. Dividends on the Bank's capital stock may not be paid in an aggregate amount greater than the aggregate retained earnings of the Bank, without the approval of the Director of the Division.

        The amount of dividends actually paid during any one period will be strongly affected by the Bank's management policy of maintaining a strong capital position. Federal law further provides that no insured depository institution may make any capital distribution (which would include a cash dividend) if, after making the distribution, the institution would be "undercapitalized," as defined in the prompt corrective action regulations. Moreover, the federal bank regulatory agencies also have the general authority to limit the dividends paid by insured banks if such payments should be deemed to constitute an unsafe and unsound practice.

General

        The Company, as the sole shareholder of the Bank is a bank holding company and is registered as such with the Federal Reserve. Bank holding companies are subject to comprehensive regulation by the Federal Reserve under the Bank Holding Company Act of 1956, as amended ("BHCA"), and the regulations of the Federal Reserve. As a bank holding company, the Company is required to file with the Federal Reserve annual reports and such additional information as the Federal Reserve may require and will be subject to regular examinations by the Federal Reserve. The Federal Reserve also has extensive enforcement authority over bank holding companies, including, among other things,

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the ability to assess civil money penalties, to issue cease and desist or removal orders and to require that a holding company divest subsidiaries (including its bank subsidiaries). In general, enforcement actions may be initiated for violations of law and regulations and unsafe or unsound practices.

Gramm-Leach-Bliley Financial Services Modernization Act of 1999

        On November 12, 1999, the Gramm-Leach-Bliley Financial Services Modernization Act of 1999 ("GLB Act") was signed into law. The GLB Act was intended to modernize the financial services industry by establishing a comprehensive framework to permit affiliations among commercial banks, insurance companies, securities firms and other financial service providers. Generally, the GLB Act:

        The Company has not elected to become a financial holding company. Under the BHCA, a bank holding company must obtain Federal Reserve approval before: (1) acquiring, directly or indirectly, ownership or control of any voting shares of another bank or bank holding company if, after such acquisition, it would own or control more than 5% of such shares (unless it already owns or controls the majority of such shares); (2) acquiring all or substantially all of the assets of another bank or bank holding company; or (3) merging or consolidating with another bank holding company.

The USA Patriot Act

        In response to the events of September 11th, President George W. Bush signed into law the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001, or the USA PATRIOT Act, on October 26, 2001. The USA PATRIOT Act gives the federal government new powers to address terrorist threats through enhanced domestic security measures, expanded surveillance powers, increased information sharing, and broadened anti-money laundering requirements. By way of amendments to the Bank Secrecy Act, Title III of the USA PATRIOT Act takes measures intended to encourage information sharing among bank regulatory agencies and law enforcement bodies. Further, certain provisions of Title III impose affirmative obligations on a broad range of financial institutions, including banks, thrifts, brokers, dealers, credit unions, money transfer agents and parties registered under the Commodity Exchange Act.

        Among other requirements, Title III of the USA PATRIOT Act imposes the following requirements with respect to financial institutions:

        - Pursuant to Section 352, all financial institutions must establish anti-money laundering programs that include, at minimum: (i) internal policies, procedures, and controls, (ii) specific designation of an anti-money laundering

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compliance officer, (iii) ongoing employee training programs, and (iv) an independent audit function to test the anti-money laundering program.

        - Section 326 of the Act authorizes the Secretary of the Department of Treasury, in conjunction with other bank regulators, to issue regulations by October 26, 2002 that provide for minimum standards with respect to customer identification at the time new accounts are opened.

        - Section 312 of the Act requires financial institutions that establish, maintain, administer, or manage private banking accounts or correspondent accounts in the United States for non-United States persons or their representatives (including foreign individuals visiting the United States) to establish appropriate, specific, and, where necessary, enhanced due diligence policies, procedures, and controls designed to detect and report money laundering.

        - Effective December 25, 2001, financial institutions are prohibited from establishing, maintaining, administering or managing correspondent accounts for foreign shell banks (foreign banks that do not have a physical presence in any country), and will be subject to certain recordkeeping obligations with respect to correspondent accounts of foreign banks.

        - Bank regulators are directed to consider a holding company's effectiveness in combating money laundering when ruling on Federal Reserve Act and Bank Merger Act applications.

        During the first quarter of 2002 the Federal Crimes Enforcement Network (FinCEN), a bureau of the Department of Treasury, issued proposed and interim regulations to implement the provisions of Sections 312 and 352 of the USA PATRIOT Act. To date, it has not been possible to predict the impact the USA PATRIOT Act and its implementing regulations may have on the Company and the Bank.

Sarbanes-Oxley Act of 2002

        The Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley Act") was signed into law by President Bush on July 30, 2002 in response to public concerns regarding corporate accountability in connection with the recent accounting scandals at Enron and WorldCom. The stated goals of the Sarbanes-Oxley Act are to increase corporate responsibility, to provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies and to protect investors by improving the accuracy and reliability of corporate disclosures pursuant to the securities laws.

        The Sarbanes-Oxley Act is the most far-reaching U.S. securities legislation enacted in some time. The Sarbanes-Oxley Act generally applies to all companies, both U.S. and non-U.S., that file or are required to file periodic reports with the Securities and Exchange Commission ("SEC"), under the Securities Exchange Act of 1934 ("Exchange Act").

        The Sarbanes-Oxley Act includes very specific additional disclosure requirements and new corporate governance rules, requires the SEC and securities exchanges to adopt extensive additional disclosure, corporate governance and other related rules and mandates further studies of certain issues by the SEC and the Comptroller General. The Sarbanes-Oxley Act represents significant federal involvement in matters traditionally left to state regulatory systems, such as the regulation of the accounting profession, and to state corporate law, such as the relationship between a board of directors and management and between a board of directors and its committees.

        The Sarbanes-Oxley Act addresses, among other matters:

• audit committees;





• certification of financial statements by the chief executive officer and the chief financial officer;





• the forfeiture of bonuses or other incentive-based compensation and profits from the sale of an issuer's securities by directors and senior officers in the twelve month period following initial publication of any financial statements that later require restatement;



 

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• a prohibition on insider trading during pension plan black out periods;





• disclosure of off-balance sheet transactions;





• a prohibition on personal loans to directors and officers;





• expedited filing requirements for Form 4s;





• disclosure of a code of ethics and filing a Form 8-K for a change or waiver of such code;





• "real time" filing of periodic reports





• the formation of a public accounting oversight board;





• auditor independence; and





• various increased criminal penalties for violations of securities laws.

        The Sarbanes-Oxley Act contains provisions which became effective upon enactment on July 30, 2002 and provisions which will become effective from within 30 days to one year from enactment. The SEC has been delegated the task of enacting rules to implement various provisions with respect to, among other matters, disclosure in periodic filings pursuant to the Exchange Act.

Acquisitions

        The BHCA also prohibits a bank holding company, with certain exceptions, from acquiring direct or indirect ownership or control of more than 5% of the voting shares of any company that is not a bank or bank holding company and from engaging directly or indirectly in activities other than those of banking, managing or controlling banks, or providing services for its subsidiaries. Under the BHCA, the Federal Reserve is authorized to approve the ownership of shares by a bank holding company in any company, the activities of which the Federal Reserve has determined to be so closely related to the business of banking or managing or controlling banks as to be a proper incident thereto. The list of activities determined by regulation to be closely related to banking within the meaning of the BHCA includes, among other things: operating a savings institution, mortgage company, finance company, credit card company or factoring company; performing certain data processing operations; providing certain investment and financial advice; underwriting and acting as an insurance agent for certain types of credit-related insurance; leasing property on a full-payout, non-operating basis; selling money orders, travelers' checks and U.S. Savings Bonds; real estate and personal property appraising; providing tax planning and preparation services; and, subject to certain limitations, providing securities brokerage services for customers.

Interstate Banking

        The Federal Reserve must approve an application of an adequately capitalized and adequately managed bank holding company to acquire control of, or acquire all or substantially all of the assets of, a bank located in a state other than such holding company's home state, without regard to whether the transaction is prohibited by the laws of any state. The Federal Reserve may not approve the acquisition of a bank that has not been in existence for the minimum time period, not exceeding five years, specified by the statutory law of the host state. Nor may the Federal Reserve approve an application if the applicant, and its depository institution affiliates, controls or would control more than 10% of the insured deposits in the United States or 30% or more of the deposits in the target bank's home state or in any state in which the target bank maintains a branch. Federal law does not affect the authority of states to limit the percentage of total insured deposits in the state which may be held or controlled by a bank holding company to the extent such limitation does not discriminate against out-of-state banks or bank holding companies. Individual states may also waive the 30% state-wide concentration limit contained in the federal law.

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        The Federal banking agencies are authorized to approve interstate merger transactions without regard to whether such transaction is prohibited by the law of any state, unless the home state of one of the banks adopted a law prior to June 1, 1997 which applies equally to all out-of-state banks and expressly prohibits merger transactions involving out-of-state banks. Interstate acquisitions of branches will be permitted only if the law of the state in which the branch is located permits such acquisitions. Interstate mergers and branch acquisitions will also be subject to the nationwide and statewide insured deposit concentration amounts described above.

        The Federal Reserve has issued a policy statement on the payment of cash dividends by bank holding companies, which expresses the Federal Reserve's view that a bank holding company should pay cash dividends only to the extent that the company's net income for the past year is sufficient to cover both the cash dividends and a rate of earning retention that is consistent with the company's capital needs, asset quality and overall financial condition. The Federal Reserve also indicated that it would be inappropriate for a company experiencing serious financial problems to borrow funds to pay dividends.

        Bank holding companies, except for certain "well-capitalized" and highly rated bank holding companies, are required to give the Federal Reserve prior written notice of any purchase or redemption of its outstanding equity securities if the gross consideration for the purchase or redemption, when combined with the net consideration paid for all such purchases or redemptions during the preceding 12 months, is equal to 10% or more of their consolidated net worth. The Federal Reserve may disapprove such a purchase or redemption if it determines that the proposal would constitute an unsafe or unsound practice or would violate any law, regulation, Federal Reserve order, or any condition imposed by, or written agreement with, the Federal Reserve.

        On May 10, 2002, the Company announced a plan to repurchase 193,659 shares of the Company's stock. This marked the Company's tenth 5% stock repurchase plan. As of September 30, 2002, the Company had repurchased 117,400 shares at an average price of $17.05. As of September 30, 2002, the Company has cumulatively repurchased 2,522,304 (38.1%) of the 6,612,500 shares that were issued when the Company went public in January 1998.

        The Federal Reserve has established capital adequacy guidelines for bank holding companies that generally parallel the capital requirements of the FDIC for the Bank. The Federal Reserve regulations provide that capital standards will be applied on a consolidated basis in the case of a bank holding company with $150 million or more in total consolidated assets.

        The Company's total risk based capital must equal 8% of risk-weighted assets and one half of the 8%, or 4%, must consist of Tier 1 (core) capital. As of September 30, 2002, the Company's total risk based capital was 24.4% of risk-weighted assets and its risk based capital of Tier 1 (core) capital was 23.2% of risk-weighted assets.

Federal Taxation

        General. The Company and the Bank report their income on a fiscal year basis using the accrual method of accounting and are subject to federal income taxation in the same manner as other corporations with some exceptions, including particularly the Bank's reserve for bad debts discussed below. The following discussion of tax matters is intended only as a summary and does not purport to be a comprehensive description of the tax rules applicable to the Bank or the Company.

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        Bad Debt Reserve. Historically, savings institutions such as the Bank which met certain definitional tests primarily related to their assets and the nature of their business ("qualifying thrift") were permitted to establish a reserve for bad debts and to make annual additions thereto, which may have been deducted in arriving at their taxable income. The Bank's deductions with respect to "qualifying real property loans," which are generally loans secured by certain interest in real property, were computed using an amount based on the Bank's actual loss experience, or a percentage equal to 8% of the Bank's taxable income, computed with certain modifications and reduced by the amount of any permitted additions to the non-qualifying reserve. Due to the Bank's loss experience, the Bank generally recognized a bad debt deduction equal to 8% of taxable income.

        The provisions repealing the current thrift bad debt rules were passed by Congress as part of "The Small Business Job Protection Act of 1996." The new rules eliminate the 8% of taxable income method for deducting additions to the tax bad debt reserves for all thrifts for tax years beginning after December 31, 1995. These rules also require that all institutions recapture all or a portion of their bad debt reserves added since the base year (last taxable year beginning before January 1, 1988). The Bank has previously recorded deferred taxes equal to the bad debt recapture and as such the new rules will have no effect on the net income or federal income tax expense. For taxable years beginning after December 31, 1995, the Bank's bad debt deduction will be determined under the experience method using a formula based on actual bad debt experience over a period of years or, if the Bank is a "large" association (assets in excess of $500 million) on the basis of net charge-offs during the taxable year. The new rules allowed an institution to suspend bad debt reserve recapture for the 1996 and 1997 tax years if the institution's lending activity for those years was equal to or greater than the institutions average mortgage lending activity for the six taxable years preceding 1996 adjusted for inflation. For this purpose, only home purchase or home improvement loans are included and the institution can elect to have the tax years with the highest and lowest lending activity removed from the average calculation. If an institution is permitted to postpone the reserve recapture, it must begin its six year recapture no later than the 1998 tax year. The unrecaptured base year reserves will not be subject to recapture as long as the institution continues to carry on the business of banking. In addition, the balance of the pre-1988 bad debt reserves continue to be subject to provisions of present law referred to below that require recapture in the case of certain excess distributions to shareholders.

        Distributions. To the extent that the Bank makes "nondividend distributions" to the Company, such distributions will be considered to result in distributions from the balance of its bad debt reserve as of December 31, 1987 (or a lesser amount if the Bank's loan portfolio decreased since December 31, 1987) and then from the supplemental reserve for losses on loans ("Excess Distributions"), and an amount based on the Excess Distributions will be included in the Bank's taxable income. Nondividend distributions include distributions in excess of the Bank's current and accumulated earnings and profits, distributions in redemption of stock and distributions in partial or complete liquidation. However, dividends paid out of the Bank's current or accumulated earnings and profits, as calculated for federal income tax purposes, will not be considered to result in a distribution from the Bank's bad debt reserve. The amount of additional taxable income created from an Excess Distribution is an amount that, when reduced by the tax attributable to the income, is equal to the amount of the distribution. Thus, if the Bank makes a "nondividend distribution," then approximately one and one-half times the Excess Distribution would be includable in gross income for federal income tax purposes, assuming a 34% corporate income tax rate (exclusive of state and local taxes). See "REGULATION OF THE BANK -- Dividends" for limits on the payment of dividends by the Bank. The Bank does not intend to pay dividends that would result in a recapture of any portion of its tax bad debt reserve.

        Corporate Alternative Minimum Tax. The Code imposes a tax on alternative minimum taxable income ("AMTI") at a rate of 20%. In addition, only 90% of AMTI can be offset by net operating loss carryovers. AMTI is increased by an amount equal to 75% of the amount by which the Bank's adjusted current earnings exceeds its AMTI (determined without regard to this preference and prior to reduction for net operating losses).

        Dividends-Received Deduction. The Company may exclude from its income 100% of dividends received from the Bank as a member of the same affiliated group of corporations. The corporate dividends-received deduction is generally 70% in the case of dividends received from unaffiliated corporations with which the Company and the Bank will not file a consolidated tax return, except that if the Company or the Bank owns more than 20% of the stock of a corporation distributing a dividend, then 80% of any dividends received may be deducted.

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        Audits. The Bank's federal income tax returns have been audited through September 30, 1997. The Bank did not incur any net increase in tax liability as a result of the audit.

Washington Taxation

        The Bank is subject to a business and occupation tax imposed under Washington law at the rate of 1.50% of gross receipts. Interest received on loans secured by mortgages or deeds of trust on residential properties is exempt from such tax.

Competition

        The Bank operates in an intensely competitive market for the attraction of savings deposits (its primary source of lendable funds) and in the origination of loans. Historically, its most direct competition for savings deposits has come from large commercial banks, thrift institutions and credit unions in its primary market area. Particularly in times of high interest rates, the Bank has faced additional significant competition for investors' funds from short-term money market securities and other corporate and government securities. The Bank's competition for loans comes principally from mortgage bankers, commercial banks and other thrift institutions. Such competition for deposits and the origination of loans may limit the Bank's future growth and earnings prospects.

Subsidiary Activities

        The Bank has one wholly-owned subsidiary, Timberland Service Corporation ("Timberland Service"), whose primary function is to act as the Bank's escrow department.

Personnel

        As of September 30, 2002, the Bank had 140 full-time employees and 28 part-time employees. The employees are not represented by a collective bargaining unit and the Bank believes its relationship with its employees is good.

Item 2. Properties

        The Bank operates 13 full-service facilities.  The following table sets forth certain information regarding the Bank's offices at September 30, 2002, all of which are owned, except for the Tacoma office, which is leased.

        Periodically, there have been various claims and lawsuits involving the Bank, such as claims to enforce liens, condemnation proceedings on properties in which the Bank holds security interests, claims involving the making and servicing of real property loans and other issues incident to the Bank's business. The Bank is not a party to any pending legal proceedings that it believes would have a material adverse effect on the financial condition or operations of the Bank.

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Item 4. Submission of Matters to a Vote of Security Holders

        No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year ended September 30, 2002.

Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters

        The Company's common stock is traded on the Nasdaq National Market under the symbol "TSBK". As of September 30, 2002, there were 4,340,976 shares of common stock issued and approximately 764 shareholders of record, excluding persons or entities who hold stock in nominee or "street name" accounts with brokers. Dividend payments by the Company are dependent primarily on dividends received by the Company from the Bank. Under federal regulations, the dollar amount of dividends the Bank may pay is dependent upon its capital position and recent net income. Generally, if the Bank satisfies its regulatory capital requirements, it may make dividend payments up to the limits prescribed in the FDIC regulations. However, institutions that have converted to a stock form of ownership may not declare or pay a dividend on, or repurchase any of, its common stock if the effect thereof would cause the regulatory capital of the institution to be reduced below the amount required for the liquidation account which was established in connection with the mutual to stock conversion.

        The following table sets forth the market price range of the Company's common stock for the years ended September 30, 2002, 2001 and 2000. This information was provided by the Nasdaq Stock Market.

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Item 6. Selected Financial Data

        The following table sets forth certain information concerning the consolidated financial position and results of operations of the Company and subsidiaries at and for the dates indicated. Since the Company had not commenced operations prior to the Bank's mutual-to-stock conversion in January 1998, the financial information presented for the periods prior to 1998 is that of the Bank only. The consolidated data is derived in part from, and should be read in conjunction with, the Consolidated Financial Statements of the Company and its subsidiary presented herein.

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Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

        Management's Discussion and Analysis of Financial Condition and Results of Operations is intended to assist in understanding the consolidated financial condition and results of operations of the Company. The information contained in this section should be read in conjunction with the Consolidated Financial Statements and accompanying notes thereto. Management's Discussion and Analysis of Financial Condition and Results of Operations and other portions of this Annual Report contain certain "forward-looking statements" concerning the future operations of Timberland Bancorp, Inc. Management desires to take advantage of the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995 and is including this statement for the express purpose of availing the Company of the protections of such safe harbor with respect to all "forward-looking statements" contained in our Annual Report. We have used "forward-looking statements" to describe future plans and strategies, including our expectations of the Company's future financial results. Management's ability to predict results or the effect of future plans or strategies is inherently uncertain. Factors which could affect actual results include interest rate trends, the general economic climate in the Company's market area and the country as a whole, the ability of the Company to control costs and expenses, competitive products and pricing, loan delinquency rates, and changes in federal and state regulation. These factors should be considered in evaluating the "forward-looking statements," and undue reliance should not be placed on such statements.

Operating Strategy

        The Bank is a community-oriented bank which has traditionally offered a wide variety of savings products to its retail customers while concentrating its lending activities on real estate loans. The primary elements of the Bank's operating strategy include:

        Emphasize Residential Mortgage Lending and Residential Construction Lending. The Bank has historically attempted to establish itself as a niche lender in its primary market areas by focusing its lending activities primarily on the origination of loans secured by one- to- four family residential dwellings, including an emphasis on loans for the construction of residential dwellings. In an effort to meet the credit needs of borrowers in its primary area, the Bank actively originates one- to- four family mortgage loans that do not qualify for sale in the secondary market under FHLMC guidelines. The Bank has also been an active participant in the secondary market, originating residential loans for sale to the FHLMC on a servicing retained basis.

        Diversify Primary Market Area by Expanding Branch Office Network. In an effort to lessen its dependence on the Grays Harbor County market whose economy has historically been tied to the timber and fishing industries, the Bank has opened branch offices in Pierce, King, Thurston and Kitsap Counties. Thurston, Pierce, King and Kitsap Counties contain the Olympia, Bremerton, and Seattle-Tacoma metropolitan areas and their economies are more diversified with the presence of government, aerospace and computer industries.

        Limit Exposure to Interest Rate Risk. In recent years, the loans that the Bank has retained in its portfolio generally have periodic interest rate adjustment features or have been relatively short-term in nature. Loans originated for portfolio retention primarily have included ARM loans and short-term construction loans. Longer term fixed-rate mortgage loans have generally been originated for sale in the secondary market. Management believes that the interest rate sensitivity of these adjustable rate and short-term loans more closely match the interest rate sensitivity of the Bank's funding sources than do other longer duration assets with fixed interest rates.

        Emphasize the Origination of Commercial Real Estate and Commercial Business Loans. The Bank established a business banking division in 1998 for the purpose of increasing the Bank's origination of commercial real estate and

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commercial business loans. Originally, three lenders were hired to staff the division. Currently, seven lenders are active in the origination of commercial loans.

        Increase the Consumer Loan Portfolio. In 2001 the Bank hired a consumer loan specialist to increase the origination of consumer loans. The consumer loans generated since that time have been secured primarily by real estate. The Bank expects to continue expanding its portfolio of consumer loans.

Market Risk and Asset and Liability Management

        General. Market risk is the risk of loss from adverse changes in market prices and rates. The Company's market risk arises primarily from interest rate risk inherent in its lending, investment, deposit and borrowing activities. The Bank, like other financial institutions, is subject to interest rate risk to the extent that its interest-earning assets reprice differently than its interest-bearing liabilities. Management actively monitors and manages its interest rate risk exposure. Although the Bank manages other risks, such as credit quality and liquidity risk, in the normal course of business management considers interest rate risk to be its most significant market risk that could potentially have the largest material effect on the Bank's financial condition and results of operations. The Bank does not maintain a trading account for any class of financial instruments nor does it engage in hedging activities or derivative instruments. Furthermore, the Bank is not subject to foreign currency exchange rate risk or commodity price risk.

        Qualitative Aspects of Market Risk. The Bank's principal financial objective is to achieve long-term profitability while reducing its exposure to fluctuating market interest rates. The Bank has sought to reduce the exposure of its earnings to changes in market interest rates by attempting to manage the mismatch between asset and liability maturities and interest rates. The principal element in achieving this objective is to increase the interest-rate sensitivity of the Bank's interest-earning assets by retaining in its portfolio, short-term loans and loans with interest rates subject to periodic adjustments. The Bank relies on retail deposits as its primary source of funds. Management believes retail deposits, compared to brokered deposits, reduce the effects of interest rate fluctuations because they generally represent a more stable source of funds. As part of its interest rate risk management strategy, the Bank promotes transaction accounts and certificates of deposit with terms of up to six years.

        The Bank has adopted a strategy that is designed to substantially match the interest rate sensitivity of assets relative to its liabilities. The primary elements of this strategy involve originating ARM loans for its portfolio; maintaining residential construction loans as a portion of total net loans receivable because of their generally shorter terms and higher yields than other one- to- four family residential mortgage loans; matching asset and liability maturities; investing in short-term securities; originating fixed-rate loans for retention or sale in the secondary market and retaining the related loan servicing rights.

        Sharp increases or decreases in interest rates may adversely affect the Bank's earnings. However, based on a rate shock analysis prepared by the FHLB of Seattle, an increase in interest rates of up to 300 basis points would increase the Bank's projected net interest income, primarily because a larger portion of the Bank's interest rate sensitive assets than interest rate sensitive liabilities would reprice within a one year period. Similarly, further decreases in interest rates would negatively affect net interest income, as repricing would have the opposite effect. Management has sought to sustain the match between asset and liability maturities and rates, while maintaining an acceptable interest rate spread. Pursuant to this strategy, the Bank actively originates adjustable rate loans for retention in its loan portfolio. Fixed-rate mortgage loans generally are originated for the immediate or future resale in the secondary mortgage market. At September 30, 2002, adjustable rate mortgage loans and adjustable rate mortgage-backed securities constituted $193.7 million or 55.6%, of the Bank's total combined mortgage loan and mortgage-backed securities portfolio. Although the Bank has sought to originate ARM loans, the ability to originate such loans depends to a great extent on market interest rates and borrowers' preferences. Particularly in lower interest rate environments, borrowers often prefer to obtain fixed rate loans.

        Consumer loans and construction and land development loans typically have shorter terms and higher yields than permanent residential mortgage loans, and accordingly reduce the Bank's exposure to fluctuations in interest rates.

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At September 30, 2002, the construction and land development, and consumer loan portfolios amounted to $80.1 million and $21.8 million, or 22.2% and 6.0% of total loans receivable (including loans held for sale), respectively.

        Quantitative Aspects of Market Risk. Management of the Bank monitors the Bank's interest rate sensitivity through the use of a model provided for the Bank by the FHLB of Seattle. The model estimates the changes in NPV (net portfolio value) and net interest income in response to a range of assumed changes in market interest rates. The model first estimates the level of the Bank's NPV (market value of assets, less market value of liabilities, plus or minus the market value of any off-balance sheet items) under the current rate environment. In general, market values are estimated by discounting the estimated cash flows of each instrument by appropriate discount rates. The model then recalculates the Bank's NPV under different interest rate scenarios. The change in NPV under the different interest rate scenarios provides a measure of the Bank's exposure to interest rate risk. The following table is provided by the FHLB of Seattle based on data at September 30, 2002.

        Computations of prospective effects of hypothetical interest rate changes are based on numerous assumptions, including relative levels of market interest rates, loan repayments and deposit decay, and should not be relied upon as indicative of actual results. Furthermore, the computations do not reflect any actions management may undertake in response to changes in interest rates.

        In the event of a 200 basis point decrease in interest rates, the Bank would be expected to experience a 16.1% decrease in NPV and a 14.7% decrease in net interest income. In the event of a 200 basis point increase in interest rates, a 6.8% decrease in NPV and an 8.6% increase in net interest income would be expected. Based upon the modeling described above, the Bank's asset and liability structure generally results in decreases in NPV and decreases in net interest income in a declining interest rate scenario. This structure also generally results in decreases in NPV and increases in net interest income in a rising interest rate environment.

        As with any method of measuring interest rate risk, certain shortcomings are inherent in the method of analysis presented in the foregoing table. For example, although certain assets and liabilities may have similar maturities or periods to repricing, they may react in different degrees to changes in market interest rates. Also, the interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market rates. Additionally, certain assets have features which restrict changes in interest rates on a short-term basis and over the life of the asset. Further, in the event of a change in interest rates, expected rates of prepayments on loans and early withdrawals from certificates could possibly deviate significantly from those assumed in calculating the table.

Comparison of Financial Condition at September 30, 2002 and 2001

        Total Assets: Total assets increased by $44.7 million to $431.1 million at September 30, 2002 from $386.3 million at September 30, 2001 primarily due to increased deposit levels.

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        Cash and Due from Financial Institutions: Cash and due from financial institutions and interest-bearing deposit balances in banks increased to $36.1 million at September 30, 2002 from $13.4 million at September 30, 2001. This increase is primarily due to investing proceeds from increased customer deposits.

        Investments, Mortgage-backed Securities and FHLB Stock: Investments, mortgage-backed securities and FHLB stock increased to $46.7 million at September 30, 2002 from $34.2 million at September 30, 2001 primarily due to the conversion of $12.2 million in fixed rate loans held for sale to mortgage-backed securities. For additional details on investments and mortgage-backed securities, see Note 3 to the Notes to Consolidated Financial Statements contained in "Item 8, Financial Statements and Supplementary Data."

        Loans Receivable and Loans Held for Sale, net of allowance for loan losses: Net loans receivable, including loans held-for-sale, decreased $1.2 million to $322.5 million at September 30, 2002 from $323.8 at September 30, 2001, primarily due to an $18.6 million decrease in the Bank's net construction loan portfolio and a $16.9 million decrease in the Bank's one-to-four family mortgage loan portfolio. The construction loan decrease resulted primarily from the pay down of loans secured by condominium projects pursuant to unit sales and the conversion of construction loans to permanent status. The decrease of one-to-four family mortgages held in the portfolio was primarily due to the conversion of $12.2 million of loans held for sale to mortgage-backed securities and the sale of $70.2 million in fixed rate one-to-four family mortgage loans during the twelve-month period. The decreases in construction and one-to-four family mortgages were partially offset by a $34.1 million increase in commercial real estate and business loans, which were originated primarily by the Bank's Business Banking Division.

        Bank owned life insurance ("BOLI"): The Bank purchased $10.0 million of BOLI during the September 30, 2002 quarter. The annual increases in the cash surrender value of the insurance policies are reported as tax-exempt non-interest income under the current provisions of the IRS code. The Bank anticipates that the tax-equivalent yield on this asset will be greater than alternative investments and will help the Bank offset the cost of employee benefit plans.

        Real Estate Owned, Net: Real Estate Owned, net, decreased to $680,000 from $1.0 million at September 30, 2001. This balance decreased due to $459,000 in one-to-four family REO's and $260,000 in land REO's being sold and was offset by the addition of $430,000 in one-to-four family REO's. For additional information, see "Item 1, Business -- Lending Activities -- Nonperforming Assets" and Note 7 to the Notes to Consolidated Financial Statements contained in "Item 8, Financial Statements and Supplementary Data."

        Deposits: Deposits increased by 20.6% to $292.3 million at September 30, 2002 from $242.4 million at September 30, 2001, primarily due to a $20.6 million increase in the Bank's money market accounts, an $11.6 million increase in N.O.W checking accounts, a $6.1 million increase in passbook savings accounts and a $6.6 million increase in non-interest bearing accounts. Management attributes the deposit growth to its targeted marketing program and to consumer uncertainty regarding alternative investment options.

        Borrowings: Borrowings decreased $7.2 million to $61.8 million at September 30, 2002 from $69.0 million at September 30, 2001, as funds from increased deposits were used to pay down the level of FHLB advances.

        Shareholders' Equity: Total shareholders' equity increased by $2.6 million to $74.4 million at September 30, 2002 from $71.8 million at September 30, 2001. The components of shareholder's equity were affected by net income of $6.9 million, the repurchase of 274,272 shares of the Company's stock for $4.4 million, the payment of $2.0 million in dividends to shareholders, and a $255,000 increase in accumulated other comprehensive income. Also affecting shareholders equity were decreases of $645,000 in the equity component related to unearned shares issued to the Management Recognition and Development Plan and $529,000 in the equity component related to the unearned shares issued to the Employee Stock Ownership Plan, and a $588,000 increase to additional paid in capital from the exercise of stock options.

        On May 10, 2002 the Company announced a plan to repurchase 193,659 shares of the Company's stock. This marked the Company's tenth 5% stock repurchase plan. As of September 30, 2002, the Company had purchased 117,400

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of these shares and cumulatively had repurchased 2,522,304 (38.1%) of the 6,612,500 shares that were issued when the Company went public in January 1998.

Comparison of Financial Condition at September 30, 2001 and 2000

        Total Assets: Total assets increased to $386.3 million at September 30, 2001 from $368.1 million at September 30, 2000, with the increase primarily reflected in a $10.8 million increase in loans receivable, a $5.1 million increase in investments and mortgage backed securities, and a $2.0 million increase in premises and equipment.

        Cash and Due from Financial Institutions: Cash and due from financial institutions and interest-bearing deposit balances in banks increased to $13.4 million at September 30, 2001 from $12.0 million at September 30, 2000.

        Investments, Mortgage-backed Securities and FHLB Stock: Investments, mortgage-backed securities and FHLB stock increased to $34.2 million at September 30, 2001 from $29.1 million at September 30, 2000. The increase is primarily a result of the purchase of $10.0 million in mortgage-backed securities in connection with the Bank's asset liability management strategies, and was partially offset by redemptions to fund share repurchases, and scheduled amortization and prepayments. During the year, the Bank converted $11.9 million in fixed rate loans held for sale to mortgage-backed securities. These newly created securities were then sold and the proceeds were used to purchase other mortgage-backed securities with shorter maturities. For additional details on investments and mortgage-backed securities, see Note 3 to the Notes to Consolidated Financial Statements contained in "Item 8, Financial Statements and Supplementary Data."

        Loans Receivable and Loans Held for sale, net of allowance for loan losses: Net loans receivable, including loans held-for-sale, increased 3.4% to $323.8 million at September 30, 2001 from $313.0 at September 30, 2000. This increase is primarily a result of $9.3 million increase in net construction loans, a $7.1 million increase in commercial real estate loans, and a $2.3 million increase in commercial business loans. These increases are partially offset by a $6.7 million decrease in one-to-four family mortgage loans as the Company sold $27.6 million in fixed rate mortgage loans during the year and converted $11.9 million in fixed rate mortgages to mortgage backed securities during the year.

        Real Estate Owned, Net: Real Estate Owned, net, decreased to $1.0 million at September 30, 2001 from $2.0 million at September 30, 2000. This balance decreased primarily due to the sale of the Bank's largest REO, a convenience store with retail space in Kitsap County, Washington. For additional information see "Item 1, Business - - Lending Activities - - Nonperforming Assets" and Note 7 to the Notes to Consolidated Financial Statements contained in "Item 8, Financial Statements and Supplementary Data."

        Deposits: Deposits increased by 14.0% to $242.4 million at September 30, 2001 from $212.6 million at September 30, 2000, with the Bank's certificate of deposit accounts, checking accounts, passbook savings accounts, and money market accounts all indicating increases from September 30, 2000 totals.

        Borrowings: Borrowings decreased by 15.0% to $69.0 million at September 30, 2001 from $81.1 million at September 30, 2000, as funds from increased deposits were used to pay down the level of FHLB advances.

        Shareholders' Equity: Total shareholders' equity decreased by $503,000 to $71.8 million at September 30, 2001 from $72.3 million at September 30, 2000. The components of shareholders' equity were affected by the repurchase of 428,827 shares of the Company's stock for $5.9 million, net income of $5.5 million, the payment of $1.9 million in dividends to shareholders, and a $580,000 increase (net of tax) in the fair value of investments available for sale. Also affecting shareholders' equity was a $529,000 increase in the equity component related to the unearned shares issued to the Employee Stock Ownership Trust and a net reduction of $753,000 in the equity components related to unearned shares issued to the Management Recognition and Development Plan.

        On September 24, 2001 the Company announced a plan to repurchase 200,872 shares of the Company's stock. This marked the Company's ninth 5% stock repurchase plan. As of September 30, 2001, the Company had repurchased

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44,000 of these shares and cumulatively had repurchased a total of 2,248,032 (34.0%) of the 6,612,500 shares that were issued when the Company went public in January 1998.

Comparison of Operating Results for Years Ended September 30, 2002 and 2001

        Net Income: Net income for the year ended September 30, 2002 was $6.89 million or $1.71 per diluted share ($1.76 per basic share) compared to net income of $5.46 million or $1.28 per diluted share ($1.30 per basic share) for the year ended September 30, 2001. The primary factors affecting the improved performance for the current year were increased net interest income, increased deposit fee income, increased income from loan sales, and a decreased provision for loan losses. These items were partially offset by higher non-interest expenses.

        Net Interest Income: Net interest income increased 9.03 % to $19.37 million for the year ended September 30, 2002 from $17.77 million for the year ended September 30, 2001, primarily due to decreased funding costs. Interest expense decreased by $3.03 million as the Company's overall cost of funds decreased to 3.59% for the year ended September 30, 2002 from 4.95% for the year ended September 30, 2001. Total interest income decreased $1.43 million to $30.26 million for the year ended September 30, 2002 from $31.69 million for the year ended September 30, 2001 primarily due to lower average yields on interest earning assets, from 8.90% in 2001 to 7.93% in 2002. The Company's net interest margin was 5.08% for the year ended September 30, 2002 compared to a net interest margin of 4.99% for the year ended September 30, 2001, primarily due to interest-bearing liabilities repricing more quickly than interest earning assets in the declining rate environment.

        Provision for Loan Losses:  The provision for loan losses decreased to $992,000 for the year ended September 30, 2002 from $1.4 million for the year ended September 30, 2001. The provision for loan losses was lower in 2002 primarily because the Bank experienced a lower level of net charge-offs in 2002. For the years ended September 30, 2002 and 2001, net charge-offs were $412,000 and $990,000, respectively. During the year ended September 30, 2001 the Bank made a special $600,000 provision for loan losses when it determined that the credit quality of a large commercial business loan had deteriorated. The loan was subsequently charged off in the year ended September 30, 2001.

        The Bank has established a systematic methodology for the determination of provisions for loan losses. On a quarterly basis the Bank performs an analysis taking into consideration historic loss experience for various loan segments, changes in economic conditions, delinquency rates, and other factors to determine the level of allowance for loan losses needed. The allowance for loan losses increased $580,000 to $3.63 million at September 30, 2002 from $3.05 million at September 30, 2001. The increased level of allowance for loan losses was primarily due to changes in the composition of the loan portfolio and increased loss factors utilized in the allowance for loan loss analysis.

        Changes in the composition of the loan portfolio were responsible for a portion of the increased allowance for loan losses. The percentage of commercial real estate loans in the Bank's loan portfolio increased to 27.0% of total loans receivable at September 30, 2002 from 17.8% at September 30, 2001, while the percentage of one- to- four family residential mortgage loans decreased to 31.3% of total loans receivable at September 30, 2002 from 35.1% at September 30, 2001. Commercial real estate lending typically involves a greater degree of risk than one- to- four family residential mortgage lending and therefore commercial real estate loans have been assigned a loss factor that is greater than the loss factor assigned to one- to- four family residential mortgage loans.

        Estimated loss factors used in the allowance for loan loss analysis are established based in part on historic charge-off data by loan category and economic conditions. Based on the trends in historical charge-offs analysis, the loss factors used in the allowance for loan loss analysis for commercial business loans and credit cards were increased during the year ended September 30, 2002. The loss estimate factors for one- to- four family mortgage loans, multi family loans, commercial real estate loans, construction loans and land loans were also increased to a lesser extent due to weaknesses and uncertainties in the regional economy.

        Based on the systematic methodology management deemed the allowance for loan losses of $3.63 million at September 30, 2002 (1.11% of loans receivable and 97.0 % of non-performing loans) adequate to provide for estimated

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losses based on an evaluation of known and inherent risks in the loan portfolio at that date. For additional information, see "Item 1, Business -- Lending Activities - Allowance for Loan Losses" included herein.

        Non-interest Income: For the year ended September 30, 2002 non-interest income increased $1.73 million to $4.66 million from $2.93 million for the year ended September 30, 2001. This increase is primarily due to an $822,000 increase in service charges on deposits, and a $609,000 increase in gain on sale of loans. The increased deposit-related service charge income is primarily a result of the Bank's checking account acquisition program. The increased loan sale gains are a result of the Company selling $70.2 million in fixed-rate one-to-four family loans during the year compared to $27.6 million in 2001.

        Non-interest Expense: Total non-interest expense increased $1.62 million for the year ended September 30, 2002 compared to 2001. This increase is primarily reflected in a $945,000 increase in salary and benefit expense due primarily to increased numbers of employees, a $239,000 increase in ATM operating expenses, a $172,000 increase in expenses related to premises and equipment resulting from new branches, and a $102,000 increase in profitability improvement consulting fees. Also affecting the year-to-year comparison was the recovery in 2001 of a prior NSF kiting related expense. This recovery reduced the non-interest expense for the 2001 year by $150,000.

        Provision for Income Taxes: The provision for income taxes increased to $3.4 million for the year ended September 30, 2002 from $2.7 million for the year ended September 30, 2001 primarily as a result of higher income before income taxes. The effective rate was 33.2% for the year ended September 30, 2002 and 33.4% for the year ended September 30, 2001.

Comparison of Operating Results for Years Ended September 30, 2001 and 2000

        Net Income: Net income for the year ended September 30, 2001 was $5.5 million, or $1.28 per diluted share ($1.30 per basic share) compared to $5.9 million, or $1.31 per diluted share ($1.31 per basic share) for the year ended September 30, 2000. Income for the year ended September 30, 2001 was increased by a $205,000 ($135,000 after income tax) gain on sale of securities, a $175,000 ($116,000 after income tax) market value recovery on loans held for sale, and a $150,000 ($99,000 after income tax) recovery of a kiting-related NSF expense. Income for the year ended September 30, 2001 was reduced by a $770,000 ($508,000 after income tax) expense related to the initial vesting of MRDP shares, $356,000 ($235,000 after income tax) in REO market value writedowns, and a $515,000 ($340,000 after income tax) increase in loan loss provisions. Income for the year ended September 30, 2000 was increased by a $408,000 ($269,000 after income tax) market value recovery on loans held for sale and the recovery of $290,000 ($191,000 after income tax) of delinquent interest and fees on a non-performing asset and reduced by a $150,000 ($99,000 after income tax) kiting related NSF expense. Net income per share for the year ended September 30, 2001 was increased by $0.05 (basic) and $0.05 (diluted) as a result of the Company's repurchase of its common shares during the year.

        Net Interest Income: Net interest income increased 11.5% to $17.8 million for the year ended September 30, 2001 from $15.9 million for the year ended September 30, 2000, primarily due to the Bank's larger loan portfolio. Total interest income increased $3.3 million to $31.7 million for the year ended September 30, 2001 from $28.4 million for the year ended September 30, 2000. The increase in net interest income was primarily a result of increased interest income from the Bank's larger loan portfolio as average loan balances increased to $323.9 million for the year ended September 30, 2001 from $289.4 million for the year ended September 30, 2000. The increased interest income was partially offset by a $1.5 million increase in interest expense, primarily due to increased deposits and increased average FHLB advances. The net interest margin increased to 4.99% for the year ended September 30, 2001 from 4.95% for the year ended September 30, 2000.

        Provision for Loan Losses:  The provision for loan losses increased to $1.4 million for the year ended September 30, 2001 from $885,000 for the year ended September 30, 2000. The provision for loan losses was higher in 2001 primarily because the Bank experienced a higher level of net charge-offs in 2001. For the years ended September 30, 2001 and 2000, net charge-offs were $990,000 and $301,000, respectively. During the year ended September 30, 2001 the Bank made a special $600,000 provision for loan losses when it determined that the credit

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quality of a large commercial business loan had deteriorated. The loan was subsequently charged off in the year ended September 30, 2001.

        The Bank has established a systematic methodology for the determination of provisions for loan losses. On a quarterly basis the Bank performs an analysis taking into consideration historic loss experience for various loan segments, changes in economic conditions, delinquency rates, and other factors to determine the level of allowance for loan losses needed. The allowance for loan losses increased $410,000 to $3.05 million at September 30, 2001 from $2.64 million at September 30, 2000. The increased level of allowance for loan losses was primarily due to increased loss factors utilized in the allowance for loan loss analysis and increased commercial business loans held in the Bank's loan portfolio.

        Changes in the composition of the loan portfolio were responsible for a portion of the increased allowance for loan losses. Commercial business loans increased by 48.7% to $7.2 million at September 30, 2001 from $4.8 million at September 30, 2000. One- to- four family residential mortgage loans, however, decreased by $6.7 million to $130.1 million at September 30, 2001 from $136.8 million at September 30, 2000. Commercial business lending typically involves a greater degree of risk than one- to- four family residential mortgage lending and therefore commercial real estate loans have been assigned a loss factor that is greater than the loss factor assigned to one- to- four family residential mortgage loans.

        Estimated loss factors used in the allowance for loan loss analysis are established based in part on historic charge-off data by loan category and economic conditions. Based on the trends in historic charge-offs analysis, the loss factors used in the allowance for loan loss analysis for commercial business loans and credit cards were increased during the year ended September 30, 2001.

        Based on the systematic methodology management deemed the allowance for loan losses of $3.05 million at September 30, 2001 (0.93% of loans receivable and 74.6 % of non-performing loans) adequate to provide for estimated losses based on an evaluation of known and inherent risks in the loan portfolio at that date. For additional information, see "Item 1, Business -- Lending Activities - Allowance for Loan Losses" included herein.

        Non-interest Income: Noninterest income increased $1.2 million to $2.9 million, for the year ended September 30, 2001 from $1.7 million for the year ended September 30, 2000. The increase was primarily due to a $533,000 increase in service charge on deposits, a $264,000 increase in gain on sale of loans, a $227,000 net increase in gain on sales of securities, a $154,000 increase in servicing income on loans sold and a $129,000 increase in ATM fees. These increases are partially offset by a $233,000 net reduction in market value recoveries on loans held for sale.

        Non-interest Expense: Total non-interest expense increased to $11.1 million for the year ended September 30, 2001 from $8.0 million for the year ended September 30, 2000. This increase is primarily due to a $1.5 million increase in salary and employee benefits (of which $770,000 related to the MRDP plan implemented in 2001), a $561,000 increase in advertising expense largely related to the Bank's checking account acquisition program, a $348,000 increase in REO related expenses, and a $248,000 increase in premises and equipment expenses. Partially offsetting these expense increases was a $150,000 recovery in June 2001 of a kiting-related NSF expense that the Company incurred during the year ended September 30, 2000.

        Provision for Income Taxes: The provision for income taxes decreased to $2.7 million for the year ended September 30, 2001 from $2.9 million for the year ended September 30, 2000 primarily as a result of lower income before income taxes. The effective rate was 33.4% for the year ended September 30, 2001 and 33.2% for the year ended September 30, 2000.

Nonperforming Assets

        Information with respect to the Bank's nonperforming assets at September 30, 2002 and September 30, 2001 is contained in "Item 1, Business -- Lending Activities -- Nonperforming Assets and Delinquencies."

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Average Balances, Interest and Average Yields/Cost

        The earnings of the Company depend largely on the spread between the yield on interest-earning assets and the cost of interest-bearing liabilities, as well as the relative amount of the Company's interest-earning assets and interest- bearing liability portfolios.

        The following table sets forth, for the periods indicated, information regarding average balances of assets and liabilities as well as the total dollar amounts of interest income from average interest-earning assets and interest expense on average interest-bearing liabilities and average yields and costs. Such yields and costs for the periods indicated are derived by dividing income or expense by the average weekly balance of assets or liabilities, respectively, for the periods presented. Average balances are derived from weekly balances. Management does not believe that the use of weekly balances instead of daily balances has caused any material difference in the information presented.

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Rate/Volume Analysis