- Quarterly Report (10-Q)

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

(Mark One)


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

For the Quarterly Period Ended September 30, 2008


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.

(Exact name of registrant as specified in its charter)


Washington		20-3153598
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

607 Pacific Avenue
Bremerton, Washington		98337
(Address of principal executive offices)		(Zip Code)

(360) 405-1200

(Registrant’s telephone number, including area code)

Not Applicable

(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):


Large accelerated filer o		Accelerated filer o		Non-accelerated filer þ (Do not check if a smaller reporting company)		Smaller reporting company o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

Indicate the number of shares outstanding on each of the registrant’s classes of common stock, as of the latest practical date.


Class		Outstanding as of November 7, 2008

Common Stock, $1.00 par value		5,574,853

WSB FINANCIAL GROUP, INC.
FORM 10-Q
September 30, 2008

INDEX


Item Number	Page
PART I Financial Information		1

1 Financial Statements		1

Consolidated Statement of Financial Condition – September 30, 2008 (Unaudited) and December 31, 2007		1

Unaudited Consolidated Statement of Operations – Three months and nine months ended September 30, 2008 and 2007		2

Unaudited Consolidated Statement of Changes in Stockholders’ Equity and Comprehensive Income (Loss) – Nine months ended September 30, 2008 and 2007		3

Unaudited Consolidated Statement of Cash Flows – Nine months ended September 30, 2008 and 2007		4

Notes to Consolidated Interim Financial Statements (Unaudited)		5

2 Management’s Discussion and Analysis of Financial Condition and Results of Operations		21

Notice About Forward-Looking Statements		21

3 Quantitative and Qualitative Disclosure About Market Risk		44

4 Controls and Procedures		48

PART II Other Information		51

1 Legal Proceedings		51

1A Risk Factors		51

2 Unregistered Sales of Equity Securities and Use of Proceeds		53

3 Defaults Upon Senior Securities		54

4 Submission of Matters to a Vote of Security Holders		54

5 Other Information		54

6 Exhibits		54

SIGNATURES		55
EX-31.1
EX-31.2
EX-32.1
EX-32.2

PART I: FINANCIAL INFORMATION

ITEM 1: FINANCIAL STATEMENTS

WSB FINANCIAL GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF FINANCIAL CONDITION


	September 30,			December 31,
	2008			2007
	Unaudited
ASSETS
Cash and cash equivalents
Cash and due from banks	$	11,954,202		$	10,026,460
Federal funds sold		43,800,000			56,900,000

Total cash and cash equivalents		55,754,202			66,926,460

Investment securities available for sale, at fair value		16,166,341			8,832,146
Federal Home Loan Bank stock, at cost		318,900			318,900
Loans		322,665,996			412,949,947
Less allowance for loan losses		(24,535,522	)		(19,513,765	)

Total loans, net		298,130,474			393,436,182

Premises and equipment, net		7,872,218			8,759,750
Accrued interest receivable		1,346,071			2,540,554
Other real estate owned		10,984,204			983,411
Deferred tax asset		7,993,102			6,496,106
Less deferred tax valuation allowance		(7,993,102	)		—

Total deferred tax asset, net		—			6,496,106

Federal income tax receivable		5,223,219			193,937
Other assets		1,275,752			845,718

Total assets	$	397,071,381		$	489,333,164


LIABILITIES AND STOCKHOLDERS’ EQUITY
Deposits
Non-interest-bearing	$	19,408,961		$	24,711,246
Interest-bearing		331,093,508			396,733,599

Total deposits		350,502,469			421,444,845

Accrued interest payable		2,057,328			1,955,434
Other liabilities		592,073			964,870
Junior subordinated debentures		8,248,000			8,248,000

Total liabilities		361,399,870			432,613,149

Stockholders’ equity
Common stock, $1 par value; 15,357,250 shares authorized; 5,574,853 and 5,574,853 shares issued and outstanding at September 30, 2008 and December 31, 2007, respectively		5,574,853			5,574,853
Additional paid-in capital		48,263,086			48,223,669
Retained earnings (accumulated deficit)		(18,223,158	)		2,853,756
Accumulated other comprehensive income		56,730			67,737

Total stockholders’ equity		35,671,511			56,720,015

Total liabilities and stockholders’ equity	$	397,071,381		$	489,333,164

See accompanying notes to unaudited consolidated financial statements

WSB FINANCIAL GROUP, INC. AND SUBSIDIARIES

UNAUDITED CONSOLIDATED STATEMENT OF OPERATIONS


	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2008			2007			2008			2007
	(Unaudited)			(Unaudited)			(Unaudited)			(Unaudited)
INTEREST INCOME
Interest and fees on loans	$	3,754,221		$	9,825,405		$	14,799,913		$	27,492,641
Interest on investments
Taxable		146,241			87,859			330,306			231,781
Tax-exempt		14,160			18,843			31,872			56,640
Interest on federal funds sold		268,512			171,096			1,291,039			584,078
Other interest income		43,819			38,627			105,409			133,044

Total interest income		4,226,953			10,141,830			16,558,539			28,498,184
INTEREST EXPENSE
Deposits		3,567,763			4,513,829			12,646,443			12,358,016
Other borrowings		—			149			—			1,241
Junior subordinated debentures		90,000			152,694			360,000			448,226

Total interest expense		3,657,763			4,666,672			13,006,443			12,807,483

NET INTEREST INCOME		569,190			5,475,158			3,552,096			15,690,701
PROVISION FOR LOAN LOSSES		—			13,361,600			11,235,000			14,179,000

Net interest income (loss) after provision for loan losses		569,190			(7,886,442	)		(7,682,904	)		1,511,701


NONINTEREST INCOME
Service charges on deposit accounts		97,053			94,913			247,728			274,688
Other customer fees		85,889			198,471			319,823			677,153
Net gain on sale of loans		—			736,676			—			2,601,585
Other income (loss)		11,398			(5,074	)		23,799			47,464

Total noninterest income		194,340			1,024,986			591,350			3,600,890


NONINTEREST EXPENSE
Salaries and employee benefits		1,533,428			2,510,467			4,770,027			7,753,209
Premises lease		72,138			79,738			232,119			251,926
Depreciation and amortization expense		197,791			206,125			611,765			603,237
Occupancy and equipment		162,340			149,246			470,520			458,557
Data and item processing		175,239			166,997			545,308			490,367
Advertising expense		62,963			59,070			142,489			154,870
Printing, stationery and supplies		36,500			37,936			123,971			143,051
Telephone expense		21,560			25,605			65,037			82,640
Postage and courier		31,130			43,702			102,225			125,449
Legal fees		871,791			33,886			1,490,989			142,826
Director fees		(3,900	)		70,200			185,600			193,200
Business and occupation taxes		37,134			83,219			146,350			239,962
Accounting and audit fees		122,495			36,787			444,399			123,252
Consultant fees		157,522			40,883			615,428			91,179
OREO losses and expense, net		412,876			170,134			583,935			207,092
Provision (benefit) for unfunded credit losses		(44,000	)		561,400			(430,000	)		561,400
Other expenses		1,214,069			492,893			2,623,719			1,355,096

Total noninterest expense		5,061,076			4,768,288			12,723,881			12,977,313

LOSS BEFORE PROVISION (BENEFIT) FOR INCOME TAXES		(4,297,546	)		(11,629,744	)		(19,815,435	)		(7,864,722	)
PROVISION (BENEFIT) FOR INCOME TAXES		—			(3,877,400	)		1,261,479			(2,624,400	)

NET LOSS	$	(4,297,546	)	$	(7,752,344	)	$	(21,076,914	)	$	(5,240,322	)


LOSS PER SHARE
Basic	$	(0.77	)	$	(1.39	)	$	(3.78	)	$	(0.94	)
Diluted	$	(0.77	)	$	(1.39	)	$	(3.78	)	$	(0.94	)

Weighted-average number of common shares outstanding		5,574,853			5,573,089			5,574,853			5,561,844
Weighted-average number of dilutive shares outstanding		5,574,853			5,573,089			5,574,853			5,561,844

See accompanying notes to unaudited consolidated financial statements

WSB FINANCIAL GROUP, INC. AND SUBSIDIARIES

UNAUDITED CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY AND
COMPREHENSIVE INCOME (LOSS)


	Common Stock
										Accumulated
							Retained			Other
					Additional		Earnings			Compre-
	Number				Paid-In		(Accumulated			hensive (Loss)
	of Shares		Amount		Capital		Deficit)			Income			Total
Balance, December 31, 2006		5,545,673	$	5,545,673	$	48,089,861	$	8,053,915		$	(32,321	)	$	61,657,128

Net loss								(5,240,322	)					(5,240,322	)

Other comprehensive income, net of tax of $5,464											10,607			10,607

Total comprehensive loss														(5,229,715	)


Stock based compensation expense						19,863								19,863
Stock options exercised		29,180		29,180		107,324								136,504


Balance, September 30, 2007 (unaudited)		5,574,853	$	5,574,853	$	48,217,048	$	2,813,593		$	(21,714	)	$	56,583,780


Balance, December 31, 2007		5,574,853	$	5,574,853	$	48,223,669	$	2,853,756		$	67,737		$	56,720,015

Net loss								(21,076,914	)					(21,076,914	)

Other comprehensive loss, net of tax of ($5,670)											(11,007	)		(11,007	)

Total comprehensive loss														(21,087,921	)


Stock based compensation expense						39,417								39,417


Balance, September 30, 2008 (unaudited)		5,574,853	$	5,574,853	$	48,263,086	$	(18,223,158	)	$	56,730		$	35,671,511

See accompanying notes to unaudited consolidated financial statements

WSB FINANCIAL GROUP, INC. AND SUBSIDIARIES

UNAUDITED CONSOLIDATED STATEMENT OF CASH FLOWS


	Nine Months Ended
	September 30,
	2008			2007
	(Unaudited)			(Unaudited)
CASH FLOWS FROM OPERATING ACTIVITIES
Net loss	$	(21,076,914	)	$	(5,240,322	)
Adjustments to reconcile net loss to net cash from operating activities
Provision for loan losses		11,235,000			14,179,000
Provision (benefit) for unfunded credit losses		(430,000	)		665,000
Provision for OREO write down		352,325			147,597
Depreciation and amortization		611,765			603,237
Amortization (accretion) of premiums/discounts		(112,263	)		(3,442	)
Stock based compensation		39,417			19,863
Net gain on sale of premises and equipment		9,063			5,624
Net loss (gain) on sale of OREO		79,478			(16,362	)
Origination of loans held for sale		—			(90,846,520	)
Proceeds from sale of loans held for sale		—			97,804,983
Net gain on sale of loans		—			(2,601,585	)
Deferred income tax (benefit) expense		6,501,776			(4,864,400	)
Net change in
Accrued interest receivable		1,194,483			(556,612	)
Other assets		(5,459,316	)		(262,674	)
Accrued interest payable		101,894			655,520
Other liabilities		57,203			259,496

Net cash from operating activities		(6,896,089	)		9,948,403

CASH FLOWS FROM INVESTING ACTIVITIES
Purchase of lease receivables		(15,023,001	)		—
Net change in loans		87,757,181			(88,282,046	)
Purchases of investments available-for-sale		(10,770,000	)		(5,745,804	)
Proceeds from calls and maturities of investments available-for-sale		3,525,000			5,300,000
Principal repayments of mortgage-backed securities		6,391			8,852
Purchase of Federal Home Loan Bank stock		—			(84,700	)
Proceeds from sale of OREO		903,932			355,158
Purchases of premises and equipment		(202,352	)		(2,264,530	)
Proceeds from sale of premises and equipment		469,056			5,500

Net cash from investing activities		66,666,207			(90,707,570	)

CASH FLOW FROM FINANCING ACTIVITIES
Net change in non-interest-bearing deposits		(5,302,285	)		793,296
Net change in interest-bearing deposits		(65,640,091	)		83,994,394
Proceeds from exercise of stock options		—			136,504

Net cash from financing activities		(70,942,376	)		84,924,194

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS		(11,172,258	)		4,165,027
CASH AND CASH EQUIVALENTS, beginning of period		66,926,460			26,198,104

CASH AND CASH EQUIVALENTS, end of period	$	55,754,202		$	30,363,131

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid for interest	$	12,904,549		$	12,151,963

Income taxes paid	$	—		$	1,915,000

NON-CASH INVESTING ACTIVITIES
Real estate acquired through foreclosure in settlement of loans	$	11,336,528		$	2,133,554

See accompanying notes to unaudited consolidated financial statements

WSB FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1 — Summary of Significant Accounting Policies

Nature of operations and basis of consolidation — On March 12, 1999, Westsound Bank (the Bank) was granted a state charter as a commercial bank whose principal activity is to engage in general commercial banking business in the Bremerton area of Kitsap County, Washington. The Bank generates commercial, mortgage and consumer loans and receives deposits from customers located primarily in Bremerton, Washington. As a Washington State chartered financial institution, the Bank is subject to regulations by the Washington State Banking Department of Financial Institutions and the Federal Deposit Insurance Corporation. Westsound Bank has branch offices in Bremerton, Silverdale, Port Angeles, Port Orchard, Sequim, Gig Harbor, Poulsbo, Federal Way, and Port Townsend, Washington.

The Bank is located in an area that has a significant U.S. Department of Defense presence. Closure or downsizing of one of the two large bases could affect operating results adversely. No such indication of closure or downsizing has been made in Department of Defense plans as indicated in budgets.

In July, 2005, WSB Financial Group, Inc. (the Company), a bank holding company, was issued a certificate of incorporation as a Washington Profit Corporation. During 2005, the Federal Reserve Bank of San Francisco granted authority to WSB Financial Group, Inc. to become a bank holding company through a reorganization of the ownership interests of Westsound Bank.

WSB Financial Group Trust I (Trust), a subsidiary of WSB Financial Group, Inc., was formed in July 2005 for the exclusive purpose of issuing Trust Preferred Securities and common securities and using the $8 million in proceeds from the issuance to acquire junior subordinated debentures issued by WSB Financial Group, Inc. In accordance with Interpretation No. 46, Consolidation of Variable Interest Entities, the Trust is not consolidated in the Company’s financial statements.

The consolidated financial statements include the accounts of WSB Financial Group, Inc. and its wholly owned subsidiaries, excluding the Trust, after eliminating all intercompany transactions.

Unaudited Interim Financial Information — The accompanying interim consolidated financial statements as of September 30, 2008 for the three month and nine month periods ended September 30, 2008 and 2007 are unaudited. The unaudited interim financial statements have been prepared on the same basis as the annual financial statements and, in the opinion of management, reflect all adjustments, which include only normal recurring adjustments, necessary to present fairly the Company’s financial position as of September 30, 2008, its results of operations for the three month and nine month periods ended September 30, 2008 and 2007, and its cash flows for the nine months ended September 30, 2008 and 2007. The results of operations for the interim periods are not necessarily indicative of the results for the full year. Certain information and footnote disclosures included in the Company’s financial statements for the year ended December 31, 2007 have been condensed or omitted from this report. Accordingly, the statements should be read with the financial statements and notes thereto included in the Company’s December 31, 2007 financial statements.

Use of estimates — The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reporting amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan losses and deferred tax asset/liability.

Cash and cash equivalents — For purposes of reporting cash flows, cash and cash equivalents are cash on hand, amounts due from banks, and federal funds sold, and have maturities of three months or less. The Bank places its cash with high credit quality institutions. The amounts on deposit fluctuate and, at times, exceed the insured limit by the U.S. Federal Deposit Insurance Corporation, which potentially subjects the Bank to credit risk. Generally, federal funds are purchased and sold for one-day periods.

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

Investment securities — Investment securities are classified into one of three categories: (1) held-to-maturity, (2) available-for-sale, or (3) trading. Investment securities are categorized as held-to-maturity when the Bank has the positive intent and ability to hold those securities to maturity. Securities which are held-to-maturity are stated at cost and adjusted for amortization of premiums and accretion of discounts, which are recognized as adjustments to interest income. The Bank had no securities classified as held-to-maturity as of September 30, 2008 and December 31, 2007. The Bank had no trading securities as of September 30, 2008 and December 31, 2007.

Investment securities categorized as available-for-sale are generally held for investment purposes (to maturity), although unanticipated future events may result in the sale of some securities. Available-for-sale securities are recorded at estimated fair value, with the net unrealized gain or loss included in comprehensive income, net of the related tax effect. Realized gains or losses on dispositions are based on the net proceeds and the adjusted carrying amount of securities sold, using the specific identification method.

Declines in the fair value of individual held-to-maturity, and available-for-sale securities below their cost that are other than temporary are recognized by write-downs of the individual securities to their fair value. Such write-downs would be included in earnings as realized losses. In estimating other-than-temporary impairment losses, management considers (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Bank to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. Gains and losses on the sale of securities are recorded on the trade date and are determined using the specific identification method.

Premiums and discounts are recognized in interest income using the interest method over the period to maturity.

Federal Home Loan Bank stock — The Bank’s investment in Federal Home Loan Bank (the FHLB) stock is carried at par value ($100 per share), which reasonably approximates its fair value. As a member of the FHLB system, the Bank is required to maintain a minimum level of investment in FHLB stock based on specified percentages of its outstanding FHLB advances. The Bank may request redemption at par value of any stock in excess of the amount the Bank is required to hold. Stock redemptions are at the discretion of the FHLB.

Loans held for sale — Loans originated and intended for sale in the secondary market are carried at the lower of aggregate cost or fair value, as determined by aggregate outstanding commitments from investors or current investor yield requirements. Net unrealized losses are recognized through a valuation allowance by charges to income. The Company had no loans held for sale at September 30, 2008 and December 31, 2007.

Mortgage loans held for sale are generally sold with the mortgage servicing rights released by the Bank. Gains or losses on sales of mortgage loans are recognized based on the difference between the selling price and the carrying value of the related mortgage loans sold.

Accounting for derivatives — The Company has engaged in the production of loans for sale to buyers and investors in the secondary mortgage market. These loan production activities expose the Company to risk that a loan’s market value may decline between the date the Company enters into an interest rate lock commitment with a borrower to fund a loan, or with a seller to purchase a loan, and the loan’s ultimate sale into the secondary market. The Company reduces its exposure to this risk by entering into contracts to sell loans to buyers at specified prices to hedge against the economic risk of market value declines. The Company considers its commitments to extend secondary market qualifying loans (the pipeline) with interest rate lock commitments to be derivatives, as well as its firm commitments to deliver loans, all of which are recognized at their estimated fair values. The Company had no interest rate lock commitment derivatives at September 30, 2008 and December 31, 2007.

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

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

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 over 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 for loan losses 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 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 is allocated based on general, classified, specific and conditions components of the loan portfolio. The classified component relates to loans that are risk rated as either doubtful, substandard or special mention. For such loans that are also classified as impaired, a specific 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 conditions component is maintained to cover uncertainties that could affect management’s estimate of probable losses. This conditions component of the allowance reflects internal and external factors that may impact the loan portfolio performance in future periods.

Foreclosed assets — Assets acquired through, or in lieu of, loan foreclosure are held for sale and are initially recorded at fair value at the date of the foreclosure, establishing a new cost basis. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or fair value less cost to sell. Revenue and expenses from operations and changes in the valuation allowance are included in net expenses from foreclosed assets.

Stock option plans — The Company accounts for all share-based payments in accordance with 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

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

share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values.

Earnings (loss) 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 2008 fiscal year, all outstanding stock options were excluded from the computation of the loss per share due to the net loss recorded during the period.

Loss per common share has been computed based on the following:


	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2008			2007			2008			2007
Numerator

Net loss	$	(4,297,546	)	$	(7,752,344	)	$	(21,076,914	)	$	(5,240,322	)

Denominator

Weighted-average number of common shares outstanding		5,574,853			5,573,089			5,574,853			5,561,844

Incremental shares assumed for stock options		—			—			—			—


Weighted-average number of dilutive shares outstanding		5,574,853			5,573,089			5,574,853			5,561,844


Basic loss per common share	$	(0.77	)	$	(1.39	)	$	(3.78	)	$	(0.94	)

Diluted loss per common share (1)	$	(0.77	)	$	(1.39	)	$	(3.78	)	$	(0.94	)


(1)		Excludes all stock options as anti-dilutive in periods with net losses.

Recent accounting pronouncements — 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 did not have a material impact on our consolidated financial statements. (See Note 13.)

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. The Company elected not to report using the Fair Value Option under SFAS 159 as of January 1, 2008.

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

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

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.

In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities — an amendment of FASB Statement No. 133” (SFAS 161). SFAS requires enhanced disclosures about an entity’s derivative and hedging activities and improves financial reporting. This statement is effective for financial statements issued for the fiscal years and interim periods beginning after November 15, 2008, with early application encouraged. SFAS 161 is not expected to have a material impact on our consolidated financial statements.

In December 2007, the FASB revised SFAS No. 141, “ Business Combinations ” (SFAS 141(R)). SFAS 141(R) improves the completeness of the information reported about a business combination by changing the requirements for recognizing assets acquired and liabilities assumed arising from contingencies. This statement requires an acquirer to recognize assets acquired and liabilities assumed arising from contractual contingencies as of the acquisition date, measured at their fair value. SFAS 141R applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008, and is not expected to have a material impact on our consolidated financial statements.

In May 2008, the FASB issued SFAS No. 162, “ The Hierarchy of Generally Accepted Accounting Principles” (SFAS 162). SFAS 162 identifies the sources of accounting principles and the framework for selecting the principles to be used in the preparation of financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles (GAAP) in the United States. This statement is effective 60 days following the SEC’s approval of the Public Company Accounting Oversight Board Auditing amendments to AU Section 411, “The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles.” SFAS 162 will not have a material effect on our consolidated financial statements.

In May 2008, the FASB issued SFAS No. 163, “Accounting for Financial Guarantee Insurance Contracts – an Interpretation of FASB Statement No. 60” (SFAS 163). SFAS 163 is limited to financial guarantee insurance contracts used in the scope of SFAS statement 60 and is effective for financial statements issued for the fiscal years beginning after December 15, 2008, and for all interim periods within those fiscal years. This statement will not affect our consolidated financial statements.

In October 2008, the FASB issued FSP FAS No. 157-3, “ Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active” (FSP 157-3). The FSP clarifies the application of FAS No. 157, Fair Value Measurements , when the market for a financial asset is not active. The FSP was effective upon issuance, including reporting for prior periods for which financial statements have not been issued. The adoption of the FSP for reporting as of September 30, 2008, did not have a material impact on our consolidated financial statements.

Note 2 — Regulatory Actions and Risk Management Plan

Regulatory Actions

The regulators determined the Bank had engaged in unsafe or unsound banking practices, by engaging in unsatisfactory lending and collection practices, operating with inadequate management and board supervision, with less than satisfactory capital in relation to its large volume of poor quality loans and with an inadequate loan valuation reserve, and with inadequate provisions for liquidity, inadequate internal routine and control policies, and in violation of various banking laws and regulations relating to internal audits and controls, real estate appraisal and lending guidelines, and responsibilities of bank directors and officers.

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

Under the terms of the FDIC order, the Bank cannot declare dividends without the prior written approval of the FDIC and the DFI. Other material provisions of the order require the Bank to: (i) review the compensation and effectiveness of Westsound Bank’s current executive officers and directors, and the structure of the board and its committees, (ii) strengthen the Bank’s board of directors’ oversight of management and operations of the Bank, (iii) improve the Bank’s internal controls, internal audit function, lending and collection policies and procedures, particularly with respect to the origination and monitoring of construction loans, (iv) maintain specified capital and liquidity ratios, and (v) prepare and submit progress reports to the FDIC and the DFI. The FDIC order will remain in effect until modified or terminated by the FDIC and the DFI. As previously reported, the Company and the Bank have been actively engaged in responding to the concerns raised in the FDIC order. As of November 13, 2008, we had filed all reports and believe we are in compliance with all requirements of the FDIC order.

The order does not restrict the Bank from transacting its normal banking business. The Bank will serve its customers in all areas including making loans, establishing lines of credit, accepting deposits and processing banking transactions. All customer deposits remain fully insured to the highest limits set by FDIC. The FDIC and DFI did not impose any monetary penalties.

FRB Notice: On February 14, 2008, the Federal Reserve Bank of San Francisco, or FRB, notified WSB Financial Group, Inc. (the “Company”) and the Bank that it had designated the Company and Westsound Bank to be in a “troubled condition” for purposes of Section 914 of the Financial Institutions Reform, Recovery and Enforcement Act of 1989. As a result of that designation neither the Company nor the Bank may appoint any new director or senior executive officer or change the responsibilities of any current senior executive officers without notifying the FRB. In addition, neither the Company nor the Bank may make indemnification and severance payments without complying with certain statutory restrictions including prior written approval of the FRB and concurrence from the FDIC. Further, the Company is generally prohibited from making any payments to any entity, including dividends and interest payments (including dividends on its trust preferred securities, and interest at the holding company level), director fees, consulting expenses and other operating expenses, without notifying the FRB for prior approval of such payments. As of November 13, 2008 we believe all recommendations by FRB have been implemented.

Capital: Although the Company and the Bank were “well capitalized” at September 30, 2008 based on their financial statements prepared in accordance with generally accepted accounting principles in the United States and the general percentages in the regulatory guidelines, the Company and the Bank understand that they are no longer regarded as “well capitalized” for federal regulatory purposes, as a result of the deficiencies cited in the FDIC order.

As a result of this reclassification, the Bank’s borrowing costs and terms from the FRB, the FHLB and other financial institutions, as well as the Bank’s premiums to the Deposit Insurance Fund administered by the FDIC to insure bank and savings association deposits are expected to increase.

Compliance Efforts: The Company and the Bank are actively engaged in responding to the concerns raised in the FDIC order, and believe that they have already addressed many of the regulators’ requirements.

Westsound Bank has begun working with these regulatory agencies and has acted promptly on directions it has received from these agencies, including the following actions:

	•		Retained a new president and chief executive officer, Terry A. Peterson, on April 15, 2008;

	•		Conducted a comprehensive review of the qualifications of management and the board of directors and consideration of potential changes that may be required;

	•		Retained an independent third party consultant to review and evaluate the loan portfolio and implemented many of his recommendations to improve the Bank’s loan approval and loan servicing processes;

	•		Added $11.2 million to total provisions for loan losses in first nine months of 2008:

	•		Strengthened collections and loss recovery teams to accelerate resolution of problem loans, including retaining two experienced loan administration and workout specialists as consultants.

	•		Began developing a capital management plan to maintain strong capital ratios;

	•		Began implementing new procedures to strengthen the monitoring of lending activities with particular emphasis on monitoring individual lender/borrower relationships;

	•		Initiated a review of loan documentation policy and is correcting documentation deficiencies;

	•		Developed a liquidity and funds management plan to address anticipated funding needs;

	•		Increasing internal controls over loan portfolio review;

	•		Establishing a communications procedure for reporting progress in all areas to the FDIC and DFI;

	•		Engaged an independent third party consultant to review management assumptions and methodology of determining the allowance for loan and lease losses.

A number of these initiatives are complete and a number of policies and procedures have been implemented. As a result, the Bank has already acted upon most of the items addressed by the FDIC order.

Risk Management Plan

Increased Reserves for Loan Losses. The Company’s provision for loan losses, levels of impaired loans and non-accrual loans and OREO property have increased significantly in the last nine months. We did not increase our provision for loan losses in the third quarter ending September 30, 2008; however, year-to-date we added $11.2 million to our provision for loan losses, based on management’s quarterly reviews, continued uncertainty in the local housing market, increases in our non-accrual loans and OREO property, which primarily relate to the maturing of our construction and land development loans, and our determination of specific impaired loans under generally accepted accounting principles. In the previous two quarters ended June 30, 2008 and March 31, 2008, we recorded provisions for loan losses of $3.5 million and $7.7 million, respectively.

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.

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

Construction and Development Loans. We are experiencing significant difficulties in our loan portfolio, particularly our construction and land development loans, which was a significant component of the $11.2 million increase in our provision for loan losses in the first nine months of 2008. We continue to work through the issues with the construction loans in Westsound Bank’s loan portfolio. The Bank has scaled back its construction loan originations in the past few months and is concentrating on working with its borrowers to complete existing projects in a timely manner and to bring past-due loans current.

During the first nine months of 2008, however, non-accrual loans increased significantly, from $24.9 million to $119.1 million, primarily as a result of maturing construction and land development loans that we are choosing not to renew in order to keep all of our legal remedy options available. After 90 days past due, these loans are placed into a non-accrual status while we work with our borrowers to maximize our recovery. Therefore, the contraction or expansion of our non-accrual loan portfolio in future periods will depend upon our ongoing collection efforts and market conditions. In the third quarter of 2008 we added 28 properties with an aggregate carrying value of $7,203,000 to OREO. OREO properties are actively marketed for sale with one property sold during the third quarter, two properties sold during the second quarter and one in the first quarter 2008. These properties had a carrying value of $983,000 and we received $904,000 resulting in a net loss on the sales of $79,000.

The real estate collateral valuations supporting our construction and land development loan portfolios have decreased along with the deterioration in the local housing market. While the overall economy in the west Puget Sound market is holding up better than many other areas of the country, the housing market is slow with weaker demand for housing, higher inventory levels, longer marketing times and lower sales prices.

As we collect our construction loans and land development loans, we expect to be able to deleverage the balance sheet over the next few quarters.

Our cash expenditures, including legal and accounting fees, associated with the collection of non-performing and classified loans 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, expensive and could divert management time and attention from our daily business, which could have a material effect on our revenues and results of operations

Net Interest Margin Compression. Net interest income before provision for loan losses has decreased significantly, reflecting lower levels of earning assets; increases in low yielding securities and non-accrual loans on the balance sheet. The increase in non-accrual loans reduced net interest income by $1.5 million in the third quarter and $6.0 million for the first nine months of 2008, in reversed interest income. Lower loan interest rates during the year, combined with the significant reduction in fee income from new loan originations, also contributed to significant margin compression.

Management has completed a strategic plan that addresses the return to a more normalized net interest margin. This plan includes a return to loan growth through origination and purchase of loans; conclusion of reversing loan interest as non-accrual loans are reduced and paid off; planned non-renewal of high cost certificates of deposit; and dedicating two employees to the business development of core deposits.

As with any plan, the Company is unable to predict the outcome of management’s plan as outlined above. Additional risks and uncertainties not currently known to us, may also materially and adversely affect our business, financial condition or results of operation.

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

Note 3 — Loans and Allowance for Loan Losses

Loans are summarized as follows:


	September 30,			December 31,
	2008			2007
Real estate loans
Construction & land development	$	171,918,122		$	253,187,532
Commercial real estate		61,845,288			72,435,273
Residential real estate		46,949,290			53,198,016
Commercial and industrial loans		39,285,083			31,376,932
Consumer loans		3,074,431			3,718,806

Gross loans		323,072,214			413,916,559
Allowance for loan losses		(24,535,522	)		(19,513,765	)
Deferred fees		(406,218	)		(966,611	)

Net loans	$	298,130,474		$	393,436,183


	Nine Months Ended
	September 30,
	2008			2007
Allowance for loan losses
Balances, beginning of period	$	19,513,765		$	3,971,789
Provision for losses		11,235,000			14,179,000
Recoveries		24,464			452
Loans charged off		(6,237,707	)		(298,890	)

Balances, end of period	$	24,535,522		$	17,852,351


	September 30,		December 31,
	2008		2007
Total non-accrual loans	$	119,067,000	$	24,923,234

Total loans 90 days or more past due and still accruing	$	—	$	399,438

Impaired loans are summarized as follows:


	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2008		2007		2008		2007
Impaired Loans
Balance at end of period (1)	$	119,071,139	$	22,884,467	$	119,071,139	$	22,884,467

Total related allowance for losses	$	17,220,675	$	4,237,285	$	17,220,675	$	4,237,285

Average investment in impaired loans	$	65,237,712	$	6,168,483	$	39,415,027	$	2,467,393

Interest income recognized on impaired loans	$	68,966	$	447,252	$	522,587	$	870,703

Cash-basis interest income received on impaired loans	$	68,966	$	300,465	$	484,512	$	771,433


(1)		Includes $119.1 million non-accrual loans at September 30, 2008 and $1.1 million at September 30, 2007.

There was $18,438 available in outstanding loan commitments on impaired loans as of September 30, 2008.

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

As of September 30, 2008, we did not add to our provision for loan losses, based on management’s quarterly review. The provision for loan losses for the first nine months of 2008 was $11.2 million, compared to $14.2 million a year ago.

No provision for loan losses was recorded for the three months ended September 30, 2008. Several factors supported this decision:

	1)		At September 30, 2008, the allowance for loan losses was $24.5 million, or 7.6% of total loans as compared to $28.1 million or 8.3% at June 30, 2008 and $19.5 million or 4.7% at December 31, 2007.

	2)		Due to our collection activities, gross loans decreased between periods by approximately $16.7 million. This decrease in overall loan balances reduced the need for additional provision in the third quarter.

	3)		On a portfolio basis, non-performing loans increased to $119.1 million at September 30, 2008 from $101.4 million at June 30, 2008. Reserve levels related to these loans were previously established at appropriate levels. As loans migrated from “criticized and classified” to “non-performing,” the specific reserve calculation resulted in no additional provision being required.

The level of the allowance for loan losses at September 30, 2008 represents management’s best estimate of probable losses inherent in the loan portfolio based on all relevant information available at this time. Management’s loan maturity distribution analysis, combined with the continued scrutiny of our loan collateral coverage as tested by our loan collection history, may necessitate future adjustments to our allowance for loan losses.

Note 4 — Deposits

Deposit account balances are summarized as follows:


	September 30,		December 31,
	2008		2007
Non-interest-bearing	$	19,408,961	$	24,711,246
Interest-bearing demand		6,874,985		12,350,558
Money market accounts		52,621,989		79,218,421
Savings deposits		9,470,368		10,338,768
Certificates of deposit exceeding $100,000		110,522,858		149,198,911
Certificates of deposit less than $100,000		151,603,308		145,626,941

	$	350,502,469	$	421,444,845

Scheduled maturities of certificates are as follows for the years ending as of September 30:


2008	$	59,102,074
2009		165,662,310
2010		18,389,103
2011		6,376,025
2012		12,421,584
2013		175,070

	$	262,126,166

Note 5 — Advances and Junior Subordinated Debentures Payable

The Bank is a member of the FHLB of Seattle. Our credit line with FHLB has been placed on hold until FHLB completes its credit analysis of the Bank and will probably be collateral dependent. These borrowings must be secured by pledging qualified loans. Borrowings generally provide for interest at the then current published rates. There were no borrowings outstanding under this credit line at September 30, 2008.

In order to manage the capital position more efficiently, the Company formed the Trust, a Delaware statutory trust formed with capital of $248,000, for the sole purpose of issuing trust preferred securities. During the third quarter of 2005, the Trust issued 8,000 Capital Securities, or the trust preferred securities, with liquidation value of $1,000 per security, for gross proceeds of $8.0 million. The entire proceeds of the issuance were invested by the Trust in $8.248 million of Junior Subordinated Deferrable Interest Debentures, or the junior subordinated debentures payable, issued by the Company, with identical maturity, repricing and payment terms as the trust preferred securities. The subordinated debentures represent the sole assets of the Trust. The subordinated debentures mature on September 15, 2035, and bear an interest rate at September 30, 2008 of 4.54% (based on 3-month LIBOR plus 1.73%), with repricing occurring and interest payments due quarterly. The Company injected $7.9 million of the net proceeds from the sale of the subordinated debentures into the Bank and retained the remaining proceeds.

The subordinated debentures are redeemable by the Company, subject to receipt of prior approval from the Federal Reserve Bank of San Francisco, on any March 15, June 15, September 15 or December 15 on or after September 15, 2010.

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

The redemption price is par plus accrued and unpaid interest, except in the case of redemption under a special event which is defined in the debenture occurring prior to September 15, 2010. The trust preferred securities are subject to mandatory redemption to the extent of any early redemption of the subordinated debentures and upon maturity of the subordinated debentures on September 15, 2035.

Holders of the trust preferred securities are entitled to a cumulative cash distribution on the liquidation amount of $1,000 per security at an interest rate at September 30, 2008 of 4.54%. For each successive period beginning on March 15 of each year, the rate will be adjusted to equal the 3-month LIBOR plus 1.73%. The Trust has the option to defer payment of the distributions for a period of up to five years, as long as we are not in default on the payment of interest on the subordinated debentures. The Company has guaranteed, on a subordinated basis, distributions and other payments due on the trust preferred securities. For financial reporting purposes, the Trust is accounted for under the equity method and is included in other assets on the accompanying consolidated statement of financial condition. The subordinated debentures issued and guaranteed by the Company and held by the Trust are reflected on the consolidated statement of financial condition in accordance with provisions of Interpretation No. 46 issued by the Financial Accounting Standards Board, or FASB, No. 46, Consolidation of Variable Interest Entities. Under applicable regulatory guidelines, all of the trust preferred securities currently qualify as Tier 1 capital, although this classification may be subject to future change.

On February 25, 2008, May 1, 2008, August 4, 2008 and November 3, 2008, the Company elected to defer payment of interest on the Junior Subordinated Debt Securities for the interest payments due March 15, 2008, June 15, 2008, September 15, 2008 and December 15, 2008, respectively, as allowed under the indenture agreement. This election was the result of the notification by the Federal Reserve Bank of San Francisco, or FRB that the Company and the Bank had been designated to be in a “troubled condition” for purposes of Section 914 of the Financial Institutions Reform, Recovery and Enforcement Act of 1989. As a result of that designation, the Company is generally prohibited from making any payments to any entity, including dividends and interest payments (including dividends on its trust preferred securities, and interest at the holding company level) without notifying the FRB for prior approval of such payments.

Note 6 — 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, 2008 we had a reserve balance of $35,000 for allowance for unfunded credit losses and $465,000 at December 31, 2007.

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


	September 30, 2008
	Amount of Commitment Expiration Per Period
	Total
	Amounts		Less Than						After 5
	Committed		1 Year		1-3 Years		3-5 Years		Years
	(In thousands)
Commitments to extend credit	$	11,197	$	8,962	$	2,235	$	—	$	—
Credit cards		2,220		—		2,220		—		—
Standby letters of credit		204		204		—		—		—

Total	$	13,621	$	9,166	$	4,455	$	—	$	—

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.

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

Contingent Liabilities for Sold Loans. In the ordinary course of business, the Bank may sell 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 did not repurchase any loans in third quarter 2008, but repurchased one real estate loan in the second quarter 2008 in the amount of $95,554 and repurchased two real estate loans totaling $715,590 in the first quarter of 2008 for a total of three loans totaling $811,144 repurchased in 2008.

Note 7 — Stockholder’s Equity and Regulatory Matters

The Company (on a consolidated basis) and the Bank are subject to various regulatory capital requirements administered by the Federal banking agencies. Failure to meet the minimum regulatory capital requirements can initiate certain mandatory and possible additional discretionary actions by regulators that if undertaken, could have a direct material effect on the Company’s and Bank’s financial statements. Under the regulatory capital adequacy guidelines and regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines involving quantitative measures of their assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification under the prompt corrective action guidelines are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Prompt corrective action provisions are not applicable to bank holding companies.

Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios of total risk-based capital and Tier 1 capital to risk-weighted assets (as defined in the regulations), and Tier 1 capital to adjusted total assets (as defined). To be categorized as well capitalized, an institution must maintain minimum total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios as disclosed in the table below.

The Company’s and the Bank’s actual and required capital amounts and ratios are as follows (dollars in thousands):


											To Be Well Capitalized
											Under the Prompt
						For Capital Adequacy					Corrective Action
	Actual					Purposes					Provisions
	Amount		Ratio			Amount		Ratio			Amount		Ratio
As of September 30, 2008
Total Risk-Based Capital (to Risk-Weighted Assets)
Consolidated	$	48,293		14.4	%	$	26,755		> 8.0	%	NA		NA
Westsound Bank	$	48,180		14.4	%	$	26,748		> 8.0	%	$	33,435		> 10.0	%

Tier 1 Capital (to Risk-Weighted Assets)
Consolidated	$	43,863		13.1	%	$	13,373		> 4.0	%	NA		NA
Westsound Bank	$	43,750		13.1	%	$	13,369		> 4.0	%	$	20,053		> 6.0	%

Tier 1 Capital (to Average Assets)
Consolidated	$	43,863		10.6	%	$	16,505		> 4.0	%	NA		NA
Westsound Bank	$	43,750		10.6	%	$	16,494		> 4.0	%	$	20,617		> 5.0	%

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


											To Be Well Capitalized
											Under the Prompt
						For Capital Adequacy					Corrective Action
	Actual					Purposes					Provisions
	Amount		Ratio			Amount		Ratio			Amount		Ratio
As of December 31, 2007
Total Risk-Based Capital (to Risk-Weighted Assets)
Consolidated	$	70,364		16.7	%	$	33,809		> 8.0	%	NA		NA
Westsound Bank	$	68,761		16.3	%	$	33,810		> 8.0	%	$	42,262		> 10.0	%

Tier 1 Capital (to Risk-Weighted Assets)
Consolidated	$	64,900		15.4	%	$	16,901		> 4.0	%	NA		NA
Westsound Bank	$	63,297		15.0	%	$	16,902		> 4.0	%	$	25,353		> 6.0	%

Tier 1 Capital (to Average Assets)
Consolidated	$	64,900		13.9	%	$	18,649		> 4.0	%	NA		NA
Westsound Bank	$	63,297		13.6	%	$	18,589		> 4.0	%	$	23,237		> 5.0	%

Although the ratios presented above show that the Company and the Bank were “well capitalized” at September 30, 2008 and December 31, 2007 based on their financial statements prepared in accordance with generally accepted accounting principles in the United States and the general percentages in regulatory guidelines, the Company and the Bank understand that they are no longer regarded as “well capitalized” for federal regulatory purposes, as a result of the deficiencies cited in the FDIC order. (See Note 2.) There are no conditions or events since the FDIC order that management believes have changed the Bank’s category.

The Company and Westsound Bank believe they remain adequately-capitalized under regulatory guidelines, as of September 30, 2008, following the additional provisions for loan losses, and management believes that the Company has sufficient capital resources and liquidity to be able to continue its normal business operations.

Federal Reserve Board Regulations require maintenance of certain minimum reserve balances on deposit with the Federal Reserve Bank. The minimum reserve requirement at September 30, 2008 and December 31, 2007 was $480,000 and $594,000, respectively. Also, under Washington State law, approval from the state banking regulators is required prior to declaring cash dividends.

Note 8 — Restrictions on Dividends, Loans and Advances

Federal and state banking regulations place certain restrictions on dividends paid and loans or advances made by the Bank to the holding company. The total amount of dividends which may be paid at any date is generally limited to the retained earnings of the Bank, and loans or advances are limited to 10 percent of the Bank’s capital stock and surplus on a secured basis.

The Bank had no retained earnings available for the payment of dividends September 30, 2008 and $3,444,000 at December 31, 2007. Accordingly, $43,807,000 of the Company’s equity in the net assets of the Bank was restricted at September 30, 2008 and $59,921,000 at December 31, 2007. Funds available for loans or advances by the Bank to the holding company amounted to $5,985,000 at September 30, 2008, and December 31, 2007.

In addition, dividends paid by the Bank to the holding company would be prohibited if the effect thereof would cause the Bank’s capital to be reduced below applicable minimum capital requirements.

See Note 2 for further restrictions.

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

Note 9 — 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, 2008:


						Weighted
				Weighted		Average
				Average		Remaining
				Exercise Price		Contractual		Aggregate
	Options			Per Share		Term (in years)		Intrinsic Value
Outstanding as of December 31, 2007		887,080		$	7.99
Authorized		—			—
Granted		100,000			6.13
Exercised		—			—
Forfeited		(165,552	)		8.28

Outstanding as of September 30, 2008		821,528		$	7.71		5.66	$	0


Exercisable as of September 30, 2008		668,849		$	7.55		4.95	$	0

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.

There were no stock options exercised during the nine months ended September 30, 2008.

The Company granted 100,000 in options during the nine months ended September 30, 2008. There was $272,000 in unrecognized compensation cost related to stock options issued in 2008 and 2007 as of September 30, 2008 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 $39,000 and $20,000 for the nine months ending September 30, 2008 and 2007 respectively.

Note 10 — Income Taxes

We account for income taxes in accordance with SFAS 109 “Accounting for Income Taxes” which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements which differ from our tax returns.

The determination of our provision of income taxes and valuation allowances require significant judgment, the use of estimates and the interpretation of complex tax laws. The Bank believes, based upon available information, that the some or all of the net deferred tax asset may not be realized in the normal course of operations and we are required to establish a valuation allowance against that portion of deferred tax assets.

During the third quarter of 2008 we increased our deferred tax asset by $1.5 million and offset it by a $1.5 million increase to our valuation allowance. In the second quarter of 2008, we recognized a full valuation allowance against our net deferred tax asset in the amount of approximately $6.5 million after experiencing losses in our operations. Our cumulative losses in operations over the last four quarters offset prior gains due to the increase in our provision for loan losses and the reversal of interest on non-accruing loans.

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

The Company adopted the provisions of FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes , on January 1, 2007. The Company had not recognized tax benefits which would require an adjustment to the January 1, 2007 beginning balance of retained earnings. The Company had no unrecognized tax benefits at January 1, 2007, December 31, 2007 or at September 30, 2008.

The Company recognizes accrued interest and penalties related to unrecognized tax benefits in tax expense. During the years ended December 31, 2007 and 2006 the Company recognized no interest and penalties.

The Company and its subsidiary file consolidated income tax returns in the U.S. Federal income jurisdiction. With few exceptions, the Company is no longer subject to U.S. Federal or state/local income tax examinations by tax authorities for years before 2004.

Note 11 — Loan Concentrations

As of September 30, 2008, in management’s judgment, a concentration of loans existed in real estate-related loans. At that date, real estate-related loans comprised 86.9% of total loans, of which approximately 53.2%, 19.2% and 14.5% were construction and land development, commercial real estate and residential real estate, respectively.

Additionally, as of September 30, 2008, 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, 2008, interest-only loans comprised 53.0% of total loans, of which approximately 86.8% were construction and land development, 8.0% were residential, 1.7% were commercial real estate, 3.5% were commercial and industrial, and 0.1% were consumer. As of December 31, 2007, interest only loans comprised 64.4% of total loans.

The Bank also had a high concentration of loans with loans to value in excess of supervisory limits. The total commitment (principal balance plus available credit) on these loans was $80,825,000 at September 30, 2008 and $64,755,000 at December 31, 2007.

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.

Note 12 — Pending Litigation

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. As is typical in these cases, all the actions have been consolidated into a single action, In RE: WSB Financial Group Securities Litigation, Master File No. CO7-1747 RAJ.

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

On October 14, 2008 the Company reported it has entered into a settlement agreement with the lead plaintiff in the pending securities class action. The class action settlement is subject to the approval of the United States District Court for the Western District of Washington.

The settlement agreement provides for the certification of a class consisting of all persons who purchased the Company’s common stock pursuant or traceable to its initial public offering completed on December 21, 2006. The total amount of the settlement is $4.85 million. The Company’s directors’ and officers’ liability insurance policy will contribute approximately $4.45 million towards the settlement amount and has previously contributed approximately $350,000 towards the Company’s legal fees. The settlement agreement contains no admission of fault or wrongdoing by the Company or the other defendants. Third quarter expenses include approximately $800,000 in legal costs associated with the settlement of the securities class action lawsuit.

As of November 3, 2008, the Company had commenced foreclosure proceedings on approximately 199 real estate loans. Some or all of these loans may result in actual foreclosures. The Company is unable to predict the outcome of these matters. The Company’s cash expenditures, including legal fees, associated with pending litigation and the regulatory proceedings described in Note 2 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.

Note 13 — Fair Value Measurements

On January 1, 2008 the Company adopted SFAS No. 157, “Fair Market Measurements” (SFAS 157). SFAS 157 establishes a framework for measuring the fair value of assets and liabilities using a hierarchy system consisting of three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are:

	Level 1 — Valuation based on quoted prices in active markets for identical assets or liabilities.

	Level 2 — Valuation based on quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar instruments in markets that are not active and model-based valuation techniques for which significant assumptions are observable in the market.

	Level 3 — Valuation generated from unobservable inputs that are supported by little or no market activity. Valuation techniques include use of pricing models, cash flow methodologies or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment of estimation.

The following table summarizes the financial assets of the Company for which fair values are determined on a recurring basis as of September 30, 2008:


			Fair value measurements using
			Quoted Prices in
			Active Markets		Significant Other		Significant
			for Identical		Observable		Unobservable
	Fair Value at		Assets		Inputs		Inputs
	9/30/2008		(Level 1)		(Level 2)		(Level 3)
Description	(In thousands)
Securities available for sale	$	16,166	$	0	$	16,166	$	0

Total	$	16,166	$	0	$	16,166	$	0

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

The following table summarizes the financial assets of the Company for which fair values are determined on a nonrecurring basis as of September 30, 2008:


			Fair value measurements using
			Quoted Prices
			in Active		Significant Other		Significant		Total Losses
			Markets for		Observable		Unobservable		Nine Months
	Fair Value at		Identical Assets		Inputs		Inputs		Ended
	9/30/2008		(Level 1)		(Level 2)		(Level 3)		9/30/2008
Description	(In thousands)
Impaired loans	$	50	$	0	$	0	$	101,850	$	12,870
Other real estate owned		10,984		0		0		10,984		352

Total	$	112,834	$	0	$	0	$	112,834	$	13,222

The following is a description of the valuation methodologies used to measure and disclose fair value of financial assets and liabilities:

Securities available for sale: Securities are recorded at fair value on a recurring basis. Fair value is based on quoted market prices, if available. If quoted market prices are not available, the fair market value is based on a matrix pricing model provided by an outside independent source.

Impaired loans: We do not record impaired loans at fair value on a recurring basis. However from time to time, nonrecurring fair value adjustments to collateral dependent loans are recorded to reflect partial write-downs based on observable market price or current appraised value of collateral.

Other real estate owned (OREO): We do not record other real estate owned at fair value on a recurring basis. All OREO properties are recorded by us at amounts which are equal to or less than the fair market value of the properties based on current independent appraisals reduced by estimated selling costs upon transfer of the loans to OREO. From time to time nonrecurring fair value adjustments to other real estate owed is recorded to reflect partial write downs based on observable market price or current appraised value of collateral.

(Remainder of page intentionally blank)

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

Notice About Forward-Looking Statements

This quarterly report on Form 10-Q includes forward-looking statements. These statements may be identified by the use of forward-looking terminology such as “anticipate,” “believe,” “continue,” “could,” “estimate,” “expect,” “intend,” “may,” “might,” “plan,” “potential,” “predict,” “should” or “will” or the negative thereof or other variations thereon or comparable terminology. We have based these forward-looking statements on our current expectations, assumptions, estimates and projections. While we believe these expectations, assumptions, estimates and projections are reasonable, such forward-looking statements are only predictions and involve known and unknown risks and uncertainties, many of which are beyond our control. These and other important factors, including those discussed in this report under the headings “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Business” may cause our actual results, performance or achievements to differ materially from any future results, performance or achievements expressed or implied by these forward-looking statements. Some of the key factors that could cause actual results to differ from our expectations are:

	•		changes in general economic conditions, either nationally or locally in the west Puget Sound and Seattle Metropolitan Statistical Area;

	•		the extent and duration of continued economic, credit and financial market disruptions and governmental actions to address these disruptions;

	•		inflation, interest rate, market and monetary fluctuations;

	•		legislative or regulatory changes or changes in accounting principles, policies or guidelines;

	•		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 our construction and land development loans;

	•		the availability of and costs associated with sources of liquidity;

	•		changes in real estate values generally, within the markets in 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 FDIC order;

	•		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.

Given these risks and uncertainties, you are cautioned not to place undue reliance on such forward-looking statements. The forward-looking statements included or incorporated by reference into this report are made only as of the date hereof. We do not undertake and specifically decline any obligation to update any such statements or to publicly announce the results of any revisions to any such statements to reflect future events or developments.

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. As of September 30, 2008 we have, on a consolidated basis, $397.1 million in total assets, net loans of $298.1 million, total deposits of $350.5 million, and stockholders’ equity of $35.7 million.

At September 30, 2008, gross loans decreased 24% year-over year to $323 million from $427 million at September 30, 2007, and decreased 22% from $413 million at December 31, 2007. Deposits declined 12% to $351 million at September 30, 2008, from $400 million a year ago, with a substantial decline in money market accounts and time deposits over $100,000 offset by growth in time deposits under $100,000. However, with the significant challenges continuing in our real estate loan portfolio, particularly our construction and development loans, and the pending regulatory matters, our financial performance in the first nine months of 2008 suffered, and we will continue to face these issues in future periods. See “—Recent Developments.” The Company’s levels of non-performing loans, impaired loans, non-accrual loans and OREO property increased significantly in the quarter ended September 30, 2008. The weakness in the local housing market is expected to continue in the near term, and the situation could deteriorate further before the market stabilizes.

We generate most of our revenue from interest on loans and investments, loan fees, and service charges. As of September 30, 2008, 80.8% of our revenue was interest on loans, 5.5% loan fees, 3.4% service charges and other non-interest income, and 10.3% 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, 2008, approximately 86.9% of our loans related to the construction or development, purchase, improvement or refinancing of commercial and residential real estate, approximately 12.1% were C&I loans and 1.0% were consumer loans. Approximately 76.1% of our revenue is derived from real estate, of which approximately 17.8% is derived from residential real estate. Including our originations of residential real estate loans, approximately 97.5% of our actual lending activities are related to real estate. Of this amount, 31.1% is residential real estate, 42.0% is construction and land development and 26.9% 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. We purchased $15.0 million in lease receivables during the third quarter of 2008, adding to our commercial loans.

We are experiencing significant difficulties in our loan portfolio, particularly our construction and land development loans, which have resulted in an $11.2 million increase in our provision for loan losses in the first nine months of 2008. These matters are discussed below in “—Recent Developments.” The adverse changes 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 53.0% of our loans are interest-only (primarily real estate construction and development) and 44.0% are variable rate, significant increases in interest rates could also result in increased loan delinquencies, defaults and foreclosures.

Nonperforming assets (NPA’s) at September 30, 2008 totaled $130.0 million which includes $119.0 million of loans on non-accrual status and $11.0 million in other real estate owned, or OREO. The allowance for loan losses was $24.5 million, or 7.60% of gross loans at September 30, 2008. During the first nine months of 2008, net charge-offs totaled $6.2 million, or 1.78% of average loans at September 30, 2008. Of the non-accrual loans, 41% were in Kitsap County, 30% were in King County, 19% were in Pierce County, and the remaining 10% were in other parts of western Washington.

The increase in non-accrual loans also impacted net interest income, as $6.0 million in interest income was reversed in the first nine months of 2008. In addition, we are maintaining a high level of liquidity using higher cost wholesale funding sources and have more than half of our deposits in time certificates. As we collect our

construction loans and development loans, we expect to be able to deleverage the balance sheet over the next few quarters. As we do this our yields and cost of funds should gradually return to more normal levels.

These factors, combined with the significant reduction in fee income from new loan originations, contributed to significant margin compression in the first nine months of 2008. Net interest margin in the third quarter dropped to 0.75% from 0.80% in the second quarter of 2008 and 4.83% in the third quarter a year ago. Year-to-date net interest margin was 1.23% compared to 4.98% a year ago. Net interest income, before the loan loss provision, was $0.6 million in the third quarter, compared to $5.5 million in the same quarter last year, and $3.5 million for the first nine months of 2008 compared to $15.7 for the same period of 2007. The third quarter net interest income was $0.6 million compared to a loss of $7.9 million the same period a year ago. Net interest income after loan losses for the first nine months was negative $7.7 million compared to $1.5 million for the same period in 2007.

Primarily because of closing our wholesale mortgage operation last fall, the Company’s noninterest income declined to $591,000 in the first nine months of 2008, compared to $3.6 million in the same period a year ago. The decline was offset somewhat by the drop in noninterest expense, which fell to $12.7 million in the period from $13.0 million in the first nine months of 2007.

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 decreased in the first nine months of 2008 as a result of the Federal Reserve’s monetary policies. Our net interest margin decreased to 1.23% compared to 4.98% for the same period 2007 due to the increase in non-accruing loans. In addition, a substantial percentage of our loan portfolio (44.0% of our total loans as of September 30, 2008) has been comprised of variable rate loans that reprice as interest rates change. The Federal Reserve reduced interest rates from 5.25% in September 2007 to 2.00% by September 30, 2008. 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.


	Key Financial Matters
	Three Months Ended						Nine Months Ended						Year Ended
	September 30,						September 30,						December 31,
	2008			2007			2008			2007			2007
	(Dollars in thousands, except per share data)
Net loss	$	(4,298	)	$	(7,752	)	$	(21,077	)	$	(5,240	)	$	(5,200	)
Basic loss per share		(0.77	)		(1.39	)		(3.78	)		(0.94	)		(0.93	)
Diluted loss per share (1)		(0.77	)		(1.39	)		(3.78	)		(0.94	)		(0.93	)
Total assets		397,071			468,049			397,071			468,049			489,333
Net loans		298,130			407,821			298,130			407,821			393,436
Total deposits		350,502			399,810			350,502			399,810			421,445
Net interest margin		0.75	%		4.83	%		1.23	%		4.98	%		4.62	%
Efficiency ratio		662.9	%		73.4	%		307.1	%		67.3	%		67.6	%
Return on average assets		(4.14	)%		(6.62	)%		(6.04	)%		(1.61	)%		(1.17	)%
Return on average equity		(44.6	)%		(47.1	)%		(58.3	)%		(11.0	)%		(8.4	)%


(1)		Excludes all stock options as anti-dilutive in periods with net losses.

Recent Developments.

Construction and Development Loans. We continue to work through the issues with the construction loans in Westsound Bank’s loan portfolio. The Bank has scaled back its construction loan originations in the past few months and is concentrating on working with its borrowers to complete existing projects in a timely manner and to bring past-due loans current.

During the first nine months of 2008, however, non-accrual loans increased significantly, from $24.9 million to $119.1 million, primarily as a result of maturing construction and land development loans that we are choosing not to renew in order to keep all of our legal remedy options available. After 90 days past due, these loans are placed into a non-accrual status while we work with our borrowers to maximize our recovery. Therefore, the contraction or expansion of our non-accrual loan portfolio in future periods will depend upon our ongoing collection efforts and market conditions. In the third quarter we added 28 properties with an aggregate carrying value of $7,203,000 to OREO. OREO properties are actively marketed for sale with one property sold during the third quarter, two properties sold during the second quarter and one in the first quarter 2008. These properties had a carrying value of $983,000 and we received $903,932 resulting in a net loss on the sales of $79,478.

The real estate collateral valuations supporting our construction and land development loan portfolios have decreased along with the deterioration in the local housing market. While the overall economy in the west Puget Sound market is holding up better than in many other areas of the country, the housing market is slow, with weaker demand for housing, higher inventory levels, longer marketing times and lower sales prices.

Our cash expenditures, including legal and accounting fees, associated with the collection of non- performing and classified loans 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, 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 Company and its subsidiary, Westsound Bank, are subject to the pending regulatory proceedings described below.

FDIC Order: On March 10, 2008, Westsound Bank (the “Bank”) entered into a Stipulation and Consent to the Issuance of an Order to Cease and Desist (the “FDIC order”) with the Federal Deposit Insurance Corporation, or FDIC, and the Washington Department of Financial Institutions, Division of Banks, or DFI. Although Westsound Bank agreed to the order, it did not admit or deny any allegations of unsafe or unsound banking practices, or any legal or regulatory violations. The order is a formal action by the FDIC and DFI requiring the Bank to take corrective measures in a number of areas. No monetary penalties were assessed in connection with the order.

Sale of Premises and Equipment. The Bank sold surplus property which was originally purchased for potential branch expansion in Shelton, Washington for $468,000 in September 2008 for a net loss of $10,000 after closing costs.

In recent months, Westsound Bank announced the construction of a new, permanent branch office in Poulsbo, and the relocation of its branch office in Silverdale. The new Silverdale branch is now located at 3035 NW Bucklin Hill Road and will offer improved parking and drive-up service.

The new branch office in Poulsbo will be constructed next to the existing office at 21895 Viking Way, at the corner of Highway 305. Westsound Bank opened the full service Poulsbo branch location in February of 2006. The new office will further enhance the service afforded to its Poulsbo clientele. The new building is scheduled to open for business in the summer of 2009.

Capital: Although the Company and the Bank were “well capitalized” at September 30, 2008 based on their financial statements prepared in accordance with generally accepted accounting principles in the United States and the general percentages in the regulatory guidelines, we understand that the Company and the Bank are no longer regarded as ‘well capitalized’ for federal regulatory purposes, as a result of the deficiencies cited in the FDIC order.

Our cash expenditures, including legal and accounting fees, associated with the regulatory proceedings and the pending litigation (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.

Deposits. As of September 30, 2008 and December 31, 2007, we had $79.5 million and $117.4 million, respectively, of deposits from wholesale sources, including brokered deposits and internet certificates of deposit. See Note 4 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 core deposits. As described above (see “—Capital Resources”), as a result of the FDIC order the Bank is subject to regulatory limitations with respect to its wholesale sourcing of deposits.

Under the Federal Deposit Insurance Corporation Improvement Act, or FDICIA, banks may be restricted in their ability to accept brokered deposits, depending on their capital classification. “Well-capitalized” banks are permitted to accept brokered deposits, but all banks that are not well-capitalized are not permitted to accept such deposits. The FDIC may, on a case-by-case basis, permit banks that are adequately capitalized to accept brokered deposits if the FDIC determines that acceptance of such deposits would not constitute an unsafe or unsound banking practice with respect to the bank. As of September 30, 2008 and December 31, 2007, we had $28.1 million and $65.0 million, respectively, of brokered deposits. As a result of the FDIC order described above in “—Recent Developments,” the Bank is subject to limitations with respect to its brokered deposits. The FDIC order prohibits Westsound Bank from increasing the amount of broker deposits above the amount outstanding on the effective date of the FDIC order, or soliciting, retaining or rolling over broker deposits except as approved by FDIC.

We believe the Company and Westsound Bank remain adequately capitalized under regulatory guidelines, as of September 30, 2008, following the provisions 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 stockholders is measured in the form of return on average equity, or ROE. We had a net loss of $4.3 million for the three months ended September 30, 2008 compared to a net loss of $7.8 million for the three months ended September 30, 2007. The primary reason for the reduced loss in third quarter 2008 compared to the same period a year ago, was because we did not have to increase our provision for loan losses this quarter. Basic earnings (loss) per share, or EPS, decreased to $(0.77) for the three months ended September 30, 2008 compared to earnings (loss) per share of $(1.39) for the three months ended September 30, 2007. Similarly, diluted EPS decreased to $(0.77) for the three months ended September 30, 2008 compared to per share of $(1.39) for the three months ended September 30, 2007. Our ROE decreased to (44.6)% for the three months ended September 30, 2008 compared to (47.1)% for the three months ended September 30, 2007.

We had a net loss of $21.1 for the nine months ended September 30, 2008 compared to a net loss of $5.2 million for the nine months ended September 30, 2007. Net income decreased due to increases in non-accrual loans, additions to the provision to loan losses and the valuation allowance for the deferred tax asset. Basic earnings (loss) per share, or EPS, decreased to $(3.78) for the nine months ended September 30, 2008 compared to $(0.94) for the nine months ended September 30, 2007. Diluted EPS decreased to $(3.78) for the nine months ended September 30, 2008 compared to $(0.94) for the nine months ended September 30, 2007. Our ROE decreased to (58.3)% for the nine months ended September 30, 2008 compared to (11.0)% for the nine months ended September 30, 2007.

Return on Average Assets. Our return on average assets, or ROA, for the three months ended September 30, 2008 was (4.14)% compared to (6.62)% for the three months ended September 30, 2007.

Our return on average assets, or ROA, for the nine months ended September 30, 2008 was (6.04)% compared to (1.61)% for the nine months ended September 30, 2007.

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 $119,067,000 in non-performing loans as of September 30, 2008 compared to $25,322,000 at December 31, 2007. Non-performing loans as a percentage of total loans were 36.85% as of September 30, 2008 compared to 6.12% at December 31, 2007. For the three months ended September 30, 2008 net charge-offs to average loans were 1.15%, as compared to 0.00% for the same period in 2007, and 1.78% for the nine months ended September 30, 2008 compared to 0.08% for the same period in 2007.

Asset Growth. 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 decreased 18.9% during the first nine months of 2008 from $489.3 million as of December 31, 2007 to $397.1 million as of September 30, 2008. Total deposits decreased 16.8% to $350.5 million as of September 30, 2008 compared to $421.4 million as of December 31, 2007. Net loans decreased 24.2% to $298.1 million as of September 30, 2008 compared to $393.4 million as of December 31, 2007.

Capital and Liquidity. Maintaining adequate capital levels has been one of our primary areas of focus. Our average equity to assets decreased to 9.3% at September 30, 2008, as a result of our net loss, compared to average equity to assets at June 30, 2008 of 10.3% and 14.1% for the three month period ending September 30, 2007. Average equity to average assets for the nine month period ending September 30, 2008 was 10.4% compared to 14.7% for the same period last year. 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, 2008 the net loan to deposit ratio had decreased to 85.1%, down from 93.4% at December 31, 2007.

Net Interest Margin. Our net interest margin decreased to 0.75% for the third quarter of 2008 compared to 4.83% for third quarter of 2007, primarily as a result of the increase in non-accruing loans. Our net interest margin for the nine months ended September 30, 2008 was 1.23% compared to 4.98% for the nine months ended September 30, 2007. Our net interest margin for the year ended December 31, 2007 was 4.62%

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 to 662.9% for the third quarter of 2008 compared to 73.4% for third quarter of 2007, as a result of decreases in net interest income and the increased non-interest expense associated with the review and collection of loans. Our efficiency ratio increased to 307.1% for the first nine months of 2008 compared to 67.3% for the first nine months of 2007. Our efficiency ratio for the year ended December 31, 2007 was 67.6%.

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 quarterly and monitor 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, 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, 2008 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 values are extrapolated from the quoted prices of similar investments. 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.

The determination of our provision of income taxes and valuation allowances require significant judgment, the use of estimates and the interpretation of complex tax laws. The Bank believes, based upon available information, that the some or all of the net deferred tax asset may not be realized in the normal course of operations and we are required to establish valuation allowances against that portion of deferred tax assets.

Stock Options. Prior to 2006, we elected to follow Accounting Principles Board Option No. 25, Accounting for Stock Issued to Employees, or APB 25, and related interpretations in accounting for employee stock options using the fair value method, and provided the required pro forma disclosures of SFAS No. 123, or SFAS 123, “Accounting for Stock-Based Compensation.” Under APB 25, because the exercise price of the options equals the estimated market price of the stock on the issuance date, no compensation expense is recorded. As required, on January 1, 2006 we adopted SFAS No. 123R, or SFAS 123R, Share-Based Payment (Revised 2004) 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 eliminates the ability to account for stock-based compensation using APB 25 and requires that such 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.

We have granted nonqualified and qualified stock options under our Stock Option Plan prior to 2006. We granted 24,000 shares in options in 2007 and 100,000 shares in the first nine months of 2008. 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, 2008 and 2007


	Three Months Ended									Nine Months Ended
	September 30,						Increase			September 30,						Increase
	2008			2007			(Decrease)			2008			2007			(Decrease)
	(Dollars in thousands, except per share data)
Consolidated Statement of Earnings Data:
Interest income	$	4,226		$	10,142		$	(5,916	)	$	16,558		$	28,498		$	(11,940	)
Interest expense		3,657			4,666			(1,009	)		13,006			12,807			199

Net interest income		569			5,476			(4,907	)		3,552			15,691			(12,139	)
Provision for loan losses		—			13,362			(13,362	)		11,235			14,179			(2,944	)

Net interest income (expense) after provision for loan losses		569			(7,886	)		8,455			(7,683	)		1,512			(9,195	)
Non-interest income		194			1,025			(831	)		591			3,601			(3,010	)
Non-interest expense		5,061			4,768			293			12,724			12,977			(253	)

Income (loss) before provision (benefit)for income taxes		(4,298	)		(11,629	)		7,331			(19,816	)		(7,864	)		(11,952	)


	Three Months Ended								Nine Months Ended
	September 30,						Increase		September 30,						Increase
	2008			2007			(Decrease)		2008			2007			(Decrease)
	(Dollars in thousands, except per share data)
Provision (benefit) for income taxes		—			(3,877	)		3,877		1,261			(2,624	)		3,885

Net income (loss)	$	(4,298	)	$	(7,752	)	$	3,454	$	(21,077	)	$	(5,240	)	$	(15,837	)

Earnings (loss) per share — basic	$	(0.77	)	$	(1.39	)	$	0.62	$	(3.78	)	$	(0.94	)	$	(2.84	)

Earnings (loss) per share — diluted	$	(0.77	)	$	(1.39	)	$	0.62	$	(3.78	)	$	(0.94	)	$	(2.84	)

The Company reported a net loss of $4.3 million or $0.77 loss per diluted share for the quarter ended September 30, 2008 as compared to a net loss of $7.8 million or $1.39 diluted earnings per share for the quarter ended September 30, 2007. The decrease in the loss is attributable to no addition to provision for loan losses during the quarter ended September 30, 2008, compared to a $13.4 provision during the quarter ended September 30, 2007. Our return on average equity was (44.6)% and our return on average assets was (4.14)% for the three months ended September 30, 2008, compared to (47.1)% and (6.62)%, respectively for the three months ended September 30, 2007.

We also reported a net loss of $21.1 million for the nine months ended September 30, 2008 compared to a net loss of $5.2 million for the nine months ended September 30, 2007. This earnings decline is attributed to the decrease in net interest income, increase in the provision for loan losses and provision for income taxes due to the valuation allowance for deferred taxes. Our return on average equity was (58.3)% and our return on average assets was (6.04)% for the nine months ended September 30, 2008 compared to (11.0)% and (1.61)%, respectively for the nine months ended September 30, 2007.

Net Interest Income and Net Interest Margin. The $4.9 million or 89.6% decrease in net interest income for the three month period ended September 30, 2008 was due to a decrease in interest income of $5.9 million, reflecting the effect of a $148.9 million decrease in average interest-earning assets, offset by a decrease in interest expense of $1.0 million. Average interest-earning assets for the nine month period ending September 30, 2008 decreased $35.1 million with interest income decreasing $11.9 million and interest expense increasing slightly by $199,000. Average interest earning assets excluded average non-accrual loans at September 30, 2008 and included $660,000 at September 30, 2007 for the nine month periods.

The average yield on our interest-earning assets was 5.60% for the three months ended September 30, 2008 period compared to 8.95% for the same period of 2007, a decrease of 3.35%. The decrease in average yield on loans was due to the increase in non-accruing loans and interest reversals. 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, and reversal of non-accrual interest. The average yield on our interest earning assets was 5.73% for the nine months ended September 30, 2008 compared to 9.04% for the same period in 2007, a 3.31% decrease.

The cost of our average interest-bearing liabilities decreased to 4.15% for the three months ended September 30, 2008 from 5.05% for the same period of 2007. In addition to broad decreases in the average rates paid by Westsound Bank on deposit balances, the decrease was the result of the change in the mix of deposits toward time deposits. Our average rate on our interest-bearing deposits decreased 0.86% to 4.14% during the three months ended September 30, 2008 from 5.00% for the same period of 2007, reflecting the lowering of deposit rates. Our average rate on interest-bearing deposits for the nine months ended September 30, 2008 was 4.40% compared to 4.97% at September 30, 2007, a decrease of 0.57%. Our average rate on total deposits (including non-interest bearing deposits) decreased to 4.16% for the nine months ended September 30, 2008 from 4.57% for the year ended December 31, 2007.

The 408 basis point decrease in our net interest margin, which decreased to 0.75% for the three months ended September 30, 2008 from 4.83% for the three months ended September 30, 2007, was due to the decrease in earning assets yield. Our net interest margin decreased 375 basis points to 1.23% for the nine months ended September 30, 2008 from 4.98% for the nine months ended September 30, 2007.

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.


	Three Months Ended September 30,
	2008								2007
						Average								Average
						Yield								Yield
	Average					or			Average					or
	Balance			Interest		Cost(6)			Balance			Interest		Cost(6)
	(Dollars in thousands)
Assets
Interest-earning assets:
Loans(1)(2)(3)	$	218,701		$	3,754		6.83	%	$	424,407		$	9,826		9.19	%
Investment securities — taxable		15,942			146		3.64	%		6,760			88		5.16	%
Investment securities — non-taxable(3)		1,387			14		4.02	%		1,814			18		3.94	%
Federal funds sold		56,281			268		1.98	%		13,285			171		5.11	%
Other investments(4)		8,088			44		2.16	%		3,077			39		5.03	%

Total interest-earning assets		300,399			4,226		5.60	%		449,343			10,142		8.95	%
Non-earning assets:
Cash and due from banks		4,569								5,999
Unearned loan fees		(429	)							(1,472	)
Allowance for loan losses		(26,993	)							(4,640	)
Other assets(1)		135,118								15,372

Total assets	$	412,664							$	464,602


Liabilities and Stockholders’ Equity
Interest-bearing liabilities:
Deposits
Interest-bearing demand	$	6,439		$	14		0.86	%	$	7,504		$	19		1.00	%
Money market		61,093			362		2.36	%		104,655			1,201		4.55	%
Savings		10,216			51		1.99	%		9,089			89		3.88	%
Time certificates of deposit		264,639			3,140		4.72	%		237,197			3,205		5.36	%

Total interest-bearing deposits		342,387			3,567		4.14	%		358,445			4,514		5.00	%
Short-term borrowings		0			0		0.00	%		11			0		0.00	%
Junior subordinated debt		8,248			90		4.34	%		8,248			152		7.31	%

Total interest-bearing liabilities		350,635			3,657		4.15	%		366,704			4,666		5.05	%
Non-interest-bearing liabilities
Demand deposits		21,102								29,634
Other liabilities		2,572								2,945

Total liabilities		374,309								399,283
Stockholders’ equity		38,355								65,319

Total liabilities and stockholders’ equity	$	412,664							$	464,602

Net interest income				$	569							$	5,476

Net interest spread(5)							1.45	%							3.91	%
Net interest margin							0.75	%							4.83	%


(1)		Average non-accrual loans are included with other non-earning assets.

(2)		Loan fees of $182,000 and $1.3 million are included in the yield computations for September 30, 2008 and 2007, respectively.

(3)		Yields on loans and securities have not been adjusted to a tax-equivalent basis.

(4)		Includes interest-bearing deposits with correspondent banks.

(5)		Net interest spread represents the average yield earned on interest earning assets less the average rate paid on interest bearing liabilities.

(6)		Annualized.


	Nine Months Ended September 30,
	2008								2007
						Average								Average
						Yield								Yield
	Average					or			Average					or
	Balance			Interest		Cost(6)			Balance			Interest		Cost(6)
	(Dollars in thousands)
Assets
Interest-earning assets:
Loans(1)(2)(3)	$	289,351		$	14,800		6.83	%	$	394,448		$	27,493		9.32	%
Investment securities — taxable		10,791			330		4.08	%		6,491			232		4.78	%
Investment securities — non-taxable(3)		1,625			32		2.63	%		1,816			56		4.12	%
Federal funds sold		78,628			1,291		2.19	%		15,001			584		5.21	%
Other investments(4)		5,827			105		2.41	%		3,518			133		5.05	%

Total interest-earning assets		386,222			16,558		5.73	%		421,274			28,498		9.04	%
Non-earning assets:
Cash and due from banks		5,067								5,525
Unearned loan fees		(588	)							(1,171	)
Allowance for loan losses		(24,084	)							(4,394	)
Other assets(1)		99,345								14,193

Total assets	$	465,962							$	435,427


Liabilities and Stockholders’ Equity
Interest-bearing liabilities:
Deposits
Interest-bearing demand	$	7,038		$	42		0.80	%	$	7,742		$	59		1.02	%
Money market		68,158			1,514		2.97	%		104,174			3,551		4.56	%
Savings		11,195			211		2.52	%		6,971			200		3.84	%
Time certificates of deposit		297,862			10,879		4.88	%		213,259			8,548		5.36	%

Total interest-bearing deposits		384,253			12,646		4.40	%		332,146			12,358		4.97	%
Short-term borrowings		0			0		0.00	%		32			1		4.18	%
Junior subordinated debt		8,248			360		5.83	%		8,248			448		7.26	%

Total interest-bearing liabilities		392,501			13,006		4.43	%		340,426			12,807		5.03	%
Non-interest-bearing liabilities
Demand deposits		22,260								28,720
Other liabilities		2,874								2,483

Total liabilities		417,635								371,629
Stockholders’ equity		48,327								63,798

Total liabilities and stockholders’ equity	$	465,962							$	435,427

Net interest income				$	3,552							$	15,691

Net interest spread(5)							1.30	%							4.01	%
Net interest margin							1.23	%							4.98	%


(1)		Average non-accrual loans are included with other non-earning assets

(2)		Loan fees of $951,000 and $3.8 million are included in the yield computations for September 30, 2008 and 2007, respectively.

(3)		Yields on loans and securities have not been adjusted to a tax-equivalent basis.

(4)		Includes interest-bearing deposits with correspondent banks.

(5)		Net interest spread represents the average yield earned on interest earning assets less the average rate paid on interest bearing liabilities.

(6)		Annualized.

The following table shows the change in interest income and interest expense and the amount of change attributable to variances in volume, rates and the combination of volume and rates based on the relative changes of volume and rates.


	Three Months Ended September 30, 2008												Nine Months Ended September 30, 2008
	Compared to Three Months												Compared to Nine Months
	Ended September 30, 2007												Ended September 30, 2007
	Net												Net
	Change			Rate			Volume			Mix			Change			Rate			Volume			Mix
	(In thousands)
Loans	$	(6,072	)	$	(10,002	)	$	(18,895	)	$	22,825		$	(12,693	)	$	(9,808	)	$	(9,794	)	$	6,909
Investment securities — taxable		58			(103	)		474			(313	)		98			(45	)		205			(62	)
Investment securities — non-taxable		(4	)		2			(17	)		11			(24	)		(27	)		(8	)		11
Federal funds sold		97			(427	)		2,196			(1,672	)		707			(452	)		3,312			(2,153	)
Other investments		5			(88	)		252			(159	)		(28	)		(93	)		117			(52	)

Total interest income		(5,916	)		(10,618	)		(15,990	)		20,692			(11,940	)		(10,425	)		(6,168	)		4,653
Interest expense:
Interest-bearing demand		(5	)		(10	)		(11	)		16			(17	)		(17	)		(7	)		7
Money market		(839	)		(2,298	)		(1,983	)		3,442			(2,037	)		(1,657	)		(1,641	)		1,261
Savings		(38	)		(173	)		44			91			11			(92	)		162			(59	)
Time certificates of deposit		(65	)		(1,519	)		1,471			(17	)		2,331			(1,024	)		4,534			(1,179	)
Short-term borrowings		0			0			0			0			(1	)		(1	)		(2	)		2
Junior subordinated debt		(62	)		(245	)		0			183			(88	)		(118	)		0			30

Total interest expense		(1,009	)		(4,245	)		(479	)		3,715			199			(2,909	)		3,046			62

Net interest income	$	(4,907	)	$	(6,373	)	$	(15,511	)	$	16,977		$	(12,139	)	$	(7,516	)	$	(9,214	)	$	4,591

Provision for Loan Losses. The provision for loan losses in each period is a charge against earnings in that period. The provision is that amount required to maintain the allowance for loan losses at a level that, in management’s judgment, is adequate to absorb probable loan losses inherent in the loan portfolio.

There was no additional provision for loan losses for the three months ended September 30, 2008 compared to $13.4 million for the three months ended September 30, 2007.

No provision for loan losses was recorded for the three months ended September 30, 2008. Several factors supported this decision:

	1)		At September 30, 2008, the allowance for loan losses was $24.5 million, or 7.6% of total loans as compared to $28.1 million or 8.3% at June 30, 2008 and $19.5 million or 4.7% at December 31, 2007.

	2)		Due to our collection activities, gross loans decreased between periods by approximately $16.7 million. This decrease in overall loan balances reduced the need for additional provision in the third quarter.

	3)		On a portfolio basis, non-performing loans increased to $119.1 million at September 30, 2008 from $101.4 million at June 30, 2008. Reserve levels related to these loans were previously established at appropriate levels. As loans migrated from “criticized and classified” to “non-performing,” the specific reserve calculation resulted in no additional provision being required.

The provision for loan losses for the nine months ended September 30, 2008 was $11.2 million compared to $14.2 million for the nine months ended September 30, 2007. Total net loans decreased by $95.3 million for the first nine months of 2008 compared to an increase of $66.3 million for the same period of 2007. We experienced $6.2 million of net loan charge-offs in the first nine months 2008 compared to $299,000 of net loan charge-offs in the same period of 2007.

For non-performing loans and any other loan where the borrower defaults on their loan agreement, Westsound Bank intends to pursue any or all remedies available pursuant to the loan documents and applicable federal and state laws, including foreclosure and pursuit of deficiencies.

Non-Interest Income. The following table presents, for the periods indicated, the major categories of non-interest income:


	Three Months Ended							Nine Months Ended
	September 30,							September 30,
					Increase							Increase
	2008		2007		(Decrease)			2008		2007		(Decrease)
	(In thousands)
Service charges and other income	$	194	$	288	$	(94	)	$	591	$	999	$	(408	)
Net gain/(loss) on sale of loans		0		737		(737	)		0		2,602		(2,602	)

Total non-interest income	$	194	$	1,025	$	(831	)	$	591	$	3,601	$	(3,010	)

The $831,000 or 81.0% decrease in total non-interest income during the three months ended September 30, 2008 was primarily influenced by the decrease in net gain on sale of loans and other loan fee income. Non-interest income for the nine months ended September 30, 2008 decreased $3.0 million or 83.6% from the same period of 2007.

Non-Interest Expense. The following tables present, for the periods indicated, the major categories of non-interest expense, which represent a re-classification of certain categories as presented in our consolidated financial statements and related notes appearing elsewhere in this report:


	Three Months								Nine Months
	Ended September 30,								Ended September 30,
						Increase								Increase
	2008			2007		(Decrease)			2008			2007		(Decrease)
	(In thousands)
Salaries, wages and employee benefits	$	1,533		$	2,510	$	(977	)	$	4,770		$	7,753	$	(2,983	)
Occupancy, equipment and depreciation		433			436		(3	)		1,315			1,314		1
Data and item processing		175			167		8			545			490		55
Advertising expense		62			59		3			142			155		(13	)
Printing, stationery and supplies		37			38		(1	)		124			143		(19	)
Telephone expense		22			26		(4	)		65			83		(18	)
Postage and courier		31			43		(12	)		102			125		(23	)
Legal fees		872			34		838			1,491			143		1,348
Director fees		(4	)		70		(74	)		186			193		(7	)
Business and occupation taxes		37			83		(46	)		146			240		(94	)
Accounting and audit fees		122			37		85			444			123		321
Consultant fees		157			41		116			615			91		524
OREO expense, net		413			170		243			584			207		377
Provision (benefit) for unfunded credit losses		(44	)		548		(592	)		(430	)		561		(991	)
Other		1,215			506		709			2,625			1,356		1,269

Total non-interest expense	$	5,061		$	4,768	$	293		$	12,724		$	12,977	$	(253	)

The $293,000 or 6.1% increase in non-interest expense for the three months ended September 30, 2008 is primarily attributable to the increase in OREO expenses, legal, consultant, accounting and audit fees, net of the decrease in salary, occupancy, other costs associated with downsizing of our mortgage division and the decrease in allowance for unfunded credit losses. Non-interest expense decreased $253,000 or 2.0% for the nine months ending September 30, 2008 from the same period of 2007. We reversed $430,000 for credit losses for the nine month period due to the decrease in undisbursed commitments. These commitments were either funded or the loans were paid off or the loans matured.

Provision (Benefit) for Income Taxes. We did not recorded a tax provision in the three months ended September 30, 2008 compared to a tax benefit of $3.9 million for the same period in the prior year. The tax provision for the nine months ending September 30, 2008 was $1.3 million compared to a tax benefit of $2.6 million for the same period in the prior year.

Our deferred tax asset was $8.0 million at September 30, 2008 and offset by the deferred tax valuation allowance of $8.0 million that was established in the second quarter 2008 for a net deferred tax balance of $0. The deferred tax asset may be used as a benefit against future earnings.

Financial Condition

Our total assets at September 30, 2008 and December 31, 2007 were $397.1 million and $489.3 million, respectively. Our average earning assets for the nine months ended September 30, 2008 and the fiscal year ended December 31, 2007 were $386.2 million and $430.7 million, respectively. Total deposits at September 30, 2008 and December 31, 2007 were $350.5 million and $421.4 million, respectively.

Loans

Our net loans at September 30, 2008 and December 31, 2007 were $298.1 million and $393.4 million, respectively, a decrease of 24.2%. While we will continue to focus on our real estate lending portfolio, we intend to diversify our lending portfolio in future periods including more C&I loans. With the problems recently identified in our loan portfolio though 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 loan portfolio can be expected to continue to decline in the near term.

The following table shows the amounts (dollars in thousands) of loans outstanding at the end of each of the periods indicated.


	At September 30, 2008					At December 31, 2007					$ Increase			% Increase
	Amount		Percent			Amount		Percent			(Decrease)			(Decrease)
Real estate loans:
Construction & land development	$	171,918		53.2	%	$	253,188		61.2	%	$	(81,270	)		(32.1	)%
Commercial real estate		61,931		19.2	%		72,435		17.5	%		(10,504	)		(14.5	)%
Residential real estate		46,863		14.5	%		53,198		12.9	%		(6,335	)		(11.9	)%
Commercial & industrial loans		39,285		12.2	%		31,377		7.6	%		7,908			25.2	%
Consumer loans		3,075		0.9	%		3,719		0.9	%		(644	)		(17.3	)%

Gross loans		323,072		100.0	%		413,917		100.0	%		(90,845	)		(21.9	)%
Allowance for loan losses		24,536					19,514					5,022			25.7	%
Deferred loan fees, net		406					967					(561	)		(58.0	)%

Net loans	$	298,130				$	393,436				$	(95,306	)		(24.2	)%

Concentrations. As of September 30, 2008, in management’s judgment, a concentration of loans existed in real estate-related loans. At that date, real estate-related loans comprised 86.9% of total loans. At December 31, 2007, real estate-related loans comprised 91.5% of total loans, of which approximately 66.8%, 19.1% and 14.1% were construction and land development, commercial real estate and residential real estate, respectively.

Additionally, as of September 30, 2008, in management’s judgment, a concentration of loans existed in interest-only loans, primarily construction and development loans secured by real estate. At that date, interest-only loans comprised 53.0% of total loans, of which approximately 86.7% were construction and land development, 8.0% were residential, 1.7% were commercial real estate, 3.5% were commercial and industrial, and 0.1% were consumer. As of December 31, 2007, interest only loans comprised 64.4% of total loans.

A continued decline in the performance of the economy, in general, or a further 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 our 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.

Non-Performing Assets (NPA’s). Generally, loans are placed on non-accrual status when they become 90 days or more past due or at such earlier time as management determines timely recognition of interest to be in doubt. Accrual of interest is discontinued on a loan when management believes, after considering economic and business conditions and collection efforts that the borrower’s financial condition is such that collection of interest is doubtful. The following table summarizes the loans for which the accrual of interest has been discontinued and loans more

than 90 days past due and still accruing interest, including those loans that have been restructured, and other real estate owned, which we refer to as OREO:


	September 30,			December 31,
	2008			2007
	(Dollars in thousands)
Non-accrual loans	$	119,067		$	24,923
Accruing loans past due 90 days or more		—			399

Total non-performing loans (NPLs)		119,067			25,322
Other real estate owned		10,984			983

Total non-performing assets (NPAs)	$	130,051		$	26,305

Selected ratios
NPLs to total loans		36.85	%		6.12	%
NPAs to total assets		32.75	%		5.38	%

Our levels of non-performing loans and OREO property increased significantly in the quarter ended September 30, 2008, primarily as a result of continued deterioration in the local housing market and the issues identified with respect to certain residential construction loans. See “Recent Developments” above.

The following table provides a break-down (dollars in thousands) by location of the Company’s loan portfolio at September 30, 2008:


	Total		Kitsap		% of			King		% of			Pierce		% of			Other		% of
	Loans		County		Loans			County		Loans			County		Loans			Counties		Loans
Real estate loans:
Spec construction	$	48,609	$	19,134		6	%	$	10,684		3	%	$	10,776		3	%	$	8,015		2	%
Custom construction		80,180		17,568		5	%		41,154		13	%		14,201		4	%		7,257		2	%

Total construction		128,789		36,702		11	%		51,838		16	%		24,977		8	%		15,272		5	%
Vacant land & land development		43,129		22,677		7	%		4,239		1	%		5,428		2	%		10,785		3	%
1-4 family mortgage		34,866		17,493		5	%		2,716		1	%		6,418		2	%		8,239		3	%
Multifamily mortgage		11,997		4,964		2	%		—		0	%		2,955		1	%		4,078		1	%
Commercial real estate		61,931		43,538		13	%		2,905		1	%		3,339		1	%		12,149		4	%
Commercial & industrial loans		39,285		20,319		6	%		14,741		5	%		2,483		1	%		1,742		1	%
Consumer loans		3,075		2,864		1	%		20		0	%		23		0	%		168		0	%

Gross loans	$	323,072	$	148,557		46	%	$	76,459		24	%	$	45,623		14	%	$	52,433		16	%

The following table provides a break-down (dollars in thousands) by non-accrual status of the Company’s loan portfolio at September 30, 2008:


								% of Non-
	Loans		% of Loans			Non-Accruals		Accruals
Real estate loans:
Spec construction	$	48,609		15	%	$	29,608		24.9	%
Custom construction		80,180		25	%		45,667		38.4	%

Total construction		128,789		40	%		75,275		63.2	%
Vacant land & land development		43,129		13	%		16,597		13.9	%
1-4 family mortgage		34,866		11	%		9,546		8.0	%
Multifamily mortgage		11,997		4	%		2,783		2.3	%
Commercial real estate		61,931		19	%		2,710		2.3	%
Commercial & industrial loans		39,285		12	%		11,860		10.0	%
Consumer loans		3,075		1	%		296		0.2	%

Gross loans	$	323,072		100	%		119,067		100.0	%

OREO Properties. At September 30, 2008 we had $11.0 million in OREO property and $1.0 million at December 31, 2007.

All OREO properties are recorded by us at amounts which are equal to or less than the fair market value of the properties based on current independent appraisals reduced by estimated selling costs.

Impaired Loans. ”Impaired loans” are loans for which it is probable that we will not be able to collect all amounts due according to the original contractual terms of the loan agreement. The category of “impaired loans” is not coextensive with the category of “non-accrual loans”, although the two categories overlap. Non-accrual loans include impaired loans, which are not reviewed on a collective basis for impairment, and are those loans on which the accrual of interest is discontinued when collectibility of principal and interest is uncertain or payments of principal or interest have become contractually past due 90 days. Management may choose to place a loan on non-accrual status due to payment delinquency or uncertain collectibility, while not classifying the loan as impaired if it is probable that we will collect all amounts due in accordance with the original contractual terms of the loan or the loan is not a commercial, commercial real estate or an individually significant mortgage or consumer loan.

In determining whether or not a loan is impaired, we apply our normal loan review procedures on a case-by-case basis taking into consideration the circumstances surrounding the loan and borrower, including the collateral value, the reasons for the delay, the borrower’s prior payment record, the amount of the shortfall in relation to the principal and interest owed and the length of the delay. We measure impairment on a loan-by-loan basis using either the present value of expected future cash flows discounted at the loan’s effective interest rate or at the fair value of the collateral if the loan is collateral dependent, less estimated selling costs. Loans for which an insignificant shortfall in amount of payments is anticipated, but where we expect to collect all amounts due, are not considered impaired. The following table summarizes our impaired loans.


	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2008		2007		2008		2007
Impaired Loans
Balance at end of period (1)	$	119,071,139	$	22,884,467	$	119,071,139	$	22,884,467

Total related allowance for losses	$	17,220,675	$	4,237,285	$	17,220,675	$	4,237,285

Average investment in impaired loans	$	65,237,712	$	6,168,483	$	39,415,027	$	2,467,393

Interest income recognized on impaired loans	$	68,966	$	447,252	$	522,587	$	870,703

Cash-basis interest income received on impaired loans	$	68,966	$	300,465	$	484,512	$	771,433


(1)		Includes $119.1 million non-accrual loans at September 30, 2008 and $1.1 million at September 30, 2007.

As of September 30, 2008 and December 31, 2007, our unfunded commitments totaled $13,621,000 and $81,610,000 respectively.

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 did not repurchase any loans in the third quarter of 2008, but repurchased three loans totaling $811,144 during the first two quarters of 2008.

Allowance for Loan Losses

We maintain an adequate allowance for loan losses, or ALLL, based on a comprehensive methodology that assesses the probable losses inherent in the loan portfolio. 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 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.

There was no additional provision for loan losses for the three months ended September 30, 2008. Management performed a loan risk identification process during the first half of 2008 that resulted in a significant increase in the loan loss allowance in these periods. This included downgrading loans prior to non-performing and obtaining updated real estate valuations in conjunction with impairment analysis.

In the third quarter of 2008 the provisioning to the allowance on the loans identified in prior periods is still adequate. The Bank’s actual charge offs against the loan loss reserves have performed closely to our expectations. Loan pay offs and transfers to OREO have decreased loan assets. We anticipate future charges offs against the allowance to be close to the current reserves for these identified loans.

Future additional provisions to the loan loss reserves may be made as appropriate as new loans are identified or as existing loan may deteriorate. See Note 3 to the Company’s unaudited consolidated financial statements for more information on the Company’s loans and allowance for loan losses.

Specific Allocations. All classified loans are carefully evaluated for loss portions or potential loss exposure. The evaluation occurs at the time the loan is classified and on a regular basis thereafter (at least quarterly). This evaluation is documented in a problem asset status report relating to a specific loan or relationship. Specific allocation of reserves considers the value of the collateral, the financial condition of the borrower, and industry and current economic trends. We review the collateral value, cash flow, and tertiary support on each classified credit. Any deficiency outlined by a real estate collateral evaluation liquidation analysis, or cash flow shortfall is accounted for through a specific allocation reserve calculation for the loan.

General Allowances. We perform a portfolio segmentation based on risk grading. Credits are rated into different categories (Grades 1-7), with a percentage of the portfolio, based on grade, allocated to the allowance. The loss factors for each risk grade are determined by management based on management’s overall assessment of the overall credit quality at month end taking into account various quantitative and qualitative factors such as trends of past due and non-accrual loans, asset classifications, loan grades, collateral value, historical loss experience and economic conditions. The first three grades, grade three of which is divided into four subcategories, are considered satisfactory or “Pass”, except 3-d for “Watch” loans requiring special monitoring. The other four grades range from a “Special Mention” category to a “Loss” category. For a discussion of these four grades, see “Business — Credit Policies” in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission for the fiscal year ended December 31, 2007.

The following table sets forth the activity in our allowance for loan losses for the periods indicated:


	As of and For The						As of and For The
	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2008			2007			2008			2007
	(Dollars in thousands)
Allowance for loan losses:
Beginning balance	$	28,140		$	4,492		$	19,514		$	3,972
Loans charged off
Real estate loans:
Construction		3,414			12			5,512			69
Commercial real estate		—			—			—			109
Residential real estate		155			—			663			47
Commercial & industrial loans		—			—			—			62
Consumer loans		55			3			62			12

Total		3,624			15			6,237			299
Recoveries:
Real estate loans:
Construction		20			—			20			—
Commercial real estate		—			—			—			—
Residential real estate		—			—			—			—
Commercial & industrial loans		—			—			—			—
Consumer loans		—			—			4			—

Total		20			0			24			0
Net loan charge-off (recovery)		3,604			15			6,213			299
Reclassification of unfunded credit commitments to other liabilities		—			13			—			—
Provision for loan losses		—			13,362			11,235			14,179

Ending balance	$	24,536		$	17,852		$	24,536		$	17,852

Loans	$	322,666		$	427,012		$	322,666		$	427,012
Average loans		329,848			424,407			365,452			394,448
Non-performing loans		119,067			2,677			119,067			2,677
Selected ratios:
Net charge-offs to average loans		1.15	%		0.00	%		1.78	%		0.08	%
Provision for loan losses to average loans		0.00	%		3.15	%		3.07	%		3.59	%
Allowance for loan losses to loans outstanding at end of period		7.60	%		4.18	%		7.60	%		4.18	%
Allowance for loan losses to non-performing loans		20.6	%		666.9	%		20.6	%		666.9	%

Our construction portfolio reflects some borrower concentration risk, and also carries the enhanced risks encountered with construction loans generally. We also finance 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. For these reasons, a higher allocation is justified in this loan category.

Our commercial real estate loans are a mixture of new and seasoned properties, retail, office, warehouse, and some industrial properties. Loans on properties are generally underwritten at a loan to value ratio of less than 80% with a minimum debt coverage ratio of 1.2 times. Our grading system allows our loan portfolio, including real estate, to be ranked across three “pass” risk grades. Generally, the real estate loan portfolio is risk rated “3 — Pass”, except a number of the residential construction loans which have been downgraded to 3-d, Watch, 4-Special Mention, 5-Substandard or for several loans, 6-Doubtful”. The risk rated reserve factor increases with each grade increase, and the general real estate portfolio grade of “3” is more reflective of the various risks inherent in the real estate portfolio, such as large size and complexity of individual credits, and overall concentration of credit risk. Accordingly, a greater allowance allocation is provided on commercial real estate loans.

The principal sources of guidance on accounting for allowances in a loan portfolio under GAAP are SFAS 5 and SFAS 114. In addition guidance given in SFAS 118 and Staff Accounting Bulletin No. 102 will be utilized and implemented as applicable.

Because there are additional risks of losses that cannot be quantified precisely or attributed to particular loans or types of loans, including general economic, other conditions and trends, we have established a portion of the allowance for loan losses based on our evaluation of these risks. This portion of our allowance is determined based on various factors including, but not limited to, general economic conditions of our market area, the growth, composition and diversification of our loan portfolio, the experience level of our lending officers and staff, and the quality of our credit risk management. As of September 30, 2008, this risk portion of the allowance for loan losses was $419,000 or 1.7% of the total allowance, compared with $381,000 or 2.0% of the total allowance as of December 31, 2007. The decrease in this risk portion of the allowance in the first nine month period of 2008 was due to the reassessment of loans and reclassifying them to specific allocations.

Investments

The carrying value of our investment securities totaled $16.2 million at September 30, 2008 and $8.8 million at December 31, 2007. Our portfolio of investment securities during 2008 and 2007 consisted primarily of federal and state government securities.

The carrying values of our portfolio of investment securities at September 30, 2008 and December 31, 2007 were as follows:


	Carrying Value at
	September 30,		December 31,		$ Increase			% Increase
	2008		2007		(Decrease)			(Decrease)
	(In thousands)
U.S. government agencies	$	14,744	$	6,980	$	7,764			111.2	%
Obligations of states and political subdivisions		1,389		1,813		(424	)		(23.4	)%
Mortgage-backed securities		33		39		(6	)		(15.4	)%

Total investment securities	$	16,166	$	8,832	$	7,334			83.0	%

Deposits

Total deposits were $350.5 million at September 30, 2008 compared to $421.4 million at December 31, 2007. The 16.8% decrease in total deposits is attributed primarily to the decrease in money market and certificates of deposit exceeding $100,000. Non-interest-bearing demand deposits decreased to $19.4 million or 5.5% of total deposits from $24.7 million, or 5.9% of total deposits, at December 31, 2007. Interest-bearing deposits are comprised of interest-bearing demand, money market accounts, regular savings accounts, time deposits of under $100,000 and time deposits of $100,000 or more.

The following table shows the average amount and average rate paid on the categories of deposits for each of the periods indicated:


	Nine Months Ended					Year Ended
	September 30, 2008					December 31, 2007
	Average		Average			Average		Average
	Balance		Rate			Balance		Rate
	(Dollars in thousands)
Interest-bearing demand	$	7,038		0.80	%	$	7,542		1.02	%
Money market		68,158		2.97	%		99,941		4.49	%
Savings		11,195		2.52	%		7,802		3.78	%
Time certificates of deposit		297,862		4.88	%		226,050		5.33	%
Non-interest bearing deposits		22,260		0.00	%		28,426		0.00	%

Total	$	406,513		4.16	%	$	369,761		4.57	%

Deposits are gathered from individuals, partnerships and corporations in our market areas. Our policy also permits the acceptance of brokered deposits subject to regulatory approval. The interest rates paid are competitively priced for each particular deposit product and structured to meet our funding requirements. We will continue to manage interest expense through deposit pricing. The 41 basis point decrease in interest rates paid during the nine months ended September 30, 2008 is reflective of the decrease in offering rates.

Stockholders’ Equity

Initial Public Offering. We priced our initial public offering of 2,300,000 shares of our common stock at $16.50 per share. We received net proceeds of approximately $40.2 million from our sale of shares after deducting sales commissions and expenses. The underwriter of the Company’s initial public offering exercised and completed its option to purchase an additional 345,000 shares of common stock to cover over-allotments effective Tuesday, December 19, 2006.

September 30, 2008 Overview. As of September 30, 2008, our stockholders’ equity totaled $35.7 million, and our equity to asset ratio was 9.0%, compared to 11.6% as of December 31, 2007. This decrease is primarily the result of the net loss for the period that resulted from the additions to the allowance for loan losses, the reversal of the tax benefit and the increase in legal fees from the class action settlement.

2007 Overview. As of December 31, 2007, our stockholders’ equity totaled $56.7 million, and our equity to asset ratio was 11.6%, compared to 15.9% as of December 31, 2006. This decrease is primarily the results of our net loss for the period that resulted from the additions to the allowance for loan losses.

Capital Resources

Current risk-based regulatory capital standards generally require banks and bank holding companies to maintain a minimum ratio of “core” or “Tier I” capital (consisting principally of common equity) to risk-weighted assets of at least 4%, a ratio of Tier I capital to adjusted total assets (leverage ratio) of at least 4% and a ratio of total capital (which includes Tier I capital plus certain forms of subordinated debt, a portion of the allowance for loan losses and preferred stock) to risk-weighted assets of at least 8%. Risk-weighted assets are calculated by multiplying the balance in each category of assets by a risk factor, which ranges from zero for cash assets and certain government obligations to 100% for some types of loans, and adding the products together.


	Regulatory Requirements
	(Greater than or equal to						Actual at September 30, 2008
	stated percentage)									WSB Financial
	Adequately Capitalized			Well Capitalized			Westsound Bank			Group, Inc.
Tier 1 leverage capital ratio		4.0	%		5.0	%		10.6	%		10.6	%
Tier 1 risk-based capital		4.0	%		6.0	%		13.1	%		13.1	%
Total risk-based capital		8.0	%		10.0	%		14.4	%		14.4	%


	Regulatory Requirements
	(Greater than or equal to						Actual at December 31, 2007
	stated percentage)									WSB Financial
	Adequately Capitalized			Well Capitalized			Westsound Bank			Group, Inc.
Tier 1 leverage capital ratio		4.0	%		5.0	%		13.6	%		13.9	%
Tier 1 risk-based capital		4.0	%		6.0	%		15.0	%		15.4	%
Total risk-based capital		8.0	%		10.0	%		16.3	%		16.7	%

Although the ratios presented above show that the Company and the Bank were “well capitalized” at September 30, 2008 and December 31, 2007 based on their financial statements prepared in accordance with generally accepted accounting principles in the United States and the general percentages in regulatory guidelines, the Company and the Bank are no longer regarded as “well capitalized” for federal regulatory purposes, as a result of the deficiencies cited in the FDIC order. See Note 2. There are no conditions or events since the FDIC order that management believes have changed the Bank’s category.

In order to manage our capital position more efficiently, we formed WSB Financial Group Trust I, a Delaware statutory trust formed with capital of $248,000, for the sole purpose of issuing trust preferred securities. During the third quarter of 2005, WSB Financial Group Trust I issued 8,000 Capital Securities, or the trust preferred securities, with liquidation value of $1,000 per security, for gross proceeds of $8.0 million. The entire proceeds of the issuance were invested by WSB Financial Group Trust I in $8.248 million of Junior Subordinated Deferrable Interest Debentures, or the subordinated debentures, issued by Westsound Bank, with identical maturity, repricing and payment terms as the trust preferred securities. The subordinated debentures represent the sole assets of WSB Financial Group Trust I. The subordinated debentures mature on September 15, 2035, and bear an interest rate at September 30, 2008 of 4.54% (based on 3-month LIBOR plus 1.73%), with repricing occurring and interest payments due quarterly. We injected $7.9 million of the net proceeds from the sale of the subordinated debentures into Westsound Bank and retained the remaining proceeds for the needs of WSB Financial Group, Inc.

The subordinated debentures are redeemable by us, subject to our receipt of prior approval from the Federal Reserve Bank of San Francisco, on any March 15, June 15, September 15 or December 15 on or after September 15, 2010.

Holders of the trust preferred securities are entitled to a cumulative cash distribution on the liquidation amount of $1,000 per security at an interest rate at September 30, 2008 of 4.54%. For each successive period beginning on March 15 of each year, the rate will be adjusted to equal the 3-month LIBOR plus 1.73%. WSB Financial Group Trust I has the option to defer payment of the distributions for a period of up to five years, as long as we are not in default on the payment of interest on the subordinated debentures. We have guaranteed, on a subordinated basis, distributions and other payments due on the trust preferred securities. For financial reporting purposes, our investment in the trust is accounted for under the equity method and is included in other assets on the accompanying consolidated balance sheet. The subordinated debentures issued and guaranteed by us and held by the trust are reflected on our consolidated balance sheet in accordance with provisions of Interpretation No. 46 issued by the Financial Accounting Standards Board, or FASB, No. 46, Consolidation of Variable Interest Entities. Under applicable regulatory guidelines, all of the trust preferred securities currently qualify as Tier 1 capital, although this classification may be subject to future change.

On February 25, 2008, May 1, 2008, August 4, 2008 and November 3, 2008 the Company elected to defer payment of interest on the Junior Subordinated Debt Securities for the interest payment due March 15, 2008, June 15, 2008, September 15, 2008 and December 15, 2008, respectively, as permitted by the indenture agreement. This election was the result of the notification by the Federal Reserve Bank of San Francisco, or FRB that the Company and the Bank had been designated to be in a “troubled condition” for purposes of Section 914 of the Financial Institutions Reform, Recovery and Enforcement Act of 1989. As a result of that designation, the Company is generally prohibited from making any payments to any entity, including dividends and interest payments (including dividends on its trust preferred securities, and interest at the hold company level) without notifying the FRB for prior approval of such payments.

The Company may incur liabilities under certain contractual agreements contingent upon the occurrence of certain events. A discussion of these contractual arrangements under which the Company may be held liable is included above under “—Financial Condition – Loans, Contingent Liabilities for Sold Loans.”

Liquidity

The ability to have readily available funds sufficient to repay fully maturing liabilities is of primary importance to depositors, creditors and regulators. Our liquidity, represented by cash and due from banks, federal funds sold and available-for-sale securities, is a result of its operating, investing and financing activities and related cash flows. In order to ensure funds are available at all times, we devote resources to projecting on a monthly basis the amount of funds that will be required and maintain relationships with a diversified customer base so funds are accessible. Liquidity requirements can also be met through short-term borrowings or the disposition of short-term assets. Our borrowing line with FHLB has been placed on hold until FHLB completes its credit analysis of the Bank

and will probably be collateral dependent. As of September 30, 2008 we had $14.8 million in securities available to be sold or pledged to the FHLB.

We have a formal liquidity policy, and in the opinion of management, our liquid assets are considered adequate to meet our cash flow needs for loan funding and deposit cash withdrawal for the next 60 to 90 days. At September 30, 2008, we had approximately $70.6 million in liquid assets comprised of $55.8 million in cash and cash equivalents (including fed funds sold of $43.8 million), and $14.8 million in available-for-sale securities.

On a long term basis, our liquidity will be met by changing the relative distribution of our asset portfolios, i.e., reducing investment or loan volumes, or selling or encumbering assets. Further, we will increase our liquidity by soliciting higher levels of deposit accounts through promotional activities and/or borrowing from our correspondent banks as well as Federal Home Loan Bank. At the current time, our long-term liquidity needs primarily relate to funds required to support loan originations and commitments and deposit withdrawals. All of these needs can currently be met by cash flows from investment payments and maturities, and investment sales if the need arises. Our liquidity is comprised of three primary classifications: cash flows from or used in operating activities; cash flows from or used in investing activities; and cash flows provided by or used in financing activities.

Net cash provided by or used in operating activities has consisted primarily of net income adjusted for certain non-cash income and expense items such as the loan loss provision, investment and other amortization and depreciation.

Our primary investing activities are the origination of real estate, commercial and consumer loans and purchase and sale of securities. We also invest in Federal Funds sold which decreased by $13.1 million at September 30, 2008 from December 31, 2007. Our net loans decreased for the nine months ended September 30, 2008 by $95.3 million. Investment securities increased to $16.2 million at September 30, 2008 from $8.8 million at December 31, 2007. At September 30, 2008 we had outstanding loan commitments of $13.4 million and outstanding letters of credit of $204,000. We anticipate that we will have sufficient funds available to meet current loan commitments.

Net cash provided by financing activities has been impacted significantly by decreases in deposit levels. During the nine months ended September 30, 2008, deposits decreased by $70.9 million. During the year ended December 31, 2006, net proceeds from our initial public offering provided an additional $40.2 million cash.

Recent Accounting Pronouncements

See Note 1 of the Consolidated Financial Statements for a discussion of recently issued or proposed accounting pronouncements.

ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Market risk is the risk of loss in a financial instrument arising from adverse changes in market prices and rates, foreign currency exchange rates, commodity prices and equity prices. Our market risk arises primarily from interest rate risk inherent in our lending and deposit taking activities. To that end, management actively monitors and manages our interest rate risk exposure. We do not have any market risk sensitive instruments entered into for trading purposes. We manage our interest rate sensitivity by matching the re-pricing opportunities on our earning assets to those on our funding liabilities.

Management uses various asset/liability strategies to manage the re-pricing characteristics of our assets and liabilities designed to ensure that exposure to interest rate fluctuations is limited within our guidelines of acceptable levels of risk-taking. Hedging strategies, including the terms and pricing of loans and deposits, and managing the deployment of our securities, are used to reduce mismatches in interest rate re-pricing opportunities of portfolio assets and their funding sources.

Interest rate risk is addressed by our Asset Liability Management Committee, or the ALCO, which is comprised of the chief executive officer, chief financial officer and chief risk officer. The ALCO monitors interest rate risk by analyzing the potential impact on the net portfolio of equity value and net interest income from potential changes in interest rates, and considers the impact of alternative strategies or changes in balance sheet structure. The ALCO manages our balance sheet in part to maintain the potential impact on net portfolio value and net interest income within acceptable ranges despite changes in interest rates.

Our exposure to interest rate risk is reviewed on at least a quarterly basis by the ALCO and our Board of Directors. Interest rate risk exposure is measured using interest rate sensitivity analysis to determine our change in net portfolio value in the event of hypothetical changes in interest rates. If potential changes to net portfolio value and net interest income resulting from hypothetical interest rate changes are not within the limits established by our Board of Directors, the Board of Directors may direct management to adjust the asset and liability mix to bring interest rate risk within board-approved limits.

Market Value of Portfolio Equity. We measure the impact of market interest rate changes on the net present value of estimated cash flows from our assets, liabilities and off-balance sheet items, defined as market value of portfolio equity, using a simulation model. This simulation model assesses the changes in the market value of interest rate sensitive financial instruments that would occur in response to an instantaneous and sustained increase or decrease (shock) in market interest rates of 100 and 200 basis points.

At September 30, 2008, our market value of portfolio equity exposure related to these hypothetical changes in market interest rates was within the current guidelines established by us. The following table shows our projected change in market value of portfolio equity for this set of rate shocks as of September 30, 2008.

Market Value of Portfolio Equity


									Percentage of
			Percentage Change			Percentage of			Portfolio Equity
Interest Rate Scenario	Market Value		from Base			Total Assets			Book Value
	(Dollars in thousands)
Up 200 basis points	$	34,495		(0.8	)%		8.7	%		96.70	%
Up 100 basis points		34,739		(0.1	)%		8.7	%		97.38	%
BASE		34,767		—			8.8	%		97.46	%
Down 100 basis points		34,667		(0.3	)%		8.7	%		97.18	%
Down 200 basis points		35,322		1.6	%		8.9	%		99.02	%

The computation of prospective effects of hypothetical interest rate changes are based on numerous assumptions, including relative levels of market interest rates, asset prepayments and deposit decay, and should not be relied upon as indicative of actual results. Further, the computations do not contemplate any actions we may undertake in response to changes in interest rates. Actual amounts may differ from the projections set forth above should market conditions vary from the underlying assumptions.

Net Interest Income Simulation. In order to measure interest rate risk at September 30, 2008, we used a simulation model to project changes in net interest income that result from forecasted changes in interest rates. This

analysis calculates the difference between net interest income forecasted using a rising and a falling interest rate scenario and a net interest income forecast using a base market interest rate derived from the current treasury yield curve. The income simulation model includes various assumptions regarding the re-pricing relationships for each of our products. Many of our assets are floating rate loans, which are assumed to re-price immediately, and to the same extent as the change in market rates according to their contracted index. Some loans and investment vehicles include the opportunity of prepayment (embedded options), and accordingly the simulation model uses national indexes to estimate these prepayments and reinvest their proceeds at current yields. Our non-term deposit products re-price more slowly, usually changing less than the change in market rates and at our discretion.

This analysis indicates the impact of changes in net interest income for the given set of rate changes and assumptions. It assumes the balance sheet grows modestly, but that its structure will remain similar to the structure at year-end. It does not account for all factors that impact this analysis, including changes by management to mitigate the impact of interest rate changes or secondary impacts such as changes to our credit risk profile as interest rates change.

Furthermore, loan prepayment rate estimates and spread relationships change regularly. Interest rate changes create changes in actual loan prepayment rates that will differ from the market estimates incorporated in this analysis. Changes that vary significantly from the assumptions may have significant effects on our net interest income.

For the rising and falling interest rate scenarios, the base market interest rate forecast was increased or decreased, on an instantaneous and sustained basis, by 100 and 200 basis points. At September 30, 2008, our net interest margin exposure related to these hypothetical changes in market interest rates was within the current guidelines established by us.

Sensitivity of Net Interest Income


									Net Interest
									Margin Change
	Adjusted Net		Percentage Change			Net Interest			(in basis
Interest Rate Scenario	Interest Income(1)		from Base			Margin Percent(1)			points)
	(Dollars in thousands)
Up 200 basis points	$	3,419		6.3	%		1.26	%		8
Up 100 basis points		3,324		3.4	%		1.22	%		4
BASE		3,215		—			1.18	%		—
Down 100 basis points		3,124		(2.8	)%		1.15	%		(3	)
Down 200 basis points		3,145		(2.2	)%		1.16	%		(2	)


(1)		These percentages are not comparable to other information discussing the percent of net interest margin since the income simulation does not take into account loan fees.

Gap Analysis. Another way to measure the impact that future changes in interest rates will have on net interest income is through a cumulative gap measure. The gap represents the net position of assets and liabilities subject to re-pricing in specified time periods.

The following table sets forth the distribution of re-pricing opportunities of our interest-earning assets and interest-bearing liabilities, the interest rate sensitivity gap (that is, interest rate sensitive assets less interest rate sensitive liabilities), cumulative interest-earning assets and interest-bearing liabilities, the cumulative interest rate sensitivity gap, the ratio of cumulative interest-earning assets to cumulative interest-bearing liabilities and the cumulative gap as a percentage of total assets and total interest-earning assets as of September 30, 2008. The table also sets forth the time periods during which interest-earning assets and interest-bearing liabilities will mature or may re-price in accordance with their contractual terms. The interest rate relationships between the re-priceable assets and re-priceable liabilities are not necessarily constant and may be affected by many factors, including the behavior of customers in response to changes in interest rates. This table should, therefore, be used only as a guide as to the possible effect changes in interest rates might have on our net interest margins.


	September 30, 2008
	Amounts Maturing or Re-pricing in
				Over			Over
				3			1
	3			Months			Year
	Months			to			to			Over
	or			12			5			5			Non-
	Less			Months			Years			Years			Sensitive(1)			Total
	(Dollars in thousands)
Assets

Cash and due from banks	$	7,484		$	—		$	—		$	—		$	4,470		$	11,954
Federal funds sold		43,800			—			—			—			—			43,800
Investment securities		1,004			3,155			11,140			781			86			16,166
Loans		92,960			42,745			56,695			11,604			118,662			322,666
Other assets(2)		567			—			—			—			1,918			2,485

Total assets	$	145,815		$	45,900		$	67,835		$	12,385		$	125,136		$	397,071


Liabilities and Stockholders’ Equity

Non-interest-bearing demand deposits	$	—		$	—		$	—		$	—		$	19,409		$	19,409
Interest-bearing demand, money market and savings		7,693			23,081			35,200			2,993			—			68,967
Time certificates of deposit		59,318			154,514			48,169			340			(215	)		262,126
Short-term debt		—			—			—			—			—			—
Long-term debt		8,248			—			—			—			—			8,248
Other liabilities		—			—			—			—			2,649			2,649
Stockholders’ equity		—			—			—			—			35,672			35,672

Total liabilities and stockholders’ equity	$	75,259		$	177,595		$	83,369		$	3,333		$	57,515		$	397,071

Period gap		70,556			(131,695	)		(15,534	)		9,052			67,621
Cumulative interest-earning assets		145,815			191,715			259,550			271,935
Cumulative interest-bearing liabilities		75,259			252,854			336,223			339,556
Cumulative gap		70,556			(61,139	)		(76,673	)		(67,621	)
Cumulative interest-earning assets to cumulative interest-bearing liabilities		1.94			0.76			0.77			0.80
Cumulative gap as a percent of:
Total assets		17.8	%		(15.4	)%		(19.3	)%		(17.0	)%
Interest-earning assets		48.4	%		(31.9	)%		(29.5	)%		(24.9	)%


(1)		Assets or liabilities and equity which are not interest rate-sensitive.

(2)		Allowance for loan losses of $24.5 million as of September 30, 2008 is included in other assets.

At September 30, 2008, we had $191.7 million in assets and $252.9 million in liabilities re-pricing within one year. This means that $61.2 million more of our interest rate sensitive liabilities than our interest rate sensitive assets will change to the then current rate (changes occur due to the instruments being at a variable rate or because the maturity of the instrument requires its replacement at the then current rate). The ratio of interest-earning assets to interest-bearing liabilities maturing or re-pricing within one year at September 30, 2008 is 0.76. This analysis indicates that at September 30, 2008, if interest rates were to increase, the gap would result in a lower net interest margin. However, changes in the mix of earning assets or supporting liabilities can either increase or decrease the net interest margin without affecting interest rate sensitivity. In addition, the interest rate spread between an asset and its supporting liability can vary significantly while the timing of re-pricing of both the asset and its supporting liability can remain the same, thus impacting net interest income. This characteristic is referred to as basis risk, and generally relates to the re-pricing characteristics of short-term funding sources such as certificates of deposit.

Gap analysis has certain limitations. Measuring the volume of re-pricing or maturing assets and liabilities does not always measure the full impact on the portfolio value of equity or net interest income. Gap analysis does not account for rate caps on products; dynamic changes such as increasing prepayment speeds as interest rates

decrease, basis risk, embedded options or the benefit of no-rate funding sources. The relation between product rate re-pricing and market rate changes (basis risk) is not the same for all products. The majority of interest-earning assets generally re-price along with a movement in market rates, while non-term deposit rates in general move more slowly and usually incorporate only a fraction of the change in market rates. Products categorized as non-rate sensitive, such as our non-interest-bearing demand deposits, in the gap analysis behave like long term fixed rate funding sources. Management uses income simulation, net interest income rate shocks and market value of portfolio equity as its primary interest rate risk management tools.

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ITEM 4: CONTROLS AND PROCEDURES

Evaluation of Controls and Procedures

Regulations under the Securities Exchange Act of 1934 require public companies to maintain “disclosure controls and procedures,” which are defined to mean a company’s controls and other procedures that are designed to ensure that information required to be disclosed in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported, within the time periods specified in the Commission’s rules and forms. Our chief executive officer and our chief financial officer, with the assistance of our principal accounting officer, based on their evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report concluded that, as disclosed below with respect to material weakness and changes in our internal control over financial reporting, the Company’s disclosure controls and procedures were not effective as of September 30, 2008.

Management is also responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Rule 13a-15(f) of the Securities Act of 1934. The Company’s internal control framework and processes are designed to provide reasonable assurance to management and the board of directors regarding the reliability of financial reporting and the preparation of the Company’s consolidated financial statements in accordance with the accounting principles generally accepted in the United States of America. In “Management’s Report on Internal Control over Financial Reporting” in our Form 10-K for the year ended December 31, 2007, management assessed the effectiveness of our internal control over financial reporting as of December 31, 2007 based on criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control—Integrated Framework. As a result of that assessment, management concluded that, as of December 31, 2007, our internal control over financial reporting was not effective. Management’s conclusion was based upon their review of the FDIC order (described below and in “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Recent Developments”) and their findings of control deficiencies that constituted a material weakness in connection with a lack of or sufficient or adequate policies, procedures, and controls with respect to the underwriting, documentation and monitoring of loans, the detection of risks related to the concentration and other risks associated with the residential construction and other loans, and the determination of our provision for loan losses and related allowance for loan losses.

Our internal control over financial reporting includes policies and procedures that pertain to the maintenance of records that accurately and fairly reflect, in reasonable detail, transactions and dispositions of assets; and provide reasonable assurances that: (1) transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States; (2) receipts and expenditures are being made only in accordance with authorizations of management and the directors of the Company; and (3) unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the Company’s financial statements are prevented or timely detected.

Limitations on Controls

Management does not expect that our disclosure controls and procedures or our internal control over financial reporting will prevent or detect all error and fraud. Any control system, no matter how well designed and operated, is based upon certain assumptions and can provide only reasonable, not absolute, assurance that its objectives will be met. Further, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, within the Company have been detected. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

Changes in Internal Control Over Financial Reporting.

The FDIC determined the Bank had engaged in unsafe or unsound banking practices, by engaging in unsatisfactory lending and collection practices, operating with inadequate management and board supervision, with less than satisfactory capital in relation to its large volume of poor quality loans and with an inadequate loan valuation reserve, and with inadequate provisions for liquidity, inadequate internal routine and control policies, and

in violation of various banking laws and regulations relating to internal audits and controls, real estate appraisal and lending guidelines, and responsibilities of bank directors and officers.

We have made or are in the process of implementing the following managerial and operational changes to correct these deficiencies and to improve our internal controls over financial reporting, including:

	•		the audit committee engaged the services of Young and Associates to perform a compensation analysis to include a peer analysis for the board of directors, senior management and department heads. This analysis was completed in the second quarter 2008.

	•		the Bank retained an experienced credit manager that had recently been hired from outside the Bank as a regional manager, as chief lending officer in June, 2007 to manage its loan origination and approval process, credit administration and controls, timely identification of risk and problem loans and emerging risks in the loan portfolio in compliance with company policies and procedures and banking laws and regulations. Credit administration now validates loan grades through an internal loan approval process developed by the chief lending officer. The chief lending officer reports to the Bank’s chief executive officer.

	•		in November, 2007 the Bank established a new special assets department. The Special Assets Department is responsible for construction, commercial real estate and commercial loan collections, reporting to the chief lending officer and the board. The Bank retained an experienced workout specialist as a consultant to this department.

	•		the Company retained a new independent loan consulting firm in the fourth quarter of 2007 to perform external reviews of the Company’s loan portfolio.

	•		the chief lending officer is revising lending policies and developing a series of new or improved reports for credit administration to better monitor credit risks internally and provide more detail about loans and credits to senior management, the Board and its loan committee, including but not limited to, concentrations, exceptions to loan policies, special assets and OREO reports, and monthly delinquent, non-accrual, classified loans and exposure. The Bank retained an experienced loan administrator as a consultant.

	•		a comprehensive risk assessment of the Bank was performed by Audit One, an independent auditing firm, in first quarter 2008. As a result of this assessment, the 2008 audit plan has been adopted by the audit committee, focusing on the lending area.

	•		the audit committee and the Board have made changes to the internal audit function. Rather than add staff to our internal audit department and take the time to train, we chose to engage third party firms that are strong, reputable companies that will provide an independent and timely audit, including Audit One and Young and Associates. All third party firms will report directly to the audit committee.

	•		the audit committee has or will engage several companies, such as accounting, audit, compliance and information technology consultants to conduct extensive internal audits in the operational and lending area. The scope of the audit will be identified and approved by the audit committee and will include loan process review, procedural review, compliance with consumer regulations, privacy, loan documentation, information reporting, reserve for loan and lease loss methodology and calculations, enterprise risk assessment, holding company activities, administrative activities, liquidity, central operations, compliance with the Bank Secrecy Act. Internal audit results are reported regularly to the audit committee on a continual basis using a modified tracking system. The department head is responsible for providing a management response to the audit committee if there are weaknesses noted in their area. Tracking of the audits will be performed by the Company’s chief risk officer.

	•		establishing a communications procedure for reporting progress in all areas to the FDIC, DFI and FRB.

•

the audit committee engaged Audit One, an independent third party audit firm to conduct testing on our internal controls over financial reporting beginning the third quarter 2008. Results will be submitted directly to the audit committee.

We believe that these corrective actions, taken as a whole, will mitigate the control deficiencies identified above but we still need to test the effectiveness of these actions. We plan to continue an on-going review and evaluation of our internal control over financial reporting, and we may make other changes as appropriate based on the results of management’s reviews and evaluations.

Except as described above, through the filing date of this report on Form 10-Q, there were no changes in our internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II: OTHER INFORMATION

ITEM 1: LEGAL PROCEEDINGS

As previously reported, 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. As is typical in these types of cases, all the actions have been consolidated into a single action, In Re: WSB Financial Group Securities Litigation, Master File No. CO7-1747 RAJ.

As of November 3, 2008, the Company had commenced foreclosure proceedings on approximately 199 real estate loans. Some or all of these loans could result in actual foreclosures. The Company is unable to predict the outcome of these matters. Our cash expenditures, including legal and other fees, associated with pending litigation and the regulatory proceedings described above (see “Management’s Discussion and Analysis of Financial Condition and Results of Operations”) 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.

In addition to the above, the Company and Westsound Bank are periodically a party to or otherwise involved in legal proceedings arising in the normal and ordinary course of business, such as claims to enforce liens, foreclose on loan defaults, and other issues incident to our business. Other than the legal and regulatory proceedings described or referenced above and the anticipated institution of additional lawsuits or claims arising out of or related to the impaired loans, management does not believe that there is any proceeding threatened or pending against the Company or the Bank which, if determined adversely, would have a material effect on the business, results of operations, cash flows, or financial position of the Company or the Bank.

ITEM 1A: RISK FACTORS

We are updating the following risk factors in our Annual Report on Form 10-K for the year ended December 31, 2007, which could materially affect our business, financial condition or future results. Any of the following risk factors as well as those described in the Form 10-K could materially and adversely affect our business, financial condition and results of operations after December 31, 2007, and these are not the only risks that we may face. Many of these factors are beyond our control, and in addition to the following risk factors you should read carefully the factors described in “Risk Factors” in the Company’s Form 10-K filed with the Securities and Exchange Commission for a description of some, but not all, risks, uncertainties and contingencies. Additional risks and uncertainties not currently known to us may also materially and adversely affect our business, financial condition or results of operations.

Restrictions imposed by regulatory actions could have an adverse effect on us and failure to comply with any of their provisions could result in further regulatory action or restrictions.

The Company and its subsidiary, Westsound Bank, are subject to regulatory actions, including an FDIC order, with respect to their operations, described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Recent Developments.”

The FDIC order identified deficiencies within credit administration in connection with a lack of sufficient or adequate policies, procedures, and control with respect to the underwriting, documentation and monitoring of loans, the detection of risks related to the concentration and other risks associated with our residential construction and land development and other loans, the determination of our provision for loan losses and possible violations or contraventions of law.

These regulatory actions may limit our growth and adversely affect our earnings.

We are experiencing significant difficulties in our loan portfolio, particularly in our residential construction, land development and mortgage loans. Over 87% of our loans are real estate related.

Approximately 86.9% of our loan portfolio as of September 30, 2008 was comprised of loans secured by real estate, including construction and development, commercial and residential real estate loans. We are experiencing significant difficulties in our loan portfolio, particularly our residential construction, land development and mortgage loans. Many of these loans are maturing and classified as non-performing assets while we work with the borrowers to maximize our recovery. In the first nine months of 2008 our non-accrual loans increased significantly, from $24.9 to $119.1 million, primarily as a result of maturing construction and land development loans that we are choosing not to renew in order to keep all of its legal remedy options available. The contraction or expansion of our non-accrual loan portfolio and OREO properties in future periods will depend upon our ongoing collection efforts and market conditions. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations”.

Defaults and related losses in our residential construction, land development and mortgage loan portfolio could be greater than currently anticipated and could result in a significant increase in other real estate owned (“OREO”) balances and number of properties to be disposed of, which would adversely affect our financial results.

Actual losses related to loans in our residential construction and land development loans may be greater then anticipated, resulting in additional provision for credit losses in future periods. In addition, as part of our collection process for all nonperforming loans, we may foreclose on and take title to the real estate serving as collateral for the loan. Real estate owned by the Bank and not used in the ordinary course of its operations is referred to as other real estate owned property. We expect to take additional properties into OREO. Increased OREO balances lead to greater expenses as we incur costs to manage and dispose of the properties and, in certain cases, complete construction of residences prior to sale. Any decrease in sale prices on homes may lead to OREO write-downs with a corresponding expense in our income statement. We expect that our earnings over the next several quarters could be negatively affected by various expenses associated with OREO, including personnel costs, insurance and taxes, completion and repair costs, and other costs associated with property ownership, as well as by the funding costs associated with assets that are tied up in real estate during the period they are held in OREO. We will also be at risk of further declines in real estate prices in the market areas in which we conduct our lending business.

The downturn in the local real estate market could cause collateral for loans made by us to decline in value, and loan delinquencies and non-performing assets to increase.

The downturn in the local real estate market could increase loan delinquencies, defaults and foreclosures, and significantly impair the value of our collateral and our ability to sell the collateral upon foreclosure. The real estate collateral in each case provides an alternate source of repayment in the event of default by the borrower and may deteriorate in value during the time the credit is extended. If real estate values decline further, it is also more likely that we would be required to increase our allowance for loan losses. If during a period of reduced real estate

values we are required to liquidate the property collateralizing a loan to satisfy the debt or to increase our allowance for loan losses, it could materially reduce our profitability and adversely affect our financial condition.

Our allowance for loan losses may not be adequate to cover actual losses.

A significant source of risk arises from the possibility that we could sustain losses due to loan defaults and non-performance on loans. We maintain an allowance for loan losses in accordance with accounting principles generally accepted in the United States to provide for such defaults and other non-performance. As of September 30, 2008, our allowance for loan losses as a percentage of loans was 7.60%. The determination of the appropriate level of loan loss allowance is an inherently difficult process and is based on numerous assumptions. The amount of future losses is susceptible to changes in economic, operating and other conditions, including changes in interest rates, that may be beyond our control. In addition, our underwriting policies, adherence to credit monitoring processes, and risk management systems and controls may not prevent unexpected losses. Our allowance for loan losses may not be adequate to cover actual loan losses. Moreover, any increase in our allowance for loan losses will adversely affect our earnings.

Our future liquidity depends in part on our ability to attract and retain deposits, which could be adversely affected by adverse publicity in our market area related to the legal and regulatory actions in which we are or may be involved.

Our liquidity could be adversely affected by unexpected deposit outflows, excessive interest rates by competitors, adverse publicity relating to regulatory and legal actions in which we are or may be involved and similar matters. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity.”

ITEM 2: UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

(a) Recent Sales of Unregistered Securities. The following sets forth information regarding all unregistered securities sold by the registrant in the three month period ended September 30, 2008:

(1) Securities Issued Upon Exercise of Stock Options. There were no shares of common stock issued by registrant in the fiscal quarter ended September 30, 2008 pursuant to the exercise of stock options under the 1999 Incentive Stock Option Plan (the “Plan”).

Such shares of common stock are issued pursuant to a written compensatory benefit plan under circumstances that comply with the requirements of Rule 701 promulgated under the Securities Act, and are thus exempted from the registration requirements of the Securities Act by virtue of Rule 701.

(b) Initial Public Offering . On December 19, 2006, the Company completed its initial public offering. The net proceeds of the offering, including the exercise of the underwriter’s over-allotment option, to the Company (after deducting expenses) were $40.2 million. The net proceeds are being held as available cash in our banking subsidiary, Westsound Bank, which in turn allows the bank to use these funds for its normal day to day funding needs. There has been no material change in the planned use of proceeds from this initial public offering as described in the Company’s final prospectus filed with the SEC.

(c) Dividends. We have not paid, and currently have no plans to pay, cash dividends to our stockholders. The payment of dividends is within the discretion of our board of directors and will depend upon our earnings, capital requirements and operating and financial position, among other factors.

Additionally, our junior subordinated debt agreement prohibits us from paying dividends if we have deferred payment of interest on outstanding trust preferred securities. See “Item 2: Management’s Discussion and Analysis of Financial Condition and Results of Operations — Capital Resources.” We are deferring interest on our trust preferred securities. See Note 5 of the Notes to Consolidated Financial Statements.

We are a legal entity separate and distinct from Westsound Bank. Because we are a holding company with no significant assets other than Westsound Bank, we will be dependent upon dividends from Westsound Bank for cash with which to pay dividends when, and if, our dividend policy changes. For a discussion of the regulatory

limitations on Westsound Bank’s ability to pay dividends, see “Supervision and Regulation — Federal and State Regulation of Westsound Bank — Dividends” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2007.

ITEM 3: DEFAULTS UPON SENIOR SECURITIES

Not applicable.

ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

Not applicable.

ITEM 5: OTHER INFORMATION

Not applicable.

ITEM 6: EXHIBITS

See Exhibit Index on pages — 56 – 57.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized


WSB FINANCIAL GROUP, INC .
(Registrant)

Date: November 13, 2008				/s/ Terry A. Peterson

				Terry A. Peterson, Chief Executive Officer

Date: November 13, 2008				/s/ Mark D. Freeman

				Mark D. Freeman, Chief Financial Officer


Exhibit
Number		Exhibit Index

3.1+		Articles of Incorporation of WSB Financial Group, Inc.

3.2+		Articles of Amendment

3.3+		Bylaws of WSB Financial Group, Inc.

3.4+		Amendment to Bylaws

10.1*+		1999 Stock Option Plan

10.2*+		Forms of 1999 Incentive Stock Option Plan Agreements

(a)+		Directors

(b)+		Employees

10.3+		Lease for Port Orchard branch, dated May 28, 2001

10.4+		Lease for Silverdale branch, dated October 1, 2001 and October 1, 2003

10.5+		Lease for Gig Harbor branch, dated March 2, 2004

10.6+		Lease for Federal Way branch, dated March 30, 2005

10.7+		Lease for Port Townsend LPO, dated August 18, 2006

10.8†+		Agreement between Westsound Bank and Fiserv Solutions Inc. dated August 11, 2006

10.9*+		Westsound Bank 401(k) Profit Sharing Plan

10.10+		Placement Agreement among the registrant, WSB Financial Group Trust I and Cohen Bros. & Company dated July 25, 2005

10.11+		Indenture by and between the registrant and JPMorgan Chase Bank, National Association, dated July 27, 2005

10.12+		Guarantee Agreement by and between the registrant and JPMorgan Chase Bank, National Association, dated July 27, 2005

10.13*+++		Employment Agreement with Terry A. Peterson

10.14*+		Employment Agreement with Mark D. Freeman

10.15*+		Form of Employment Agreement with other executive officers

10.16+		Form of Indemnification Agreement with directors

10.17+		Audit Committee Charter

10.18+		Compensation Committee Charter


Exhibit
Number		Exhibit Index

10.19+		Corporate Governance/Nominating Committee Charter

10.20++		Separation Agreement with David K. Johnson (previously filed with the Securities and Exchange Commission on Form 8-K on February 4, 2008)

31.1		Certification of Chief Executive Officer.

31.2		Certification of Chief Financial Officer.

32.1		Certification (of Terry A. Peterson) pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2		Certification (of Mark D. Freeman) pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.


*		Compensatory plan or arrangement

†		Confidential treatment has been requested with respect to certain portions of this exhibit. Omitted portions have been filed separately with the Securities and Exchange Commission.

+		Previously filed with the Company’s Amendment No. 5 to the S-1 registration statement filed with the Securities and Exchange Commission on December 8, 2006, file no. 333-137058.

++		Previously filed with the Company’s Annual Report on Form 10-K for the year ended December 31, 2007, filed with the Securities and Exchange Commission on March 31, 2008.

+++		Previously filed with the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2008, filed with the Securities and Exchange Commission on August 12, 2008.

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