WSB Financial 10K 2007 Annual report | WSFGQ Filing

Exhibit 13

PORTIONS OF ANNUAL REPORT TO SHAREHOLDERS FOR THE
YEAR ENDED DECEMBER 31, 2007 INCORPORATED BY REFERENCE

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

You should read the following discussion and analysis of our financial condition and results of operations together with “Summary Consolidated Financial Information” and our consolidated financial statements and related notes appearing elsewhere in this report. This discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of many factors, including those set forth under “Risk Factors” and elsewhere in this report.

Overview

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

We currently have, on a consolidated basis, $489.3 million in total assets, net loans of $393.4 million, total deposits of $421.4 million, and stockholders’ equity of $56.7 million. Since our founding we have experienced significant growth, adding branches and loan production offices. With the pending litigation and regulatory proceedings, the problems recently identified in our loan portfolio and the decline in demand for real estate loans, which we and other community banks have focused on for growth the past several years, our rate of growth can be expected to decline, particularly in the near term.

We generate most of our revenue from interest on loans and investments, loan fees, service charges, and mortgage banking income. As of December 31, 2007, 75.0% of our revenue was interest on loans, 10.7% loan fees, 6.8% mortgage banking income, 4.0% service charges and 3.5% 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 December 31, 2007, approximately 91.5% of our loans related to the construction or development, purchase, improvement or refinancing of commercial and residential real estate, approximately 7.6% were C&I loans and 0.9% were consumer loans. Approximately 86.0% of our revenue is derived from real estate, of which approximately 25.0% is derived from residential real estate. Including our originations of residential real estate loans which are sold in the secondary market, approximately 92.5% of our actual lending activities are related to real estate. Of this amount, 33.3% is residential real estate, 53.6% is construction and land development, and 5.6% is commercial real estate.

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

We are experiencing difficulties in our loan portfolio which have resulted in a $13.4 million increase in our provision for loan losses in the third quarter of 2007 and a $1.7 million increase in the fourth quarter of 2007. These matters are discussed below in “—Recent Developments.” An adverse change in the economy affecting values of real estate generally, or in west Puget Sound, could, because of our high concentration of loans secured by real estate, materially and adversely affect our profitability, growth and financial condition. Further, because approximately 64.4% of our loans are interest-only (primarily real estate construction and development) and 39.4% are variable rate, significant increases in interest rates could also result in increased loan delinquencies, defaults and foreclosures.

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

Market interest rates increased in 2007 as a result of the Federal Reserve’s monetary policies. Our net interest margin remained relatively constant at an average of 5.65% through 2007, however, because we are in an “asset neutral” position, based on our current net interest income simulation. In addition, a substantial percentage of our loan portfolio (39.4% of our total loans as of December 31, 2007) has been comprised of variable rate loans that reprice as interest rates rise or fall. The Federal Reserve began reducing interest rates in September 2007. As interest rates decline, our margins could also decrease until we can adjust the mix of our assets and liabilities to compensate for the changed interest rate environment. Our net interest margin decreased to 4.62% in 2007, primarily as a result of higher rates paid on deposits.


	Key Financial Measures
	Years Ended December 31,
	2007			2006			2005			2004			2003
	(Dollars in thousands, except per share data)
Net income (loss)	$	(5,200	)	$	3,885		$	2,412		$	1,340		$	631
Basic earnings (loss) per share		(0.93	)		1.35			0.91			0.59			0.36
Diluted earnings (loss) per share		(0.93	)		1.18			0.82			0.55			0.35
Total assets		489,333			386,754			249,998			137,416			76,012
Net loans(1)		393,436			340,208			207,172			117,623			58,222
Total deposits		421,445			315,022			224,167			123,593			68,003
Net interest margin		4.62	%		5.65	%		5.90	%		6.77	%		5.71	%
Efficiency Ratio		67.6	%		65.3	%		67.9	%		70.4	%		66.6	%
Return on average assets		-1.17	%		1.28	%		1.28	%		1.37	%		1.04	%
Return on average equity		-8.4	%		19.6	%		16.6	%		13.6	%		9.9	%


(1)		Includes loans held for sale.

Recent Developments

Loan Reviews.As of September 30, 2007 and December 31, 2007, we recorded additional provisions for loan losses primarily related to our real estate loan portfolio following a comprehensive evaluation based on representative samplings of our entire loan portfolio conducted by our senior management and an independent consultant, The Alford Spencer Financial Group, Inc. of Sacramento, California, with expertise in analyzing loan portfolios and determining loan loss allowances, provisions and charge-offs under regulatory guidelines and generally accepted accounting principles. An additional provision for loan losses of $13.4 million or $8.5 million after-tax was recorded in the third quarter of 2007 based on the loan reviews, and an additional $1.7 million in the fourth quarter. The recording of the 2007 loan loss provision results in a provision for loan losses of $15.9 million for the year ended December 31, 2007.

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

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

Regulatory Proceedings.Westsound Bank has signed an agreement with the Federal Deposit Insurance Corporation (FDIC) and the Washington Department of Financial Institutions, Division of Banks (DFI) to enter into a cease and desist order which primarily addresses the Bank’s lending practices and the Company is implementing a comprehensive plan to achieve full compliance.

Although Westsound Bank has agreed to the order, it has not admitted or denied 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 by the FDIC in connection with the order.

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.

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.

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.

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.

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have advised the Company and the Bank that they will no longer be regarded as ‘well capitalized’ for federal regulatory purposes, as a result of the deficiencies cited in the FDIC order.

Westsound Bank has been reclassified from “well capitalized” to “adequately capitalized.” 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 (generally up to $100,000 per customer), 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, including the $13.3 million increase in loan loss reserves, as reported in the Company’s quarterly report on Form 10-Q for the period ended September 30, 2007, which was filed February 1, 2008. See Part II, Item 9A(T): Controls and Procedures. The Company is also complying with the terms of the FRB notice, and has exercised its option to start deferring payments of quarterly interest on its trust preferred securities on March 15, 2008, as permitted by the indenture agreement.

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

	•		Conducting a comprehensive review of the qualifications of management and existing staff and consideration of potential changes that may be required;

	•		Engaged a management recruiting firm to conduct a nationwide search for a new chief executive officer, and identified highly qualified candidates for the position;

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

	•		Added $13.9 million to total provisions for loan losses and unfunded commitments in the third quarter of 2007 and increased fourth quarter 2007 reserves by $1.7 million;

	•		Strengthened collections and loss recovery teams to accelerate resolution of problem loans.

	•		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.

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 several items addressed by the order.

Our cash expenditures, including legal and accounting fees, associated with the regulatory proceedings and the pending litigation described below (see Part I, Item 3: 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

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revenues and results of operations. The adverse resolution of any specific lawsuit or potential regulatory action or proceeding could have a material adverse effect on our business, results of operations, and financial condition.

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

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

While the economy generally remains strong in our west Puget Sound market, the housing market is slow, with weaker demand for housing, higher inventory levels and longer marketing times. The Seattle Times recently reported though that the median price of single family homes in this market remained comparable to a year ago. As a result of the recent deterioration in the local housing market, the current problems in the mortgage banking and lending market and the issues we have identified with respect to certain residential construction loans, as well as some commercial real estate, C&I and other loans, the Company determined that it would record provisions for loan losses for the quarters ending September 30, 2007 and December 31, 2007. Weakness in the local housing market is expected to continue in the near term, and the situation could deteriorate further before the market stabilizes.

The Company has repurchased three real estate loans totaling $1,465,590 in the past several months, under the terms of the loan sale agreements which generally allow the purchaser to require us to repurchase loans upon which the borrower has defaulted or paid off within several months after the closing of the sale. A number of mortgage loans previously sold by the Company remain subject to repurchase under such provisions if the borrower has defaulted. See “—Financial Condition — Loans, Contingent Liabilities for Sold Loans” below. The reduced liquidity in the secondary mortgage market and availability in take-out lending programs have also impacted the market value and anticipated gains and servicing income related to our mortgage loans held-for-sale.

Deposits.As of March 18, 2008 and December 31, 2007, we had $123.0 million and $117.4 million, respectively, of deposits from wholesale sources, including brokered deposits and Internet certificates of deposit. See Note 3 to the Company’s unaudited consolidated financial statements for more information on the Company’s deposits. Management has developed and is implementing strategic advertising campaigns and promotions to attract and maintain core deposits and reduce its recent reliance on wholesale funding sources which are generally more rate-sensitive and considered a less stable funding source than local retail deposit relationships, or so-called core deposits. As described above (see “—Capital Resources”), as a result of the FDIC order the Bank is subject to regulatory limitations with respect to its wholesale sourcing of deposits.

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

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

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The Company and Westsound Bank remain adequately capitalized under regulatory guidelines, as of December 31, 2007, following the additional 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 shareholders is measured in the form of return on average equity, or ROE. Our net income for the year ended December 31, 2007 decreased 233.9% to a net loss of $5.2 million compared to net income of $3.9 million for the year ended December 31, 2006. Net income decreased due to the significant additions to the allowance for loan losses in the third and fourth quarters of 2007. Basic earnings per share, or EPS, decreased to $(0.93)for the year ended December 31, 2007 compared to $1.35 for the year ended December 31, 2006. Diluted EPS decreased to $($0.93) for the year ended December 31, 2007 compared to $1.18 for the year ended December 31, 2006. Our net loss drove our ROE to (8.35%) for the year ended December 31, 2007 compared to 19.6% for the year ended December 31, 2006.

Return on Average Assets.Our return on average assets, or ROA, for the year ended December 31, 2007 was (1.17%)% compared to 1.28% for the year ended December 31, 2006.

Asset Quality.For all banks and bank holding companies, asset quality has a significant impact on the overall financial condition and results of operations. Asset quality is measured in terms of nonperforming loans and assets as a percentage of total loans and total assets, and net charge-offs as a percentage of average loans. These measures are key elements in estimating the future earnings of a financial institution. We had $25,322,000 in non-performing loans as of December 31, 2007 compared to $219,000 at December 31, 2006. Non-performing loans as a percentage of total loans were 6.36% as of December 31, 2007 compared to 0.06% at December 31, 2006. For the year ended December 31, 2007 net charge-offs to average loans were 0.01%, as compared to no net charge-offs for the year ended December 31, 2006.

Asset Growth.Because revenues from both net interest income and non-interest income are a function of asset size, the continued growth in assets has a direct impact on increasing net income and EPS. The majority of our assets are loans, and the majority of our liabilities are deposits, and therefore the ability to generate loans and deposits are fundamental to our asset growth. Total assets increased 26.5% during 2007 from $386.8 million as of December 31, 2006 to $489.3 million as of December 31, 2007. Total deposits increased 33.8% to $421.4 million as of December 31, 2007 compared to $315.0 million as of December 31, 2006. Net loans increased 19.5% to $393.4 million as of December 31, 2007 compared to $340.2 million as of December 31, 2006.

Capital and Liquidity.Maintaining adequate capital levels in light of our rapid growth has been one of our primary areas of focus. Our average equity to average assets has increased from 6.5% for 2006 to 14.0% for 2007.

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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 December 31, 2007 the net loan to deposit ratio had decreased to 93.4%, down from 108.0% at December 31, 2006.

Net Interest Margin.Our net interest margin decreased to 4.62% for 2007 compared to 5.65% for 2006.

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) increased to 67.6% for 2007 compared to 65.3% for 2006.

Critical Accounting Policies

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

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

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

We maintain an ALLL based on a number of quantitative and qualitative factors, including levels and trends of past due and non-accrual loans, asset classifications, loan grades, change in volume and mix of loans, collateral value, historical loss experience, size and complexity of individual credits 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 levels of the allowance as of December 31, 2007, are 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 instruments. 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

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reflected in the financial statements and their related tax basis using enacted tax rates in effect for the year in which the differences are expected to be recovered or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes. Any estimated tax exposure items identified would be considered in a tax contingency reserve. Changes in any tax contingency reserve would be based on specific developments, events, or transactions.

Stock Options.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 options for 24,000 shares in 2007. Our stock options for employees include a service condition that relates only to vesting. The stock options generally vest over five years at the rate of 20% per year. Compensation expense is amortized on a straight-line basis over the vesting period of the award.

The determination of the fair value of stock options using an option-pricing model is affected by our stock price as well as assumptions regarding a number of complex and subjective variables. The methods used to determine these variables are generally similar to the methods used prior to fiscal 2006 for purposes of our pro forma information under SFAS 123. The volatility assumption is based on a combination of the historical volatility of our common stock and the volatilities of similar companies over a period of time equal to the expected term of the stock options. The volatilities of similar companies are used in conjunction with our historical volatility because of the lack of sufficient relevant history equal to the expected term. 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

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consists primarily of employee compensation and benefits, occupancy, equipment and depreciation expense, and other operating expenses.

Financial Overview for the Years Ended December 31, 2007 and 2006


	2007			2006		Increase (Decrease)
	(Dollars in thousands, except per share data)
Consolidated Statement of Earnings Data:
Interest income	$	37,396		$	28,342	$	9,054
Interest expense		17,514			11,785		5,729

Net interest income		19,882			16,557		3,325
Provision for loan losses		15,879			1,523		14,356

Net interest income after provision for loan losses		4,003			15,034		(11,031	)
Non-interest income		4,531			4,672		(141	)
Non-interest expense		16,494			13,854		2,640

Income before provision for income taxes		(7,960	)		5,852		(13,812	)
Provision for income taxes		(2,760	)		1,967		(4,727	)

Net income	$	(5,200	)	$	3,885	$	(9,085	)

Earnings per share — basic	$	(0.93	)	$	1.35	$	(2.28	)

Earnings per share — diluted	$	(0.93	)	$	1.18	$	(2.11	)

The Company reported a net loss of $5.2 million or $0.93 loss per diluted share for the year ended December 31, 2007 as compared to net income of $3.9 million or $1.18 diluted earnings per share for the year ended December 31, 2006. The loss is attributable to a $15.9 million provision for loan losses during the year ended December 31, 2007, compared to a $1.5 million provision during the year ended December 31, 2006. Our return on average equity was (8.35)% and our return on average assets was (1.17)% for the year ended December 31, 2007, compared to 19.6% and 1.28%, respectively for the year ended December 31, 2006.

Net Interest Income and Net Interest Margin.The $3.3 million, 20.1% increase in net interest income for the period was due to (i) an increase in interest income of $9.1 million, reflecting the effect of a $137.8 million increase in average interest-earning assets offset by (ii) an increase in interest expense of $5.7 million. Average interest-earning assets increased $137.8 million with interest income increasing $9.1 million and interest expense increasing $5.7 million. Average interest-bearing liabilities increased $92.6 million.

The average yield on our interest-earning assets was 8.68% for fiscal 2007 compared to 9.68% for 2006, a decrease of 1.00%. The decrease in the average yield on our interest-earning assets primarily resulted from the increase in non-accruing loans and interest reversals.

The cost of our average interest-bearing liabilities increased to 5.01% for the year ended December 31, 2007 from 4.59% for fiscal 2006. In addition to broad increases in the average rates paid by Westsound Bank on deposit balances, the increase was the result of a change in the mix of deposits toward higher-paying time deposits.

Our average rate on our interest-bearing deposits increased 0.45% from 4.50% during the year ended December 31, 2006 to 4.95% for the year ended December 31, 2007, reflecting the change in the mix of deposits toward higher-paying time deposits. Our average rate on total deposits (including non-interest bearing deposits) increased to 4.57% for the year ended December 31, 2007 from 4.08% for 2006.

The 103 basis point decrease in our net interest margin, which decreased to 4.62% for the year ended December 31, 2007 from 5.65% for 2006, was due to our higher cost of funding and the decrease in earning assets yield.

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.

13-10


	Year Ended December 31, 2007								Year Ended December 31, 2006
						Average								Average
						Yield								Yield
	Average					or			Average					or
	Balance			Interest		Cost			Balance			Interest		Cost
	(Dollars in thousands)
Assets

Interest-earning assets:
Loans(1)(2)(3)	$	401,109		$	35,958		8.96	%	$	276,865		$	27,634		9.98	%
Investment securities — Taxable		6,598			316		4.79	%		6,363			265		4.16	%
Investment securities — Non-taxable(3)		1,815			76		4.19	%		1,823			76		4.17	%
Federal funds sold		17,732			879		4.96	%		5,915			282		4.77	%
Other investments(4)		3,400			167		4.91	%		1,876			85		4.53	%

Total interest-earning assets		430,654			37,396		8.68	%		292,842			28,342		9.68	%
Non-earning assets:
Cash and due from banks		5,784								6,272
Unearned loan fees		(1,175	)							(489	)
Allowance for loan losses		(7,781	)							(3,257	)
Other assets		15,620								8,748

Total assets	$	443,102							$	304,116


Liabilities and Stockholders’ Equity
Interest-bearing Liabilities:
Deposits
Interest-bearing demand	$	7,542		$	77		1.02	%	$	11,682		$	71		0.61	%
Money market		99,941			4,486		4.49	%		114,527			5,157		4.50	%
Savings		7,802			295		3.78	%		3,844			59		1.53	%
Time certificates of deposit		226,050			12,052		5.33	%		117,400			5,857		4.99	%

Total interest-bearing deposits		341,335			16,910		4.95	%		247,453			11,144		4.50	%
Short-term borrowings		24			1		4.17	%		1,323			75		5.67	%
Junior subordinated debt		8,248			603		7.31	%		8,248			566		6.86	%

Total interest-bearing liabilities		349,607			17,514		5.01	%		257,024			11,785		4.59	%
Non-interest-bearing liabilities
Demand deposits		28,426								25,736
Other liabilities		2,815								1,526

Total liabilities		380,848								284,286
Stockholders’ equity		62,254								19,830

Total liabilities and stockholders’ equity	$	443,102							$	304,116

Net interest income				$	19,882							$	16,557

Net interest spread(5)							3.67	%							5.09	%
Net interest margin							4.62	%							5.65	%


(1)		Includes average non-accrual loans of $1,518,000 at December 31, 2007 and $50,000 at December 31, 2006.

(2)		Loan fees of $4.5 million and $5.4 million are included in the yield computations for 2007 and 2006, 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.

13-11

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.


	Year Ended December 31, 2007
	Compared to Year
	Ended December 31, 2006
	Net Change			Rate			Volume				Mix
	(In thousands)
Loans	$	8,324		$	(2,814	)	$	12,401			$	(1,263	)
Investment securities — taxable		51			40			10				1
Investment securities — non-taxable		0			0			0				0
Federal funds sold		597			11			563				23
Other investments		82			7			69		��		6

Total interest income		9,054			(2,756	)		13,043				(1,233	)
Interest expense:
Interest-bearing demand		6			48			(25	)			(17	)
Money market		(671	)		(16	)		(657	)			2
Savings		236			86			61				89
Time certificates of deposit		6,195			402			5,420				373
Short-term borrowings		(74	)		(20	)		(74	)			20
Junior subordinated debt		37			37			0				0

Total interest expense		5,729			537			4,725				467

Net interest income	$	3,325		$	(3,293	)	$	8,318			$	(1,700	)

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.

The provision for loan losses for fiscal 2007 was $15.9 million compared to $1.5 million for 2006. We experienced $337,000 of net loan charge-offs in 2007 compared to $23,000 net loan charge-offs in 2006. The provision increased significantly in the third and fourth quarters of 2007, primarily as a result of the reassessment of our mortgage loan portfolio in light of recent deterioration in the local housing market and the issues identified with respect to certain residential construction loans. See “—Recent Developments” above. Total net loans increased by $68.2 million for 2007 and $133.0 million for 2006.

For non-performing loans and any other loan where the borrower defaults on his 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:


	Year Ended December 31,
	2007		2006		Increase (Decrease)
	(In thousands)
Service charges and other income	$	1,686	$	1,189	$	497
Loan brokerage and referral fees		1,363		1,574		(211	)
Net gain/(loss) on sale of loans		1,482		1,909		(427	)

Total non-interest income	$	4,531	$	4,672	$	(141	)

The $141,000 or 3.0% decrease in total non-interest income during the year ended December 31, 2007 was primarily influenced by the decrease in gains on sale of loans.

13-12

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:


	Year Ended December 31,
	2007		2006		Increase (Decrease)
	(In thousands)
Salaries, wages and employee benefits	$	9,486	$	9,258	$	228
Occupancy, equipment and depreciation		1,767		1,462		305
Data and item processing		698		512		186
Advertising expense		180		215		(35	)
Printing, stationery and supplies		191		219		(28	)
Telephone expense		111		111		0
Postage and courier		155		132		23
Legal fees		301		45		256
Director fees		321		303		18
Business & occupation taxes		344		274		70
Accounting and audit fees		254		77		177
Consultant fees		216		64		152
OREO losses and expenses, net		266		0		266
Provision for unfunded credit losses		361		0		361
Other		1,843		1,182		661

Total non-interest expense	$	16,494	$	13,854	$	2,640

The $2.6 million or 19.1% increase in non-interest expense for the year ended December 31, 2007 is primarily attributable to the increase in allowance for unfunded credit losses, OREO losses and expense, and public reporting fees and costs. We added $361,000 for unfunded credit losses for fiscal 2007. We also wrote down several OREO properties by $38,715.

Provision (Benefits) for Income Taxes.We recorded a tax benefit of $2.8 million for 2007 compared to a $2.0 million provision for the prior year. Our effective tax rate was approximately 34.7% for 2007 and 33.6% for 2006. Any difference from the expected rate in either periods was largely due to the non-taxable nature of income from municipal securities.

Financial Overview for the Years Ended December 31, 2006 and 2005


	2006		2005		Increase (Decrease)
	(Dollars in thousands, except per share data)
Consolidated Statement of Earnings Data:
Interest income	$	28,342	$	15,693	$	12,649
Interest expense		11,785		5,182		6,603

Net interest income		16,557		10,511		6,046
Provision for loan losses		1,523		1,351		172

Net interest income after provision for loan losses		15,034		9,160		5,874
Non-interest income		4,672		5,241		(569	)
Non-interest expense		13,854		10,692		3,162

Income before provision for income taxes		5,852		3,709		2,143
Provision for income taxes		1,967		1,297		670

Net income	$	3,885	$	2,412	$	1,473

Earnings per share — basic	$	1.35	$	0.91	$	0.44

Earnings per share — diluted	$	1.18	$	0.82	$	0.36

Our net income grew by 61.1% to $3.9 million for the year ended December 31, 2006 as compared to $2.4 million for the fiscal year 2005. This was attributable principally to an increase in net interest income of $6.0 million

13-13

partially offset by a $3.2 million increase in non-interest expense. The increase in net interest income was the result of an increase in the volume of interest-earning assets, primarily loans offset by an increase in our cost of funds resulting from a increase in market rates for interest-bearing deposits. Our return on average equity was 19.6% and return on average assets was 1.28% for the year ended December 31, 2006, compared to 16.6% and 1.28%, respectively for fiscal 2005.

Net Interest Income and Net Interest Margin.The $6.0 million, 57.5% increase in net interest income for the period was due to (i) an increase in interest income of $12.6 million, reflecting the effect of a $114.8 million increase in average interest-earning assets offset by (ii) an increase in interest expense of $6.6 million.

The average yield on our interest-earning assets was 9.68% for fiscal 2006 compared to 8.81% for 2005, an increase of 0.87%. The increase in the average yield on our interest-earning assets resulted from an increase in market rates, repricing on our adjustable rate loans, and new loans originated with higher interest rates because of the rising interest rate environment.

The cost of our average interest-bearing liabilities increased to 4.59% for the year ended December 31, 2006 from 3.4% for fiscal 2005. In addition to broad increases in the average rates paid by Westsound Bank on deposit balances, the increase was the result of a change in the mix of deposits toward higher-paying time deposits, as well as the addition of our junior subordinated debt.

Our average rate on our interest-bearing deposits increased 1.14% from 3.36% during the year ended December 31, 2005 to 4.50% for the year ended December 31, 2006, reflecting increases in general market rates as well as change in mix of deposits toward higher-paying time deposits. Our average rate on total deposits (including non-interest bearing deposits) increased to 4.08% for the year ended December 31, 2006 from 2.97% for 2005.

The 25 basis point decrease in our net interest margin, which decreased to 5.65% for the year ended December 31, 2006 from 5.90% for 2005, was due to our higher cost of funding that was somewhat offset by an increase in earning assets yield.


	Fiscal Year Ended December 31,
	2006								2005
						Average								Average
						Yield								Yield
	Average					or			Average					or
	Balance			Interest		Cost			Balance			Interest		Cost
	(Dollars in thousands)
Assets

Interest-earning assets:
Loans(1)(2)(3)	$	276,865		$	27,634		9.98	%	$	161,357		$	15,088		9.35	%
Investment securities — taxable		6,363			265		4.16	%		5,003			202		4.04	%
Investment securities — non-taxable(3)		1,823			76		4.17	%		1,736			62		3.57	%
Federal funds sold		5,915			282		4.77	%		8,938			295		3.30	%
Other investments(4)		1,876			85		4.53	%		1,051			46		4.38	%

Total interest-earning assets		292,842			28,342		9.68	%		178,085			15,693		8.81	%

Non-earning assets:
Cash and due from banks		6,272								5,312
Unearned loan fees		(489	)							(191	)
Allowance for loan losses		(3,257	)							(1,712	)
Other assets		8,748								6,217

Total assets	$	304,116							$	187,711

13-14


	Fiscal Year Ended December 31,
	2006							2005
					Average							Average
					Yield							Yield
	Average				or			Average				or
	Balance		Interest		Cost			Balance		Interest		Cost
	(Dollars in thousands)
Liabilities and Stockholders’ Equity
Interest-bearing liabilities:
Deposits
Interest-bearing demand	$	11,682	$	71		0.61	%	$	10,895	$	44		0.40	%
Money market		114,527		5,157		4.50	%		69,722		2,765		3.97	%
Savings		3,844		59		1.53	%		4,474		44		0.98	%
Time certificates of deposit		117,400		5,857		4.99	%		63,576		2,145		3.37	%

Total interest-bearing deposits		247,453		11,144		4.50	%		148,667		4,998		3.36	%
Short-term borrowings		1,323		75		5.67	%		142		5		3.52	%
Junior subordinated debt		8,248		566		6.86	%		3,437		179		5.21	%

Total interest-bearing liabilities		257,024		11,785		4.59	%		152,246		5,182		3.40	%
Non-interest-bearing liabilities
Demand deposits		25,736							19,884
Other liabilities		1,526							1,031

Total liabilities		284,286							173,161
Stockholders’ equity		19,830							14,550

Total liabilities and stockholders’ equity	$	304,116						$	187,711

Net interest income			$	16,557						$	10,511

Net interest spread(5)						5.09	%						5.41	%
Net interest margin						5.65	%						5.90	%


(1)		Includes average non-accrual loans of $50,000 at December 31, 2006 and $39,000 at December 31, 2005.

(2)		Loan fees of $5.4 million and $3.1 million are included in the yield computations for fiscal 2006 and 2005, 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.

13-15


	Year Ended December 31, 2006
	Compared to Year
	Ended December 31, 2005
	Net Change			Rate			Volume			Mix
				(In thousands)
Loans	$	12,546		$	1,017		$	10,801		$	728
Investment securities — taxable		63			6			55			2
Investment securities — non-taxable		14			10			3			1
Federal funds sold		(13	)		131			(100	)		(44	)
Other investments		39			2			36			1

Total interest income		12,649			1,166			10,795			688

Interest expense:
Interest-bearing demand		27			22			3			2
Money market		2,392			374			1,777			241
Savings		15			25			(6	)		(4	)
Time certificates of deposit		3,712			1,027			1,816			869
Short-term borrowings		70			3			42			25
Junior subordinated debt		387			57			251			79

Total interest expense		6,603			1,508			3,883			1,212

Net interest income	$	6,046		$	(342	)	$	6,912		$	(524	)

The provision for loan losses for fiscal 2006 was $1.5 million compared to $1.4 million for 2005. We experienced $23,000 of net loan charge-offs in 2006 compared to no net loan charge-offs in 2005. The provision increased primarily due to the significant increase in loans. Total net loans increased by $133.0 million for 2006 and $89.5 million for 2005.

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


	Year Ended December 31,
	2006		2005		Increase (Decrease)
	(In thousands)
Service charges and other income	$	1,189	$	840	$	349
Loan brokerage and referral fees		1,574		1,799		(225	)
Net gain/(loss) on sale of loans		1,909		2,584		(675	)
Net gain/(loss) on sale of securities		0		18		(18	)

Total non-interest income	$	4,672	$	5,241	$	(569	)

The $569,000 or 10.9% decrease in total non-interest income during the year ended December 31, 2006 was primarily influenced by the decrease in gains on sale of loans.

13-16


	Year Ended December 31,
	2006		2005		Increase (Decrease)
	(In thousands)
Salaries, wages and employee benefits	$	9,258	$	7,265	$	1,993
Occupancy, equipment and depreciation		1,462		1,115		347
Data and item processing		512		363		149
Advertising expense		215		183		32
Printing, stationery and supplies		219		213		6
Telephone expense		111		78		33
Postage and courier		132		109		23
Legal fees		45		28		17
Director fees		303		233		70
Foreclosed assets, net		0		2		(2	)
Business & occupation taxes		274		188		86
Other		1,323		915		408

Total non-interest expense	$	13,854	$	10,692	$	3,162

The $3.2 million or 29.6% increase in non-interest expense for the year ended December 31, 2006 is primarily attributable to the salary, occupancy and other costs associated with our new offices.

Provision for Income Taxes.We recorded tax provisions of $2.0 million for 2006 compared to $1.3 million for the prior year. Our effective tax rate was approximately 33.6% for 2006 and 35.0% for 2005. Any difference from the expected rate in either periods was largely due to the non-taxable nature of income from municipal securities.

Financial Condition

Our total assets at December 31, 2007, December 31, 2006 and December 31, 2005 were $489.3 million, $386.8 million and $250.0 million, respectively. Our average earning assets for the year ended December 31, 2007, and the fiscal years ended December 31, 2006 and December 31, 2005 were $430.7 million, $292.8 million and $178.1 million, respectively. Total deposits at December 31, 2007, December 31, 2006 and December 31, 2005 were $421.4 million, $315.0 million and $224.2 million, respectively.

Loans

Our net loans at December 31, 2007, December 31, 2006 and December 31, 2005 were $393.4 million, $340.2 million, and $207.2 million, respectively, an annual increase of 15.6%, 64.2%, and 76.2% over the prior period, respectively. Net loans include loans held for sale. 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 rate of loan growth can be expected to decline, particularly in the near term. See “Business — Our Strategy.”

The following table shows the amounts of loans (including loans held for sale) outstanding at the end of each of the periods indicated.


	December 31,
	2007		2006		2005		2004		2003
	(In thousands)
Real estate loans:
Construction	$	253,188	$	194,709	$	103,772	$	41,211	$	15,592
Commercial real estate		72,435		67,224		46,947		36,191		13,987
Residential real estate		53,198		63,942		43,689		24,659		13,162
Commercial & industrial loans		31,377		15,629		13,123		14,549		14,117
Consumer loans		3,719		3,235		2,484		2,202		1,942

Gross loans		413,917		344,739		210,015		118,812		58,800

13-17


	December 31,
	2007		2006		2005		2004		2003
	(In thousands)
Allowance for loan losses		19,514		3,972		2,520		1,189		578
Deferred loan fees, net		967		559		323		0		0

Net loans	$	393,436	$	340,208	$	207,172	$	117,623	$	58,222

The following tables show the amounts of loans outstanding as of December 31, 2007, and December 31, 2006, which, based on remaining scheduled repayments of principal, were due in one year or less, more than one year through five years, and more than five years. Lines of credit or other loans having no stated maturity and no stated schedule of repayments are reported as due in one year or less. In the table below, loans are classified as real estate- related if they are collateralized by real estate. The table also presents, for loans with maturities over one year, an analysis with respect to fixed interest rate loans and floating interest rate loans.

As of December 31, 2007:


	Maturity								Rate Structure for
	One		One						Loans Maturing Over
	Year		through		Over				One Year
	or		Five		Five				Fixed		Floating
	Less		Years		Years		Total		Rate		Rate
	(In thousands)
Real estate loans:
Construction & land development	$	220,631	$	21,821	$	10,736	$	253,188	$	16,222	$	16,335
Commercial real estate		5,781		10,300		56,354		72,435		14,669		51,985
Residential real estate		25,387		13,146		14,665		53,198		16,155		11,656
Commercial & industrial loans		9,538		9,615		12,224		31,377		12,947		8,892
Consumer & other loans		746		2,843		130		3,719		1,783		1,190

Total	$	262,083	$	57,725	$	94,109	$	413,917	$	61,776	$	90,058

As of December 31, 2006:


	Maturity								Rate Structure for
	One		One						Loans Maturing Over
	Year		through		Over				One Year
	or		Five		Five				Fixed		Floating
	Less		Years		Years		Total		Rate		Rate
	(In thousands)
Real estate loans:
Construction & land development	$	167,072	$	19,077	$	8,560	$	194,709	$	14,797	$	12,840
Commercial real estate		2,473		9,469		55,282		67,224		11,658		53,093
Residential real estate		26,771		10,834		26,337		63,942		20,215		16,956
Commercial & industrial loans		7,431		4,095		4,103		15,629		4,486		3,712
Consumer & other loans		415		2,602		218		3,235		1,767		1,053

Total	$	204,162	$	46,077	$	94,500	$	344,739	$	52,923	$	87,654

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

13-18

loans comprised 64.4% of total loans, of which approximately 84.1% were construction and land development, 8.2% were residential, 4.0% were commercial real estate, 3.5% were commercial and industrial, and 0.2% were consumer.

Our interest-only loans are secured by real estate or in the case of commercial and industrial loans, may also be secured by other business assets, such as accounts receivable, equipment and inventory. These loans generally mature within 6 to 30 months depending on the estimated completion date of the project in the case of construction, land development, residential and commercial real estate loans. Commercial and industrial loans normally mature within 12 months. Interest-only loans bear interest at a variable or fixed rate, with accrued interest payable monthly or in the case of our construction, land development, commercial and residential mortgage loans, interest may, at borrower’s option be accrued and paid upon completion of the project. We monitor our interest-only loans for collectibility through our credit underwriting policies and procedures which are described below under “Business — Our Business Activities — Lending,” by taking prompt action if any required payments are not made, and by requiring our lending staff to monitor and provide progress reports to senior management periodically with respect to the percentage of completion of the project, borrower’s project costs to date and any variance from the budget established for the project, and the performance by borrower of all other financial and other loan covenants. As of December 31, 2007, we did not have any option ARMs or negative amortizing loans.

The following table shows the amounts of our interest-only loans in each loan category at the end of the periods indicated.


	December 31,		December 31,
	2007		2006
	(In thousands)
Real estate loans:
Construction & land development loans
Interest only	$	224,105	$	168,804
Principal and interest		29,083		27,582
Commercial real estate loans
Interest only		10,596		13,669
Principal and interest		61,839		67,081
Residential real estate loans
Interest only		21,778		24,762
Principal and interest		31,420		23,918
Commercial & industrial loans
Interest only		9,329		4,623
Principal and interest		22,048		12,114
Consumer and other loans
Interest only		589		258
Principal and interest		3,130		1,928

Total	$	413,917	$	344,739

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 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.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

13-19

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:


	December 31,
	2007			2006			2005			2004			2003
	(Dollars in thousands)
Non-accrual loans	$	24,923		$	219		$	128		$	100		$	—
Accruing loans past due 90 days or more		399			—			—			—			—

Total non-performing loans (NPLs)		25,322			219			128		$	100			—
Other real estate owned		983			—			—			30			30

Total non-performing assets (NPAs)	$	26,305		$	219		$	128		$	130		$	30

Selected ratios
NPLs to total loans		6.12	%		0.06	%		0.06	%		0.09	%		0.00	%
NPAs to total assets		5.38	%		0.06	%		0.05	%		0.09	%		0.04	%

Our levels of non-performing loans and OREO property increased significantly in the year ended December 31, 2007, primarily as a result of the reassessment of our mortgage loan portfolio in light of recent deterioration in the local housing market and the issues identified with respect to certain residential construction loans. See “Recent Developments” above.

OREO Properties.We had $983,411 of OREO property at December 31, 2007, and no OREO property at December 31, 2006 and December 31, 2005.

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:

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	Year Ended December 31,
	2007		2006
Impaired Loans
Balance at end of period (1)	$	25,437,668	$	—

Total related allowance for losses	$	5,009,141	$	—

Average investment in impaired loans	$	7,375,426	$	—

Interest income recognized on impaired loans	$	1,254,832	$	—

Interest income received on impaired loans	$	1,094,351	$	—


(1)		Includes $11.8 million non-accrual loans.

As a separate categorization, any troubled debt restructurings are defined as loans that we have agreed to modify by accepting below-market terms, either by granting interest rate concessions or by deferring principal and/or interest payments.

We had $25,437,668 impaired loans at December 31, 2007, and no material impaired loans at December 31, 2006 or December 31, 2005.

At December 31, 2007, we had no loans not disclosed above as non-accrual loans, as to which we had serious doubts as to the ability of the borrower to comply with the present loan repayment terms and which may result in disclosure of these loans as non-accrual loans.

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 December 31, 2007 we had a reserve balance of $465,000 for allowance for unfunded credit losses and $103,600 at December 31, 2006.

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.

As of December 31, 2007 and December 31, 2006, our unfunded commitments totaled $81,610,000 and $110,907,000 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 has repurchased one real estate loan totaling $750,000 in the fourth quarter 2007 and two loans for $715,590 during the first quarter 2008.

Allowance for Loan Losses

We must 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

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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.

Our provision for loan losses and levels of impaired loans and non-accrual loans increased significantly in the year ended December 31, 2007, primarily as a result of the reassessment of our mortgage loan portfolio in light of recent deterioration in the local housing market and the issues identified with respect to certain residential construction loans. See “Recent Developments” above.

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 3 of which is divided into four subcategories, are considered satisfactory or “Pass,” except for 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”.

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


	Years Ended December 31,
	2007			2006			2005			2004				2003
	(Dollars in thousands)
Allowance for loan losses:
Beginning balance	$	3,972		$	2,520		$	1,189		$	578			$	351
Loans charged off													��
Real estate loans:
Construction		69			—			—			—				—
Commercial real estate		—			—			—			—				—
Residential real estate		156			—			—			—				20
Commercial & industrial loans		88			21			—			—				—
Consumer loans		26			4			1			22				—

Total		339			25			1			22				20
Recoveries:
Real estate loans:
Construction		—			—			—			—				—
Commercial real estate		—			—			—			—				—
Residential real estate		—			—			—			—				13
Commercial & industrial loans		—			2			1			—				12
Consumer loans		2			—			—			1				—

Total		2			2			1			1				25
Net loan charge-off (recovery)		337			23			—			21				(5	)
Reclassification of unfunded credit commitments to other liabilities		—			(48	)		(20	)		(22	)			(8	)
Provision for loan losses		15,879			1,523			1,351			654				230

Ending balance	$	19,514		$	3,972		$	2,520		$	1,189			$	578

Loans	$	413,917		$	344,739		$	210,015		$	118,812			$	58,800
Average loans		401,198			276,865			161,357			82,118				47,535
Non-performing loans		25,322			219			128			100				—
Selected ratios:
Net charge-offs to average loans		0.08	%		0.01	%		0.00	%		0.03	%			(0.01	)%

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	Years Ended December 31,
	2007			2006			2005			2004			2003
	(Dollars in thousands)
Provision for loan losses to average loans		3.96	%		0.55	%		0.84	%		0.80	%		0.48	%
Allowance for loan losses to loans outstanding at end of period		4.71	%		1.15	%		1.20	%		1.00	%		0.98	%
Allowance for loan losses to non-performing loans		77.1	%		1813.7	%		1968.8	%		1189.0	%		N/A

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 “4” 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.

We allocate our allowance for loan losses by assigning general percentages to our major loan categories (construction, commercial real estate, residential real estate, C&I and consumer), assigning specific percentages to each category of loans rated from 4 through 7 in accordance with the guidelines established by the regulatory agencies, and making specific allocations when factors are present requiring a greater reserve than would be required using the assigned risk rating allocation, which is typically based on a review of appraisals or other collateral analysis. The following table indicates management’s allocation of the allowance and the percent of loans in each category to total loans as of each of the following dates:


	December 31,
	2007					2006					2005					2004					2003
			Percent of					Percent of					Percent of					Percent of					Percent of
			Loans in					Loans in					Loans in					Loans in					Loans in
			Each					Each					Each					Each					Each
	Allocation		Category			Allocation		Category			Allocation		Category			Allocation		Category			Allocation		Category
	of the		to Total			of the		to Total			of the		to Total			of the		to Total			of the		to Total
	Allowance		Loans			Allowance		Loans			Allowance		Loans			Allowance		Loans			Allowance		Loans
	(Dollars in Thousands)
Construction & land development	$	1,860		61.2	%	$	1,460		56.5	%	$	778		49.4	%		309		34.7	%	$	117		26.5	%
Commercial real estate		601		17.5	%		504		19.5	%		352		22.4	%		271		30.5	%		105		23.8	%
Residential real estate		143		12.9	%		160		18.5	%		109		20.8	%		62		20.8	%		33		22.4	%
Commercial & industrial loans		149		7.6	%		117		4.5	%		98		6.2	%		109		12.2	%		106		24.0	%
Consumer loans		42		0.9	%		32		0.9	%		25		1.2	%		22		1.9	%		19		3.3	%

Direct and Unallocated	$	16,719				$	1,698				$	1.157				$	416				$	198


Total	$	19,514		100.0	%	$	3,972		100.0	%	$	2,520		100.0	%	$	1,189		100.0	%	$	578		100.0	%

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

13-23

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. This portion of our allowance has increased in recent years primarily as a result of our loan growth and because a relatively high percentage of our loans are unseasoned. At December 31, 2007, 85.1% of our total loan portfolio consisted of loans booked in the last two years, including loan renewals. This risk portion of the allowance for loan losses increased from the prior period due to the reassessment of loans. As of December 31, 2007, this risk portion of the allowance for loan losses was $3,175,000 or 16.3% of the total allowance, compared with $1,625,000 or 40.9% of the total allowance as of December 31, 2006.

Investments

The carrying value of our investment securities totaled $8.8 million at December 31, 2007, $8.2 million at December 31, 2006 and $8.2 million at December 31, 2005. Our portfolio of investment securities during 2007, 2006 and 2005 consisted primarily of federal and state government securities.

The carrying value of our portfolio of investment securities at December 31, 2007, 2006 and 2005 was as follows:


	Carrying Value at December 31,
	2007		2006		2005
	(In thousands)
U.S. government agencies	$	6,980	$	6,382	$	6,327
Obligations of states and political subdivisions		1,813		1,812		1,825
Mortgage-backed securities		39		50		83
Other securities		—		—		—

Total investment securities	$	8,832	$	8,244	$	8,235

The following tables show the maturities of investment securities at December 31, 2007 and December 31, 2006, and the weighted average yields of such securities, excluding the benefit of tax-exempt securities:


	December 31, 2007
						After One Year but					After Five Years but
	Within One Year					within Five Years					within Ten Years					After Ten Years
	Amount		Yield			Amount		Yield			Amount		Yield			Amount		Yield
								(Dollars in thousands)
U.S. government agencies	$	998		4.52	%	$	5,982		4.95	%	$	—		—		$	—		—
Obligations of states and political subdivisions		—		—			502		3.80	%		1,089		4.25	%		222		4.55	%
Mortgage-backed securities		8		4.52	%		31		4.52	%		—		—			—		—
Other securities		—		—			—		—			—		—			—		—

Total available for sale	$	1,006		4.52	%	$	6,515		4.86	%	$	1,089		4.25	%	$	222		4.55	%


	December 31, 2006
						After One Year but					After Five Years but
	Within One Year					within Five Years					within Ten Years					After Ten Years
	Amount		Yield			Amount		Yield			Amount		Yield			Amount		Yield
								(Dollars in thousands)
U.S. government agencies	$	2,298		4.59	%	$	3,093		4.55	%	$	991		6.66	%	$	—		—
Obligations of states and political subdivisions		—		—			246		3.80	%		809		4.09	%		757		4.35	%
Mortgage-backed securities		6		4.64	%		44		4.64	%		—		—			—		—
Other securities		—		—			—		—			—		—			—		—

Total available-for-sale	$	2,304		4.59	%	$	3,383		4.50	%	$	1,800		5.56	%	$	757		4.35	%

Deposits

Total deposits were $421.4 million at December 31, 2007 compared to $315.0 million at December 31, 2006 and $224.2 million at December 31, 2005. The increase in total deposits since December 31, 2005 is attributed primarily to our market growth and entering into new markets. Non-interest-bearing demand deposits decreased to $24.7 million, or 5.9% of total deposits, at December 31, 2007, from $26.9 million, or 8.5% of total deposits, at December 31, 2006, and from $21.8 million, or 9.8% of total deposits, at December 31, 2005. Interest-bearing

deposits are comprised of 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:


	Years Ended December 31,
	2007					2006					2005
	Average		Average			Average		Average			Average		Average
	Balance		Rate			Balance		Rate			Balance		Rate
	(Dollars in Thousands)
Interest-bearing demand	$	7,542		1.02	%	$	11,682		0.61	%	$	10,895		0.40	%
Money market		99,941		4.49	%		114,527		4.50	%		69,722		3.97	%
Savings		7,802		3.78	%		3,844		1.53	%		4,474		0.98	%
Time certificates of deposit		226,050		5.33	%		117,400		4.99	%		63,576		3.37	%
Non-interest bearing deposits		28,426		0.00	%		25,736		0.00	%		19,884		0.00	%

Total	$	369,761		4.57	%	$	273,189		4.08	%	$	168,551		2.97	%

Additionally, the following table shows the maturities of CDs of $100,000 or more at December 31, 2007:


	December 31,
	2007
	(In thousands)
Due in three months or less	$	37,459
Due in over three months through six months		38,605
Due in over six months through twelve months		32,092
Due in over twelve months		41,043

Total	$	149,199

Deposits are gathered from individuals, partnerships and corporations in our market areas. Our policy also permits the acceptance of brokered deposits. 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.

Shareholders’ 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.

December 31, 2007 Overview.As of December 31, 2007, our shareholders’ 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 result of our asset growth and the net loss for the period that resulted from the additions to the allowance for loan losses.

2006 Overview.As of December 31, 2006, our shareholders’ equity totaled $61.7 million, and our equity to asset ratio was 15.9%, compared to 6.4% as of December 31, 2005. This increase is attributed to the $40.2 million net proceeds of our initial public offering completed December 19, 2006.

Stock Split.In August 2006, we completed a 6.1429-to-1 stock split effected in the form of a stock dividend. This resulted in issuing 5.1429 additional shares of stock to the common shareholders for each share previously held. As a result of the stock split, the accompanying consolidated financial statements reflect an increase in the number of outstanding shares of common stock and the $2,301,842 transfer of the par value of these additional shares from capital surplus. All share and per share amounts have been restated to reflect the retroactive effect of the stock split, except for our capitalization.

13-25

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 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	%


	Regulatory Requirements
	(Greater than or equal to						Actual at December 31, 2006
	stated percentage)									WSB Financial
	Adequately Capitalized			Well Capitalized			Westsound Bank			Group, Inc.
Tier 1 leverage capital ratio		4.0	%		5.0	%		19.4	%		19.8	%
Tier 1 risk-based capital		4.0	%		6.0	%		19.7	%		20.2	%
Total risk-based capital		8.0	%		10.0	%		20.9	%		21.4	%

Although the Company and the Bank were “well capitalized” at 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 the regulatory guidelines, the FRB and the FDIC have advised the Company and the Bank that they will no longer be regarded as “well capitalized” for federal regulatory purposes, as a result of the deficiencies cited in the FDIC order. See “Management’s Discussions and Analysis of Results of Operations and Financial Condition – Recent Developments.” There are no conditions or events since the FDIC order that management believes have changed the Bank’s category.

The Company and Westsound Bank remain adequately-capitalized under regulatory guidelines, as of December 31, 2007, and management believes that the Company has sufficient capital resources and liquidity to be able to continue its normal business operations.

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 us, 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 December 31, 2007 of 7.42% (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.

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.

13-24

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 December 31, 2007 of 7.42%. 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, the Company elected to defer payment of interest on the Junior Subordinated Debt Securities for the interest payment due March 15, 2008, 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.

Contractual Obligations

The following table sets forth our significant contractual obligations at December 31, 2007:


			Payments Due by Period
			Less
			Than						After
			1		1-3		3-5		5
Contractual Obligations	Total		Year		Years		Years		Years
	(In Thousands)
Junior subordinated deferrable interest debentures	$	8,248	$	—	$	—	$	—	$	8,248
Time certificates of deposit		294,826		205,932		70,365		18,529		—
Operating lease obligations		887		294		514		79		—

Total	$	303,961	$	206,226	$	70,879	$	18,608	$	8,248

The following table sets forth our other significant commitments at December 31, 2007:


			Amount of Commitment Expiration Per
			Period
			Less
	Total		Than						After
	Amounts		1		1-3		3-5		5
Other Commitments	Committed		Year		Years		Years		Years
	(In Thousands)
Commitments to extend credit	$	78,580	$	72,024	$	6,556	$	—	$	—
Credit cards		2,315		—		2,315		—		—
Standby letters of credit		715		715		—		—		—

Total	$	81,610	$	72,739	$	8,871	$	—	$	—

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.”

13-27

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. We have borrowing lines at correspondent banks totaling $20.0 million. Our credit line of $16.0 million with the FHLB has been placed on hold until FHLB completes its credit analysis of the Bank and will probably be collateral dependent. As of December 31, 2007 we had $7.2 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 December 31, 2007, we had approximately $75.7 million in liquid assets comprised of $66.9 million in cash and cash equivalents (including fed funds sold of $56.9 million), and $8.8 million in available-for-sale securities.

On a long term basis, our liquidity will be met by changing the relative distribution of its asset portfolios, i.e., reducing investment or loan volumes, or selling or encumbering assets. Further, it will increase 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. Increases in net loans for the year ended December 31, 2007, and the years ended December 31, 2006 and 2005, were $53.2 million, $133.0 million, and $89.5 million, respectively. Investment securities were $8.8 million at December 31, 2007, and $8.2 million at December 31, 2006. At December 31, 2007 we had outstanding loan commitments of $80.9 million and outstanding letters of credit of $715,000. 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 increases in deposit levels. During the year ended December 31, 2007, and the years ended December 31, 2006 and 2005, deposits increased by $106.4 million, $90.9 million and $100.6 million, respectively. During the year ended December 31, 2006, net proceeds from our initial public offering provided an additional $40.2 million cash. During the year ended December 31, 2005, proceeds from the issuance of cumulative trust preferred securities provided an additional $8.0 million cash.

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.

13-28

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 December 31, 2007, 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 December 31, 2007.

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	$	58,047		4.0	%		11.9	%		102.34	%
Up 100 basis points		57,172		2.5	%		11.7	%		100.80	%
BASE		55,798		—			11.4	%		98.37	%
Down 100 basis points		56,182		0.7	%		11.5	%		99.05	%
Down 200 basis points		55,362		(0.8	)%		11.3	%		97.61	%

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 December 31, 2007, 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

13-29

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 December 31, 2007, 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	$	15,111		8.0	%		3.30	%		24
Up 100 basis points		14,584		4.2	%		3.19	%		13
BASE		13,993		—			3.06	%		—
Down 100 basis points		13,296		(5.0	)%		2.91	%		(15	)
Down 200 basis points		12,746		(8.9	)%		2.79	%		(27	)


(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 December 31, 2007. 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.

13-30


	December 31, 2007
	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	$	2,425		$	—		$	—		$	—		$	7,601		$	10,026
Federal funds sold		56,900			—			—			—			—			56,900
Investment securities		1,393			2,305			4,246			785			103			8,832
Loans		180,842			117,258			75,436			15,440			23,974			412,950
Other assets(2)		567			—			—			—			58			625

Total assets	$	242,127		$	119,563		$	79,682		$	16,225		$	31,736		$	489,333


Liabilities and Stockholders’ Equity

Non-interest-bearing demand deposits	$	—		$	—		$	—		$	—		$	24,711		$	24,711
Interest-bearing demand, money market and savings		12,195			36,583			47,754			5,376			—			101,908
Time certificates of deposit		78,237			127,846			76,462			12,431			(150	)		294,826
Short-term debt		—			—			—			—			—			—
Long-term debt		8,248			—			—			—			—			8,248
Other liabilities		—			—			—			—			2,920			2,920
Stockholders’ equity		—			—			—			—			56,720			56,720

Total liabilities and stockholders’ equity	$	98,680		$	164,429		$	124,216		$	17,807		$	84,201		$	489,333

Period gap		143,447			(44,866	)		(44,534	)		(1,582	)		(52,465	)
Cumulative interest-earning assets		242,127			361,690			441,372			457,597
Cumulative interest-bearing liabilities		98,680			263,109			387,325			405,132
Cumulative gap		143,447			98,581			54,047			52,465
Cumulative interest-earning assets to cumulative interest-bearing liabilities		2.45			1.37			1.14			1.13
Cumulative gap as a percent of:
Total assets		29.3	%		20.1	%		11.0	%		10.7	%
Interest-earning assets		59.2	%		27.3	%		12.2	%		11.5	%


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

(2)		Allowance for loan losses of $19.5 million as of December 31, 2007.

At December 31, 2007, we had $361.7 million in assets and $263.1 million in liabilities re-pricing within one year. This means that $98.6 million more of our interest rate sensitive assets than our interest rate sensitive liabilities 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 December 31, 2007 is 1.37. This analysis indicates that at December 31, 2007, if interest rates were to increase, the gap would result in a higher 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.

13-31

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.

Recent Accounting Pronouncements

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

13-32

INDEX TO FINANCIAL STATEMENTS


Report of Independent Registered Public Accounting Firm

Consolidated Statement of Financial Condition

Consolidated Statement of Operations

Consolidated Statement of Changes in Stockholders’ Equity and Comprehensive Income (Loss)

Consolidated Statement of Cash Flows

Notes to Consolidated Financial Statements

13-33

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Shareholders
WSB Financial Group, Inc.

We have audited the accompanying consolidated statement of financial condition of WSB Financial Group, Inc. and Subsidiaries (Company) as of December 31, 2007 and 2006, and the related consolidated statements of operations, changes in stockholders’ equity and comprehensive income (loss), and cash flows for each of the three years in the period ended December 31, 2007. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform an audit of its internal control over financial reporting. An audit includes consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of WSB Financial Group, Inc. and Subsidiaries as of December 31, 2007 and 2006, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2007, in conformity with accounting principles generally accepted in the United States of America.

As discussed in Note 2 to the consolidated financial statements, the Company’s bank subsidiary has entered into Stipulation and Consent to the Issuance of an Order to Cease and Desist with the Federal Deposit Insurance Corporation and Washington Department of Financial Institutions.

/s/ Moss Adams LLP

Everett, Washington
March 31, 2008

13-34

WSB FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF FINANCIAL CONDITION


	December 31,			December 31,
	2007			2006
ASSETS
Cash and cash equivalents
Cash and due from banks	$	10,026,460		$	9,048,104
Federal funds sold		56,900,000			17,150,000

Total cash and cash equivalents		66,926,460			26,198,104

Investment Securities available for sale, at fair value		8,832,146			8,243,643
Federal Home Loan Bank stock, at cost		318,900			234,200
Loans held for sale		—			11,007,194
Loans		412,949,947			333,172,808
Less allowance for loan losses		(19,513,765	)		(3,971,789	)

Total loans, net		393,436,182			329,201,019

Premises and equipment, net		8,759,750			7,845,740
Accrued interest receivable		2,540,554			1,980,117
Other real estate owned		983,411			—
Deferred tax asset		6,496,106			827,910
Other assets		1,039,655			1,216,227

Total assets	$	489,333,164		$	386,754,154


LIABILITIES AND STOCKHOLDERS’ EQUITY
Deposits
Non-interest-bearing	$	24,711,246		$	26,864,122
Interest-bearing		396,733,599			288,157,881

Total deposits		421,444,845			315,022,003

Accrued interest payable		1,955,434			1,108,688
Other liabilities		964,870			718,335
Junior subordinated debentures		8,248,000			8,248,000

Total liabilities		432,613,149			325,097,026

Stockholders’ equity
Common stock, $1 par value; 15,357,250 shares authorized; 5,574,853 and 5,545,673 shares issued and outstanding at December 31, 2007 and December 31, 2006, respectively		5,574,853			5,545,673
Additional paid-in capital		48,223,669			48,089,861
Retained earnings		2,853,756			8,053,915
Accumulated other comprehensive income (loss)		67,737			(32,321	)

Total stockholders’ equity		56,720,015			61,657,128

Total liabilities and stockholders’ equity	$	489,333,164		$	386,754,154

	��
		See accompanying notes.

13-35

WSB FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF OPERATIONS


	Year ended December 31,
	2007			2006		2005
INTEREST INCOME
Interest and fees on loans	$	35,958,390		$	27,633,568	$	15,088,071
Interest on investments
Taxable		316,280			265,174		201,208
Tax-exempt		75,510			75,842		61,692
Interest on federal funds sold		879,040			282,055		295,224
Other interest income		166,581			84,466		46,666

Total interest income		37,395,801			28,341,105		15,692,861

INTEREST EXPENSE
Deposits		16,910,386			11,143,894		4,997,880
Other borrowings		1,241			75,232		5,069
Junior subordinated debentures		603,017			565,486		178,529

Total interest expense		17,514,644			11,784,612		5,181,478
NET INTEREST INCOME		19,881,157			16,556,493		10,511,383
PROVISION FOR LOAN LOSSES		15,879,000			1,522,917		1,351,814

Net interest income after provision for loan losses		4,002,157			15,033,576		9,159,569


NONINTEREST INCOME
Service charges on deposit accounts		381,380			255,659		178,651
Other customer fees		789,513			878,372		605,984
Net gain on sale of loans		2,845,046			3,483,303		4,383,487
Other income		515,029			54,754		72,674

Total noninterest income		4,530,968			4,672,088		5,240,796


NONINTEREST EXPENSE
Salaries and employee benefits		9,486,241			9,257,885		7,264,567
Premises lease		328,825			338,113		246,222
Depreciation and amortization expense		824,207			611,766		371,273
Occupancy and equipment		613,537			511,886		497,093
Data and item processing		698,446			511,610		362,544
Advertising expense		180,194			214,680		183,163
Printing, stationery and supplies		191,392			218,935		213,338
Telephone expense		110,757			110,625		77,589
Postage and courier		154,911			132,320		108,799
Legal fees		301,124			44,570		28,330
Director fees		321,000			303,334		233,410
Business and occupation taxes		343,628			273,522		187,795
Accounting and audit fees		253,680			76,987		43,170
Consultant fees		216,127			63,805		44,108
OREO losses and expense, net		265,891			—		—
Provision for unfunded credit losses		361,400			—		—
Other expenses		1,841,652			1,183,523		830,836

Total noninterest expense		16,493,012			13,853,561		10,692,237


INCOME (LOSS) BEFORE PROVISION (BENEFIT) FOR INCOME TAXES		(7,959,887	)		5,852,103		3,708,128

PROVISION (BENEFIT) FOR INCOME TAXES		(2,759,728	)		1,967,420		1,296,558


NET INCOME (LOSS)	$	(5,200,159	)	$	3,884,683	$	2,411,570


EARNINGS (LOSS) PER SHARE
Basic	$	(0.93	)	$	1.35	$	0.91
Diluted	$	(0.93	)	$	1.18	$	0.82

Weighted-average number of common shares outstanding		5,565,123			2,870,022		2,642,628
Weighted-average number of dilutive shares outstanding		5,565,123			3,285,622		2,925,092


		See accompanying notes.

13-36

WSB FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOME (LOSS)



														Accumulated
	Common Stock							Additional						Other
	Number							Paid-In			Retained			Comprehensive
	of Shares				Amount			Capital			Earnings			Income (Loss)			Total
Balance, December 31, 2004		2,594,485			$	2,594,485		$	8,441,366		$	1,883,859		$	(8,148	)	$	12,911,562

Net income												2,411,570						2,411,570

Other comprehensive loss, net of tax of $28,164															(56,229	)		(56,229	)

Total comprehensive income																		2,355,341


Tax benefit of stock options exercised									42,670									42,670
Stock issued for director fees		16,530				16,530			135,805									152,335
Stock options exercised		84,772				84,772			245,528									330,300
Issuance of stock		26,261				26,261			187,289									213,550


Balance, December 31, 2005		2,722,048			$	2,722,048		$	9,052,658		$	4,295,429		$	(64,377	)	$	16,005,758

Net income												3,884,683						3,884,683

Other comprehensive income, net of tax of ($15,710)															32,056			32,056

Total comprehensive income																		3,916,739


Tax benefit of stock options exercised									375,643									375,643
Fractional shares repurchased		(228	)			(228	)		(758	)		(2,008	)					(2,994	)
Stock repurchases		(14,068	)			(14,068	)		(46,786	)		(124,189	)					(185,043	)
Stock issued for director fees		10,473				10,473			113,460									123,933
Stock options exercised		182,448				182,448			1,003,808									1,186,256
Net proceeds from issuance of common stock in public offering		2,645,000				2,645,000			37,591,836									40,236,836


Balance, December 31, 2006		5,545,673			$	5,545,673		$	48,089,861		$	8,053,915		$	(32,321	)	$	61,657,128

Net loss												(5,200,159	)					(5,200,159	)
				��
Other comprehensive income, net of tax of ($51,545)															100,058			100,058

Total comprehensive loss																		(5,100,101	)


Stock based compensation expense									26,484									26,484
Stock options exercised		29,180				29,180			107,324									136,504


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


		See accompanying notes.

13-37

WSB FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS


	Year Ended December 31,
	2007			2006			2005
CASH FLOWS FROM OPERATING ACTIVITIES
Net (loss) income	$	(5,200,159	)	$	3,884,683		$	2,411,570
Adjustments to reconcile net (loss) income to net cash from operating activities
Provision for loan losses		15,879,000			1,522,917			1,351,814
Provision for unfunded credit losses		361,400			—			—
Provision for OREO write-down		186,312			—			—
Depreciation and amortization		824,207			611,766			371,273
Amortization (accretion) of premiums/discounts		(2,318	)		6,764			10,288
Director fees paid by stock in lieu of cash		—			123,933			152,335
Excess tax benefits from stock options exercised		—			(375,643	)		(42,670	)
Stock based compensation		26,484			—			—
Net gain on sale of premises and equipment and OREO		(410,049	)		—			—
Origination of loans held for sale		(93,986,895	)		(122,304,063	)		(144,919,748	)
Proceeds from sale of loans held for sale		107,839,135			123,512,035			142,595,483
Net gain on sale of loans		(2,845,046	)		(3,483,303	)		(4,388,487	)
Deferred income tax benefit		(5,719,741	)		(674,367	)		(511,058	)
Net change in
Accrued interest receivable		(560,437	)		(981,095	)		(556,272	)
Other assets		176,572			(226,477	)		199,266
Accrued interest payable		846,746			874,514			107,370
Other liabilities		(114,865	)		(625,037	)		1,091,667

Net cash from operating activities		17,300,346			1,866,627			(2,127,169	)

CASH FLOWS FROM INVESTING ACTIVITIES
Net change in loans		(82,247,717	)		(132,283,986	)		(84,167,657	)
Purchases of investments available-for-sale		(5,745,804	)		(1,000,000	)		(3,841,294	)
Proceeds from calls and maturities of investments available-for-sale		5,300,000			1,000,000			—
Principal repayments of mortgage-backed securities		11,222			32,490			69,688
Purchase of Federal Home Loan Bank stock		(84,700	)		—			(133,000	)
Proceeds from sale of other real estate owned		980,193			—			—
Purchases of premises and equipment		(2,713,201	)		(2,440,783	)		(3,835,657	)
Proceeds from sale of premises and equipment		1,368,671			—			—

Net cash from investing activities		(83,131,336	)		(134,692,279	)		(91,907,920	)

CASH FLOW FROM FINANCING ACTIVITIES
Net change in non-interest-bearing deposits		(2,152,876	)		5,074,312			7,065,877
Net change in interest-bearing deposits		108,575,718			85,780,918			93,508,104
Proceeds from the issuance of junior subordinated debentures payable		—			—			8,248,000
Net proceeds from sale of stock		—			40,236,836			213,550
Proceeds from exercise of stock options		136,504			1,186,256			330,300
Excess tax benefit from stock options exercised		—			375,643			42,670
Fractional share payout		—			(2,994	)		—
Stock repurchases		—			(185,043	)		—

Net cash from financing activities		106,559,346			132,465,928			109,408,501

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS		40,728,356			(359,724	)		15,373,412
CASH AND CASH EQUIVALENTS, beginning of period		26,198,104			26,557,828			11,184,416

CASH AND CASH EQUIVALENTS, end of period	$	66,926,460		$	26,198,104		$	26,557,828

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid for interest	$	16,667,898		$	10,910,098		$	5,074,108

Income taxes paid	$	2,790,000		$	2,550,000		$	555,000

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


		See accompanying notes.

13-38

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 branches and/or loan production 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 inter-company transactions. All share and per share information has been retroactively adjusted to reflect split effective August 15, 2006 (See Note 17).

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.

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 December 31, 2007 and 2006. The Bank had no trading securities as of December 31, 2007 and 2006.

13-39

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

Note 1 — Summary of Significant Accounting Policies (continued)

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.

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 December 31, 2007. The fair value and notional value of interest rate lock commitments was approximately $(6,200) at December 31, 2006. The fair value and notional amount of forward sale commitments was approximately $6,200 at December 31, 2006.

13-40

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

Note 1 — Summary of Significant Accounting Policies (continued)

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

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

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

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

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

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

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

13-41

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

Note 1 — Summary of Significant Accounting Policies (continued)

Transfers of financial assets- Transfers of financial assets are accounted for as sales, when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Bank, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Bank does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity.

Premises and equipment- Land is carried at cost. Other premises and equipment are carried at cost net of accumulated depreciation. Depreciation is computed using the straight-line method based on the estimated useful lives of the related assets, ranging from 3 to 25 years. Maintenance and repairs are expensed as incurred while major additions and improvements are capitalized. Leasehold improvements are amortized over the life of the building lease.

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 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.

Income taxes- Income taxes are provided for the tax effects of the transactions reported in the financial statements and consist of taxes currently due plus deferred taxes related primarily to differences between the basis of the allowance for loan losses, organization costs, depreciation, and benefit associated with net operating losses. The deferred tax assets and liabilities are determined using the liability method and represent the future tax return consequences of those differences, which will either be taxable or deductible when the assets and liabilities are recovered or settle. Deferred tax assets and liabilities are reflected at income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settle. As changes in the tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes.

Stock option plans- Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 123(R),Share-Based Payment,which is a revision of SFAS No. 123,Accounting for Stock-Based Compensation.SFAS 123(R) supersedes Accounting Principles Board Opinion No. 25,Accounting for Stock Issued to Employees, and amends SFAS No. 95,Statement of Cash Flows. Generally, the approach in SFAS 123(R) is similar to the approach described in SFAS 123. However, SFAS 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. There were 24,000 shares granted for options in 2007 and none in 2006.

Prior to the Company’s adoption of SFAS 123(R) on January 1, 2006, employee stock options were accounted from under the intrinsic value method as allowed under Accounting Principles Board Opinion (APB) No. 25. Stock options are generally granted at exercise prices not less than the fair market value of common stock on the date of grant. Under APB No. 25, no compensation expense was recognized pursuant to the Company’s stock option plans for stock options that are granted at exercise prices not less than the fair market value of common stock on the date of grant.

13-42

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

Note 1 — Summary of Significant Accounting Policies (continued)

The pro forma effect on the Company’s earnings as a result of option issuances (determined using the minimum value method) for the year ended December 31, 2005 is as follows:


	2005
Net income as reported	$	2,411,570
Additional compensation for fair value of stock options, net of tax		(501,686	)


Pro forma net income	$	1,909,884


Basic earnings per share
As reported	$	0.91
Pro forma	$	0.72

Diluted earnings per share	$	0.82
Pro forma	$	0.65

Earnings per common share- Basic earnings per share represents income available to common stockholders divided by the weighted-average number of common shares outstanding during the period. Diluted earnings per share reflect 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.

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


	2007			2006		2005
Numerator
Net (loss) income	$	(5,200,159	)	$	3,884,683	$	2,411,570
Denominator
Weighted-average number of common shares outstanding		5,565,123			2,870,022		2,642,628
Incremental shares assumed for stock options (1)		—			415,600		282,464

Weighted-average number of dilutive shares outstanding		5,565,123			3,285,622		2,925,092


Basic earnings (loss) per common share	$	(0.93	)	$	1.35	$	0.91
Diluted earnings (loss) per common share (2)	$	(0.93	)	$	1.18	$	0.82


(1)		There were no anti-dilutive options at December 31, 2007, December 31, 2006, or December 31, 2005.

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

13-43

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

Note 1 — Summary of Significant Accounting Policies (continued)

Comprehensive income- Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and losses on available-for-sale securities, are reported as a separate component of the equity section of the balance sheet, such items, along with net income, are components of comprehensive income.

The components of other comprehensive income (loss) and related tax effects are as follows:


	2007			2006			2005
Unrealized holding gain (loss) on available-for-sale securities	$	151,603		$	47,766		$	(84,393	)
Tax (provision) benefit		(51,545	)		(15,710	)		28,164


Net-of-tax-amount	$	100,058		$	32,056		$	(56,229	)

The components of accumulated other comprehensive income (loss), included in stockholders’ equity are as follows:


	2007			2006			2005
Unrealized holding gain (loss) on available-for-sale securities	$	102,631		$	(48,971	)	$	(96,737	)
Tax (provision) benefit		(34,894	)		16,650			32,360


Net-of-tax-amount	$	67,737		$	(32,321	)	$	(64,377	)

Advertising costs- Advertising costs are expensed when incurred. Total advertising expenses were $180,194, $214,680, and $183,163 in 2007, 2006, and 2005, respectively.

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 is not expected to have a material impact on our consolidated financial statements.

13-44

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

Note 1 — Summary of Significant Accounting Policies (continued)

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

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

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

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.

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

13-45

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

Note 2 — Regulatory Actions

13-46

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

Note 2 — Regulatory Actions (continued)

Capital: Although as previously reported, the Company and the Bank were “well capitalized” at September 30, 2007 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 FRB and the FDIC have advised the Company and the Bank that they will no longer be regarded as ‘well capitalized’ for federal regulatory purposes, as a result of the deficiencies cited in the FDIC order.

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, including the $13.3 million increase in loan loss reserves, as reported in the Company’s quarterly report on Form 10-Q for the period ended September 30, 2007, which was filed February 1, 2008. The Company is also complying with the terms of the FRB notice, and has exercised its option to start deferring payments of quarterly interest on its trust preferred securities on March 15, 2008, as permitted by the indenture agreement.

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

	•		Conducting a comprehensive review of the qualifications of management and existing staff and consideration of potential changes that may be required;

	•		Engaged a management recruiting firm to conduct a nationwide search for a new chief executive officer, and identified highly qualified candidates for the position which is expected to be filled by April 30, 2008 subject to regulatory approval;

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

	•		Added $13.9 million to total provisions for loan losses and unfunded commitments in the third quarter of 2007 and increased fourth quarter 2007 reserves by $1.7 million;

	•		Strengthened collections and loss recovery teams to accelerate resolution of problem loans.

	•		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.

13-47

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

Note 2 — Regulatory Actions (continued)

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 several items addressed by the FDIC order.

Note 3 — Investment Securities

Amortized cost and approximate fair values of investment securities at December 31, 2007 and 2006 are summarized as follows:



			Gross		Gross Unrealized Losses
	Amortized		Unrealized		Less Than 12			12 Months or
	Cost		Gain		Months			Longer			Fair Value
December 31, 2007

Available for sale
Municipal securities	$	1,810,241	$	17,213		—		$	(14,631	)	$	1,812,823
Mortgage-backed		39,136		—		—			(22	)		39,114
Federal agencies		6,880,138		102,311		(457	)		(1,783	)		6,980,209


	$	8,729,515	$	119,524	$	(457	)	$	(16,436	)	$	8,832,146


December 31, 2006

Available for sale
Municipal securities	$	1,818,774	$	7,238		—		$	(14,487	)	$	1,811,525
Mortgage-backed		50,752		—		(551	)		—			50,201
Federal agencies		6,423,088		—		(1,654	)		(39,517	)		6,381,917


	$	8,292,614	$	7,238	$	(2,205	)	$	(54,004	)	$	8,243.643

The amortized cost and estimated fair value of investment securities available for sale at December 31, 2007, by contractual maturity, are as follows:


	Available-for-sale
	Amortized Cost		Fair Value
Accounts maturing in
One year or less	$	1,008,302	$	1,006,570
After one year through five years		6,403,650		6,514,484
After five years through ten years		1,099,499		1,089,372
After ten years		218,064		221,720


	$	8,729,515	$	8,832,146

Expected maturities will differ from contractual maturities because issuers may have the right to call obligation with or without penalties.

There were no sales of securities available for sale in 2007, 2006, and 2005.

13-48

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

Note 3 — Investment Securities (continued)

Investment securities valued at $1,684,589 and $1,273,230 have been pledged at December 31, 2007 and 2006, respectively, to secure certain deposits.

Management evaluates securities for other-than-temporary impairment at least on an annual basis, and more frequently when economic or market concerns warrant such evaluation. Consideration is given to (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.

At December 31, 2007, five investment securities have fair values less than amortized cost and therefore contain unrealized losses. The Bank has evaluated these securities and has determined that the decline in value is temporary, and is related to the change in market interest rates since purchase. The decline in value is not related to any company or industry specific event. The Bank anticipates full recovery of amortized cost with respect to these securities at maturity or sooner in the event of a more favorable market interest rate environment.

The following table shows gross unrealized losses and fair value of securities with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by category and length of time that individual securities have been in a continuous unrealized loss position at December 31, 2007 and 2006:


	Less than 12 Months					12 Months or More					Total
	Gross					Gross					Gross
	Unrealized					Unrealized					Unrealized
	Losses			Fair Value		Losses			Fair Value		Losses			Fair Value
December 31, 2007

Available for sale
Municipal securities	$	—				$	(14,631	)	$	404,392	$	(14,631	)	$	404,392
Mortgage-backed		—			—		(22	)		39,114		(22	)		39,114
Federal agencies		(457	)		623,426		(1,783	)		498,217		(2,240	)		1,121,643

	$	(457	)	$	623,426	$	(16,436	)	$	941,723	$	(16,893	)	$	1,565,149


December 31, 2006

Available for sale
Municipal securities	$	—				$	(14,487	)	$	945,681	$	(14,487	)	$	945,681
Mortgage-backed		(551	)		50,201		—					(551	)		50,201
Federal agencies		(1,654	)		2,298,110		(39,517	)		3,083,806		(41,171	)		5,381,916

	$	(2,205	)	$	2,348,311	$	(54,004	)	$	4,029,487	$	(56,209	)	$	6,377,798

13-49

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

Note 4 — Loans and Allowance for Loan Losses

Loans at December 31 are summarized as follows:


	2007			2006
Real estate loans	$	378,820,821		$	314,869,567
Commercial and industrial loans		31,376,932			15,628,593
Individual loans for household and other personal expenditures		2,612,883			2,186,922
Other loans		1,105,922			1,046,687
Deferred fees		(966,611	)		(558,961	)


	$	412,949,947		$	333,172,808


	2007			2006			2005
Allowance for loan losses
Balances, beginning of period	$	3,971,789		$	2,520,323		$	1,188,939
Provision for losses		15,879,000			1,522,917			1,351,814
Recoveries		2,064			1,851			524
Loans charged off		(339,088	)		(24,702	)		(954	)

Reclassification of allowance for unfunded credit commitments to other liabilities		—			(48,600	)		(20,000	)


Balances, end of period	$	19,513,765		$	3,971,789		$	2,520,323

A summary of past due and nonaccrual loans is as follows:


	2007		2006
Total non-accrual loans	$	24,923,234	$	219,129


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

Provision for Loan Losses.As of September 30, 2007 and December 31, 2007, we recorded provisions for loan losses primarily related to our real estate loan portfolio following a comprehensive evaluation based on representative samplings of our entire loan portfolio conducted by our senior management and an independent consultant with expertise in analyzing loan portfolios and determining loan loss allowances, provisions and charge-offs under regulatory guidelines and generally accepted accounting principles. An additional provision for loan losses of $13.4 million or $8.5 million after-tax was recorded in the third quarter of 2007 based on the loan reviews, and an additional provision of $1.7 million, or $1.1 million after-tax, was recorded in the fourth quarter of 2007 based on management’s quarterly assessment. The recording of the 2007 loan loss provisions results in a provision for loan losses of $15.9 million for the year ended December 31, 2007.

The Company’s provision for loan losses, levels of non-performing loans and OREO property, allowance for loan losses, levels of impaired loans and non-accrual loans increased significantly in the quarters ended September 30, 2007 and December 31, 2007, primarily as a result of the reassessment of the Company’s real estate loan portfolio in light of recent deterioration in the local housing market, the current problems in the mortgage banking and lending market and the issues we have identified with respect to certain residential construction loans, as well as some commercial real estate, C&I and other loans. The Company determined that it would record additional provisions for loan losses for the quarters ending September 30, 2007 and December 31, 2007. Weakness in the local housing market is expected to continue in the near term, and the situation could deteriorate further before the market stabilizes.

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

13-50

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

Note 4 — Loans and Allowance for Loan Losses (continued)

Impaired loans are summarized as follows:


	December 31,
	2007		2006
Impaired Loans
Balance at end of period (1)	$	25,437,668	$	—

Total related allowance for losses	$	5,009,141	$	—

Average investment in impaired loans	$	7,375,426	$	—

Interest income recognized on impaired loans	$	1,245,832	$	—

Interest income received on impaired loans	$	1,094,351	$	—


(1)		Includes $11.8 million non-accrual loans.

The Bank has entered into transactions with certain directors and executive officers. Such transactions were made in the ordinary course of business on substantially the same terms and conditions, including interest rates and collateral, as those prevailing at the same time for comparable transactions with other customers, and did not, in the opinion of management, involve more than normal credit risk or present other unfavorable features.

The aggregate balances and activity for loans to such related parties for 2007 and 2006 are as follows:


	2007			2006
Balance at beginning of year	$	7,561,384		$	3,668,984
New loans or advances		2,056,363			4,710,063
Payoffs/Repayments		(3,048,864	)		(817,663	)


Balance at end of year	$	6,568,883		$	7,561,384

The Bank held in the loan portfolio approximately $266,397,000 in interest-only loans at December 31, 2007 and $212,116,000 at December 31, 2006. These loans consist primarily of short-term real estate construction loans and land development loans.

13-51

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

Note 5 — Premises and Equipment

A summary of premises and equipment at December 31, 2007 and 2006 is as follows:


	2007			2006
Leasehold improvements	$	505,474		$	384,098
Equipment, furniture, and software		2,949,445			2,614,195
Land and buildings		7,482,389			6,436,811


	$	10,937,308		$	9,435,104
Accumulated depreciation		(2,177,558	)		(1,589,364	)


	$	8,759,750		$	7,845,740

Depreciation and amortization expense was $824,207, $611,766 and $371,273 in 2007, 2006, and 2005 respectively.

Note 6 — Deposits

Deposit account balances at December 31 are summarized as follows:


	2007		2006
Non-interest-bearing	$	24,711,246	$	26,864,122
Interest-bearing demand		12,350,558		8,810,738
Money market accounts		79,218,421		104,221,222
Savings deposits		10,338,768		3,454,168
Certificates of deposit exceeding $100,000		149,198,911		79,317,401
Certificates of deposit less than $100,000		145,626,941		92,354,352


	$	421,444,845	$	315,022,003

Scheduled maturities of certificates are as follows for the years ending December 31:


2008	$	205,932,482
2009		64,417,576
2010		5,946,415
2011		6,098,298
2012		12,431,081


	$	294,825,852

The Bank held related party deposits of $1,404,078 and $2,210,089 at December 31, 2007 and 2006, respectively.

13-52

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

Note 7 — Advances and Junior Subordinated Debentures Payable

At December 31, 2007, two committed lines of credit arrangements totaling $10,000,000 each were available to the Bank from unaffiliated banks with maturities dated June 30, 2008. These lines provide for interest at the then existing federal funds rate. There were no borrowings outstanding under these credit arrangements at December 31, 2007 or 2006.

The Bank is a member of the FHLB of Seattle. Our credit line of $16.0 million with FHLB has been placed on hold until FHLB completes its credit analysis of the Bank and will probably be collateral dependent. These borrowing must be secured by pledging of qualified loans. Borrowings generally provide for interest at the then current published rates. There were no borrowings outstanding under this credit line at December 31, 2007 or 2006.

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 December 31, 2007 of 7.42% (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.

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 December 31, 2007 of 7.42%. 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, the Company elected to defer payment of interest on the Junior Subordinated Debt Securities for the interest payment due March 15, 2008, as allowed under the Indenture. This election was the result of the notification by the Federal Reserve Bank of San Francisco, or FRB that WSB Financial Group, Inc. (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.

13-53

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

Note 8 — Income Taxes

The components of the provision for income taxes for 2007, 2006, and 2005 are as follows:


	2007			2006			2005
Current	$	2,960,013		$	2,641,787		$	1,807,616
Deferred		(5,719,741	)		(674,367	)		(511,058	)


Income tax expense (benefit)	$	(2,759,728	)	$	1,967,420		$	1,296,558

The provision for income tax differs from that computed by applying the U.S. Federal income tax rate of 34% to pretax income as a result of the following:


	2007						2006						2005
				Percent of						Percent of						Percent of
				Pretax						Pretax						Pretax
	Amount			Income			Amount			Income			Amount			Income
Income tax at statutory rate	$	(2,706,362	)		34.0	%		1,989,715			34.0	%	$	1,260,764			34.0	%
Increase (decrease) resulting from Tax-exempt income	$	(20,949	)		0.3	%	$	(21,407	)		-0.4	%	$	(18,237	)		-0.5	%
Other		(32,417	)		0.4	%		(888	)		0.0	%		54,031			1.5	%


Total provision (benefit) for income tax	$	(2,759,728	)		34.7	%	$	1,967,420			33.6	%	$	1,296,558			35.0	%

The nature and components of the Bank’s net deferred tax asset, established at a tax rate of 34% is as follows:


	2007		2006
Deferred tax assets
Allowance for loan losses	$	6,792,780	$	1,385,632
Unrealized loss on securities		—		16,650
Depreciation		24,749		(9,368	)
Other		287,162		(47,883	)


Total deferred tax assets		7,104,691		1,345,031


Deferred tax liabilities
Deferred loan fees and costs		573,690		517,121
Unrealized gain on securities		34,895		—


Total deferred tax liabilities		608,585		517,121


Net deferred tax asset	$	6,496,106	$	827,910

13-54

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

Note 8 — Income Taxes (continued)

The Bank believes, based upon available information, that the net deferred tax asset will be realized in the normal course of operations.

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 and at December 31, 2007.

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 9 — Loan Commitments and Contingent Liabilities

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

December 31, 2007


	Amount of Commitment Expiration Per Period
	Total
	Amounts		Less Than						After
	Committed		1 Year		1-3 Years		3-5 Years		5 Years
	(In thousands)
Other Commitments
Commitments to extend credit	$	78,580	$	72,024	$	6,556		—		—
Unused credit card lines		2,315		—		2,315		—		—
Standby letters of credit		715		715		—		—		—

Total	$	81,610	$	72,739	$	8,871		—		—

13-55

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

Note 9 — Loan Commitments and Contingent Liabilities (continued)

December 31, 2006


	Amount of Commitment Expiration Per Period
	Total
	Amounts		Less Than						After
	Committed		1 Year		1-3 Years		3-5 Years		5 Years
	(In thousands)
Other Commitments
Commitments to extend credit	$	108,309	$	89,543	$	18,766		—		—
Unused credit card lines		2,212		—		2,212		—		—
Standby letters of credit		386		386		—		—		—

Total	$	110,907	$	89,929	$	20,978		—		—

Note 10 — 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.

13-56

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

Note 10 — Stockholder’s Equity and Regulatory Matters (continued)

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 December 31, 2007
Total Risk-Based Capital (to Risk-Weighted Assets)
Consolidated	$	70,364		16.7	%	$	33,809	³	8.0	%	NA		NA
Westsound Bank	$	68,761		16.3	%	$	33,810	³	8.0	%	$	42,262	³	10.0	%

Tier 1 Capital (to Risk-Weighted Assets)
Consolidated	$	64,900		15.4	%	$	33,802	³	8.0	%	NA		NA
Westsound Bank	$	63,297		15.0	%	$	16,902	³	4.0	%	$	25,353	³	6.0	%

Tier 1 Capital (to Average Assets)
Consolidated	$	64,900		13.9	%	$	37,299	³	8.0	%	NA		NA
Westsound Bank	$	63,297		13.6	%	$	18,589	³	4.0	%	$	23,237	³	5.0	%

As of December 31, 2006
Total Risk-Based Capital (to Risk-Weighted Assets)
Consolidated	$	74,013		21.4	%	$	27,655	³	8.0	%	NA		NA
Westsound Bank	$	72,262		20.9	%	$	27,647	³	8.0	%	$	34,559	³	10.0	%

Tier 1 Capital (to Risk-Weighted Assets)
Consolidated	$	69,937		20.2	%	$	27,657	³	8.0	%	NA		NA
Westsound Bank	$	68,186		19.7	%	$	13,824	³	4.0	%	$	20,736	³	6.0	%

Tier 1 Capital (to Average Assets)
Consolidated	$	69,937		19.8	%	$	28,243	³	8.0	%	NA		NA
Westsound Bank	$	68,186		19.4	%	$	14,095	³	4.0	%	$	17,619	³	5.0	%

Although the ratios presented above show that the Company and the Bank were “well capitalized” at 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 FRB and the FDIC have advised the Company and the Bank that they will no longer be 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.

13-57

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

Note 10 — Stockholder’s Equity and Regulatory Matters (continued)

The Company and Westsound Bank remain adequately-capitalized under regulatory guidelines, as of December 31, 2007, following the additional provision for loan losses, and management believes that the Company has sufficient capital resources and liquidity to be able to continue its normal business operations.

Federal Reserve Board Regulations require maintenance of certain minimum reserve balances on deposit with the Federal Reserve Bank. The minimum reserve requirement at December 31, 2007 and 2006 was $594,000 and $707,000 respectively. Also, under Washington State law, approval from the state banking regulators is required prior to declaring cash dividends.

Note 11 — Commitments

The Bank leases space for branches and operations. These leases run for a period ranging from two to ten years and allow for established rent increases each year. All leases require the Bank to pay all taxes, maintenance and utility costs, as well as maintain certain types of insurance.

The minimum lease payments for each of the next five years are as follows:


2008	$	293,986
2009		288,790
2010		224,849
2011		78,740
2012		—

Rent expense for 2007, 2006, and 2005 was $328,825, $338,113, and $246,222 respectively. Rental income for 2007, 2006 and 2005 was $0, $9,534, and $31,753 respectively.

The Silverdale branch and adjacent mortgage office is leased from a Director. The lease is for ten years and commenced on October 1, 2001. The lease contains two five-year renewal options. Monthly rent expense for the Silverdale branch is approximately $6,900 per month. In 2007, the Bank paid a director $56,000 to provide consulting services related to new branch locations.

Note 12 — Employee Benefits

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. In 2002, the stockholders approved an additional allocation of 184,287 shares. The stockholders approved additional allocations of 614,290 shares in 2005 and 614,290 shares in 2004. 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 compensation cost that has been charged against income for the Plan was $26,484, $0, and $0 for 2007, 2006, and 2005, respectively. The total income tax benefit recognized in the income statement was $0 for 2007, 2006, and 2005. There was no compensation cost capitalized during 2007, 2006, or 2005.

13-58

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

Note 12 – Employee Benefits (continued)

The fair value of each option award is estimated on the date of grant using the Black-Scholes-Merton valuation model that uses the assumptions noted in the following table. Expected volatilities are based on historical volatility of the Company’s stock and other factors. The Company uses historical data to estimate option exercises and employee terminations, as separate groups of employees that have similar historical exercise behavior are considered separately for valuation purposes. The expected term of options granted is derived from the output of that analysis and represents the period of time that options granted are expected to be outstanding. The risk-free interest rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant. The assumptions used for option awards granted were as follows:


	2007			2006		2005
Risk-free interest rate		4.74	%		N/A		4.31	%
Dividend yield rate		0.00	%		N/A		0.00	%
Weighted average expected life of options	6.5 years				N/A	5 years

There were no grants in 2006.

Stock option transactions are summarized in the following table. Amounts have been adjusted to reflect a 6.1429-for-1 common stock split in August 2006:


						Weighted
				Weighted		Average
				Average		Remaining
				Exercise		Contractual		Aggregate
				Price Per		Term		Intrinsic
	Options			Share		(in years)		Value
Outstanding as of December 31, 2006		940,172		$	7.61
Authorized		—			—
Granted		24,000			19.00
Exercised		(29,180	)		4.68
Forfeited		(47,912	)		8.02

Outstanding as of December 31, 2007		887,080		$	7.99		6.74	$	0

Exercisable as of December 31, 2007		760,493		$	7.55		6.61	$	0

The weighted average remaining terms for outstanding and exercisable stock options at December 31, 2006 were approximately 8 years each. The aggregate intrinsic value at December 31, 2007 was $0 for stock options outstanding and stock options exercisable. 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. As of December 31, 2007, there was $121,000 of total unrecognized compensation cost related to stock options.

13-59

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

Note 12 – Employee Benefits (continued)

The intrinsic value of stock options exercised during the year ended December 31, 2007 was $363,429. The intrinsic value of stock options exercised during the year ended December 31, 2006 was $1,331,943.

Cash received from option exercises was $136,504, $1,186,256 and $330,300 for 2007, 2006 and 2005, respectively. The actual tax benefit realized for the tax deduction from option exercise of the share-based payment arrangements total $0, $375,643 and $42,670 for 2007, 2006 and 2005, respectively.

401(k) Plan- The Bank established a retirement savings 401(k) plan in 2002 in which all employees may participate after attaining the age of 18. The Bank may, at its sole discretion, contribute and allocate to each eligible participant’s account, a percentage of the participant’s elective deferral or it may make non-elective contributions to the participant’s accounts The Bank made contributions of $83,000, $75,000, and $46,000 in 2007, 2006 and 2005 respectively. There was $43,000 in forfeited contributions during 2007.

Note 13 — Fair Value of Financial Instruments

SFAS No. 107,Disclosures about Fair Value of Financial Instruments, requires disclosure of fair value information about financial instruments for which it is practicable to estimate fair value. As defined by SFAS No. 107, financial instruments include the categories listed below. It does not include the value of premises and equipment, and intangible assets such as customer relationships and core deposit intangibles. Fair values of off-statement condition lending commitments standby letters of credit and guarantees are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counter parties’ credit standing. The fair value of the fees at December 31, 2007, was insignificant. See Note 9 for the notional amount of the commitments to extend credit.

13-60

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

Note 13 — Fair Value of Financial Instruments (continued)

The following table summarizes carrying amounts, estimated fair values and assumptions used by the Bank to estimate fair value as of December 31, 2007 and 2006:


	Carrying Amount		Estimated Fair Value
2007
Assets
Cash and cash equivalents	$	66,926,460	$	66,926,460
Securities available for sale	$	8,832,146	$	8,832,146
Loans receivable	$	412,949,947	$	412,545,000
Accrued interest receivable	$	2,540,554	$	2,540,554
FHLB Stock	$	318,900	$	318,900

Liabilities
Checking, savings and money market	$	126,618,993	$	126,618,993
Certificates of deposit	$	294,825,852	$	295,593,692
Accrued interest payable	$	1,955,434	$	1,955,434
Junior subordinated debentures payable	$	8,248,000	$	8,248,000

2006
Cash and cash equivalents	$	26,198,104	$	26,198,104
Securities available for sale	$	8,243,643	$	8,243,643
Loans receivable	$	333,172,808	$	329,855,000
Loans held for sale	$	11,007,194	$	11,007,194
Accrued interest receivable	$	1,980,117	$	1,980,117
FHLB Stock	$	234,200	$	234,200

Liabilities
Checking, savings and money market	$	143,350,250	$	143,350,250
Certificates of deposit	$	171,671,753	$	171,477,000
Accrued interest payable	$	1,108,688	$	1,108,688
Junior subordinated debentures payable	$	8,248,000	$	8,248,000

The following methods and assumptions were used to estimate the fair value of financial instruments:

Cash and cash equivalents- The carrying amount of these items is a reasonable estimate of their fair value.

Investment securities available for sale- The fair value is based on quoted market prices, if available. If quoted market prices are not available, the fair value is based on a matrix pricing model provided by an outside independent source.

Loans receivable- The fair value is estimated by discounting the future cash flows and estimated prepayments using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining term. Some loan types were valued at carrying value because of their floating rate or expected maturity characteristics.

Loans held for sale- The carrying amount of these items is a reasonable estimate of their fair value.

13-61

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

Note 13 — Fair Value of Financial Instruments (continued)

FHLB stock- The fair value is based upon the redemption value of the stock, which equates to its carrying value.

Customer accounts- The fair value of demand deposits, savings accounts, and money market accounts is the amount payable on demand at the reporting date. The fair value of fixed-maturity certificates is estimated by discounting the estimated future cash flows using the rates currently offered for deposits with similar remaining maturities.

Accrued interest receivable and payable -The carrying amounts reported in the consolidated financial statement for accrued interest receivable and payable approximate their fair value.

Junior subordinated debentures payable- The carrying amount of junior subordinated debentures payable is a reasonable estimate of the fair value.

Note 14 — Loan Concentrations

As of December 31, 2007, in management’s judgment, a concentration of loans existed in real estate-related loans. At that date, real estate-related loans comprised 91.5% of total loans, 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 December 31, 2007, in management’s judgment, a concentration of loans existed in interest-only loans, primarily construction and development loans secured by real estate. The Company’s construction portfolio reflects some borrower concentration risk, and also carries the enhanced risks encountered with construction loans generally. The Company also finances contractors, including a number of small builders and individuals, on a speculative basis. Construction loans are generally more risky than permanent mortgage loans because they are dependent upon the borrower’s ability to complete the project within budget, the borrower’s ability to generate cash to service the loan (by selling or leasing the project), and the value of the collateral depends on project completion when market conditions may have changed. At December 31, 2007, interest-only loans comprised 64.4% of total loans, of which approximately 84.1% were construction and land development, 8.2% were residential, 4.0% were commercial real estate, 3.5% were commercial and industrial, and 0.2% were consumer. As of December 31, 2006, interest only loans comprised 61.5% of total loans.

The Bank also had a high concentration of loans with loans to value ratios in excess of supervisory limits. The original maximum credit on these loans was $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.

13-62

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

Note 15 — 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’s retained earnings available for the payment of dividends was $3,444,000 at December 31, 2007 and $8,333,000 at December 31, 2006. Accordingly, $59,921,000 of the Corporation’s equity in the net assets of the Bank was restricted at December 31, 2007 and $59,821,000 December 31, 2006. Funds available for loans or advances by the Bank to the holding company amounted to $12,673,000 at December 31, 2007, compared to $13,631,000 at December 31, 2006.

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 financial statement Note 2 for further restrictions.

Note 16 — Condensed Financial Statements of Parent Company

Financial information pertaining only to WSB Financial Group, Inc. is as follows:


Statement of Financial Condition
	December 31, 2007		December 31, 2006
Assets
Cash and cash equivalents	$	654,340	$	1,055,676
Investments in common stock of Westsound Bank		63,365,254		68,154,370
Other assets		948,421		813,543


Total assets	$	64,968,015	$	70,023,589


Liabilities and stockholders’ equity
Accounts Payable		—	$	118,461
Junior subordinated debentures payable	$	8,248,000		8,248,000
Stockholders’ equity		56,720,015		61,657,128


Total liabilities and stockholders’ equity	$	64,968,015	$	70,023,589

13-63

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

Note 16 — Condensed Financial Statements of Parent Company (continued)


Statement of Operations
	Year ended December 31,
	2007			2006
Income
Interest income	$	18,131		$	17,003
Dividend income from Westsound Bank		700,000			400,000


Total income		718,131			417,003

Operating expenses
Interest expense junior subordinated debentures		603,018			565,486
Salaries and employee benefits		191,712			—
Travel and entertainment		9,687			—
Legal expenses		118,208			6,271
Accounting an audit fees		134,198			—
Other expense		107,172			3,787


Total operating expenses		1,163,995			575,544

Net loss before income tax benefit		(445,864	)		(158,541	)

Income tax benefit		134,879			189,900


Income (loss) before equity in undistributed net income (loss) of Westsound Bank		(310,985	)		31,359

Equity in undistributed net income (loss) of Westsound Bank		(4,889,174	)		3,853,324


Net income (loss)	$	(5,200,159	)	$	3,884,683

13-64

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

Note 16 — Condensed Financial Statements of Parent Company (continued)


Statement of Cash Flows
	Year ended December 31,
	2007			2006
Cash flows from operating activities
Net (loss) income	$	(5,200,159	)	$	3,884,683
Adjustments to reconcile net income (loss) to net cash from operating activities
Equity in undistributed net (income) loss of Westsound Bank		4,889,174			(3,853,324	)
Dividend income from Westsound Bank		(700,000	)		(400,000	)
Stock issued for director fees		—			123,933
Stock based compensation		26,484			—
Excess tax benefits from stock options exercised		—			(375,643	)
Increase in other assets		(134,878	)		(37,566	)
Increase (decrease) in other liabilities		(118,461	)		118,461


Net cash from operating activities		(1,237,840	)		(539,456	)

Cash Flows from Investing Activities
Investment in Westsound Bank		—			(40,550,000	)

Cash flows from financing activities
Proceeds from public offering, net		—			40,236,836
Dividends received from Westsound Bank		700,000			400,000
Proceeds from exercise of stock options and stock issued		136,504			1,186,256
Excess tax benefits from stock options exercised		—			375,643
Fractional share payout		—			(2,994	)
Stock repurchases		—			(185,043	)


Net cash from financing activities		836,504			42,010,698

Net increase (decrease) in cash and cash equivalents		(401,336	)		921,242

Cash and cash equivalents, beginning of year		1,055,676			134,434


Cash and cash equivalents, end of year	$	654,340		$	1,055,676

Note 17 — Stock Split

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

13-65

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

Note 18 — Initial Public Offering

On December 19, 2006, the Company completed its initial public offering. The total price to the public for the shares offered and sold by the Company, including the over-allotment, was $43.6 million. The amount of expenses incurred for the Company’s account in connection with the offering includes approximately $2.5 million of underwriting discounts and commissions and offering expenses of approximately $.9 million.

Note 19 — 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. The lead plaintiff is the Police and Fire Retirement System for the City of Detroit, whose consolidated complaint is due March 28, 2008.

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

As of March 14, 2008, the Company had commenced collection activities on approximately 171 real estate loans by sending notices of default to the borrowers. Some or all of these loans may result in foreclosure actions.

The Company is unable to predict the outcome of these matters. The Company’s cash expenditures, including legal fees, associated with the pending litigation and the regulatory proceedings described in Note 20, “Recent Developments — Regulatory Proceedings” below, 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 20 — Downsizing of Mortgage Division

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

13-66

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

Note 21 — Selected Quarterly Financial Data(Unaudited)


	Quarter Ended
	March 31,		June 30,		September 30,			December 31,
(Dollars in thousands except per share data)	2007		2007		2007			2007			Total
Interest income	$	8,641	$	9,715	$	10,142		$	8,898		$	37,396
Interest expense		3,809		4,332		4,666			4,707			17,514


Net interest income		4,832		5,383		5,476			4,191			19,882
Provision for loan losses		491		326		13,362			1,700			15,879

Net interest income (loss) after provision for loan losses		4,341		5,057		(7,886	)		2,491			4,003


Noninterest income		1,345		1,231		1,025			930			4,531
Noninterest expense		4,059		4,150		4,768			3,517			16,494

Income (loss) before federal income tax expense (benefit)		1,627		2,138		(11,629	)		(96	)		(7,960	)
Provision (benefit) for federal income tax		545		708		(3,877	)		(136	)		(2,760	)

Net income (loss)	$	1,082	$	1,430	$	(7,752	)	$	40		$	(5,200	)

Earnings (loss) per share
Basic	$	0.20	$	0.26	$	(1.39	)	$	0.01		$	(0.93	)
Diluted	$	0.18	$	0.24	$	(1.39	)	$	0.01		$	(0.93	)

Weighted-average shares outstanding
Basic		5,548,283		5,563,887		5,573,089			5,574,853			5,565,123
Diluted		6,109,233		5,926,369		5,573,089			5,650,715			5,565,123


	Quarter Ended
	March 31,		June 30,		September 30,		December 31,
(Dollars in thousands except per share data)	2006		2006		2006		2006		Total
Interest income	$	5,690	$	6,713	$	7,688	$	8,251	$	28,342
Interest expense		2,238		2,599		3,261		3,687		11,785


Net interest income		3,452		4,114		4,427		4,564		16,557
Provision for loan losses		305		498		464		256		1,523

Net interest income after provision for loan losses		3,147		3,616		3,963		4,308		15,034


Noninterest income		1,221		1,099		1,224		1,128		4,672
Noninterest expense		2,949		3,207		3,446		4,252		13,854

Income before federal income tax expense		1,419		1,508		1,741		1,184		5,852
Provision for federal income tax		519		461		581		406		1,967

Net income (loss)	$	900	$	1,047	$	1,160	$	778	$	3,885

Earnings (loss) per share
Basic	$	0.33	$	0.38	$	0.42	$	0.24	$	1.35
Diluted	$	0.29	$	0.33	$	0.36	$	0.21	$	1.18

Weighted-average shares outstanding
Basic		2,727,645		2,736,244		2,752,163		3,259,489		2,870,022
Diluted		3,089,106		3,152,021		3,203,347		3,693,464		3,285,622

13-67

Positive
Negative
Uncertain
Constraining
Legalese
Litigious
Readability	H.S. freshman Avg

WSB Financial (WSFGQ) Inactive 10-K2007 FY Annual report

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