WSFG Wsb Financial Grp. (MM)

 

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

(Mark One)

þ		Quarterly Report Under Section 13 or 15(d) of the Securities Exchange Act of 1934

For the Quarterly Period Ended September 30, 2007

or

o		Transition Report Pursuant to Section 13 or 15(D) Of The Securities Exchange Act Of 1934

For the transition period from                                           to                                          

Commission file number: 001-33188

WSB FINANCIAL GROUP, INC.
FORM 10-Q
SEPTEMBER 30, 2007

INDEX

Item Number		Page
PART I Financial Information			1
1 Financial Statements			1
Consolidated Statement of Financial Condition – September 30, 2007 (Unaudited) and December 31, 2006			1
Unaudited Consolidated Statement of Operations – Three months and nine months ended September 30, 2007 and 2006			2
Unaudited Consolidated Statement of Changes in Stockholders’ Equity – Nine months ended September 30, 2007 and 2006			3
Unaudited Consolidated Statement of Cash Flows – Nine months ended September 30, 2007 and 2006			4
Notes to Consolidated Interim Financial Statements (Unaudited)			5
2 Management’s Discussion and Analysis of Financial Condition and Results of Operations			16
Notice About Forward-Looking Statements			16
3 Quantitative and Qualitative Disclosure About Market Risk			37
4 Controls and Procedures			41
PART II Other Information			42
1 Legal Proceedings			42
1A Risk Factors			42
2 Unregistered Sales of Equity Securities and Use of Proceeds			43
3 Defaults Upon Senior Securities			44
4 Submission of Matters to a Vote of Security Holders			44
5 Other Information			44
6 Exhibits			44
SIGNATURES			45
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2

PART I: FINANCIAL INFORMATION

See accompanying notes to unaudited consolidated financial statements

See accompanying notes to unaudited consolidated financial statements

See accompanying notes to unaudited consolidated financial statements

WSB FINANCIAL GROUP, INC. AND SUBSIDIARIES

WSB FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS — (Continued)

      Loans and allowances for loan losses — Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off are reported at their outstanding principal adjusted for any charge-offs, the allowance for loan losses, any deferred fees or costs on originated loans and unamortized premiums or discounts on purchased loans. Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, are deferred and recognized as an adjustment of the related loan yield using the interest method.

     The Bank considers loans impaired when it is probable the Bank will be unable to collect all amounts as scheduled under the loan agreement. Impaired loans are measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate, or, as a practical expedient, at the loan’s observable market price or the fair value of the collateral, if the loan is collateral dependent. Changes in these values will be reflected in income and as adjustments to the allowance for loan losses.

     The accrual of interest on impaired loans is generally discontinued at the time the loan is 90 days past due or when, in management’s opinion, the borrower may be unable to meet payments as they become due. Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record and the amount of the shortfall in relation to the principal and interest owed. When interest accrual is discontinued, all unpaid accrued interest is reversed. Interest income is subsequently recognized only to the extent cash payments are received, or payment is considered certain. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.

     The allowance is based on a continuing review of loans which includes consideration of actual loss experience, changes in the size and character of the portfolio, identification of individual problem situations which may affect the borrower’s ability to repay, and evaluations of the prevailing and anticipated economic conditions. This evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision, as more information becomes available.

     The allowance for loan losses is increased by charges to income and decreased by charge-offs (net of recoveries). While management uses available information to recognize losses on loans, changes in economic conditions may necessitate revision of the estimate in future years. In addition, various regulatory agencies, as an integral part of their examination processes, periodically review the Bank’s allowance for loan losses. Such agencies may require the Bank to recognize additional losses based on their judgment using information available to them at the time of their examination.

     The allowance consists of specific, classified, and general condition components. The specific component relates to loans that are classified as either doubtful, substandard or special mention. For such loans that are also classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan are lower than the carrying value of that loan. The general component covers non-classified loans and is based on historical loss experience adjusted for qualitative factors. A general condition component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The general condition component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.

     Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Bank does not separately identify individual consumer and residential loans for impairment disclosures, unless such loans are the subject of a restructuring agreement.

WSB FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS — (Continued)

      Stock option plans — Effective January 1, 2006, the Bank adopted Statement of Financial Accounting Standards (SFAS) No. 123(R), Share-Based Payment, which is a revision of SFAS No. 123, Accounting for Stock-Based Compensation. SFAS 123(R) supersedes Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and amends SFAS No. 95, Statement of Cash Flows. Generally, the approach in SFAS 123(R) is similar to the approach described in SFAS 123. However, SFAS 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values.

      Earnings per common share — Basic earnings per share represents income available to common stockholders divided by the weighted-average number of common shares outstanding during the period. Diluted earnings per share reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income that would result from the assumed issuance. Potential common shares that may be issued by the Company relate solely to outstanding stock options, and are determined using the treasury stock method. For the 2007 fiscal year, all outstanding stock options were excluded from the computation of the loss per share because they were antidilutive due to the net loss recorded during the year.

     Earnings per common share have been computed based on the following:

      Recent accounting pronouncements - In July 2006, the Financial Accounting Standards Board (FASB) issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (FIN 48). This pronouncement requires a certain methodology for measuring and reporting uncertain tax positions, as well as disclosures. FIN 48 became effective January 1, 2007. The adoption of FIN 48 did not have a material effect on our consolidated financial statements for the periods ended September 30, 2007.

WSB FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS — (Continued)

          In March 2006, the FASB issued SFAS No. 156, “Accounting for Servicing of Financial Assets, an amendment of SFAS No. 140” (SFAS 156). SFAS 156 requires the recognition of a servicing asset or liability under specified circumstances, and if practicable, all separately recognized servicing assets and liabilities to be initially measured at fair value. Additionally, SFAS 156 allows an entity to choose one of two methods when subsequently measuring its servicing assets and liabilities: the amortization method or the fair value method. The amortization method provided under SFAS 140, employs lower of cost or market (locom) valuation. The new fair value method allows mark ups, in addition to the mark downs under locom. SFAS 156 permits a one-time reclassification of available-for-sale securities to the trading classification. This statement became effective January 1, 2007. The adoption of SFAS 156 did not have a material effect on our consolidated financial statements for the periods ended September 30, 2007.

          In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (SFAS 157). SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS 157 applies under other accounting pronouncements that require or permit fair value measurements. Accordingly, SFAS 157 does not require any new fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. SFAS 157 is not expected to have a material impact on our consolidated financial statements..

          In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and other Post-retirement Plans — an amendment of FASB Statements No. 87, 88, 106, and 132(R)” (SFAS 158). SFAS 158 improves financial reporting by requiring an employer to recognize the overfunded or underfunded status of a defined benefit post-retirement plan as an asset or liability in its statement of financial position and to recognize changes in that funded status in the year in which the changes occur through comprehensive income of a business entity or changes in unrestricted net assets of a not-for-profit organization. SFAS 158 also improves financial reporting by requiring an employer to measure the funded status of a plan as of the date of its year-end statement of financial position, with limited exceptions. An employer with publicly traded equity securities is required to initially recognize the funded status of a defined benefit post-retirement plan and to provide the required disclosures as of the end of the fiscal year ending after December 15, 2006. The requirement to measure plan assets and benefit obligations as of the date of the employer’s fiscal year-end statement of financial position is effective for fiscal years ending after December 15, 2008. SFAS 158 is not expected to have a material impact on our consolidated financial statements..

          In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities - an amendment of FASB Statement No. 115 ” (SFAS 159). SFAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value. The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reporting earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. SFAS 159 is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. SFAS 159 is not expected to have a material impact on our consolidated financial statements.

          In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements — an amendment of ARB No. 51” (SFAS 160). SFAS 160 applies to all entities that prepare consolidated financial statements, except not-for-profit organizations, but will affect only those entities that have an outstanding noncontrolling interest in one or more subsidiaries or that deconsolidate a subsidiary. The objective is to improve relevance, comparability, and transparency of the financial information that a reporting entity provides in its consolidated financial statements by establishing accounting and reporting standards. SFAS 160 is effective for annual periods after December 15, 2008. SFAS 160 is not expected to have a material impact on our consolidated financial statements.

           Reclassifications - Certain amounts in the prior period financial statements have been reclassified to conform to the current year’s presentation and do not affect previously reported net income, equity, or earnings per share.

Impaired loans are summarized as follows:

WSB FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Note 4 — Incentive stock option plan

          The Company’s stockholders approved an Incentive Stock Option Plan on May 19, 1999. The purpose of the plan is to increase ownership interest in the Company by employees and directors of the Company, and to provide an incentive to serve as an employee and/or director of the Company. The stockholders originally approved 184,287 shares of common stock to the Plan. The stockholders approved additional allocations of 614,290 in 2005, 614,290 in 2004 and 184,287 shares in 2002. The maximum term of a stock option granted under the plan is ten years. Incentive stock options generally vest over a five year period while non-qualified stock options generally vest immediately.

The following table summarizes the stock option activity for the nine months ended September 30, 2007. Amounts have been adjusted to reflect a 6.1429-for 1 common stock split in August 2006:

          The intrinsic value for stock options is calculated based on the exercise price of the underlying awards and the market price of our common stock as of the reporting date.

          The intrinsic value of stock options exercised during the nine months ended September 30, 2007 was $363,429.

          The Company granted options for 24,000 shares with a fair value of $149,990 during the quarter ended March 31, 2007 and did not grant any options in the quarters ended June 30, 2007 or September 30, 2007. There was $123,000 in unrecognized compensation cost related to these stock options as of September 30, 2007 that is expected to be recognized as expense using a graded vesting over a five year period. Compensation expense related to these options was approximately $20,000 for the nine months ending September 30, 2007.

Note 5 — Stock Split

     Effective August 15, 2006 the Company’s Board of Directors approved a 6.1429-for-1 common stock split for shareholders of record on August 15, 2006. All share and per share information has been retroactively adjusted to reflect this stock split. The Board of Directors also approved an amendment to the Articles of Incorporation increasing the authorized shares from 2,500,000 to 15,357,250.

WSB FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Note 6 — Commitments

     In August 2006, the Company entered into employment agreements with its executive officers. The agreements provide for a base salary set by the Board of Directors and for potential annual bonuses at the discretion of the Compensation Committee. Upon a change in control the agreements provide for change in control payments ranging from the executive’s base salary to two times base salary. The agreements are for an indefinite term, until terminated by the executive or the Company.

Note 7 — Income Taxes

          On January 1, 2007 the Company adopted FIN 48. The adoption of FIN 48 did not have a material effect on our consolidated financial statements for the periods ended September 30, 2007.

Note 8 — Downsizing of Mortgage Division

          In September 2007, the Company decided, as a result of a reduction in mortgage demand, and the uncertainty and elimination of various secondary marketing conduits, to downsize its mortgage division and eliminate 33 positions in this division, generating pre-tax charges of $87,500 and $52,580, respectively, in the third and fourth quarters of 2007.

Note 9 — Recent Developments

           Provision for Loan Losses . As of September 30, 2007, we recorded a provision for loan losses primarily related to our real estate loan portfolio following a comprehensive evaluation based on representative samplings of our entire loan portfolio conducted by our senior management and an independent consultant with expertise in analyzing loan portfolios and determining loan loss allowances, provisions and charge-offs under regulatory guidelines and generally accepted accounting principles. An additional provision for loan losses of $13.4 million or $8.5 million after-tax was recorded in the third quarter of 2007 based on the loan reviews. This resulted in an after-tax impact of $1.44 per diluted share in the third quarter 2007 results. The recording of the 2007 loan loss provision results in a provision for loan losses of $14.2 million for the nine month period ended September 30, 2007.

          The Company’s provision for loan losses, levels of non-performing loans and OREO property, allowance for loan losses, levels of impaired loans and non-accrual loans increased significantly in the quarter ended September 30, 2007, primarily as a result of the reassessment of the Company’s real estate loan portfolio in light of recent deterioration in the local housing market, the current problems in the mortgage banking and lending market and the issues we have identified with respect to certain residential construction loans, as well as some commercial real estate, C&I and other loans, the Company determined that it would record a provision for loan losses for the quarter ending September 30, 2007. Weakness in the local housing market is expected to continue in the near term, and the situation could deteriorate further before the market stabilizes.

          Although the Company believes it is using the best information available to make determinations with respect to the allowance for loan losses and its current allowance for loan losses is adequate for such purposes, management reviews the loan portfolio each quarter and adjustments may be necessary in future periods if the assumptions used in making our initial determinations prove to be incorrect.

          The Company and Westsound Bank remain well-capitalized under regulatory guidelines, as of September 30, 2007, following the additional provision for loan losses, and management believes that the Company has sufficient capital resources and liquidity to be able to continue its normal business operations.

WSB FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

           Regulatory Proceedings . The pending examination of the Company’s subsidiary, Westsound Bank, by the Federal Deposit Insurance Corporation, or “FDIC”, and the Washington Department of Financial Institutions, or “DFI”, is substantially completed. The FDIC and DFI have advised the Company’s management that in the opinion of the regulators, Westsound Bank violated certain banking laws and regulations that are primarily related to the origination, administration and monitoring of construction and mortgage loans. The examiners recently indicated to the Company’s management that they intend to recommend that the FDIC and DFI take regulatory action against the Bank with respect to such lending practices and activities, including possible monetary penalties, further increases in allowances for loan losses, and/or charge-offs of impaired loans. Such regulatory action should not restrict Westsound Bank from transacting banking business in compliance with federal and state banking laws and regulations. The Bank expects to continue to serve its customers in all areas including making loans, establishing lines of credit, accepting deposits and processing banking transactions. A final decision on regulatory action is not anticipated until at least February, 2008, after supervisory review by the FDIC’s regional and national offices.

           Gain on Land Sale. The Company recently sold a tract of undeveloped land that it had originally acquired for a future headquarters site, and that had been targeted for sale by the Company since it purchased its current headquarters site in downtown Bremerton. The Company recognized a gain of $412,478 in the fourth quarter on the sale, which closed on October 9, 2007.

Note 10 — Loan Commitments and Contingent Liabilities

           Loan Commitments. Many of our lending relationships contain funded and unfunded elements. The funded portion is reflected on our balance sheet. For lending relationships carried at historical cost, the unfunded component of these commitments is not recorded on our balance sheet until a draw is made under the credit facility; however, a reserve is established for probable losses. At September 30, 2007 we had a reserve balance of $665,000 for allowance for unfunded credit losses and $117,000 at December 31, 2006.

          The following table summarizes the total unfunded, or off-balance sheet, credit extension commitment amounts by expiration date.

          Legally binding commitments to extend credit generally have specified rates and maturities. Certain of these commitments have adverse change clauses that help to protect us against deterioration in the borrowers’ ability to pay.

           Contingent Liabilities for Sold Loans. In the ordinary course of business, the Bank sells loans without recourse that may have to be subsequently repurchased due to defects that occurred during the origination of the loan. The defects are categorized as documentation errors, underwriting errors, early payment defaults, breach of representation or warranty, delinquencies and fraud. When a loan sold to an investor without recourse fails to perform according to its contractual terms, the investor will typically review the loan file to determine whether defects in the origination process occurred. If a defect is identified, the Bank may be required to either repurchase the loan or indemnify the investor for losses sustained. If there are no such defects, the Bank has no commitment to repurchase the loan. The Bank has recorded no reserve to cover loss exposure related to these guarantees. The Company has repurchased one real estate loan totaling $750,000 in the fourth quarter 2007.

WSB FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Note 11 — Loan Concentrations

     As of September 30, 2007, in management’s judgment, a concentration of loans existed in real estate-related loans. At that date, real estate-related loans comprised 91.5% of total loans. At December 31, 2006, real estate-related loans comprised 94.5% of total loans, of which approximately 59.8%, 20.6% and 19.6% were construction and land development, commercial real estate and residential real estate, respectively.

     Additionally, as of September 30, 2007, in management’s judgment, a concentration of loans existed in interest-only loans, primarily construction and development loans secured by real estate. The Company’s construction portfolio reflects some borrower concentration risk, and also carries the enhanced risks encountered with construction loans generally. The Company also finances contractors, including a number of small builders and individuals, on a speculative basis. Construction loans are generally more risky than permanent mortgage loans because they are dependent upon the borrower’s ability to complete the project within budget, the borrower’s ability to generate cash to service the loan (by selling or leasing the project), and the value of the collateral depends on project completion when market conditions may have changed. At September 30, 2007, interest-only loans comprised 64.2% of total loans, of which approximately 83.2% were construction and land development, 8.2% were residential, 5.3% were commercial real estate, 3.1% were commercial and industrial, and 0.2% were consumer. As of December 31, 2006, interest only loans comprised 61.5% of total loans.

     Our loan portfolio is also concentrated in real estate and a substantial majority of our loans and operations are in west Puget Sound, and therefore our business is particularly vulnerable to a downturn in the local real estate market.

     A substantial decline in the performance of the economy, in general, or a decline in real estate values in our primary market areas, in particular, could have an adverse impact on collectibility, increase the level of real estate-related non-performing loans, or have other adverse effects which alone or in the aggregate could have a material adverse effect on the Company’s business, financial condition, results of operations and cash flows. Interest-only loans also carry greater risk than principal and interest loans do, to the extent that no principal is paid prior to maturity, particularly during a period of rising interest rates and declining real estate values.

WSB FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Note 12 — Pending Litigation and Regulatory Proceedings

     In October 2007, a purported securities fraud class action lawsuit was commenced in the United States District Court for the Western District of Washington against the Company and certain of its directors and current and former officers alleging violations of Sections 11 and 15 of the Securities Act of 1933 and seeking an unspecified amount of compensatory damages and other relief in connection with the Company’s initial public offering. Since then four additional, similar actions have been filed in the U.S. District Court in the Western District of Washington. The Company expects, as is typical in these types of cases, that all the actions will be consolidated into a single action and that a consolidated complaint will be filed. No lead plaintiff has yet been appointed.

     The Company received a letter dated December 13, 2007, from the San Francisco Regional Office of the Securities and Exchange Commission (“SEC”) requesting that the Company produce certain documents concerning, various issues that have been the subject of recent public disclosure by the Company. The SEC’s letter notes that the request should not be construed as any indication by the SEC or its staff that any violation of law has occurred, or as an adverse reflection upon any person, entity or security. The Company is in the process of gathering and preparing to produce documents in response to the SEC’s request. The Company intends to cooperate with the SEC staff.

     As of January 24, 2008, the Company had commenced collection activities on approximately 95 real estate loans by sending notices of default to the borrowers. Some or all of these loans may result in foreclosure actions.

     The Company is unable to predict the outcome of these matters. The Company’s cash expenditures, including legal fees, associated with the pending litigation and the regulatory proceedings described in Note 9, “Recent Developments — Regulatory Proceedings” above, cannot be reasonably predicted at this time. Litigation and any potential regulatory actions or proceedings can be time-consuming and expensive and could divert management time and attention from the Company’s business, which could have a material adverse effect on its revenues and results of operations. The adverse resolution of any specific lawsuit or potential regulatory action or proceeding could have a material adverse effect on the Company’s business, results of operations, and financial condition.

ITEM 2: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Notice About Forward-Looking Statements

      You should read the following discussion and analysis of our financial condition and results of operations together with our consolidated financial statements and related notes appearing elsewhere in this report. In addition to historical information, this report contains forward-looking statements. These forward-looking statements are made in reliance upon the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. The words “believe,” “expect,” “anticipate,” “intend,” “estimate,” “forecast,” “project,” “should” and similar expressions are intended to identify such forward-looking statements. Forward-looking statements include, among others, statements about our future performance, the continuation of historical trends, the sufficiency of our sources of capital for future needs, the effects of our initial public offering, pending regulatory proceedings, adequacy of allowances for loan losses and controls, and the expected impact of recently issued accounting pronouncements. These forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those reflected in the forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which reflect management’s opinions only as of the date hereof. The Company undertakes no obligation to revise or publicly release the results of any revision to these forward-looking statements. Factors that might cause such a difference include, but are not limited to, those discussed in the section entitled “Risk Factors” in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission for the fiscal year ended December 31, 2006 and in Part II, Item 1A: Risk Factors of this report, and the following:

	•		the adequacy of our credit risk management and the allowance for loan losses, Westsound Bank’s asset quality, and our ability to collect on delinquent loans, including the residential construction loans;
	•		changes in the value of collateral securing loans that we have made, including the residential construction loans;
	•		the availability of and costs associated with sources of liquidity;
	•		changes in real estate values generally, within which we generate loans, which could adversely affect the demand for loans and may adversely affect collateral held on outstanding loans;
	•		our ability to successfully defend against claims asserted against us in lawsuits arising out of, or related to, our lending operations or any regulatory action taken against us, as well as any unanticipated litigation, regulatory, or other judicial proceedings;
	•		our ability to successfully operate under the terms of the regulatory action expected to be taken by the FDIC in the first quarter of 2008;
	•		the success of the Company at managing the risks involved in the foregoing; and
	•		other risks which may be described in our future filings with the SEC under the Securities Exchange Act of 1934.

Overview

     We are a bank holding company headquartered in Bremerton, Washington. We emphasize a service-oriented culture with a sales-based delivery model focused primarily on real estate lending products and supplemented by commercial banking products and services. We deliver these products through nine full service branches that are located primarily in the west Puget Sound area.

     We currently have, on a consolidated basis, $468 million in total assets, net loans of $407.8 million (including loans held for sale), total deposits of $399.8 million, and stockholders’ equity of $56.6 million. Since our founding we have experienced significant growth, adding branches and loan production offices. With the pending litigation and regulatory proceedings, the problems recently identified in our loan portfolio and the decline in

demand for real estate loans, which we and other community banks have focused on for growth the past several years, our rate of growth can be expected to decline, particularly in the near term.

     We generate most of our revenue from interest on loans and investments, loan fees, service charges, and mortgage banking income. As of September 30, 2007, 73.9% of our revenue was interest on loans, 11.8% loan fees, 8.1% mortgage banking income, 3.1% service charges and 3.1% interest on investments. We offer a variety of loans to our customers, including commercial and residential real estate loans, construction and land development loans, commercial and industrial loans, and to a lesser extent, consumer loans. As of September 30, 2007, approximately 91.5% of our loans related to the construction or development, purchase, improvement or refinancing of commercial and residential real estate, approximately 7.6% were C&I loans and 0.9% were consumer loans. Approximately 87.7% of our revenue is derived from real estate, of which approximately 27.1% is derived from residential real estate. Including our originations of residential real estate loans which are sold in the secondary market, approximately 92.4% of our actual lending activities are related to real estate. Of this amount, 33.2% is residential real estate, 53.5% is construction and land development, and 5.7% is commercial real estate.

     We offer a wide range of real estate and other loan products to meet the demands of our customers. We have also recently increased our emphasis on C&I lending, although the portion of the loan portfolio invested in C&I loans is still relatively small. While continuing our commitment to commercial real estate lending, we expect C&I lending to become increasingly important for us over time.

     We are experiencing difficulties in our loan portfolio which have resulted in a $13.4 million increase in our provision for loan losses in the third quarter of 2007. These matters are discussed below in “—Recent Developments.” An adverse change in the economy affecting values of real estate generally, or in west Puget Sound, could, because of our high concentration of loans secured by real estate, materially and adversely affect our profitability, growth and financial condition. Further, because approximately 64.2% of our loans are interest-only (primarily real estate construction and development) and 38.9% are variable rate, significant increases in interest rates could also result in increased loan delinquencies, defaults and foreclosures.

     Deposits are our primary source of funding. Our largest expenses are interest on these deposits and salaries and employee benefits. We measure our performance by calculating our net interest margin, return on average assets, and return on average equity. Net interest margin is calculated by dividing net interest income, which is the difference between interest income on interest-earning assets (such as loans and securities) and interest expense on interest-bearing liabilities (such as customer deposits and other borrowings which are used to fund those assets), by total average earning assets. Net interest income is our largest source of revenue. Interest rate fluctuations, as well as changes in the amount and type of earning assets and liabilities, combine to affect net interest income. We also measure our performance by our efficiency ratio, which is calculated by dividing non-interest expense less amortization of core deposit intangibles by the sum of net interest income on a tax equivalent basis and non-interest income.

     Market interest rates increased in 2007 as a result of the Federal Reserve’s monetary policies. Our net interest margin remained relatively constant at an average of 5.65% through 2007, however, because we are in an “asset neutral” position, based on our current net interest income simulation. In addition, a substantial percentage of our loan portfolio (38.9% of our total loans as of September 30, 2007) has been comprised of variable rate loans that reprice as interest rates rise or fall. The Federal Reserve began reducing interest rates in September 2007. As interest rates decline, our margins could also decrease until we can adjust the mix of our assets and liabilities to compensate for the changed interest rate environment. Our net interest margin decreased to 4.98% in the first nine months of 2007, primarily as a result of higher rates paid on deposits.

Recent Developments.

      Loan Reviews . As of September 30, 2007, we recorded an additional provision for loan losses primarily related to our real estate loan portfolio following a comprehensive evaluation based on representative samplings of our entire loan portfolio conducted by our senior management and an independent consultant, The Alford Spencer Financial Group, Inc. of Sacramento, California, with expertise in analyzing loan portfolios and determining loan loss allowances, provisions and charge-offs under regulatory guidelines and generally accepted accounting principles. An additional provision for loan losses of $13.4 million or $8.5 million after-tax was recorded in the third quarter of 2007 based on the loan reviews. This resulted in an after-tax impact of $1.44 per diluted share in the third quarter 2007 results. The recording of the 2007 loan loss provision results in a provision for loan losses of $14.2 million for the nine month period ended September 30, 2007.

     The $13.4 million increase in our provision for loan losses in the third quarter of 2007, substantially more than the $7 million to $9 million management previously estimated in the Company’s Current Report on Form 8-K filed on November 21, 2007. The additional increase resulted from an independent loan consultant’s report, new information regarding specific loans, and weaknesses discovered in our loan underwriting, documentation and approval procedures, and credit risk management. The loan reviews also considered updated estimated fair market and resale values of the collateral, for our residential loans. Further, while management’s prior estimates focused primarily on the construction loan portfolio, the independent loan consultant review encompassed all loan categories and commitments.

     Although we believe we are using the best information available to make determinations with respect to the allowance for loan losses and our current allowance for loan losses is adequate for such purposes, management reviews the loan portfolio each quarter and adjustments may be necessary in future periods if the assumptions used in making our initial determinations prove to be incorrect.

     Our cash expenditures, including legal and accounting fees, associated with the collection of the loans determined to be impaired or downgraded and added to our watch list cannot be reasonably predicted, and the actual amount of such expenditures will depend upon the manner in which our collection efforts are structured and conducted. However, these efforts can be time consuming and expensive and could divert management time and attention from our business, which could have a material effect on our revenues and results of operations.

      Regulatory Proceedings . The pending examination of the Company’s subsidiary, Westsound Bank, by the Federal Deposit Insurance Corporation, or “FDIC”, and the Washington Department of Financial Institutions, or “DFI”, is substantially completed. As previously reported, the FDIC and DFI have advised the Company’s management that in the opinion of the regulators, Westsound Bank violated certain banking laws and regulations

that are primarily related to the origination, administration and monitoring of construction and mortgage loans. The examiners recently indicated to the Company’s management that they intend to recommend that the FDIC and DFI take regulatory action against the Bank with respect to such lending practices and activities, including possible monetary penalties, further increases in allowances for loan losses, and/or charge-offs of impaired loans. Such regulatory action should not restrict Westsound Bank from transacting banking business in compliance with federal and state banking laws and regulations. The Bank expects to continue to serve its customers in all areas including making loans, establishing lines of credit, accepting deposits and processing banking transactions. All customer deposits will remain fully insured to the highest limits set by the FDIC. We do not expect a final decision on regulatory action until at least February, 2008, after supervisory review by the FDIC’s regional and national offices.

     Our cash expenditures, including legal and accounting fees, associated with the regulatory proceedings and the pending litigation described below (see Part II, Item 1: Legal Proceedings) cannot be reasonably predicted at this time. Litigation and any potential regulatory actions or proceedings can be time-consuming and expensive and could divert management time and attention from our business, which could have a material adverse effect on our revenues and results of operations. The adverse resolution of any specific lawsuit or potential regulatory action or proceeding could have a material adverse effect on our business, results of operations, and financial condition.

      Changes in the Mortgage Lending Industry and Real Estate Market. Like other mortgage lenders throughout the country, the residential mortgage lending division of Westsound Bank is operating in a challenging market environment today for institutions engaged in real estate-based lending and mortgage banking activities, making it more difficult or expensive to sell mortgage loans, particularly so-called jumbo or nonconforming loans which are loans over $417,000.

     The Bank’s management has identified some deterioration in certain of its construction loans in particular, and is reassessing its lending relationships with some of these borrowers. Generally, these loans are secured by single-family homes, completed and listed or to be listed for sale or under construction. The homes are generally custom-type homes in higher-end areas with views or other amenities rather than tract or production homes. Many of these loans were originally underwritten based on a commitment letters from large national mortgage lenders, to provide a take-out loan for long-term financing of the completed home under programs which did not require the borrowers to document their income with pay stubs, tax returns or other supporting documentation. These so-called “stated income” loan programs are no longer offered by those lenders, and their commitment letters may not be legally binding . Westsound Bank stopped making these types of loans in April, 2007.

     While the economy generally remains strong in our west Puget Sound market, the housing market has slowed down, with weaker demand for housing, higher inventory levels and longer marketing times. The Seattle Times recently reported though that the median price of single family homes in this market remained comparable to a year ago. As a result of the recent deterioration in the local housing market, the current problems in the mortgage banking and lending market and the issues we have identified with respect to certain residential construction loans, as well as some commercial real estate, C&I and other loans, the Company determined that it would record a provision for loan losses for the quarter ending September 30, 2007. Weakness in the local housing market is expected to continue in the near term, and the situation could deteriorate further before the market stabilizes.

     The Company has repurchased one real estate loan totaling $750,000 in the past several months, under the terms of the loan sale agreements which generally allow the purchaser to require us to repurchase loans upon which the borrower has defaulted or paid off within several months after the closing of the sale. A number of mortgage loans previously sold by the Company remain subject to repurchase under such provisions if the borrower has defaulted. See “—Financial Condition — Loans, Contingent Liabilities for Sold Loans” below. The reduced liquidity in the secondary mortgage market and availability in take-out lending programs have also impacted the market value and anticipated gains and servicing income related to our mortgage loans held-for-sale.

      Deposits. Since September 30, 2007, the Bank’s deposits grew from $399.8 million to $421.6 million and $426.7 million at December 31, 2007 and January 28, 2008, respectively. The increase in total deposits since September 30, 2007 is attributed primarily to our loan growth. As of January 28, 2008, December 31, 2007 and September 30, 2007, we had $65.3 million, $65.2 million and $38.2 million, respectively, of deposits from wholesale sources, including brokered deposits and Internet certificates of deposit. See Note 3 to the Company’s unaudited consolidated financial statements for more information on the Company’s deposits. Management has developed and is implementing strategic advertising campaigns and promotions to attract and maintain core deposits and reduce its recent reliance on wholesale funding sources which are generally more rate-sensitive and considered a less stable funding source than local retail deposit relationships, or so-called core deposits. As described above (see “—Capital Resources”), the Bank is currently well-capitalized and, therefore, is not subject to any regulatory limitations with respect to its wholesale sourcing of deposits.

      Downsizing of Mortgage Division. The Company previously announced its decision to downsize its mortgage division and eliminate 33 positions in this division, generating estimated pre-tax charges of $87,500 and $52,580, respectively, in the third and fourth quarters of 2007. The Company continues to make residential mortgage loans with its reduced staff.

      Gain on Land Sale. The Company recently sold a tract of undeveloped land that it had originally acquired for a future headquarters site, and that had been targeted for sale by the Company since it purchased its current

headquarters site in downtown Bremerton. The Company recognized a gain of $412,478 in the fourth quarter on the sale, which closed on October 9, 2007.

     The Company and Westsound Bank remain well-capitalized under regulatory guidelines, as of September 30, 2007, following the additional provision for loan losses described above, and management believes the Company has sufficient capital resources and liquidity to be able to continue its normal business operations. See “—Capital Resources” and “Liquidity” below.

Key Factors in Evaluating Financial Condition and Results of Operations

     As a bank holding company, we focus on a number of key factors in evaluating our financial condition and results of operations including:

	•		Return on Average Equity;
	•		Return on Average Assets;
	•		Asset Quality;
	•		Asset Growth;
	•		Capital and Liquidity;
	•		Net Interest Margin; and
	•		Operating Efficiency.

      Return on Average Equity. Our return to our shareholders is measured in the form of return on average equity, or ROE. We had a net loss of $7.8 million for the three months ended September 30, 2007 compared to net income of $1.2 million for the three months ended September 30, 2006. The net loss was due to the significant increase in the provision for loan losses. Basic earnings (loss) per share, or EPS, decreased to $(1.39) for the three months ended September 30, 2007 compared to earnings per share of $0.42 for the three months ended September 30, 2006. Similarly, diluted EPS decreased to $(1.39) for the three months ended September 30, 2007 compared to earnings per share of $0.36 for the three months ended September 30, 2006. Our ROE decreased to (47.1)% for the three months ended September 30, 2007 compared to 24.4% for the three months ended September 30, 2006.

     We recorded a net loss of $5.2 million for the nine months ended September 30, 2007 compared to $3.1 million net income for the nine months ended September 30, 2006. This loss resulted from the increase in provision for loan losses. Basic earnings (loss) per share, or EPS, decreased to $(0.94) for the nine months ended September 30, 2007 compared to earnings per share of $1.13 for the nine months ended September 30, 2006. Diluted EPS decreased to $(0.94) for the nine months ended September 30, 2007 compared to diluted earnings per share of $0.99 for the nine months ended September 30, 2006. Our ROE decreased to (11.0)% for the nine months ended September 30, 2007 compared to 23.5% for the nine months ended September 30, 2006.

      Return on Average Assets. Our return on average assets, or ROA, for the three months ended September 30, 2007 was (6.62)% compared to 1.44% for the three months ended September 30, 2006. Our return on average assets, or ROA, for the nine months ended September 30, 2007 was (1.61)% compared to 1.44% for the nine months ended September 30, 2006.

      Asset Quality. For all banks and bank holding companies, asset quality has a significant impact on the overall financial condition and results of operations. Asset quality is measured in terms of nonperforming loans and assets as a percentage of total loans and total assets, and net charge-offs as a percentage of average loans. These measures are key elements in estimating the future earnings of a financial institution. We had $2,677,000 in non-performing loans as of September 30, 2007 compared to $219,000 at December 31, 2006. Non-performing loans as a percentage of total loans were 0.63% as of September 30, 2007 compared to 0.06% at December 31, 2006. For the nine months ended September 30, 2007 net charge-offs to average loans were 0.00%, as compared to 0.01% for the year ended December 31, 2006.

      Asset Growth. Because revenues from both net interest income and non-interest income are a function of asset size, the continued growth in assets has a direct impact on increasing net income and EPS. The majority of our assets are loans, and the majority of our liabilities are deposits, and therefore the ability to generate loans and

deposits are fundamental to our asset growth. Total assets increased 21.0% during the first nine months of 2007 from $386.8 million as of December 31, 2006 to $468.0 million as of September 30, 2007. Total deposits increased 26.9% to $399.8 million as of September 30, 2007 compared to $315.0 million as of December 31, 2006. Net loans increased 19.9% to $407.8 million as of September 30, 2007 compared to $340.2 million as of December 31, 2006.

      Capital and Liquidity. Maintaining adequate capital levels in light of our rapid growth has been one of our primary areas of focus. Our actual equity to assets increased to 15.9% at December 31, 2006, as a result of our initial public offering, and our average equity to average assets at September 30, 2007 was 14.7%. We monitor liquidity levels to ensure we have adequate sources available to fund our loan growth. The key measure we use to monitor liquidity is the net loan to deposit ratio. At September 30, 2007 the net loan to deposit ratio had decreased to 102.0%, down from 108.0% at December 31, 2006. Maintaining appropriate liquidity levels is imperative to us in order to continue normal business operations.

      Net Interest Margin. Our net interest margin decreased to 4.83% for the third quarter of 2007 compared to 5.71% for third quarter of 2006, primarily as a result of higher rates on deposits. Our net interest margin for the nine months ended September 30, 2007 was 4.98% compared to 5.80% for the nine months ended September 30, 2006. Our net interest margin for the year ended December 31, 2006 was 5.65%

      Operating Efficiency. Operating efficiency is the measure of how efficiently earnings before taxes are generated as a percentage of revenue. Our efficiency ratio (operating expenses divided by net interest income plus non-interest income) deteriorated somewhat, increasing to 73.4% for the third quarter of 2007 compared to 61.0% for third quarter of 2006, as a result of the increased non-interest expense associated with operating as a public company. Our efficiency ratio increased to 67.3% for the first nine months of 2007 compared to 62.1% for the first nine months 2006. Our efficiency ratio for the year ended December 31, 2006 was 65.3%.

Critical Accounting Policies

     Our accounting policies are integral to understanding our financial results. Our most complex accounting policies require management’s judgment to ascertain the valuation of assets, liabilities, commitments and contingencies. We have established detailed policies and control procedures that are intended to ensure valuation methods are well controlled and applied consistently from period to period. In addition, the policies and procedures are intended to ensure that the process for changing methodologies occurs in an appropriate manner. The following is a brief description of our current accounting policies involving significant management valuation judgments.

      Allowance for Loan Losses. The allowance for loan losses represents our best estimate of the probable losses inherent in the existing loan portfolio. The allowance for loan losses is increased by the provision for loan losses charged to expense and reduced by loans charged off, net of recoveries.

     We evaluate our allowance for loan losses monthly. We believe that the allowance for loan losses, or ALLL, is a “critical accounting estimate” because it is based upon management’s assessment of various factors affecting the collectibility of the loans, including current economic conditions, past credit experience, delinquency status, the value of the underlying collateral, if any, and a continuing review of the portfolio of loans. For a discussion of the allowance and our methodology, see “Financial Condition — Allowance for Loan Losses.”

     We maintain an ALLL based on a number of quantitative and qualitative factors, including levels and trends of past due and non-accrual loans, asset classifications, loan grades, change in volume and mix of loans, collateral value, historical loss experience, size and complexity of individual credits, staff experience and economic conditions. Provisions for loan losses are provided on both a specific and general basis. Specific allowances are provided for impaired credits for which the expected/anticipated loss is measurable. General valuation allowances are based on a portfolio segmentation based on risk grading, with a further evaluation of various quantitative and qualitative factors noted above.

     We periodically review the assumptions and formulae by which additions are made to the specific and general valuation allowances for losses in an effort to refine such allowances in light of the current status of the factors described above.

     Although we believe the level of the allowance as of September 30, 2007 was adequate to absorb probable losses in the loan portfolio, a decline in local economic, or other factors, could result in increasing losses that cannot be reasonably predicted at this time.

      Available for Sale Securities. Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities, requires that available-for-sale securities be carried at fair value. We believe this is a “critical accounting estimate” in that the fair value of a security is based on quoted market prices or if quoted market prices are not available, fair value is based on a matrix pricing model. Management utilizes the services of a reputable third-party vendor to assist with the determination of estimated fair values. Adjustments to the available-for-sale securities fair value impact the consolidated financial statements by increasing or decreasing assets and stockholders’ equity.

      Income Taxes. We use the liability method in accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based upon the difference between the values of the assets and liabilities as reflected in the financial statements and their related tax basis using enacted tax rates in effect for the year in which the differences are expected to be recovered or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes. Any estimated tax exposure items identified would be considered in a tax contingency reserve. Changes in any tax contingency reserve would be based on specific developments, events, or transactions.

      Stock Options. As required, on January 1, 2006 we adopted SFAS 123R, which establishes standards for the accounting for transactions in which an entity (i) exchanges its equity instruments for goods and services, or (ii) incurs liabilities in exchange for goods and services that are based on the fair value of the entity’s equity instruments or that may be settled by the issuance of the equity instruments. SFAS 123R requires that stock-based compensation transactions be recognized over the service period, which is usually the same as the vesting period, as compensation cost in the income statement based on their fair values on the measurement date, which is generally the date of the grant.

     We adopted SFAS 123R using a modified prospective approach. Under the modified prospective approach, prior periods are not revised for comparative purposes. The valuation provisions of SFAS 123R apply to new awards and to awards that are outstanding on the effective date and subsequently modified or cancelled. Compensation expense, net of estimated forfeitures, for awards outstanding at the effective date is recognized over the remaining service period using the compensation cost calculated in prior periods. On January 1, 2006, the Company was a non-public entity that had historically used the minimum value method of the Black-Scholes model. Accordingly the value of options granted prior to January 1, 2006, regardless of vesting, will not be reflected in the income statement of the Company for any period.

     We have granted nonqualified and qualified stock options under our Stock Option Plan prior to 2006. We did not grant any options in 2006. We granted 24,000 shares in options in the first quarter of 2007 and none in the second and third quarters 2007. Our stock options for employees include a service condition that relates only to vesting. The stock options generally vest over five years at the rate of 20% per year. Compensation expense is amortized on a straight-line basis over the vesting period of the award.

     The determination of the fair value of stock options using an option-pricing model is affected by our stock price as well as assumptions regarding a number of complex and subjective variables. The volatility assumption is based on a combination of the historical volatility of our common stock over a period of time equal to the expected term of the stock options. The expected term of employee stock options represents the weighted-average period the stock options are expected to remain outstanding. The expected term assumption is estimated based primarily on the options’ vesting terms and remaining contractual life and employees’ expected exercise and post-vesting employment termination behavior. The risk-free interest rate assumption is based upon observed interest rates on the grant date appropriate for the term of the employee stock options. The dividend yield assumption is based on the expectation of no future dividend payouts by us.

     As share-based compensation expense under SFAS 123R is based on awards ultimately expected to vest, it is reduced for estimated forfeitures. SFAS 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.

Results of Operations

     Our results of operations depend primarily on net interest income, which is the difference between interest income and interest expense. Interest income is the earnings we receive on our interest earning assets, such as loans and investments, and interest expense is the expense we incur on our interest bearing liabilities, such as interest bearing deposits and other borrowings. Factors that determine the level of net income include the volume of earning assets and interest bearing liabilities, yields earned and rates paid, fee income, non-interest expense, the level of non-performing loans and other non-earning assets, and the amount of non-interest bearing liabilities supporting earning assets. Non-interest income includes service charges and other deposit related fees, and non-interest expense consists primarily of employee compensation and benefits, occupancy, equipment and depreciation expense, and other operating expenses.

Financial Overview for the Three and Nine Months Ended September 30, 2007 and 2006

     The Company reported a net loss of $7.8 million or $1.39 loss per diluted share for the quarter ended September 30, 2007 as compared to net income of $1.2 million or $0.36 diluted earnings per share for the quarter ended September 30, 2006. The loss is attributable to a $13.4 million provision for loan losses during the quarter ended September 30, 2007, compared to a $0.5 million provision during the quarter ended September 30, 2006. Our return on average equity was (47.1)% and our return on average assets was (6.62)% for the three months ended September 30, 2007, compared to 24.4% and 1.44%, respectively for the three months ended September 30, 2006.

     The Company had a net loss of $5.2 million for the nine months ended September 30, 2007 as compared to net income of $3.1 million for the nine months ended September 30, 2006. This was attributable principally to an increase in the provision for loan losses. Our return on average equity was (11.0)% and our return on average assets was (1.61)% for the nine months ended September 30, 2007, compared to 23.5% and 1.44%, respectively for the nine months ended September 30, 2006.

      Net Interest Income and Net Interest Margin. The $1.0 million, 23.7% increase in net interest income for the three month period ended September 30, 2007 was due to (i) an increase in interest income of $2.5 million, reflecting the effect of a $141.7 million increase in average interest-earning assets offset by (ii) an increase in interest expense of $1.4 million. Net interest income for the nine months ended September 30, 2007 increased $3.7 million, 30.8% from the same period 2006. Average interest-earning assets increased $145.0 million with interest income increasing $8.4 million and interest expense increasing $4.7 million.

     The average yield on our interest-earning assets was 8.95% for the three months ended September 30, 2007 period compared to 9.91% for the same period of 2006, a decrease of 0.96%. The average yield on our interest-

earning assets was 9.04% for the nine months ended September 30, 2007 compared to 9.72% for the same period of 2006, a decrease of 0.68%. The decrease in the average yield on our interest-earning assets resulted from a decrease in market rates, repricing on our adjustable rate loans, and new loans originated with lower interest rates because of the decreasing interest rate environment in 2007.

     The cost of our average interest-bearing liabilities increased to 5.05% for the three months ended September 30, 2007 from 4.74% for the same period of 2006. The cost of our average interest-bearing liabilities increased to 5.03% for the nine months ended September 30, 2007 from 4.45% for the same period of 2006. In addition to broad increases in the average rates paid by Westsound Bank on deposit balances, the increase was the result of a change in the mix of deposits toward higher-paying time deposits.

     Our average rate on our interest-bearing deposits increased 0.34% from 4.66% during the three months ended September 30, 2006 to 5.00% for the same period of 2007, reflecting the change in the mix of deposits toward higher-paying time deposits. Our average rate on interest-bearing deposits for the nine months ended September 30, 2007 was 4.97% compared to 4.36% at September 30, 2006 an increase of 0.61%. Our average rate on total deposits (including non-interest bearing deposits) increased to 4.58% for the nine months ended September 30, 2007 from 4.08% for the year ended December 31, 2006.

     The 88 basis point decrease in our net interest margin, which decreased to 4.83% for the three months ended September 30, 2007 from 5.71% for the three months ended September 30, 2006, was due to our higher cost of funding and the decrease in earning assets yield. Our net interest margin decreased 82 basis points to 4.98% for the nine months ended September 30, 2007 from 5.80% for the nine months ended September 30, 2006.

     The following table sets forth a summary of average balances with corresponding interest income and interest expense as well as average yield and cost information for the periods presented. Average balances are derived from daily balances, and non-accrual loans are included as interest earning assets for purposes of this table.