Cascade Financial (CASB) 10-K 2006 FY Annual report

CASCADE FINANCIAL CORPORATION SELECTED FINANCIAL DATA

(Dollars in thousands, except per share data)

	FOR THE YEARS ENDED
	DECEMBER 31,
	2006			2005			2004			2003			2002
Interest income	$	82,658		$	67,802		$	55,316		$	50,363		$	52,470
Interest expense		43,268			31,276			22,919			22,753			26,446
Net interest income		39,390			36,526			32,397			27,610			26,024
Provision for loan losses		1,000			945			675			1,275			1,895
Net interest income after provision for loan losses		38,390			35,581			31,722			26,335			24,129
Other income		6,026			6,333			4,747			5,306			4,039
Other expense		24,586			22,606			20,317			17,733			16,321
Income before income taxes		19,830			19,308			16,152			13,908			11,847
Net income		13,355			13,046			10,785			9,599			8,072
Net income per common share, basic (1)		1.11			1.09			0.96			0.94			0.81
Net income per common share, diluted (1)		1.08			1.06			0.93			0.90			0.78
Book value per share (1)		9.53			8.76			8.06			6.21			5.59
	AT DECEMBER 31,
		2006			2005			2004			2003			2002
Assets	$	1,345,254		$	1,211,784		$	1,088,955		$	885,220		$	804,463
Loans, net		996,015			867,049			794,466			567,094			546,677
Cash and securities		282,301			278,747			228,644			290,537			229,880
Deposits		855,449			795,768			721,908			564,314			509,850
Borrowings		121,485			66,270			36,356			50,123			30,879
FHLB advances		243,000			236,000			228,000			200,000			197,500
Stockholders’ equity		115,199			105,193			96,250			63,957			56,640
Nonperforming loans		851			1,987			532			1,921			956
	FINANCIAL RATIOS
	FOR THE YEARS ENDED
	DECEMBER 31,
		2006			2005			2004			2003			2002
Return on assets		1.05	%		1.13	%		1.09	%		1.13	%		1.05	%
Return on equity		12.24			13.13			13.22			15.81			15.49
Return on tangible equity		16.08			17.82			16.24			15.81			15.49
Net interest margin		3.26			3.35			3.44			3.35			3.44
Efficiency ratio		54.14			52.75			54.70			53.87			54.29
Dividend payout ratio		28.43			25.66			25.81			18.31			8.21
Average stockholders’ equity to average assets		8.55			8.60			8.25			7.15			6.75
Total risk-based capital to risk- weighted assets		11.22			10.86			11.18			13.42			13.30
Tier 1 capital to average total assets		8.99			8.23			8.14			8.49			8.20

(1)Per common share data is retroactively adjusted to reflect all stock splits and stock dividends

This statement has not been reviewed, or confirmed for accuracy or relevance, by the Federal Deposit Insurance Corporation.

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MANAGEMENT DISCUSSION AND ANALYSIS

The following discussion is provided for the consolidated operations of Cascade Financial Corporation (the “Corporation”) as of December 31, 2006. The Corporation has only one operating subsidiary: Cascade Bank (the “Bank”). The purpose of this discussion is to focus on significant factors concerning the Corporation’s financial condition and results of operations, and to provide a more comprehensive review of the Corporation’s operating results and financial condition than can be obtained from reading the consolidated financial statements alone. This discussion should be read with the consolidated financial statements and the notes thereto.

In addition to historical information, this report contains certain "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995 ("PSLRA"). This statement is included for the express purpose of availing the Corporation of the protections of the safe harbor provisions of the PSLRA. The forward-looking statements contained herein are subject to factors, risks, and uncertainties that may cause actual results to differ materially from those projected. The following items are among the factors that could cause actual results to differ materially from the forward-looking statements: higher than expected loan delinquency rates; general economic conditions, including their impact on capital expenditures; business conditions in the banking industry; recent world events and their impact on interest rates, businesses, and customers; the regulatory environment; new legislation; vendor quality and efficiency; employee retention factors; rapidly-changing technology; competitive factors, including increased competition with community, regional, and national financial institutions; fluctuating interest rate environments; and similar matters. Readers are cautioned not to place undue reliance on these forward-looking statements, which reflect management's analysis only as of the date of the statement. The Corporation undertakes no obligation to publicly revise or update these forward-looking statements to reflect events or circumstances that arise after the date of this report. Readers should carefully review the risk factors described in this and other documents the Corporation files from time to time with the Securities and Exchange Commission.

Acquisition

On June 3, 2004, the Corporation acquired Issaquah Bancshares, Inc. (“Issaquah”). The acquisition was accounted for using the purchase method of accounting and accordingly, the assets and liabilities were recorded based on their fair values at the acquisition date. Shares of Issaquah were exchanged for cash or cash and shares of the Corporation resulting in the issuance of 1,597,279 new shares. The merger enhanced Cascade’s commercial banking franchise by expanding Cascade’s presence in east King County. Total Issaquah assets on June 3, 2004, were approximately $131.0 million and the total value of the transaction, both cash and stock, was approximately $34.3 million as measured under the provisions of FAS 141. In addition to the shares issued, the Corporation paid cash of $9.5 million in connection with the merger. The Bank booked $26.3 million in intangible assets associated with the transaction including $25.2 million in goodwill and a $1.1 million core deposit intangible that is being amortized using the straight-line method over an eight-year period of time.

Critical Accounting Estimates

Corporations may apply certain critical accounting estimates requiring management to make subjective or complex judgments, often as a result of the need to estimate the effect of matters that are inherently uncertain. The Bank considers its only material critical accounting estimate to be the allowance for loan losses. We believe that the accounting estimate related to the allowance for loan losses is a "critical accounting estimate" because: (1) it is highly susceptible to change from period to period because it requires management to make assumptions about future losses on loans; and (2) the impact of a sudden large loss could significantly reduce the allowance and potentially require increased provisions to replenish the allowance, which would negatively affect earnings.

The allowance for loan losses is established through a provision for loan losses charged against earnings. The balance of the allowance for loan losses is maintained at the amount management believes will be adequate to absorb known and inherent losses in the loan portfolio. The appropriate balance of the allowance for loan losses is determined by applying estimated loss factors to the credit exposure from outstanding loans. Estimated loss factors are based on subjective measurements including management’s assessment of the internal risk classifications, changes in the nature of the loan portfolio, industry concentrations, and the impact of current local, regional and national economic factors on the quality of the loan portfolio. Changes in these estimates and assumptions are reasonably possible and may have a material impact on the Corporation’s consolidated financial statements, results of operation, or liquidity.

For additional information regarding the allowance for loan losses, its relation to the provision for loan losses and risk related to asset quality, see Note 4 in the Consolidated Financial Statements for the year ended December 31, 2006, and “Management’s Discussion and Analysis of Financial Condition and Results of Operation - Provision for Loan Losses.”

Critical Accounting Policies

The Corporation’s significant accounting policies are described in Note 1 of the Notes to Consolidated Financial Statements included in Item 7 of this report and are essential to understanding Management's Discussion and Analysis of Financial Condition and Results of Operations. 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 which affect the reported amounts and disclosures. Actual results may differ from these estimates under different assumptions or conditions. The following policies involve a higher degree of judgment than do our other significant accounting policies detailed in Note 1 of the Notes to Consolidated Financial Statements included in Item 8 of this report.

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Allowance for Loan Losses

The Bank reviews historical origination and charge-off relationships, charge-off experience factors, collection data, delinquency reports, estimates of the value of the underlying collateral, economic conditions and trends, and other information in order to make the necessary judgments as to the appropriateness of the provision for loan losses and the allowance for loan losses. Loans are charged-off to the allowance for loan losses when the Bank repossesses the collateral or the account is otherwise deemed uncollectible. The Bank believes that the allowance for loan losses is adequate to cover probable losses inherent in its loan portfolio; however, because the allowance for loan losses is based on estimates, there can be no assurance that the ultimate charge-off amount will not exceed the estimates.

Investments

The Bank classifies its investments as either available-for-sale or held-to-maturity. Available-for-sale securities are reported at their fair value, which is determined by obtaining quoted market prices. Unrealized gains and losses on available-for-sale securities are included in other comprehensive income and excluded from earnings. Realized gains and losses and declines in fair value judged to be other than temporary are included in earnings. The fair value of financial instruments is discussed in more detail in Note 16 of the Notes to Consolidated Financial Statements included in Item 8 of this report.

Accrued Taxes

The Bank estimates tax expense based on the amount it expects to owe various tax authorities. Taxes are discussed in more detail in Note 10 of the Notes to Consolidated Financial Statements included in Item 8 of this report. Accrued taxes represent the net estimated amount due or to be received from taxing authorities. In estimating accrued taxes, management assesses the relative merits and risks of the appropriate tax treatment of transactions taking into account statutory, judicial and regulatory guidance in the context of our tax position.

FINANCIAL CONDITION

Total Assets

The Corporation’s total assets at December 31, 2006, were $----1.3 billion, compared to $1.2 billion at December 31, 2005, an increase of 11.0%. The increase in 2006 is due entirely to internal growth. The Corporation’s total assets at December 31, 2004, were $1.1 billion.

Investment Securities

Securities designated as available-for-sale decreased to $142.6 million at December 31, 2006, versus $152.5 million at December 31, 2005. Securities designated as held-to-maturity increased to $96.8 million at December 31, 2006, from $95.1 million a year earlier. The securities in both portfolios consist of notes issued by Government Sponsored Enterprises (“GSE” e.g. FHLB, FNMA) or mortgage-backed securities issued by either FNMA or FHLMC or a mortgage conduit. Investments include $11.9 million of Federal Home Loan Bank of Seattle stock at December 31, 2006. All investment securities received the highest credit rating from at least one of the major rating agencies.

Loan Portfolio

Net loans increased to $996.0 million at December 31, 2006, a -14.9% increase over $867.0 million at December 31, 2005. Net loans were $794.5 million at December 31, 2004.

Business banking loans increased from $394.0 million at December 31, 2005, to $442.4 million at December 31, 2006, a 12.3% increase. The strong growth in this portfolio was the result of our ability to win new borrowing customers in a very competitive market. Net construction loans increased to $290.0 million from $166.0 million during the year. This portfolio experienced rapid turnover as the housing market remained very robust during the year. Commercial real estate loans decreased from $141.1 million at December 31, 2005, to $119.3 million at December 31, 2006. Most of the decrease was related to the sale of $29.8 million of loans from this category. The Corporation’s loan focus remains on small businesses, builders and developers in the Puget Sound Area. Construction lending is directed toward building single-family housing and land development for single-family housing. The Bank generally confines its lending to the Puget Sound Region of Washington state.

Total single-family residential loans increased from $95.4 million at December 31, 2005, to $96.4 million at December 31, 2006. The Corporation sells the vast majority of its 30-year fixed-rate loans, its 15-year fixed-rate loans, and many of its conforming intermediate term hybrid ARMs in the secondary mortgage market. Cascade sold $34.1 million of seasoned loans in the fourth quarter including the $29.8 million in commercial loans referenced above. Multifamily loans outstanding decreased from $52.1 million at December 31, 2005, to $34.7 million at December 31, 2006. The Corporation has de-emphazied this product line due to intense pricing pressure.

Consumer loans decreased $4.5 million to $27.7 million as of December 31, 2006. The Bank’s consumer loan portfolio is comprised of home equity loans and lines of credit, installment loans, and credit card loans. Home equity loans generally take the form of a second mortgage. In terms of direct consumer loans, the Bank has not emphasized this line of business, concluding that it is at a competitive disadvantage against the very aggressive pricing of large banks, captive finance companies and the specialty credit card issuers.

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The chart below indicates the mix of the loan portfolio as of the dates indicated:

	December 31, 2006						December 31, 2005						December 31, 2004
(Dollars in thousands)	AMOUNT			PERCENT			AMOUNT			PERCENT			AMOUNT			PERCENT
Business banking	$	442,391			43.78	%	$	394,034			44.75	%	$	292,117			36.21	%
Commercial real estate		119,298			11.81			141,109			16.02			178,704			22.15
Total business-like loans		561,689			55.59			535,143			60.77			470,821			58.36
Residential		96,350			9.53			95,429			10.83			105,975			13.14
Construction		289,993			28.70			165,957			18.84			107,431			13.32
Consumer		27,686			2.74			32,160			3.65			30,125			3.73
Multifamily		34,719			3.44			52,057			5.91			92,372			11.45
Total loans		1,010,437			100.00	%		880,746			100.00	%		806,724			100.00	%
Deferred loan fees, net		(3,434	)					(3,443	)					(2,695	)
Allowance for losses on loans		(10,988	)					(10,254	)					(9,563	)
Loans, net	$	996,015					$	867,049					$	794,466

Allowance for Loan Losses

Management provides for possible loan losses by maintaining an allowance. The allowance for loan losses reflects management’s best estimate of probable losses as of a particular balance sheet date, but there is no guarantee that management’s estimate will be sufficient to cover actual loan losses. The allowance for loan losses is maintained at a level considered adequate based on management’s assessment of various factors affecting the loan portfolio, including local economic conditions, growth of the loan portfolio, past loss experience, and its composition. Increases in the allowance for loan losses made through provisions primarily reflect loan growth, loan loss experience risks inherent in lending and the impact of the economic climate on the loan portfolio.

Management determines the amount of the allowance for loan losses by utilizing a loan grading system to determine risk in the loan portfolio and by considering the results of credit reviews. The loan portfolio is separated by quality and then by loan type. Loans of acceptable quality are evaluated as a group, by loan type, with a specific loss rate assigned to the total loans in each type, but unallocated to any individual loan. Conversely, each adversely classified loan is individually analyzed to determine an estimated loss amount. A valuation allowance is also assigned to these adversely classified loans, but at an assumed higher reserve rate due to the greater risk of loss. Past due and impaired loans are actively managed to minimize the potential loss of principal.

At December 31, 2006, the allowance for loan losses was $11.0 million (1.09% of total loans) compared to $10.3 million (1.16% of total loans) at December 31, 2005, and $9.6 million (1.19% of total loans) at December 31, 2004. During 2006, the Corporation added $1.0 million to the allowance compared to $945,000 in 2005. In 2004, the Corporation assumed the $1.4 million allowance of Issaquah in the acquisition. The Corporation was able to prudently maintain its ratio of the allowance to loans outstanding due to the low level in net loan charge-offs and the small amount of nonperforming loans.

Net loan charge-offs were $266,000 in 2006 (or 0.03% of average loans outstanding) compared to $254,000 in 2005 (or 0.03% of average loans outstanding). Net charge-offs were $218,000 for the year ended December 31, 2004. The coverage ratio (the allowance for loan losses to nonperforming loans) was 1,291% at December 31, 2006, 516% at December 31, 2005, and 1,798% at December 31, 2004.

Deposit Accounts

Deposit accounts totaled $855.4 million at December 31, 2006, an increase of $59.6 million or 7.5% over $795.8 million at December 31, 2005. The Bank assumed $101.8 million in deposits with the acquisition of Issaquah in 2004. Checking account balances, primarily through the implementation of the High Performance Checking program, grew 15.8% to $139.5 million during the year as the Bank continued its sales efforts to generate transaction accounts. Money market deposit account balances grew by 51.6% to $275.3 million with rates competitive with those offered by money market funds. Certificates of deposit decreased 11.1% to $425.5 million. As business banking activity increases, management expects to increase its noninterest-bearing or low interest accounts through the growth of commercial checking accounts.

The market for deposits has remained very competitive. It remains a key goal of the Bank to increase its demand deposit account balances.

Other Borrowings

The Bank uses Federal Home Loan Bank of Seattle (“FHLB”) advances to provide intermediate and longer term funding, as well as to augment deposits. At December 31, 2006, the Bank had $243.0 million in FHLB advances compared to $236.0 million as of December 31, 2005. For 2006, FHLB advances averaged 18.6% of assets compared to 20.8% in 2005. Subject to its Line of Credit with the FHLB, the availability of collateral, and the parameters of liquidity management, the Bank will continue to use advances as a funding source.

The Bank also uses repurchase agreements for funding. At December 31, 2006, the Bank had executed $95.7 million in repurchase agreements compared to $51.1 million a year earlier. In 2000, the Corporation issued $10.3 million in trust preferred securities, which are termed “junior subordinated debentures payable.” These junior subordinated debentures payable have a fixed rate of 11% and mature on March 1, 2030, but are callable at a premium beginning March 1, 2010. In December 2004, the Corporation issued an additional $5.2 million in

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junior subordinated debentures payable. These securities have a fixed coupon of 5.82% for the first 5 years and then float at three-month LIBOR plus 1.90% for the remaining 25 years. The securities are callable at par after 5 years. On March 30, 2006, the Corporation issued an additional $10.3 million in junior subordinated debentures payable. These obligations have an initial rate of 6.65% set for 5 years and then convert to a three-month LIBOR plus 1.40% for the remaining 25 years. The securities are callable at par after 5 years. Junior subordinated debentures payable are considered Tier 1 capital by financial institution regulators.

Capital

Banking regulations require the Bank to maintain minimum levels of capital. As of December 31, 2006, Cascade Bank remained a “well-capitalized” institution (the FDIC’s highest rating), under regulatory guidelines, with a core capital-to-asset ratio of 8.96% and a risk-based capital-to-asset ratio of 11.20%. The Bank’s regulatory capital ratios are discussed in more detail in Note 13 of the Notes to Consolidated Financial Statements included in Item 8 of this report.

Federal Reserve guidelines require the Corporation, on a consolidated basis, to maintain minimum levels of capital as well. At December 31, 2006, the Corporation's total risk-based capital to risk-weighted assets was 11.22%, compared to 10.86% at December 31, 2005, and 11.18% at December 31, 2004. The Corporation projects that earnings retention and existing capital will be sufficient to fund anticipated asset growth and the existing level of cash dividends, while maintaining a “well-capitalized” designation under the FDIC and Federal Reserve guidelines. The Corporation has paid its shareholders a cash dividend on a quarterly basis since 2002. In May 2006, the Corporation paid a 5-for-4 stock split. Average shares outstanding, stock options, net income per share and book value per share for all periods presented have been retroactively adjusted to reflect the stock split. For the year, the Corporation returned $3.6 million in dividends to its shareholders compared to $3.2 million in 2005. The dividend payout ratio (the ratio of dividends paid to net income) for 2006 was 28%.

The Corporation is committed to managing capital for maximum shareholder benefit and maintaining protection for depositors and creditors. The Corporation manages various capital levels at both the holding company and subsidiary bank level to attempt to maintain adequate capital ratios and levels in accordance with external regulations and capital guidelines established by the Board of Directors.

RESULTS OF OPERATIONS

Earnings

Cascade Financial Corporation earned net income for the year ended December 31, 2006, of $13.4 million, an increase of 2.4% over the $13.0 million net income in the year ended December 31, 2005. Earnings per fully diluted share (EPS) were $1.08 in 2006 and $1.06 in 2005. In 2004, the Corporation incurred $356,000 of acquisition-related expenses in connection with its acquisition of Issaquah, which translated to approximately $0.03 a share. Without those expenses, 2004 diluted EPS would have been $0.96. Higher net interest income due to increased earning assets contributed to the improved results. Income was also enhanced by increased checking fees and other service fees, which partially offset the decline in gains on the sale of loans and the decline in other income. The Corporation earned net income of $10.8 million or $0.93 per fully diluted share for the fiscal year ended December 31, 2004.

Return on Average Equity

Return on average equity for the year ended December 31, 2006, was 12.24% compared to 13.13% for the same period of 2005. Return on average equity for the fiscal year ending December 31, 2004 was 13.22%.

Return on Average Tangible Equity

Return on average tangible equity (average equity less goodwill) was 16.08% compared to 17.82% in 2005. The June 2004 acquisition of Issaquah generated $26.3 million in goodwill and intangibles as assets and a like amount of capital. Eliminating the average intangible asset and reducing the capital by the same amount produces average tangible equity.

Return on average tangible equity is determined by methods other than those in accordance with accounting principles generally accepted in the United States of America (“GAAP”). This measure excludes the average balance of acquisition-related goodwill and intangibles in determining average tangible shareholders’ equity. Management believes the presentation of this financial measure, excluding the impact of these items, provides useful supplemental information that is essential for a proper understanding of the financial results of Cascade Financial Corporation. This disclosure should not be viewed as a substitute for results determined to be in accordance with GAAP, nor is it necessarily comparable to non-GAAP performance measures that may be presented by other companies.

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A summary of tangible equity follows:

(Dollars in thousands)	2006			2005
Net income	$	13,355		$	13,046
Average equity		109,103			99,370
Average goodwill & intangibles		26,040			26,142
Average tangible equity		83,063			73,228
Return on average tangible equity		16.08	%		17.82	%

Net Interest Income

The largest component of the Corporation’s earnings is net interest income. Net interest income is the difference between interest earned on earning assets (primarily loans, interest-bearing deposits with banks, and investment securities) and the interest expense associated with interest-bearing liabilities (deposits and borrowings). Interest earned and interest paid is affected by general economic conditions, including the demand for loans, cost of deposits, market rates of interest, government policies, and the action of regulatory authorities. The Corporation’s operations are sensitive to changes in interest rates and the resulting impact on net interest income.

Net interest income for the year ended December 31, 2006, increased by 7.9%, or $2.9 million, to $39.4 million from $36.5 million for the year ended December 31, 2005. The improvement in net interest income was primarily due to the growth in our level of average earning assets. Net interest income for the fiscal year ended December 31, 2004 was $32.4 million.

Average earning assets increased 10.8% to $1.2 billion for the year ended December 31, 2006, from $1.1 billion for the year ended December 31, 2005. Average earning assets were $942.8 million for the year ended December 31, 2004.

Net interest margin is net interest income expressed as a percent of average earning assets. The net interest margin for the year ended December 31, 2006, was 3.26%, compared to 3.35% for the year ended December 31, 2005. While the yield on assets has improved over the last year, liability costs have also increased. The yield on earning assets increased 62 basis points to 6.85% in 2006. The cost of interest-bearing liabilities increased 79 basis points to 4.01% during the year. The increase was due to increases in short-term interest rates, a flat yield curve and fierce competition for deposits.

Average Balances and an Analysis of Average Rates Earned and Paid

The following tables show average balances and interest income or interest expense, with the resulting average yield or rate by category or average earning asset or interest-bearing liability. 

	FOR THE YEARS ENDED DECEMBER 31,
	2006							2005							2004
			INTEREST							INTEREST							INTEREST
	AVERAGE		AND		YIELD/			AVERAGE		AND		YIELD/			AVERAGE		AND		YIELD/
	BALANCE		DIVIDEND		COST			BALANCE		DIVIDEND		COST			BALANCE		DIVIDEND		COST
(Dollars in thousands)
ASSETS
Interest-earning assets (1)
Residential loans	$	98,476	$	5,582		5.67	%	$	104,789	$	5,882		5.61	%	$	106,187	$	6,219		5.86	%
Multifamily loans		42,574		2,863		6.72			74,650		4,910		6.58			91,410		5,839		6.39
Commercial real estate loans		144,094		9,821		6.82			166,736		10,957		6.57			122,958		7,888		6.41
Construction loans		214,290		19,376		9.04			133,975		10,199		7.61			88,635		5,579		6.29
Consumer loans		30,064		2,304		7.66			31,352		2,210		7.05			32,016		2,254		7.04
Business banking loans		426,194		31,158		7.31			343,182		23,441		6.83			250,166		16,447		6.57
Total loans		955,692		71,104		7.44			854,684		57,599		6.74			691,372		44,226		6.4
Securities available-for-sale		148,917		6,735		4.52			134,157		5,582		4.16			155,563		6,693		4.3
Securities held-to-maturity		96,668		4,563		4.72			93,069		4,306		4.63			91,747		4,326		4.72
Daily interest-earning deposits		5,356		256		4.79			6,912		315		4.56			4,123		71		1.72
Total securities and interest-earning deposits		250,941		11,554		4.60			234,138		10,203		4.36			251,433		11,090		4.41
Total interest-earning assets		1,206,633		82,658		6.85	%		1,088,822		67,802		6.23	%		942,805		55,316		5.87	%
Noninterest-earning assets
Office properties and equipment, net		12,093							12,741							11,117
Real estate, net		-							328							769
Other noninterest-earning assets		56,830							53,847							33,976
Total assets	$	1,275,556						$	1,155,738						$	988,667

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	FOR THE YEARS ENDED DECEMBER 31,
	2006								2005								2004
				INTEREST								INTEREST								INTEREST
	AVERAGE			AND		YIELD/			AVERAGE			AND		YIELD/			AVERAGE			AND		YIELD/
	BALANCE			DIVIDEND		COST			BALANCE			DIVIDEND		COST			BALANCE			DIVIDEND		COST
(Dollars in thousands)
LIABILITIES AND EQUITY
Interest-bearing liabilities
Savings accounts	$	14,748		$	75		0.51	%	$	15,465		$	67		0.43	%	$	14,895		$	43		0.29	%
Checking accounts		45,039			656		1.46			39,618			245		0.62			29,562			93		0.31
Money market accounts		229,788			8,505		3.70			170,641			3,255		1.91			145,626			1,872		1.29
Certificates of deposit		446,437			19,339		4.33			467,388			14,747		3.16			401,620			9,151		2.28
Total interest-bearing deposits		736,012			28,575		3.88			693,112			18,314		2.64			591,703			11,159		1.89
Other interest-bearing liabilities
FHLB advances		237,888			11,194		4.71			239,896			11,031		4.60			210,023			10,601		5.05
Other interest-bearing liabilities		104,085			3,499		3.36			39,495			1,931		4.89			41,511			1,159		2.79
Total interest-bearing liabilities		1,077,985			43,268		4.01			972,503			31,276		3.22			843,237			22,919		2.72
Other liabilities		88,468								83,865								63,855
Total liabilities		1,166,453								1,056,368								907,092
Stockholders’ equity		109,103								99,370								81,575
Total liabilities and
stockholders’ equity	$	1,275,556							$	1,155,738							$	988,667
Net interest income (2)				$	39,390							$	36,526							$	32,397
Interest rate spread (3)							2.84	%							3.01	%							3.15	%
Net interest margin (4)							3.26	%							3.35	%							3.44	%
Average interest-earning assets
to average interest-bearing
liabilities		111.93	%							111.96	%							111.81	%

(1)  Does not include interest on loans 90 days or more past due

(2)  Interest and dividends on total interest-earning assets less interest on total interest-bearing liabilities

(3)  Total interest-earning assets yield less total interest-bearing liabilities cost

(4)  Net interest income as an annualized percentage of total interest-earning assets

Other Income

Other income is derived from sources other than interest and fees on earning assets. The Corporation’s primary sources of other income are service charge fees on deposit accounts, other service fees, the accretion of cash surrender value of bank owned life insurance (“BOLI”), gains on the sale of single-family residential loans, gains on the sale of securities, and rental income, primarily on space at the building that formerly served as the headquarters of Issaquah. Other income for the year ending December 31, 2006, was $6.0 million, compared to $6.3 million and $4.7 million for the same periods in 2005 and 2004, respectively. This decrease was attributable primarily to a $382,000 decrease in gain on sale of loans, which was partially offset by an increase of $187,000 in checking fees and an increase of $240,000 in other services fees. The decrease in gain on sale of loans is primarily due to lower loan sales. Other income for 2006 was also reduced by a $150,000 charge on the termination of an interest rate swap.

Other Expense

Other expense represents costs not associated with deposits and other interest-bearing liabilities. It includes expenses associated with personnel, premises and equipment, data processing, and other operations.

Other expense increased by $2.0 million to $24.6 million for the year ended December 31, 2006, from $22.6 million and $20.3 million for 2005 and 2004, respectively. The increase in expense was partially due to costs of $381,000 in core processor conversion expense and the first year of expensing stock options at a cost of $287,000. Salaries and employee benefits increased overall by $577,000 to $12.7 million.

A standard measurement used to calculate the overhead costs of financial institutions is the efficiency ratio. The efficiency ratio is calculated by dividing other expense by total revenue, which generally indicates how much an institution spends to generate a dollar of revenue. The lower the efficiency ratio, the more efficient the institution. For the years ending December 31, 2006, 2005, and 2004, the Corporation’s efficiency ratio was 54.14%, 52.75%, and 54.70%, respectively. Management continues to look for ways to improve the efficiency ratio by increasing other income and net interest income while diligently controlling costs and maintaining high standards of service.

Liquidity Management

Liquidity is a term used to define the Corporation's ability to meet its financial commitments. The Corporation is required by prudent business practice and its regulators to maintain adequate levels of liquidity. The main liquidity requirements are funding customer loan requests and deposit outflows of Cascade Bank. Primary sources of liquidity are cash and cash equivalents, which include highly liquid investments. At December 31, 2006, December 31, 2005, and December 31, 2004, cash and cash equivalents totaled $42.9 million, $31.1 million, and $13.0 million, respectively. Another source of liquidity is the Corporation’s investment portfolio, which consists of investment-grade securities. These securities are of the highest credit quality and can be sold or used as collateral to secure borrowings.

15

The primary source of borrowings is Federal Home Loan Bank of Seattle (FHLB-Seattle) advances and repurchase agreements. At December 31, 2006, $227.8 million of additional borrowing capacity remained under Cascade Bank’s existing credit line from the FHLB-Seattle, which is 35% of Cascade’s assets. The use of this Line of Credit is subject to the availability of eligible collateral, which includes residential mortgages, investment grade securities, and commercial real estate mortgages. At December 31, 2006, Cascade had unencumbered eligible collateral of approximately $70.9 million to pledge against the line. In addition, Cascade Bank has the ability to borrow through repurchase agreements. Under these agreements, borrowings are collateralized with mortgage-backed securities or other investment securities.

The Bank has Fed funds borrowing lines with three of its correspondent banks. Cascade used each of these lines during the year. The Bank also opened a Line of Credit with the Federal Reserve Bank of San Francisco. As of December 31, 2006, there were no outstanding balances in any of these lines.

Liquidity management is of critical importance to Cascade Bank in that it significantly relies upon wholesale sources of funds (e.g. FHLB-Seattle advances). While these sources have proven to be stable and reliable, an interruption in the availability of these sources could have an adverse impact on the operations of the Corporation. Also see the Consolidated Statement of Cash Flows in the financial statement section of this filing for further information regarding liquidity.

Interest Rate Risk Management

Management considers interest rate risk to be a significant market risk that could have a material effect on the Corporation’s financial condition and results of operations.

The Corporation has taken steps to balance its sensitivity to changes in interest rates by altering its asset and liability mix. The origination of floating-rate loans such as business, construction and other prime based loans is emphasized. The vast majority of fixed-rate loans have repricing periods with a maximum of five years. The mix of floating- and fixed-rates assets is designed to mitigate the impact of rate changes on the Corporation’s net interest income. Virtually all fixed-rate residential loans with maturities greater than five years are sold into the secondary market. However, the Bank has sought to add prepayment provisions to its newly originated fixed and adjustable rate loans. Many of the Bank’s fixed-rate loans do not have such provisions for prepayment fees, and as a result, a drop in rates can precipitate a refinancing of the Bank’s assets.

Interest rate risk is monitored using several methodologies, principally financial modeling. The earnings exposure to interest rate changes is evaluated in the context of certain upward and downward interest rate changes occurring instantaneously. At December 31, 2006, a 200 basis point increase in rates would decrease forecasted net interest income over a twelve-month period by approximately 5.3%. A 200 basis point decrease in rates would decrease interest income by 1.6% according to the model.

The changes of the fair value of assets and liabilities and the resulting impact on the fair value of equity are also modeled under different rate scenarios. In the 200 basis point increase scenario, the fair value of equity declines by $26.1 million or 16.6%, which is within the guideline established by the Bank’s Asset/Liability Policy.

The Corporation does not maintain a trading account for any class of financial instrument. Moreover, the Corporation is not subject to foreign currency exchange rate risk or commodity price risk.

The individual categories of assets and liabilities that are subject to interest rate sensitivity as of December 31, 2006, are shown in the following table.

	INTEREST REPRICING ASSUMPTIONS
	<1 YEAR		1-3 YEARS		3-5 YEARS		5-10 YEARS		10 YEARS AND UP		TOTAL		FAIR VALUE
(Dollars in thousands)
Interest-Sensitive Assets
Total loans	$	692,582	$	157,360	$	153,753	$	6,613	$	129	$	1,010,437	$	1,016,976
Investments and other Interest-earning assets		54,170		15,621		81,443		87,735		18,851		257,820		243,364
Interest-Sensitive Liabilities
Checking accounts	$	11,451	$	12,492	$	18,738	$	8,432	$	938	$	52,051	$	52,051
Money market accounts		268,964		1,945		2,918		1,313		146		275,286		275,286
Savings accounts		3,335		3,638		5,456		2,456		273		15,158		15,158
Certificates of deposit (1)		381,305		33,379		10,115		700		-		425,499		424,844
Borrowings		257,176		2,186		69,348		10,000		-		338,710		338,859
Junior subordinated debentures payable		-		-		15,465		-		10,310		25,775		27,465

(1) Net of ($312) mark-to-market on swap

Off-Balance Sheet Arrangements: Credit Commitments

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.

16

The Bank underwrites its standby letters of credit using its policies and procedures applicable to loans in general. Standby letters of credit are made on an unsecured and secured basis. The Bank has not incurred any losses on its commitments in 2006 or 2005.

A summary of the notional amount of the Bank’s financial instruments with off-balance sheet risk at December 31, 2006, follows:

(Dollars in thousands)		TOTAL
Commitments to extend credit	$	215,105
Standby letters of credit and financial guarantees written		4,924
Unused commitments on bankcards		12,751
Total	$	232,780

Contractual Obligations and Commitments

The following table sets forth the Corporation’s long-term contractual obligations:

	PAYMENTS DUE PER PERIOD
(Dollars in thousands)		<1 YEAR		1-3 YEARS		3-5 YEARS		THEREAFTER		TOTAL
Certificates of deposit	$	381,304	$	33,379	$	10,115	$	700	$	425,498
Federal Home Loan Bank advances		32,000		41,000		55,000		115,000		243,000
Operating lease obligations		758		1,515		1,457		7,764		11,494
Junior subordinated debentures payable		-		-		-		25,775		25,775
Total	$	414,062	$	75,894	$	66,572	$	149,239	$	705,767

At December 31, 2006, the Corporation’s long-term contractual obligations related to debt totaled $268.8 million. See additional discussion under Notes 7 and 8 to the Consolidated Financial Statements for the year ended December 31, 2006.

The Corporation also has operating leases comprised of leases for office space.

Summation of Factors That May Affect Financial Condition and Future Results

Credit risk: The most significant risk that may impact Cascade Financial Corporation would be a deterioration in the quality of the loan portfolio. Cascade’s loan growth has been focused on commercial lending. While it has not been the Corporation’s experience, historically for the banking industry, commercial loans have higher levels of losses than residential loans. The Corporation’s ability to meet its profitability and growth goals would be severely compromised with a large number of impaired credits. In addition, the Corporation and its subsidiary, Cascade Bank, could face regulatory restrictions on its activities.

Interest rate risk: While the Corporation actively manages its exposure to changes in interest rates, volatile interest rates and/or changes in the shape of the yield curve could have a meaningful impact on Cascade’s net income. Many of the assets and liabilities of the Corporation have embedded options, which add another layer of complexity in its interest rate risk management practices.

Liquidity: Disruptions in the capital markets could have a major impact on the Corporation’s net income and balance sheet. As a user of Federal Home Loan Bank advances, repurchase agreements and brokered CDs, interruption or truncation of these sources of funds could force the Corporation to liquidate assets at an inauspicious time or curtail lending activity, which could adversely affect customer relationships.

Recently issued accounting pronouncements: In December 2004, the FASB issued No. 123(R), Share-Based Payment, which is a revision of No. 123, Accounting for Stock-Based Compensation. Statement 123(R) supersedes APB Opinion No. 25, which the Corporation had used to report stock options granted to employees and directors. Statement 123(R) requires all share-based payments to employees, including stock options, be recognized in the income statement based on their fair values. The adoption of this accounting standard reduced our earnings per share by $0.02 in 2006.

Available Information

A copy of the Corporation’s annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to such reports filed pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, are available free of charge on or through our website located at www.cascadebank.com as soon as reasonably practicable after filing with the United States Securities and Exchange Commission. These reports are also available to shareholders, at no charge, upon written request to the Secretary of Cascade Financial Corporation at 2828 Colby Avenue, Everett, Washington 98201.

17

Report of Independent Registered Public Accounting Firm

The Board of Directors

Cascade Financial Corporation:

We have audited the accompanying consolidated balance sheets of Cascade Financial Corporation and subsidiaries (Corporation) as of December 31, 2006 and 2005, and the related consolidated statements of income, stockholders' equity and comprehensive income, and cash flows for the three years in the period ended December 31, 2006. We also have audited management's assessment included in the accompanying Management’s Report on Internal Control over Financial Reporting that the Corporation maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Corporation’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on these financial statements, an opinion on management's assessment, and an opinion on the effectiveness of the Corporation's internal control over financial reporting 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 financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audit of financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinion.

The company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Cascade Financial Corporation and subsidiaries as of December 31, 2006 and 2005, and the results of their operations and cash flows for each of the three years in the period ended December 31, 2006, in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, management's assessment that Cascade Financial Corporation and subsidiaries maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Furthermore, in our opinion, Cascade Financial Corporation and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

/s/ Moss Adams LLP

Everett, Washington

March 14, 2007

18

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Consolidated Balance Sheets

Years ended December 31, 2006, and 2005

	DECEMBER 31,
(Dollars in thousands)	2006			2005
ASSETS
Cash on hand and in banks	$	23,707		$	16,616
Interest-bearing deposits in other financial institutions		19,172			14,493
Securities available-for-sale		130,656			140,596
Securities held-to-maturity		96,846			95,122
Federal Home Loan Bank (FHLB) stock		11,920			11,920
Loans, net		996,015			867,049
Goodwill		25,195			25,195
Core deposit intangible, net		775			916
Premises and equipment, net		12,003			12,270
Cash surrender value of bank owned life insurance (BOLI)		17,974			17,313
Accrued interest receivable and other assets		10,991			10,294
Total assets	$	1,345,254		$	1,211,784
LIABILITIES AND STOCKHOLDERS’ EQUITY
Liabilities:
Deposits	$	855,449		$	795,768
Federal Home Loan Bank advances		243,000			236,000
Securities sold under agreements to repurchase		95,710			51,058
Junior subordinated debentures payable		25,775			15,212
Advance payments by borrowers for taxes and insurance		703			689
Dividends payable		967			864
Accrued interest payable, expenses, and other liabilities		8,451			7,000
Total liabilities	$	1,230,055		$	1,106,591
Stockholders’ equity:
Preferred stock, $.01 par value. Authorized 500,000 shares;
no shares issued or outstanding		-			-
Common stock, $.01 par value. Authorized 25,000,000 shares;
issued and outstanding 12,093,699 shares at December
31, 2006,and 12,004,734 shares at December 31, 2005		121			120
Additional paid-in capital		39,430			38,125
Retained earnings, substantially restricted		77,952			68,945
Accumulated other comprehensive (loss)		(2,304	)		(1,997	)
Total stockholders’ equity		115,199			105,193
Total liabilities and stockholders’ equity	$	1,345,254		$	1,211,784

(See accompanying notes to consolidated financial statements.)

19

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Consolidated Statements of Income

Years ended December 31, 2006, 2005, and 2004

	YEARS ENDED
	DECEMBER 31,
(Dollars in thousands, except share amounts)	2006			2005		2004
Interest income:
Loans	$	71,104		$	57,599	$	44,226
Securities held-to-maturity		4,563			4,306		4,292
Securities available-for-sale		6,723			5,534		6,291
FHLB dividends		12			48		436
Interest-bearing deposits		256			315		71
Total interest income		82,658			67,802		55,316
Interest expense:
Deposits		28,576			18,314		11,159
FHLB advances		11,193			11,031		10,601
Securities sold under agreements to repurchase		1,619			733		436
Junior subordinated debentures payable		1,880			1,198		723
Total interest expense		43,268			31,276		22,919
Net interest income		39,390			36,526		32,397
Provision for loan losses		1,000			945		675
Net interest income after provision for loan losses		38,390			35,581		31,722
Other income:
Gain on sale of loans		483			865		228
Gain on sale of securities available-for-sale, net		-			67		510
(Loss) gain on sale of REO, net		(27	)		33		82
Checking service fees		3,311			3,124		2,069
Other service fees		1,156			916		704
BOLI		769			764		566
Other		334			564		588
Total other income		6,026			6,333		4,747
Other expenses:
Salaries and employee benefits		12,691			12,114		11,483
Occupancy		3,450			3,323		2,745
Data processing		392			646		448
Marketing		1,094			810		547
B&O tax		1,027			713		487
Merger expense		-			-		356
Other		5,932			5,000		4,251
Total other expenses		24,586			22,606		20,317
Income before provision for income taxes		19,830			19,308		16,152
Provision for income taxes		6,475			6,262		5,367
Net income	$	13,355		$	13,046	$	10,785
Net income per common share, basic		1.11			1.09		0.96
Weighted average number of shares
outstanding, basic	$	12,060,191		$	11,977,824	$	11,190,616
Net income per share, diluted		1.08			1.06		0.93
Weighted average number of shares
outstanding, diluted	$	12,363,198		$	12,319,873	$	11,595,290

(See accompanying notes to consolidated financial statements.)

20

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Consolidated Statements of Stockholders’ Equity and Comprehensive Income

Years ended December 31, 2006, 2005, and 2004

												ACCUMULATED
												OTHER			TOTAL
						ADDITIONAL						COMPREHENSIVE			STOCK-
				COMMON		PAID-IN			RETAINED			INCOME			HOLDERS’
(Dollars in thousands, except share amounts)	SHARES			STOCK		CAPITAL			EARNINGS			(LOSS), NET			EQUITY
Balances at December 31, 2003		8,241,288		$	82	$	11,921		$	52,109		$	(155	)	$	63,957
Cash dividends		-			-		-			(2,777	)		-			(2,777	)
Options exercised, including
related tax benefit		63,865			1		634			-			-			635
Net income		-			-		-			10,785			-			10,785
Shares repurchased		(8,754	)		-		(8	)		(142	)		-			(150	)
Other comprehensive loss,
net of tax (benefit) of $(537)		-			-		-			-			(992	)		(992	)
Issaquah Bank merger		1,263,423			13		24,779			-			-			24,792
Balances at December 31, 2004		9,559,822			96		37,326			59,975			(1,147	)		96,250
Cash dividends		-			-		-			(3,260	)		-			(3,260	)
Options exercised, including													-
related tax benefit		81,019			-		803			-			-			803
Net income		-			-		-			13,046			-			13,046
Shares repurchased		(40,953	)		-		(42	)		(816	)		-			(858	)
Other comprehensive income,
net of tax (benefit) of $(457)		-			-		-			-			(850	)		(850	)
Issaquah Bank merger		3,899			-		62			-			-			62
Balances at December 31, 2005		9,603,787			96		38,149			68,945			(1,997	)		105,193
Stock split (5-for-4)		2,410,282			24		(33	)		-			-			(9	)
Cash dividends		-			-		-			(3,706	)		-			(3,706	)
Options exercised, including													-
related tax benefit		122,920			1		1,058			-			-			1,059
Stock compensation expense													-
net of tax benefit		-			-		287			-			-			287
Net income		-			-		-			13,355			-			13,355
Shares repurchased		(43,290	)		-		(31	)		(642	)		-			(673	)
Other comprehensive income,
net of tax (benefit) of $(165)		-			-		-			-			(307	)		(307	)
Balances at December 31, 2006		12,093,699		$	121	$	39,430		$	77,952		$	(2,304	)	$	115,199

Comprehensive Income				YEARS ENDED
				DECEMBER 31,
	2006			2005			2004
Net income	$	13,355		$	13,046		$	10,785
Increase in unrealized gain (loss) on securities
available-for-sale, net of tax (benefit)
of $(165), $(452) and $(346).		(307	)		(840	)		(622	)
Increase in unrealized gain on swaps
Available-for-sale, net of tax expense
of $0, $114 and $119.		—			213			232
Less reclassification adjustment for gains on
securities included in net income, net of
tax (benefit) of $0, $(23) and $(173).		—			(44	)		(337	)
Less reclassification adjustment for gains on
swaps included in net income, net of tax
(benefit) of $0, $(96) and $(137).		—			(179	)		(265	)
Comprehensive income	$	13,048		$	12,196		$	9,793

 (See accompanying notes to consolidated financial statements.)

21

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Consolidated Statements of Cash Flows

Years ended December 31, 2006, 2005, and 2004

	YEARS ENDED
	DECEMBER 31,
(Dollars in thousands)	2006			2005			2004
Cash flows from operating activities:
Net income	$	13,355		$	13,046		$	10,785
Adjustments to reconcile net income to net
cash provided by (used in) operating activities:
Depreciation and amortization of premises and equipment		1,917			1,874			1,553
Provision for losses on loans		1,000			945			675
Increase in cash surrender value of bank owned life insurance		(661	)		(663	)		(488	)
Amortization of retained servicing rights		6			30			40
Amortization of core deposit intangible		141			141			70
Deferred income taxes		178			(150	)		(100	)
Deferred loan fees, net		(9	)		748			516
Gain on sale of loans		(483	)		(865	)		(228	)
Stock-based compensation		287			-			-
Excess tax benefits from stock-based compensation		(314	)		(301	)		(199	)
Net gain on sales of securities available-for-sale		-			(67	)		(510	)
Loss on sales of premises and equipment		-			-			6
Net loss (gain) on sale of real estate owned, investment property
and other repossessed assets		27			(33	)		(82	)
Federal Home Loan Bank stock dividend received		-			(48	)		(436	)
Net change in accrued interest receivable and other assets		(562	)		(156	)		6,945
Net change in accrued interest payable, expenses
and other liabilities		1,764			2,392			227
Net cash provided by operating activities		16,646			16,893			18,774
Cash flows from investing activities:
Loans originated, net of principal repayments		(133,462	)		(71,352	)		(230,120	)
Purchases of securities held-to-maturity		(3,434	)		(10,054	)		(35,436	)
Proceeds from sales/calls on securities held-to-maturity		-			-			26,095
Principal repayments on securities held-to-maturity		2,020			6,271			4,876
Principal repayments on securities available-for-sale		15,184			22,318			31,471
Purchases of securities available-for-sale		(5,716	)		(58,289	)		(93,167	)
Proceeds from sales of securities available-for-sale		-			6,488			127,261
Purchases of premises and equipment		(1,846	)		(1,345	)		(5,802	)
Proceeds from sales/retirements of premises and equipment and REO		269			25			5
Proceeds from loan participations sold		3,988			(1,747	)		446
Cash used for acquisition		-			-			(9,546	)
Purchase of bank owned life insurance		-			-			(5,000	)
Net cash used in investing activities		(122,997	)		(107,685	)		(188,917	)
Subtotal, carried forward	$	(106,351	)	$	(90,792	)	$	(170,143	)

(See accompanying notes to consolidated financial statements.)

22

Consolidated Statements of Cash Flows, Continued
	YEARS ENDED
	DECEMBER 31,
(Dollars in thousands)	2006			2005			2004
Subtotal, brought forward	$	(106,351	)	$	(90,792	)	$	(170,143	)
Cash flows from financing activities:
Proceeds from issuance of common stock		736			564			436
Dividends paid		(3,603	)		(3,163	)		(2,589	)
Repurchase of common stock		(673	)		(858	)		(150	)
Excess tax benefits from stock-based compensation		314			301			199
Net increase in deposits		59,681			73,860			157,594
Net increase in Federal Home Loan Bank advances		7,000			8,000			28,000
Net increase (decrease) in securities sold under agreements
to repurchase		44,652			30,156			(19,009	)
Net increase (decrease) in advance payments by borrowers
for taxes and insurance		14			12			(380	)
Proceeds from junior subordinated debentures payable		10,000			-			5,000
Net cash provided by financing activities		118,121			108,872			169,101
Net increase (decrease) in cash and cash equivalents		11,770			18,080			(1,042	)
Cash and cash equivalents at beginning of period		31,109			13,029			14,071
Cash and cash equivalents at end of period	$	42,879		$	31,109		$	13,029
Supplemental disclosures of cash flow information -
Cash paid during the period for:
Interest	$	40,241		$	30,642		$	21,326
Income taxes		6,700			4,716			5,802
Supplemental schedule of non-cash investing activities:
Net mortgage loans transferred to real estate owned		-			-			1,339
Mark-to-market on securities available-for-sale		472			1,308			1,529
Issaquah Bank merger		-			-			24,792

(See accompanying notes to consolidated financial statements below.)

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollars in thousands, except share amounts)

(1) Summary of Significant Accounting Policies

The accounting and financial reporting policies of Cascade Financial Corporation and subsidiaries (the “Corporation”) conform to accounting principles generally accepted in the United States of America and to general practice within the financial institutions industry, where applicable. In preparing the consolidated financial statements, management makes estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of income and expense. Actual results could differ from those estimates. A material estimate that is particularly susceptible to significant change relates to the determination of the allowance for losses on loans and the valuation of real estate acquired in connection with foreclosures or in satisfaction of loans. In connection with the determination of the estimated losses on loans and foreclosed assets held-for-sale, management obtains independent appraisals for significant properties.

The following is a description of the more significant policies that the Corporation follows in preparing and presenting its consolidated financial statements.

23

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollars in thousands, except share amounts)

(a) Basis of Presentation

The consolidated financial statements include the accounts of the Corporation, its subsidiaries, Cascade Bank (the “Bank”) and the Bank’s subsidiary, Cascade Investment Services, Inc. All significant intercompany balances and transactions have been eliminated in the consolidation. In January 2003, the Financial Accounting Standards Board (FASB) issued Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities and, in December 2003, issued Revised Interpretation No. 46 (FIN 46R), Consolidation of Variable Interest Entities, which replaced FIN 46. Historically, issuer trusts that issued trust preferred securities (junior subordinated debentures payable) have been consolidated by their parent companies and trust preferred securities have been treated as eligible for Tier 1 capital treatment by bank holding companies under Federal Reserve Board (FRB) rules and regulations relating to minority interests in equity accounts of consolidated subsidiaries.

In a Supervisory Letter dated July 2, 2003, the FRB stated that trust preferred securities continue to qualify as Tier 1 capital until notice is given to the contrary. The FRB will review the regulatory implications of any accounting treatment changes and will provide further guidance if necessary or warranted.

(b) Cash Equivalents

The Corporation considers all interest-bearing deposits and short-term highly liquid investment securities with an original maturity of three months or less to be cash equivalents.

(c) Interest-Bearing Deposits with Financial Institutions

Interest-bearing deposits with other financial institutions are carried at cost and include interest-bearing deposits at the Federal Home Loan Bank. At times throughout the year, the Bank has balances that exceed FDIC insurance limits.

(d) Federal Home Loan Bank (FHLB) Stock

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's investment in FHLB stock is carried at par value ($100 per share), which reasonably approximates its fair value. 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. During 2002, the FHLB revised its capital structure from the issuance of one class of stock to two, B (1) and B (2) stock. Class B (1) stock can be sold back to the FHLB at cost, but is restricted as to purchase, sale and redemption. Class B (2) is not a required investment for institutions and is not restricted to purchase and sale, but has the same redemption restrictions as Class B (1) stock. Included in the balance sheet as of December 31, 2006, and 2005, the Bank has $11,920 and $0 of Class B (1) and B (2) stock.

(e) Transfer 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.

(f) Mortgage Servicing Rights

Servicing assets are recognized when rights are acquired through the sale of mortgage loans or when the Bank originates and sells mortgage loans and retains the servicing. Loans serviced for others are not included in the accompanying consolidated balance sheets. In 2006, the Bank sold $34.1 million of commercial real estate and multifamily loans and retained the servicing. In the two previous years the Bank had not retained the servicing on any loans sold. Capitalized servicing rights are reported in other assets. Mortgage loans serviced for others include whole loans sold. Loans being serviced totaled $39.0 million and $15.6 million at December 31, 2006, and 2005, respectively. Included in the 2005 total is $9.2 million of loans serviced on a short-term interim servicing agreement.

Servicing fee income is recorded for fees earned for servicing loans. The fees are based on a contractual percentage of the outstanding principal; or a fixed amount per loan and are recorded as income when earned. The amortization of mortgage servicing rights is netted against loan servicing fee income.

(g) Marketing Costs

The Bank expenses most marketing costs as they are incurred but some marketing costs are capitalized and amortized over the useful life of the expenditure. Marketing expense was $1.1 million, $810, and $547 for the years ended December 31, 2006, 2005, and 2004, respectively.

24

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollars in thousands, except share amounts)

(h) Comprehensive Income

Comprehensive income is comprised of net income and other comprehensive income. Other comprehensive income includes items previously recorded directly to equity, such as unrealized gains and losses on securities available-for-

sale and certain derivative instruments. Comprehensive income is presented with the consolidated statement of shareholders’ equity.

(i) Segment Reporting

The Corporation’s sole operating subsidiary is Cascade Bank, which is managed along four major lines of business: business banking, retail banking, construction lending and income property lending. The financial performance of these business lines is measured by the Corporation’s profitability reporting processes, which utilize various management accounting techniques to ensure that each business line’s financial results reflect the underlying performance of that business. The Bank’s operations are solely in the financial services industry and include providing to its customers traditional banking and other financial services. The administrative group, although not considered a line of business, is responsible for the management of investments, interest rate risk, marketing, data processing, as well as regulatory and stockholder reporting. The Bank operates primarily in the Puget Sound geographical region of Washington state.

(j) Earnings Per Share (EPS) Data

The Corporation displays basic and diluted EPS in the consolidated statement of income. Basic EPS is computed by dividing net income by the weighted average number of shares outstanding during the year. Diluted EPS is computed by dividing net income by diluted weighted average shares outstanding, which includes common stock equivalent shares outstanding using the treasury stock method, unless such shares are anti-dilutive. Common stock equivalents include stock options.

(k) Goodwill and Other Intangible Assets

Net assets of companies acquired in purchase transactions are recorded at fair value at the date of acquisition. Identified intangibles are amortized on an accelerated basis over the period benefited. Goodwill is not amortized but is reviewed for potential impairment on a quarterly basis at the reporting unit level. The impairment test is performed in two phases. The first step of the goodwill impairment test compares the fair value of the reporting unit with its carrying amount, including goodwill. If the fair value of the reporting unit exceeds its carrying amount, goodwill of the reporting unit is considered not impaired; however, if the carrying amount of the reporting unit exceeds its fair value, an additional procedure must be performed. That additional procedure compares the implied fair value of the reporting unit’s goodwill (as defined in SFAS No. 142, “Goodwill and Other Intangible Assets”, (SFAS 142)) with the carrying amount of that goodwill. An impairment loss is recorded to the extent that the carrying amount of goodwill exceeds its implied fair value. The excess cost over fair value of net assets acquired consists mainly of goodwill and core deposit premiums. Core deposit intangibles are amortized on a straight-line basis over 8 years. Intangibles are evaluated periodically, and at least annually, for impairment.

Goodwill and other intangible assets consisted of the following at December 31, 2006 and 2005:

	GROSS CARRYING AMOUNT
Intangible assets carrying value		2006		2005
Core deposit intangible, net	$	775	$	916
Goodwill		25,195		25,195
Total	$	25,970	$	26,111

Amortization and write-downs of intangible assets for 2006 and 2005, was as follows:

	AMORTIZATION AND WRITE-DOWN YEARS ENDED DECEMBER 31
Intangible assets amortization and impairment		2006		2005
Core deposit intangible	$	141	$	141
Mortgage servicing rights		6		30
Total	$	147	$	171

25

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollars in thousands, except share amounts)

Estimated existing intangible asset amortization for the next five years is as follows:

Estimated amortization expense
For year ended 12/31/07	$	199
For year ended 12/31/08		178
For year ended 12/31/09		167
For year ended 12/31/10		160
For year ended 12/31/11		154

(l) Loans

Almost all of the Corporation's loans are located in Washington state, primarily in the Puget Sound Region. At December 31, 2006, the Corporation's loans were classified as one-to-four-family residences (9%), multifamily residences (3%), real estate construction (29%), business assets (44%), consumer assets (3%), and non-owner occupied commercial real estate properties (12%). Accordingly, the ultimate collectibility of the Corporation's loan portfolio is susceptible to changes in the economic and real estate market conditions in the Puget Sound Region.

Business banking loans comprise 44% of the total loan portfolio. Most of the business banking loans are secured with collateral such as commercial property, business inventories, accounts receivable, equipment and personal property of the borrowers and/or guarantors. At December 31, 2006, $22.3 million in commercial real estate loans were unsecured. Home equity loans and Lines of Credit account for the majority of the consumer loan portfolio.

Real estate loans originated by the Corporation are generally secured by no less than 80% of the lesser of the appraised value or purchase price of the underlying property. The Corporation currently requires first mortgage, residential customers to obtain private mortgage insurance on all loans above an 80% loan-to-value ratio.

Loans are stated at principal amounts outstanding, net of deferred loan fees and costs.

Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off generally are reported at their outstanding unpaid principal balances adjusted for charge-offs, the allowance for loan losses, and any deferred fees or costs on originated loans. Interest income is accrued on the unpaid principal balance.

Interest Income

Interest is accrued only if deemed collectible. Accrual of interest income is generally discontinued when a loan becomes 90 days past due and accrued interest amounts are reversed. Once interest has been paid to date or management considers the loan to be fully collectible, it is returned to accrual status.

Loan origination fees and certain direct origination costs are deferred and amortized as an adjustment of the loans' yield over the contractual life of the loan using the interest method. In the event loans are sold, the remaining net deferred loan origination fees or costs are recognized as a component of the gains or losses on the sale of loans. When portfolio loans pay off before their contractual maturity, the remaining deferred fees or costs are recognized as interest income or expense.

Loan commitment fees are deferred until loans are funded, at which time they are amortized into interest income using the effective interest method. If the commitment period expires, the fees are recognized as service charges.

Impairment of Loans and Allowance for Loan Losses

The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.

The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectibility of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.

The allowance consists of specific, general and unallocated 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 is lower than the carrying value of that loan. The general component covers nonclassified loans and is based on historical loss experience adjusted for qualitative factors. An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated 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.

A loan is considered impaired when, based on current information and events, it is probable that the Corporation will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. 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

26

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollars in thousands, except share amounts)

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. Impairment is measured on a loan-by-loan basis for commercial and construction loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent.

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

Management believes the allowance for losses on loans is adequate. While management uses available information to recognize losses on these assets, future additions to the allowances will be necessary based on

changes in economic conditions, particularly in the western Washington region. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Corporation’s allowances for losses on loans. Such agencies may require the Corporation to recognize additions to the allowances, or change valuations, based on their judgments about information available to them at the time of their examinations.

(m) Sales of Loans

Any loan that management determines will not be held-to-maturity is classified as held-for-sale at the time of origination. Loans originated and designated as held-for-sale are intended for sale in the secondary market and are carried at the lower of cost or estimated fair value in the aggregate. Gains or losses on the sale of such loans are based on the specific identification method. Net unrealized losses, if any, are recognized through a valuation allowance by charges to income. The Bank held $311 in loans held for sale at December 31, 2006, and $539 loans held for sale at December 31, 2005. Loans are sold without recourse on a best efforts, servicing released basis. In December 2006, the Bank sold $34.1 million in commercial and multifamily loans in which the servicing was retained.

(n) Securities

Debt and equity securities, including MBS, may be classified as trading, available-for-sale, or held-to-maturity. Securities classified as trading are carried at fair value with unrealized gains and losses reported in earnings. Securities available-for-sale are carried at fair value, with unrealized gains and losses reported as a component of other comprehensive income. Investment securities held-to-maturity are carried at amortized cost or principal balance, adjusted for amortization of premiums and accretion of discounts. Amortization of premiums and accretion of discounts are calculated using a method that approximates the level yield method. The Corporation has the ability, and it is management’s intention, to hold held-to-maturity securities until maturity. Investments with fair values that are less than the amortized cost are considered impaired. Impairment may result from either a decline in the financial condition of the issuing entity or, in the case of fixed interest rate investments, from rising interest rates. At each financial statement date, management assesses each investment to determine if impaired investments are temporarily impaired or if the impairment is other-than-temporary based upon the positive and negative evidence available. Evidence evaluated includes, but is not limited to, industry analyst reports, credit market conditions, interest rate trends, and the intent and ability of the Corporation to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery of fair value. If negative evidence outweighs positive evidence that the carrying amount is recoverable within a reasonable period of time, the impairment is deemed to be other-than-temporary and the security is written down in earnings as a realized loss in the period in which such determination is made. Gains and losses on the sale of securities are recorded on the settlement date and are determined based on the specific identification method.

(o) Real Estate Owned

Real estate owned includes real estate acquired in settlement of loans. Real estate owned is recorded at the lower of cost or fair value, based upon the most recent appraisal, less estimated costs to sell. Development, improvement and direct holding costs related to the property are capitalized. Any loss recorded at the time a foreclosure occurs is classified as a charge-off against the allowance for loan losses. Losses that result from the ongoing periodic valuation of these properties are charged to operations in the period in which they are identified. Real estate owned at December 31, 2006, and December 31, 2005, was $0, and $0, respectively.

(p) Premises and Equipment

Land is carried at cost. Buildings and equipment are stated at cost less accumulated depreciation. Straight-line depreciation is provided over the estimated useful lives of the respective assets. Leasehold improvements are amortized over the estimated useful lives of the improvements, or terms of the related leases, whichever is shorter.

27

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollars in thousands, except share amounts)

(q) Income Taxes

We account for income taxes in accordance with SFAS No. 109 “Accounting for Income Taxes” (“SFAS 109”), under the liability method which requires recognition of deferred tax assets and liabilities for the expected future income tax consequences of transactions that have been included in the Consolidated Financial Statements. Under this method, deferred tax assets and liabilities are determined based on the difference between the financial statement and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. When circumstances warrant, we assess the likelihood that our net deferred tax assets will more likely than not be recovered from future projected taxable income.

(r) Stock-Based Compensation

The Corporation previously accounted for its stock option plan in accordance with the provisions of Accounting

Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees. Effective January 1, 2006, the Corporation adopted Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment,” (“SFAS 123(R)”) using the modified prospective method. Statement 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. See Note 15 to the Consolidated Financial Statements for a further discussion on stock-based compensation.

(s) Interest Rate Swap Agreements

For asset/liability management purposes, the Corporation uses interest rate swap agreements to hedge various exposures or to modify interest rate characteristics of various instruments. Interest rate swaps are contracts in which a series of interest rate flows are exchanged over a prescribed period. The notional amount on which the interest payments are based is not exchanged. Such derivatives are linked to specific assets or liabilities, and have high correlation between the contract and the underlying item being hedged, both at inception and throughout the hedge period.

Interest rate swap agreements are utilized to convert a portion of variable-rate debt to a fixed-rate (cash flow hedge), or to convert a portion of fixed-rate assets to a variable-rate (fair value hedge).

Under SFAS No. 133, as amended, the gain or loss on a swap designated and qualifying as a fair value hedging instrument, as well as the offsetting gain or loss on the hedged item attributable to the risk being hedged, is recognized currently in earnings in the same accounting period. The effective portion of the gain or loss on a swap designated and

qualifying as a cash flow hedging instrument is reported as a component of other comprehensive income. The ineffective portion of the gain or loss on the swap instrument, if any, is recognized in current earnings.

Interest rate derivative financial instruments receive hedge accounting treatment only if they are designated as a hedge and are expected to be, and are, effective in substantially reducing interest rate risk arising from the assets and liabilities. Those swaps that do not meet the hedging criteria discussed below would be recorded at fair value with changes in fair value recorded in current income. Swaps must meet specific effectiveness tests (e.g., over time the change in their fair values due to the designated hedge risk must be within 80 to 125 percent of the opposite change in the fair values of the hedged assets or liabilities). If periodic assessment indicates derivatives no longer provide an effective hedge, the derivatives contracts would be closed out and settled or mark-to-market through income.

Beginning January 1, 2001, in accordance with SFAS No. 133, hedges of variable-rate debt are accounted for as cash flow hedges, with changes in fair value recorded in derivative assets or liabilities and other comprehensive income. The net settlement (upon close out or termination) that offsets changes in the value of the hedged debt is deferred and amortized into net interest income over the life of the hedged debt. Hedges of fixed-rate assets are accounted for as fair value hedges, with changes in fair value recorded in derivative assets or liabilities and interest income. The net settlement (upon close out or termination) that offsets changes in the value of the assets adjusts the basis of the assets and is deferred and amortized to interest income over the life of the assets. The portion, if any, of the net settlement amount that did not offset changes in the value of the hedged asset or liability is recognized immediately in noninterest income.

Cash flows resulting from the derivative financial instruments that are accounted for as hedges of assets and liabilities are classified in the cash flow statement in the same category as the cash flows of the items being hedged.

Derivative financial instruments are recognized as assets and liabilities on the consolidated balance sheet and measured at fair value.

(t) Off-Balance Sheet Credit Related Financial Instruments

In the ordinary course of business, the Corporation enters into commitments to extend credit, including commitments under lines of credit, bank cards, letters of credit, and standby letters of credit and guarantees. Such financial instruments are recorded when they are funded.

(u) Bank Owned Life Insurance (BOLI)

The carrying amount of BOLI approximates its fair value, net of any surrender charges. Fair value of BOLI is estimated using the cash surrender value.

28

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollars in thousands, except share amounts)

(v) Reclassifications

Certain balances have been reclassified to conform to the 2005 presentation.

(w) Earnings Per Share

Basic earnings per share represents income available to common stockholders divided by the weighted-average number of common shares outstanding during the period. Diluted earnings per share reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income that would result from the assumed issuance. Potential common shares that may be issued by the Corporation relate solely to outstanding stock options, and are determined using the treasury stock method.

(x) Recent Accounting Pronouncements

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)." This Statement 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. This Statement 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 No. 158 is not expected to have a material impact on the Company.

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

In June 2006, the FASB issued Interpretation No. 48 “Accounting for Uncertainty in Income Taxes — An Interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 is effective as of the beginning of the first annual period beginning after December 15, 2006. FIN 48 defines the threshold for recognizing the tax benefits of a tax return filing position in the financial statements as “more-likely-than-not” to be sustained by the taxing authority. This is different than the accounting practice currently followed by the Company, which is to recognize the best estimate of the impact of a tax position only when the position is “probable” of being sustained on audit based solely on the technical merits of the position. The term “probable” is consistent with the use of the term in SFAS No. 5 “Accounting for Contingencies,” to mean that “the future event or events are likely to occur.” Cascade has analyzed its tax positions and does not believe that any tax positions would not rise to the level of more likely than not and therefore FIN 48 is not expected to have a material impact on the Company.

(2) Restricted Assets

Federal Reserve Board regulations require that the Bank maintain certain minimum reserve balances as either cash on hand, in the vault or on deposit with the Federal Reserve Bank. The minimum reserve balance as of December 31,

2006, and 2005, was approximately $5,629 and $3,494, respectively.

(3) Securities

A summary of securities at December 31, 2006, and December 31, 2005, follows:

	DECEMBER 31, 2006
	AMORTIZED COST		GROSS UNREALIZED GAINS LESS THAN 1 YEAR		GROSS UNREALIZED GAINS MORE THAN 1 YEAR		GROSS UNREALIZED LOSSES LESS THAN 1 YEAR			GROSS UNREALIZED LOSSES MORE THAN 1 YEAR			FAIR VALUE
Securities available-for-sale
MBS	$	38,428	$	47	$	3	$	(18	)	$	(713	)	$	37,747
Agency notes		95,772		-		-		-			(2,863	)		92,909
	$	134,200	$	47	$	3	$	(18	)	$	(3,576	)	$	130,656

29

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollars in thousands, except share amounts)

	DECEMBER 31, 2006
	AMORTIZED COST		GROSS UNREALIZED GAINS LESS THAN 1 YEAR		GROSS UNREALIZED GAINS MORE THAN 1 YEAR		GROSS UNREALIZED LOSSES LESS THAN 1 YEAR			GROSS UNREALIZED LOSSES MORE THAN 1 YEAR			FAIR VALUE
Securities held-to-maturity
MBS	$	25,218	$	7	$	-	$	(14	)	$	(873	)	$	24,338
Agency notes		70,853		-		-		(24	)		(2,406	)		68,423
Corporate/other		775		-		-		-			-			775
	$	96,846	$	7	$	-	$	(38	)	$	(3,279	)	$	93,536

	DECEMBER 31, 2005
	AMORTIZED COST		GROSS UNREALIZED GAINS LESS THAN 1 YEAR		GROSS UNREALIZED GAINS MORE THAN 1 YEAR		GROSS UNREALIZED LOSSES LESS THAN 1 YEAR			GROSS UNREALIZED LOSSES MORE THAN 1 YEAR			FAIR VALUE
Securities available-for-sale
MBS	$	47,847	$	16	$	14	$	(71	)	$	(383	)	$	47,423
Agency notes		95,822		-		-		(2,258	)		(391	)		93,173
	$	143,669	$	16	$	14	$	(2,329	)	$	(774	)	$	140,596

	AMORTIZED COST		GROSS UNREALIZED GAINS LESS THAN 1 YEAR		GROSS UNREALIZED GAINS MORE THAN 1 YEAR		GROSS UNREALIZED LOSSES LESS THAN 1 YEAR			GROSS UNREALIZED LOSSES MORE THAN 1 YEAR			FAIR VALUE
Securities held-to-maturity
MBS	$	23,830	$	-	$	8	$	(188	)	$	(601	)	$	23,049
Agency notes		70,827		-		-		(376	)		(1,845	)		68,606
Corporate/other		465		-		-		-			-			465
	$	95,122	$	-	$	8	$	(564	)	$	(2,446	)	$	92,120

At December 31, 2006, Cascade had 31 securities with a gross unrealized loss totaling $3.6 million in our available-for-sale portfolio with a fair value of $113.0 million that had an unrealized loss for greater than one year and 21 held-to-maturity securities with a gross unrealized loss totaling $3.3 million with a fair value of $87.0 million that have had an unrealized loss for more than one year. The majority of the impairment on available-for-sale securities was in the Agency Notes category, which accounted for 81% of the total impairment. As of December 31, 2006, the Bank had 35 available-for-sale and 23 held-to-maturity securities included in the temporarily impaired report, compared to 5 available-for-sale and 3 held-to-maturity with unrealized gains. The temporary impairment was less than 3% of the total book value of investments. Temporarily impaired securities are a result of an increase in interest rates and are expected to regain their value as the securities near maturity and/or market rates decline; other-than-temporarily impaired securities are a result of contractual failure by the issuer and are not expected to rebound and are considered not collectable. At December 31, 2006, the Bank had no securities with other-than-temporary impairments.

Certain investment securities shown above currently have fair values less than amortized cost and therefore contain unrealized losses. The Corporation 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. All are rated AAA for credit quality by at least one major rating agency. The decline in value is not related to any company or industry specific event. The Corporation 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.

As of December 31, 2006, and 2005, the Corporation was required to maintain 79,050 and 100,122 shares, respectively, of $100 par value FHLB stock.

Accrued interest receivable on securities and interest-bearing deposits was $2,318 and $2,214 at December 31, 2006, and 2005, respectively.

Proceeds from the sale of securities available-for-sale including calls on securities held-to-maturity and gross realized gains and losses are summarized as follows for the year ended December 31, 2006, 2005, and 2004.

30

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollars in thousands, except share amounts)

	PROCEEDS		GAINS		LOSSES
Year ended December 31, 2006	$	-	$	-	$	-
Year ended December 31, 2005		6,488		68		(1	)
Year ended December 31, 2004		153,356		510		-

The following table shows the contractual or expected maturities of the Corporation’s securities available-for-sale at December 31, 2006:

	WITHIN ONE		ONE TO		OVER FIVE TO		OVER TEN
	YEAR		FIVE YEARS		TEN YEARS		YEARS		TOTAL
Amortized Cost
MBS	$	1,464	$	28,991	$	6,010	$	1,963	$	38,428
Agency notes	$	-	$	47,970	$	47,747	$	55	$	95,772
Total amortized cost	$	1,464	$	76,961	$	53,757	$	2,018	$	134,200
Fair Value
MBS	$	1,462	$	28,630	$	5,841	$	1,814	$	37,747
Agency notes	$	-	$	47,125	$	45,729	$	55	$	92,909
Total fair value	$	1,462	$	75,755	$	51,570	$	1,869	$	130,656

The following table shows the contractual or expected maturities of the Corporation’s securities held-to-maturity at December 31, 2006:

	WITHIN ONE		ONE TO		OVER FIVE TO		OVER TEN
	YEAR		FIVE YEARS		TEN YEARS		YEARS		TOTAL
Amortized Cost
MBS	$	-	$	-	$	-	$	25,218	$	25,218
Agency notes		-		16,000		17,898		36,955		70,853
Corporate/other		-		-		-		775		775
Total amortized cost	$	-	$	16,000	$	17,898	$	62,948	$	96,846
Fair Value
MBS	$	-	$	-	$	-	$	24,338	$	24,338
Agency notes		-		15,717		17,390		35,316		68,423
Corporate/other		-		-		-		775		775
Total fair value	$	-	$	15,717	$	17,390	$	60,429	$	93,536

Securities are classified based upon contractual maturity dates. Actual maturities may differ from contractual maturities because the borrowers have the right to prepay their obligations. The fair value of securities pledged as collateral to secure public deposits were $54.2 million at December 31, 2006, and $17.0 million at December 31, 2005. The fair value of securities of $41.0 million were pledged to the FHLB at December 31, 2006, and $99.6 million at December 31, 2005. The fair value of securities pledged to fund repurchase agreements were $109.1 million at December 31, 2006, and $57.2 million at December 31, 2005. The fair value of securities of $956 was also pledged to third parties as collateral for derivative contracts at December 31, 2006.

(4) Loans and Allowance for Loan Losses

A summary of loans at December 31, 2006, and 2005, follows:

	DECEMBER 31,			DECEMBER 31,
	2006			2005
Residential	$	96,350		$	95,429
Multifamily		34,719			52,057
Commercial real estate		119,298			141,109
Construction(1)		289,993			165,957
Business banking		442,391			394,034
Consumer		27,686			32,160
Total loans		1,010,437			880,746
Deferred loan fees, net		(3,434	)		(3,443	)
Allowance for loan losses		(10,988	)		(10,254	)
Loans	$	996,015		$	867,049
Loans serviced for others	$	39,032		$	15,598

(1) Construction loans are net of loans in process

31

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollars in thousands, except share amounts)

The increase in loans serviced for others was due to a $34.1 million sale of multifamily and commercial loans in December.

Accrued interest on loans was $5,281 and $4,078 at December 31, 2006, and December 31, 2005, respectively. Loans to officers and directors totaled $311 at December 31, 2006, $300 at December 31, 2005, and $2.7 million at December 31, 2004. Repayments totaling $6, $39, and $502 were received and additional advances of $17, $17, and $0 were made for the years ended December 31, 2006, 2005, and 2004, respectively. Additionally, in 2006, $2.3 million in loans were excluded since the director previously included was no longer affiliated with the Bank.

At December 31, 2006, the composition of the loan portfolio was as follows:

	FIXED		VARIABLE		ADJUSTABLE
	RATE		RATE (1)		RATE
Term to maturity
Less than one year	$	22,809	$	209,602	$	7,874
1-3 years		74,309		98,842		11,363
3-5 years		41,101		834		13,623
5-10 years		111,120		19,121		234,702
10-20 years		6,740		4,041		25,053
Over 20 years		5,684		13,338		110,281
Total	$	261,763	$	345,778	$	402,896

(1)   Variable includes all Prime, LIBOR, or Treasury indexed loans with a repricing frequency of three months or less

Nonaccrual loans totaled $851, $1,987, and $532, respectively, at December 31, 2006, December 31, 2005, and December 31, 2004. If interest on these loans had been recognized, such income would have been $27, $82, and $2 respectively, for the periods ended December 31, 2006, 2005, and 2004. The Corporation has no commitments to extend additional credit on loans that are nonaccrual. At December 31, 2006, 2005, and 2004, loans totaling $9,396, $17,485, and $9,319, were adversely classified loans, for which there were $46 in allocated allowances. The $46 allocated allowance was on one loan with a principal balance of $105. Of the adversely classified loans, $223, $1,511, and $166 were under foreclosure. The average balance of adversely classified loans for the year ended December 31, 2006, and December 31, 2005, respectively, was $13,826, and $13,130 and the Corporation recognized $759, and $760 of related interest income on such loans during the time such loans were adversely classified.

At December 31, 2006, 2005, and 2004, impaired loans totaled $859, $1,987, and $644, respectively. The average balance during the years ended December 31, 2006, 2005 and 2004 were $796, $1,226, and $1,089, respectively. The allowance for loan losses related to these loans was approximately $401 in 2006, $801 in 2005, and $269 in 2004. Interest collected on these loans in cash and included in income was not considered significant for 2006, 2005, and 2004. If interest on these loans had been accrued, the additional amount of such income would not have been significant for 2006, 2005, and 2004. At December 31, 2006, there were no commitments to lend additional funds to borrowers whose loans were classified as impaired.

At December 31, 2006, and December 31, 2005, the Bank had no loans that were 90 days or more past due and still accruing.

At December 31, 2006, the Corporation had outstanding commitments of $4,541 to fund loans with fixed interest rates and $16,871 for loans with adjustable rates.

The Corporation had non-mandatory forward commitments totaling $364 and $157 to sell loans into the secondary market at December 31, 2006, and December 31, 2005, respectively.

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. While approximately 100% of commercial letters of credit are utilized, a significant portion of such utilization is on an immediate payment basis. The Bank evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if it is deemed necessary by the Bank upon extension of credit, is based on management's credit evaluation of the borrower. Collateral held varies but may include accounts receivable, inventory, property, plant and equipment, and income-producing commercial properties.

Unfunded commitments under commercial Lines of Credit, revolving credit lines and loans in process are commitments for possible future extensions of credit to existing customers.

Standby letters of credit and financial guarantees written are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements, bond financing, and similar transactions. The Bank underwrites its standby letters of credit using its policies and procedures applicable to loans in general. Standby letters of credit are made on an unsecured and secured basis. The Bank has not been required to perform on any financial guarantees during the past two years. The Bank did not incur any significant losses on its commitments in 2006 or 2005.

32

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollars in thousands, except share amounts)

At December 31, 2006, and 2005, the following financial instruments with off-balance sheet risk were outstanding:

	2006		2005
Commitments to grant loans(1)	$	18,203	$	26,742
Unfunded commitments under lines of credit/loans in process		196,902		189,573
Standby letters of credit and financial guarantees written		4,924		5,241
Unused commitments on bankcards		12,751		11,873
Total	$	232,780	$	233,429

(1)   Excludes $3.2 million in commitments to originate/sell loans into the secondary market as of December 31, 2006, and $197 as of December 31, 2005

A summary of the allowance for losses on loans follows:

	YEARS ENDED DECEMBER 31,
	2006			2005			2004
Balances at beginning of year	$	10,254		$	9,563		$	7,711
Issaquah Bank allowance assumed		-			-			1,395
Provision for loss		1,000			945			675
Recoveries		148			266			223
Charge-offs		(414	)		(520	)		(441	)
Balances at end of year	$	10,988		$	10,254		$	9,563

(5) Premises and Equipment

A summary of premises and equipment follows:

	ESTIMATED		DECEMBER 31,			DECEMBER 31,
	USEFUL LIVES		2006			2005
Land			$	2,577		$	2,577
Buildings		40 years		10,936			10,703
Leasehold improvements		Lease term		2,229			2,186
Furniture and equipment		2-10 years		14,679			13,305
				30,421			28,771
Accumulated depreciation and amortization				(18,418	)		(16,501	)
			$	12,003		$	12,270

Total depreciation and amortization expense was $1,917, $1,874, and $1,553 for the years ended December 31, 2006, 2005, and 2004, respectively.

The Bank leases space for various branches. These leases run for a period ranging from 2 to 12 years and allow for established rent increases each year. Generally these leases require the Bank to pay all taxes, maintenance and utility costs, as well as maintain certain types of insurance. The annual lease commitments at December 31, 2006, are as follows:

Years ending December 31,	2007	$	693
	2008		693
	2009		693
	2010		664
	2011		664
	Thereafter		6,796
		$	10,203

Rental expense charged to operations was approximately $693, $642, and $482 for the years ended December 31, 2006, 2005, and 2004, respectively.

(6) Deposits

Deposits at December 31, 2006, and 2005, are summarized as follows:

	DECEMBER 31,		DECEMBER 31,
	2006		2005
Noninterest-bearing checking accounts	$	87,456	$	80,402
Interest-bearing checking accounts		52,051		40,066
Money market deposit accounts		275,286		181,621
Savings accounts		15,158		15,169
Certificates of deposit		425,498		478,510
	$	855,449	$	795,768

33

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollars in thousands, except share amounts)

Time deposit accounts in amounts of $100 thousand or more totaled $257.0 million and $294.2 million at December 31, 2006, and December 31, 2005, respectively.Deposits by executive officers and directors totaled $2.3 million at December 31, 2006, and $4.0 million at December 31, 2005.

				DEPOSIT ACCOUNTS
	WEIGHTED AVERAGE			WITH BALANCES		ACCRUED INTEREST
	INTEREST RATE			IN EXCESS		PAYABLE ON
	ON DEPOSITS			OF $100,000		DEPOSITS
December 31, 2006		3.86	%	$	552,522	$	5,176
December 31, 2005		2.89			479,480		1,952

A summary of interest expense on deposits follows:

	YEARS ENDED DECEMBER 31,
	2006		2005		2004
Checking and money market accounts	$	9,160	$	3,500	$	1,965
Savings accounts and time deposits		19,416		14,814		9,194
	$	28,576	$	18,314	$	11,159

Maturities of time deposits at December 31, 2006, are as follows:

Years ending December 31,	2007	$	381,305
	2008		33,378
	2009		5,098
	2010		3,845
	2011		1,172
	Thereafter		700
		$	425,498

(7) Junior Subordinated Debentures Payable (Trust Preferred Securities)

On March 1, 2000, $10.3 million of 11% junior subordinated debentures payable due March 1, 2030, were issued by a wholly owned business Trust whose common equity is 100% owned by Cascade Financial Corporation, Cascade Capital Trust I. The Trust exists for the exclusive purposes of issuing and selling the junior subordinated debentures payable, using the proceeds from the sale of the capital securities to acquire junior subordinated debentures payable, issued by Cascade Financial Corporation, and engaging in only those other activities necessary, advisable or incidental to the above. The Corporation used the proceeds for general corporate purposes including stock repurchases and investment in its subsidiary bank. As a result of the adoption of FIN 46R, we deconsolidated the Trust and all periods in the consolidated financial statements have been restated to reflect this change. The $10.3 million of junior subordinated debentures payable issued by the Corporation to the Trust were reflected as junior subordinated debentures payable in the consolidated balance sheet at December 31, 2005, and 2004. The junior subordinated debentures payable will mature on March 1, 2030 unless redeemed prior to such date if certain conditions are met. The Trust will redeem the trust preferred securities when we pay the junior subordinated debentures payable at maturity or upon any earlier redemption of the junior subordinated debentures payable.

In October 2003, Cascade entered into an interest rate swap agreement with a third party as a hedge of the interest rate on the Corporation’s junior subordinated debentures payable. Under the terms of the agreement, Cascade received an 11% fixed-rate and paid a floating-rate of USD-six month LIBOR-BBA plus 520 basis points. The unrealized loss on the interest rate swap was $253 as of December 31, 2005. The swap was terminated in December 2006 at a loss of $150.

On December 15, 2004, the Corporation issued $5.2 million in junior subordinated debentures payable, Cascade Capital Trust II. These securities have a fixed coupon of 5.82% for the first 5 years and then float at 3-month LIBOR plus 1.90% for the remaining 25 years. The securities are callable at par after 5 years. These securities are considered Tier 1 capital by financial institution regulators.

On March 30, 2006, the Corporation issued an additional $10.3 million in junior subordinated debentures payable, Cascade Capital Trust III. These securities have a fixed coupon of 6.50% for the first 5 years and then float, if not called, at 3-month LIBOR plus 1.40% for the remaining 25 years. These debentures are also considered Tier 1 capital for regulatory purposes.

The junior subordinated debentures payable issued under Cascade Capital Trust II and III incorporate the same structure for the same purposes as Cascade Capital Trust I.

34

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollars in thousands, except share amounts)

(8) FHLB Advances

FHLB advances are summarized as follows:

	DECEMBER 31,					DECEMBER 31,
	2006					2005
			WEIGHTED					WEIGHTED
			AVERAGE					AVERAGE
			INTEREST					INTEREST
MATURITY DATE	AMOUNT		RATE			AMOUNT		RATE
At December 31,
2006	$	-		-	%	$	23,000		4.65	%
2007(1)		32,000		5.87			22,000		6.06
2008		2,000		3.51			2,000		3.51
2009(2)		39,000		5.00			39,000		4.31
2010		45,000		5.83			60,000		5.32
2011		10,000		3.88			10,000		3.88
Thereafter(3)		115,000		4.04			80,000		3.38
	$	243,000		4.76	%	$	236,000		4.42	%

(1)   Includes $10,000 tied to 1 month LIBOR

(2)   Includes $25,000 tied to 3 month LIBOR

(3)   Includes $65,000 tied to 3 month LIBOR

	YEARS ENDED DECEMBER 31,
	2006		2005
Maximum amount of outstanding FHLB advances at any month-end	$	256,000	$	251,000
Average amount of outstanding FHLB advances during the year		237,888		239,896

The Corporation had $143.0 million in fixed-rate advances as of December 31, 2006, where the FHLB has the option to convert these advances to variable-rate advances after a specified period.

At December 31, 2006, the Bank had an unused Line of Credit from the FHLB-Seattle of $231.0 million subject to the availability of eligible collateral. The Bank’s credit line with the FHLB-Seattle is 35% of total assets, or up to approximately $474.0 million and is subject to certain collateral requirements.

FHLB advances are collateralized by otherwise unencumbered permanent residential mortgages, investment grade securities, and other eligible real estate mortgages. Federal statute requires all members of the FHLB to maintain collateral on FHLB borrowings and advances equivalent to the amount borrowed on a daily basis.

(9) Securities Sold Under Agreements to Repurchase and Lines of Credit

The Corporation enters into sales of securities under agreements to repurchase (reverse repurchase agreements) that are treated as financing arrangements. Accordingly, the obligations to repurchase securities sold are reflected as a liability in the consolidated balance sheets, and the securities underlying the agreements remain in the asset accounts. The securities underlying the agreements are under the Corporation’s control and are held by nationally known government security dealers who are recognized as primary dealers by the Federal Reserve Board, or other investment banking firms approved by the Corporation’s Board of Directors.

Securities sold under agreements to repurchase the same securities consist of agency notes and/or mortgage-backed securities summarized as follows:

						UNDERLYING SECURITIES
			WEIGHTED			BOOK VALUE,
			AVERAGE			INCLUDING
	BALANCE		INTEREST			ACCRUED		MARKET
	OUTSTANDING		RATE			INTEREST		VALUE
December 31, 2006	$	95,710		1.42	%	$	113,026	$	109,145
December 31, 2005		51,058		1.68			58,950		57,200

Financial data pertaining to repurchase agreements follows:

	YEARS ENDED DECEMBER 31,
	2006		2005
Maximum amount of outstanding agreements at any month-end	$	96,007	$	51,058
Average amount of outstanding agreements during the year		81,284		24,051

35

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollars in thousands, except share amounts)

The Corporation used $95.0 million of repurchase agreements that adjust to a spread under three-month LIBOR for periods ranging from six months to one year and then adjust to a fixed-rate for the remainder of the agreement unless the lender terminates the agreement.

The Bank has Fed funds borrowing lines with three of its correspondent banks. One line is for $15.0 million and matures July 1, 2007. The other two facilities are for $10.0 million; one matures June 30, 2007, and the other has no maturity date. Interest rates for these lines are quoted at the time of borrowing and are subject to certain collateral requirements. The Bank used each of these lines during the year. The Bank also has the ability to borrow from the Federal Reserve Bank of San Francisco based on the amount of collateral pledged. As of December 31, 2006, there were no outstanding balances on any of these lines.

(10) Income Taxes

Income tax expense (benefits) includes the following components:

	YEARS ENDED
	DECEMBER 31,
	2006		2005			2004
Current	$	6,297	$	6,412		$	5,467
Deferred		178		(150	)		(100	)
	$	6,475	$	6,262		$	5,367

As required by SFAS 109, we continually review the likelihood that deferred tax assets will be realized in future tax periods under the more likely than not criteria. In making this judgment SFAS 109 requires that all available evidence, both positive and negative, should be considered to determine whether, based on the weight of that evidence, a valuation allowance is required. As of December 31, 2006, we had $4.6 million of deferred tax assets and net deferred tax assets (after deferred tax liabilities) of $555 related to the U.S. tax jurisdictions whose recoverability is dependent upon future profitability.

In the future, our effective tax rate could be adversely affected by several factors, many of which are outside of our control. Our effective tax rate is affected by the proportion of revenues and income before taxes in the various domestic and international jurisdictions in which we operate. Further, we are subject to changing tax laws, regulations and interpretations in multiple jurisdictions in which we operate, as well as the requirements, pronouncements and rulings of certain tax, regulatory and accounting organizations. We estimate our annual effective tax rate each quarter based on a combination of actual and forecasted results of subsequent quarters. Consequently, significant changes in our actual quarterly or forecasted results may impact the effective tax rate for the current or future periods.

For the year ended December 31, 2006, the Corporation's effective tax rate was 32.7% compared to 32.4% for the year ended December 31, 2005. Decreased tax benefits related to interest on tax exempt loans and increases in cash surrender value of bank owned life insurance comprised the significant portion of the differences in the effective tax rates between the two years.

Income tax expense differs from that computed by applying the U.S. federal income tax rate of 35% to pretax income for the years ended December 31^st as a result of the following:

	2006			2005			2004
Computed “expected” tax expense	$	6,941		$	6,758		$	5,588
Bank owned life insurance (BOLI)		(231	)		(232	)		(169	)
Tax exempt interest		(341	)		(284	)		(69	)
Nondeductible acquisition cost		-			-			122
Nondeductible option cost		101			-			-
Other, net		5			20			(105	)
	$	6,475		$	6,262		$	5,367

Under certain provisions of the Internal Revenue Code, the Corporation was allowed a statutory bad debt deduction (based upon a percentage of taxable income before such deduction) for additions to tax bad debt reserves established for the purpose of absorbing losses on loans or property acquired through foreclosure. This amount represents allocations of income to bad debt deductions for tax reporting purposes only. Reduction of amounts so allocated for purposes other than tax bad debt losses will create income for tax reporting purposes only, which will be subject to the then-current corporate income tax rate.

36

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollars in thousands, except share amounts)

The following table presents major components of the net deferred tax asset (liability) resulting from differences between financial reporting and tax bases at December 31, 2006, and December 31, 2005:

	DECEMBER 31,			DECEMBER 31,
	2006			2005
Deferred tax assets:
Securities available-for-sale	$	1,240		$	1,075
Loans		3,316			3,087
Gross deferred tax assets		4,556			4,162
Deferred tax liabilities:
Deferred loan fees		(1,660	)		(1,221	)
Core deposit intangible		(267	)		(317	)
Premises and equipment		(203	)		(204	)
FHLB stock		(1,732	)		(1,732	)
Other		(139	)		(120	)
Gross deferred tax liabilities		(4,001	)		(3,594	)
Net deferred tax asset	$	555		$	568

A valuation allowance for deferred tax assets was not considered necessary at December 31, 2006 or 2005. Management believes the Corporation will fully realize its total deferred income tax assets as of December 31, 2006, and 2005, based upon its total deferred income tax liabilities, previous taxes paid and its current and expected future levels of taxable income.

(11) Acquisition

On June 3, 2004, the Corporation acquired Issaquah Bancshares, Inc. (“Issaquah”). The acquisition was accounted for using the purchase method of accounting and accordingly, the assets and liabilities were recorded based on their fair values at the acquisition date. Shares of Issaquah were exchanged for cash or cash and shares of the Corporation. The merger enhances the Corporation’s commercial banking franchise by expanding its presence in east King County. Total Issaquah assets on June 3, 2004, were approximately $131.0 million and the total value of the transaction, both cash and stock, was approximately $34.3 million as measured under the provisions of FAS 141. The Corporation issued approximately 1.3 million shares and paid cash of $9.5 million in connection with the merger. The Bank booked $26.3 million in intangible assets associated with the transaction including $25.2 million in goodwill and a $1.1 million core deposit intangible that is amortized under the straight-line method over an eight year period of time.

The following information presents unaudited pro forma results of operations for the years ended December 31, 2004 and 2003, as though the Issaquah acquisition had occurred on January 1, 2003. The pro forma results do not necessarily indicate the results that would have been obtained had the acquisition actually occurred on January 1, 2003.

	YEARS ENDED DECEMBER 31, (unaudited)
	2004		2003
Net interest income	$	34,736	$	32,736
Provision for credit losses		700		1,465
Noninterest income		4,983		6,030
Noninterest expense		22,818		21,075
Income before provision for income taxes		16,201		16,226
Provision for income taxes		5,379		5,088
Net income	$	10,822	$	11,138
Basic earnings per share	$	0.97	$	0.94
Diluted earnings per share	$	0.94	$	0.92

37

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollars in thousands, except share amounts)

The fair values of the Issaquah assets acquired and liabilities assumed as of June 3, 2004, were initially recorded as follows:

Investment securities	$	23,087
Loans and leases, net		94,556
Premises		3,866
Goodwill		25,195
Core deposit intangibles		1,127
Other assets		825
	$	148,656
Deposits	$	101,759
Other borrowings		15,200
Other liabilities		960
Acquisition cost, net of cash acquired		30,737
	$	148,656

As a result of the merger and merger-related activities, the Corporation incurred expenses that were classified as merger-related. The components of these charges for the year ended December 31, 2004, were as follows:

Professional fees	$	354
Other		2
	$	356

(12) Earnings Per Share

The following table presents EPS information:

	YEARS ENDED
	DECEMBER 31,
	2006		2005		2004
Net income	$	13,355	$	13,046	$	10,785
Common shares outstanding (basic)		12,060,191		11,977,824		11,190,616
Effect of dilutive stock options		303,007		342,049		404,674
Common shares outstanding (diluted)		12,363,198		12,319,873		11,595,290
EPS, basic	$	1.11	$	1.09	$	0.96
EPS, diluted		1.08		1.06		0.93

For purposes of calculating basic and diluted earnings per share, the numerator of net income is the same. There were outstanding options to purchase 196,554, 143,939, and 136,544 shares of common stock at December 31, 2006, December 31, 2005, and December 31, 2004, respectively, that are considered non-dilutive and have been excluded from the above calculation. Non-dilutive options have an exercise price that is greater than the current market price of the stock.

(13) Stockholders’ Equity

(a) Restrictions on Dividends

Current regulations allow the Bank to pay dividends on its stock if its regulatory capital would not thereby be reduced below the amount required for the statutory capital requirements set by the Federal Deposit Insurance Corporation (FDIC).

(b) Regulatory Capital

The Corporation (on a consolidated basis) and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Corporation's and Bank's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Corporation and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification 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.

38

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollars in thousands, except share amounts)

Quantitative measures established by regulation to ensure capital adequacy require the Corporation and the Bank to maintain minimum amounts and ratios (set forth in the following table) of total and Tier 1 capital (as defined in the

regulations) to risk-weighted assets (as defined) and of Tier 1 capital (as defined) to average assets (as defined). Management believes, as of December 31, 2006, and 2005, that the Corporation and the Bank met all capital adequacy requirements to which they are subject. To be categorized as well-capitalized, an institution must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in the following tables. There are no conditions or events since the notification that management believes have changed the Bank's category.

At December 31, 2006, banking regulations required institutions to have a minimum total risk-based capital to risk-weighted assets ratio of 8% and a Tier 1 (core) capital to adjusted total assets ratio of 4%.

At December 31, 2006, the Bank was in compliance with the regulatory requirements for well-capitalized institutions.

As of December 31, 2006, the most recent notification from the FDIC categorized the Bank as well-capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since the notification that management believes have changed the Bank's category.

						MINIMUM
						REQUIREMENTS
						FOR CAPITAL					WELL-CAPITALIZED
	ACTUAL					ADEQUACY					REQUIREMENTS
CASCADE BANK	AMOUNT		RATIO			AMOUNT		RATIO			AMOUNT		RATIO
December 31, 2006:
Total risk-based capital to risk-weighted assets (1)	$	127,132		11.20	%	$	90,816		8.00	%	$	113,521		10.00	%
Tier I (core) capital to risk-weighted assets		116,144		10.23			45,408		4.00			68,112		6.00
Tier I (core) capital to average total assets		116,144		8.96			51,850		4.00			64,813		5.00
December 31, 2005:
Total risk-based capital to risk-weighted assets (1)	$	105,401		10.77	%		78,277		8.00	%		97,846		10.00	%
Tier I (core) capital to risk-weighted assets		95,147		9.72			39,138		4.00			58,707		6.00
Tier I (core) capital to average total assets		95,147		8.15		$	46,718		4.00		$	58,397		5.00

The Corporation, as a bank holding company regulated by the Federal Reserve, is also subject to capital requirements that are similar to those for Cascade Bank.

						MINIMUM
						REQUIREMENTS
						FOR CAPITAL					WELL-CAPITALIZED
	ACTUAL					ADEQUACY					REQUIREMENTS
CASCADE FINANCIAL CORP	AMOUNT		RATIO			AMOUNT		RATIO			AMOUNT		RATIO
December 31, 2006:
Total risk-based capital to risk-weighted assets (1)	$	127,504		11.22	%	$	90,935		8.00	%	$	113,668		10.00	%
Tier I (core) capital to risk-weighted assets		116,516		10.25			45,467		4.00			68,201		6.00
Tier I (core) capital to average total assets		116,516		8.99			51,850		4.00			64,813		5.00
December 31, 2005:
Total risk-based capital to risk-weighted assets (1)	$	106,332		10.86	%	$	78,326		8.00	%		97,907		10.00	%
Tier I (core) capital to risk-weighted assets		96,078		9.81			39,163		4.00			58,744		6.00
Tier I (core) capital to average total assets		96,078		8.23			46,718		4.00		$	58,397		5.00

(1)The FDIC and the Federal Reserve require institutions to maintain Tier I capital of not less than one-half of total capital

(14) Mortgage Servicing Rights

The increase in mortgage servicing rights is the result of the $34.1 million loan sale, servicing retained, in December 2006. A summary of capitalized mortgage servicing rights, included in other assets, at December 31, 2006, and December 31, 2005, follows:

	DECEMBER 31,			DECEMBER 31,
	2006			2005
Balance at beginning of year		10			40
Additions		170			-
Amortization		(6	)		(30	)
Allowance for losses		-			-
Balance at end of year		174			10

The fair value of servicing rights was determined using a discount rate of 12% and a prepayment speed of 400%.

39

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollars in thousands, except share amounts)

(15) Employee Benefit Plans

(a) Savings Plan

The Corporation maintains a savings plan under section 401(k) of the Internal Revenue Code, covering substantially

all full-time employees. Under the plan, employee contributions are matched by the Corporation at a rate of 50% of the first $12 contributed. Such matching becomes vested over a period of five years of credited service. Employees may make investments in various stock, fixed income or money market plans, or may purchase stock in the Corporation.

The Corporation contributed $313, $287, and $290 to the plan for the years ended December 31, 2006, 2005, and 2004, respectively.

(b) Employee Stock Ownership Plan

The Corporation established an employee stock ownership plan (ESOP) which became effective on July 1, 1992, for employees of the Corporation and the Bank, who have at least one year of continuous service. The Corporation pays all ESOP expenses. The shares of Cascade Financial Corporation stock purchased by the ESOP are held in a suspense account for allocation among the participants. Benefits become 20% vested after the first year of service with an additional 20% vesting each year thereafter until 100% vesting after five years. Allocations to individual participant’s accounts are based on total compensation during the year. Forfeitures are reallocated annually

among remaining participating employees. For the years ended December 31, 2006, 2005, and 2004, the Corporation contributed $0, $0, and $14, respectively, to the ESOP, which is invested in Cascade Financial Corporation stock. During the year the Corporation terminated the Employee Stock Ownership Plan and all shares were transferred into the individual 401(k) savings plans of participating employees.

(c) Employee Stock Purchase Plan

The Corporation maintains an employee stock purchase plan, under the terms of which 213,212 shares of common stock have been authorized for issuance. The plan allows employees of the Corporation with three months of service the opportunity to purchase common stock through accumulated salary deductions during each offering period. On the first day of each six-month offering period (January 1 and July 1 of each year), eligible employees who elect to participate are granted options to purchase a limited number of shares and unless the participant withdraws from the plan, the option is automatically exercised on the last day of each offering period. The aggregate number of shares to be purchased in any given offering is determined by dividing the accumulated salary deduction for the period by the lower of 85% of the market price of a common share at the beginning or end of an offering period.

(d) Stock Options

The shareholders of the Corporation approved two stock option plans to promote the best interest of the Corporation and its shareholders by providing an incentive to employees and directors. The plans permit the grant of incentive stock options and non-qualified stock options.

Options are granted to certain employees and directors at prices equal to the market value of the stock on the dates the options were granted. The options granted have a term of 10 years from the grant date. Incentive stock options granted to employees vest over a five-year period. Non-qualified options granted to directors vest over a four-year period. Compensation expense is recorded as if each vesting portion of the award is a separate award. The maximum number of options that may be issued under the plan is 937,500 (as adjusted for stock splits and dividends). The Corporation had 592,200 and 552,286 shares available for grant at December 31, 2006, and 2005, respectively.

Accounting for Stock Options

On January 1, 2006, the Corporation adopted Statement 123(R), applying the modified prospective method. Statement 123(R) requires all equity-based payments to employees, including grants of employee stock options, to be recognized in the Consolidated Statements of Income at the fair value of the award over the requisite service period. Under the modified prospective method, the Corporation is required to record equity-based compensation expense for all awards granted after the date of adoption and for the unvested portion of previously granted awards outstanding as of the date of adoption.

Compensation cost charged against income for stock option expense was $287 for 2006. The total income tax benefit recognized in the income statement for stock based compensation arrangements was $314 for 2006.

The fair values of the options granted to the Corporation’s employees were estimated on the date of grant using the Black-Scholes valuation model. The application of this valuation model involves assumptions that are judgmental and sensitive in the determination of compensation expense.

The following table provides the range of assumptions used for stock options granted:

	Years Ended December 31,
	2006			2005			2004
Risk-free interest rate		4.50	%		3.00	%		2.25	%
Expected life in years		5			8			8
Expected volatility		24	%		24	%		24	%
Dividend yield		2.03	%		2.02	%		1.77	%

40

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollars in thousands, except share amounts)

Historical information was the primary basis for the selection of the expected volatility, expected dividend yield and the expected lives of the options. The Corporation has collected a long history of option activity and feels that this historical information presents the best basis for future projections. The risk-free interest rate was selected based upon U.S. Treasury issues with a term equal to the expected life of the option being valued at the time of the grant.

A summary of option activity as of and for the year ended December 31, 2006 is as follows:

	Options			Weighted- Average Exercise Price per Share		Weighted- Average Remaining Contractual Term (in years)		Aggregate Intrinsic Value
Outstanding as of December 31, 2005		732,252		$	7.72
Granted		106,038			15.11
Exercised		(127,313	)		5.25
Forfeited/Canceled		(7,371	)		9.79
Outstanding as of December 31, 2006		703,606		$	9.26		5.76	$	5,511,642
Exercisable as of December 31, 2006		383,916		$	6.70		4.38	$	3,988,346

All amounts have been adjusted retroactively to reflect the 5-for-4 stock split paid in May 2006.

All options granted have limited rights that enable a holder upon a change in control of the Corporation to elect to receive cash equal to the difference between the exercise price of the option and the fair market value of the common stock on the date of exercise. At December 31, 2006, and December 31, 2005, 383,916 and 308,718 shares, respectively, were fully exercisable.

The weighted average fair value of options granted under the Corporation's stock option plan was $3.77, $3.86, and $4.29, respectively for the years ended December 31, 2006, December 31, 2005, and December 31, 2004. The total intrinsic value of options exercised was $1,292, $1,051 and $656, respectively, during the years ended December 31, 2006, 2005, and 2004. As of December 31, 2006, there was $466 of total unrecognized compensation cost related to stock options. That cost is expected to be recognized over a weighted average period of 1.6 years. Cash received from option exercises under all share-based payment arrangements was $670, $443, and $348 for the years ended December 31, 2006, 2005 and 2004, respectively.

As a result of adopting Statement 123(R) on January 1, 2006, the Corporation’s income before income taxes and net income for the year ended December 31, 2006 are $287 and $283 lower, respectively than if it had continued to account for share-based compensation under Opinion No. 25. Basic and diluted earnings per share for the year ended December 31, 2006 would have been $1.13 and $1.10, respectively, if the Corporation had not adopted Statement 123(R), compared to reported basic and diluted earnings per share of $1.11 and $1.08, respectively.

Prior to the adoption of Statement 123(R), the Corporation presented all tax benefits of deductions resulting the exercise of stock options as operating cash flows in the Statement of Cash Flows. Statement 123(R) requires the cash flow resulting from the tax benefits resulting from tax deductions in excess of the compensation cost recognized for those options (excess tax benefits) to be classified as financing cash flows. The $314 excess tax benefit classified as a financing cash inflow would have been classified as an operating cash inflow if the Corporation had not adopted Statement 123(R).

The following table illustrates the effect on net income and earnings per share for the years ended December 31, 2005 and 2004, if the Corporation had applied the fair value recognition provisions of SFAS 123(R) to stock-based employee compensation:

	YEARS ENDED
	DECEMBER 31,
	2005		2004
Net Income, as reported	$	13,046	$	10,785
Add: Stock-based employee compensation expense included in reported
net income, net of related tax effects		-		-
Deduct: Total stock-based employee compensation expense determined
under fair value based method for all awards, net of related tax effects		167		183
Pro Forma Net Income	$	12,879	$	10,602

41

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollars in thousands, except share amounts)

	YEARS ENDED
	DECEMBER 31,
	2005		2004
Net income per common share - Basic
As reported	$	1.09	$	0.96
Pro forma		1.07		0.94
Net income per common share - Diluted
As reported	$	1.06	$	0.93
Pro forma		1.05		0.91

(16) Fair Value of Financial Instruments

The fair value estimates presented below are subjective in nature, involve uncertainties and matters of significant judgment and, therefore, are not necessarily indicative of the amounts the Corporation could realize in a current market exchange. The Corporation has not included certain material items in its disclosure, such as the value of the long-term relationships with the Corporation’s lending and deposit customers, since this is an intangible and not a financial instrument. Additionally, the estimates do not include any tax ramifications. There may be inherent weaknesses in any calculation technique, and changes in the underlying assumptions used, including discount rates and estimates of future cash flows, that could materially affect the results. For all of these reasons, the aggregation of the fair value calculations presented herein do not represent, and should not be construed to represent, the underlying value of the Corporation.

The following table presents a summary of the fair value of the Corporation’s financial instruments:

	DECEMBER 31,				DECEMBER 31,
	2006				2005
	CARRYING		ESTIMATED		CARRYING		ESTIMATED
	VALUE		FAIR VALUE		VALUE		FAIR VALUE
Financial assets:
Cash and cashequivalents	$	42,879	$	42,879	$	31,109	$	31,109
Securities available-for-sale		130,656		130,656		140,596		140,596
Securities held-to-maturity		96,846		93,536		95,122		92,120
FHLB Stock		11,920		11,920		11,920		11,920
Loans, net		996,015		1,002,554		867,049		875,083
Financial liabilities:
Deposit accounts(1)		855,449		854,795		795,768		794,759
Borrowings		338,710		338,859		287,058		288,060
Junior subordinated debentures payable (2)		25,775		27,465		15,212		15,212
Mark-to-market on swaps	$	312	$	312	$	564	$	564

(1)   Net of ($312) mark-to-market on swap for 2006 and ($311) for 2005

(2)   Net of ($253) mark-to-market on swap for 2005 (see note 17 to the Consolidated Financial Statements for the year ended December 31, 2006)

Cash and Cash Equivalents

The carrying amount represents fair value.

Securities including mortgage backed securities and FHLB stock

Fair values are based on quoted market prices or dealer quotations.

Loans

Fair values are estimated using current market interest rates to discount future cash flows for each of the six different loan types. Interest rates used to discount the cash flows are based on U.S. Treasury yields or other market interest rates with appropriate spreads for each segment. The spread over the Treasury yields or other market rates is used to account for liquidity, credit quality and higher servicing costs. Prepayment rates are based on expected future prepayment rates, or, where appropriate and available, market prepayment rates.

Deposit Accounts

The fair value of deposits with no stated maturity, such as checking accounts, money market deposit accounts and savings accounts, equals the amount payable on demand. The fair value of certificates of deposits is calculated based on the discounted value of contractual cash flows. The discount rate is equal to the rate currently offered on similar products.

Borrowings

The fair value is calculated based on the discounted cash flow method, adjusted for market interest rates and terms to maturity.

42

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollars in thousands, except share amounts)

Junior Subordinated Debentures Payable (Trust Preferred Securities)

The fair value is calculated based on the amounts required to settle the contracts, adjusted for market interest rates and terms to maturity.

Swaps

The fair value is calculated based on the discounted cash flow method, adjusted for changes in swap spreads to the underlying treasury securities.

(17) On-Balance Sheet Derivative Instruments and Hedging Activities

Derivative Financial Instruments

The Corporation has derivative financial instruments in the form of interest rate swap agreements, which derive their value from underlying interest rates. These transactions involve both credit and market risk. Direct credit exposure is

limited to the net difference between the calculated amounts to be received and paid, and any change in fair value of

the contract in which the counterparty would owe the Corporation if the contract were terminated. Such difference, which represents the fair value of the derivative instruments, is reflected on the Corporation's balance sheet as derivative assets and derivative liabilities. The Corporation controls the credit risk of its financial contracts through credit approvals, limits and monitoring procedures, and does not expect any counterparties to fail to meet their obligations.

Off-balance-sheet financial instruments - commitments to extend credit, standby letters of credit and financial guarantees represent the principal categories of off-balance instruments (Note 4).  The fair value of these commitments is not considered material because they are for a short period of time and subject to customary credit terms.

Risk Management Policies - Hedging Instruments

The primary focus of the Corporation’s asset/liability management program is to monitor the sensitivity of the Corporation’s net income and fair value of equity under varying interest rate scenarios to take steps to control its risks (see Management Discussion and Analysis - Interest Rate Risk Management).

Interest Rate Risk Management - Fair Value Hedging Instruments

The Corporation holds fixed- and variable-rate assets and liabilities. Fixed-rates may expose the Corporation to variability in their fair value due to changes in the level of interest rates. The Corporation may utilize interest rate swaps as an asset/liability management strategy to hedge the change in value of the assets due to changes in interest rate assumptions.

The information pertaining to a terminated interest rate swap agreement used to hedge junior subordinated debentures payable (trust preferred securities) is as follows:

	DECEMBER 31,
	2005
Notional amount	$	10,000
Weighted average pay rate		8.60	%
Fixed receive rate		11.00	%
Maturity in years		25.2
Unrealized loss relating to interest rate swap	$	(253	)

This agreement provided for the Corporation to make payments at a variable rate determined by a six-month LIBOR in exchange for receiving payments at a fixed rate. The swap was terminated in December 2006 at a loss of $150.

Risk management results for the years ended December 31, 2006, and 2005, related to the balance sheet hedging of junior subordinated debentures payable indicate that the hedge was 100% effective and that there was no component of the derivative instrument’s gain or loss which was excluded from the assessment of hedge effectiveness.

The information pertaining to an outstanding interest rate swap agreement used to hedge certificates of deposit is as follows:

	DECEMBER 31,
	2006			2005
Notional amount	$	10,000		$	10,000
Weighted average pay rate		5.14	%		3.30	%
Fixed receive rate		5.00	%		5.00	%
Maturity in years		7.4			8.4
Unrealized loss relating to interest rate swap	$	(312	)	$	(311	)

43

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollars in thousands, except share amounts)

This agreement provides for the Corporation to make payments at a variable-rate determined by a three-month LIBOR in exchange for receiving payments at a fixed rate.

Risk management results for the years ended December 31, 2006, and 2005, related to the balance sheet hedging of certificates of deposit indicate that the hedge was 100% effective and that there was no component of the derivative instrument’s gain or loss during which was excluded from the assessment of hedge effectiveness.

The Corporation enters into rate lock commitments to extend credit to borrowers for generally a 30-day or 60-day period for the origination of loans.

On March 13, 2002, the Financial Accounting Standards Board determined that loan commitments related to the origination or acquisition of mortgage loans that will be held-for-sale must be accounted for as derivative instruments. Accordingly, the Corporation adopted such accounting on July 1, 2002, and such commitments, along with any related fees received from potential borrowers, are recorded at fair value in derivative assets or liabilities, with changes in fair value recorded in the net gain or loss on sale of mortgage loans. Since the Corporation originates its saleable loans on a “best effort” basis and delivers those loans to the purchaser within 10 days at the committed price, there will generally be no gain or loss recorded on those commitments.

The Corporation had non-mandatory forward commitments totaling $364 and $157 to sell loans into the secondary market at December 31, 2006, and December 31, 2005, respectively.

(18) Contingencies

The Corporation is a defendant in various legal proceedings arising in connection with its business. It is the opinion of management that the financial position and the results of operations of the Corporation will not be materially adversely affected by the final outcome of these legal proceedings and that adequate provision has been made in the accompanying consolidated financial statements.

At periodic intervals, the Washington State Department of Financial Institutions and the Federal Deposit Insurance Corporation routinely examine the Corporation’s financial statements as part of their legally prescribed oversight of the banking industry. Based on these examinations, the regulators can direct that the Corporation’s financial statements be adjusted in accordance with their findings.

(19) Condensed Financial Information of Cascade Financial Corporation

Following are the condensed financial statements of Cascade Financial Corporation (parent only) for the period indicated:

BALANCE SHEET	December 31, 2006		December 31, 2005
Assets:
Cash	$	829	$	637
Investment in subsidiary		139,827		119,262
Other assets		1,765		2,390
	$	142,421	$	122,289
Liabilities and stockholders’ equity:
Other liabilities	$	1,447	$	1,884
Junior subordinated debentures payable		25,775		15,212
Stockholders’ equity		115,199		105,193
	$	142,421	$	122,289

INCOME STATEMENT	FOR THE YEARS ENDED DECEMBER 31,
	2006			2005			2004
Equity in undistributed net income of the subsidiary	$	14,836		$	13,992		$	11,833
Interest income - junior subordinated debentures payable		58			46			35
Operating expenses		(460	)		(299	)		(704	)
Interest expense - junior subordinated debentures payable		(1,880	)		(1,198	)		(723	)
Income before benefit for income taxes		12,554			12,541			10,441
Benefit for income taxes		801			505			344
Net income	$	13,355		$	13,046		$	10,785

44

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollars in thousands, except share amounts)

STATEMENT OF CASH FLOWS	FOR THE YEARS ENDED DECEMBER 31,
	2006			2005			2004
Cash flows from operating activities:
Net income	$	13,355		$	13,046		$	10,785
Adjustments to reconcile net income to net cash
(used in) operating activities:
Equity in net income of subsidiaries		(14,836	)		(13,992	)		(11,833	)
Increase (decrease) in other assets		938			195			(1,303	)
(Decrease) increase in other liabilities		(287	)		134			257
Net cash used in operating activities		(830	)		(617	)		(2,094	)
Cash flows from investing activities:
Dividends received from subsidiaries		4,250			4,000			12,882
Investment in subsidiary		(10,000	)		-			(5,000	)
Cash used for acquisition		-			-			(9,546	)
Net cash provided (used) by investing activities		(5,750	)		4,000			(1,664	)
Cash flows from financing activities:
Repurchase of common stock		(673	)		(858	)		(150	)
Proceeds from exercise of stock options		1,050			865			635
Dividends paid		(3,605	)		(3,163	)		(2,589	)
Proceeds from junior subordinated debentures payable		10,000			-			5,000
Net cash (used) provided by financing activities		6,772			(3,156	)		2,896
Net increase (decrease) in cash and cash equivalents		192			227			(862	)
Cash and cash equivalents:
Beginning of year		637			410			1,272
End of year	$	829		$	637		$	410
Supplemental schedule of non-cash investing activities:
Issaquah Bank merger		-			-			24,792

(20) Lines of Business

The Corporation’s sole operating subsidiary is Cascade Bank, which is managed along four major lines of business: business banking, construction lending, income property lending and retail banking. The administrative group, although not considered a line of business, is responsible for the management of investments, interest rate risk, marketing, data processing and regulatory and stockholder reporting. The financial performance of these business lines is measured by the Corporation’s profitability reporting processes, which utilize various management accounting techniques to ensure that each business line’s financial results reflect the underlying performance of that business.

Each line of business segment is managed by a senior executive. Back office support is provided to each segment through executives responsible for information systems, finance and administration.

The principal activities conducted by business banking are the origination and servicing of commercial business loans and associated merchant services. Retail banking includes all deposit products, with their related fee income, and all consumer loan products such as home equity and installment loans, single-family loans and credit card products. The construction unit provides financing to builders and developers for residential construction and land acquisition and development. The income property unit originates loans secured by multifamily properties and commercial real estate.

The Bank’s reportable business segments are the strategic lines of business noted above, which are managed by the Management Committee, under the direction of the President and Chief Executive Officer. The Management Committee, which is the senior decision making group of the Bank, is comprised of seven members including the President and Chief Executive Officer. To better assess the contribution of its various business lines, the Bank generates segment results that include balances directly attributable to business line activities. Expenses or activities not directly controlled by business unit managers are allocated to the administrative unit. In this way, management can assess the performance of a particular business line. The Bank is constantly analyzing its lines of business performance and developing better ways to measure profitability.

The accounting policies of the segments are the same as those described in “Note 1: Summary of Significant Accounting Policies.” Direct revenues and expenses are allocated to business segments in determining their net income. Corporate overhead, centralized support costs and other costs are assigned to the administrative unit. The Corporation evaluates performance based on net income of the respective business segments. Depreciation is allocated to the segments based upon the utilization of the assets by the segments. All depreciating assets are included in administrative unit’s total assets.

45

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollars in thousands, except share amounts)

The organizational structure of the Bank and the allocated methodologies it employs result in business line financial results that are not necessarily comparable across companies. As such, the Bank’s business line performance may not be directly comparable with similar information from other financial institutions.

YEAR ENDED DECEMBER 31, 2006
	BUSINESS		CONS- TRUCTION		INCOME PROPERTY		RETAIL		ADMIN- ISTRATION			TOTAL
Condensed Income Statement
Net interest income after
provision for loan losses	$	14,872	$	14,597	$	4,702	$	1,702	$	2,517		$	38,390
Other income		310		321		-		4,283		1,112			6,026
Other expense		1,340		332		332		2,291		20,291			24,586
Contribution before overhead		13,842		14,586		4,370		3,694		(16,662	)		19,830
Support transfer		7,079		4,105		3,243		2,235		(16,662	)		-
Income before provision for
income tax		6,763		10,481		1,127		1,459		-			19,830
Provision for income taxes		2,208		3,423		367		477		-			6,475
Net income	$	4,555	$	7,058	$	760	$	982	$	-		$	13,355
At December 31, 2006
Total assets	$	442,391	$	289,993	$	34,719	$	124,036	$	454,115		$	1,345,254
YEAR ENDED DECEMBER 31, 2005
		BUSINESS		CONS- TRUCTION		INCOME PROPERTY		RETAIL		ADMIN- ISTRATION			TOTAL
Condensed Income Statement
Net interest income after
provision for loan losses	$	15,110	$	8,544	$	7,331	$	1,783	$	2,813		$	35,581
Other income		76		23		623		4,135		1,476			6,333
Other expense		1,496		423		870		2,223		17,594			22,606
Contribution before overhead		13,690		8,144		7,084		3,695		(13,305	)		19,308
Support transfer		5,408		2,075		3,717		2,105		(13,305	)		-
Income before provision for
income tax		8,282		6,069		3,367		1,590		-			19,308
Provision for income taxes		2,688		1,964		1,101		509		-			6,262
Net income	$	5,594	$	4,105	$	2,266	$	1,081	$	-		$	13,046
At December 31, 2005
Total assets	$	394,034	$	165,957	$	193,166	$	127,589	$	331,038		$	1,211,784
YEAR ENDED DECEMBER 31, 2004
		BUSINESS		CONS- TRUCTION		INCOME PROPERTY		RETAIL		ADMIN- ISTRATION			TOTAL
Condensed Income Statement
Net interest income after
provision for loan losses	$	12,497	$	4,996	$	8,219	$	2,485	$	3,525		$	31,722
Other income		75		7		-		2,871		1,794			4,747
Other expense		1,446		435		738		2,208		15,490			20,317
Contribution before overhead		11,126		4,568		7,481		3,148		(10,171	)		16,152
Support transfer		3,544		1,266		3,063		1,942		(9,815	)		-
Income before provision for
income tax		7,582		3,302		4,418		1,206		(356	)		16,152
Provision for income taxes		2,465		1,072		1,431		391		8			5,367
Net income	$	5,117	$	2,230	$	2,987	$	815	$	(364	)	$	10,785
At December 31, 2004
Total assets	$	292,117	$	107,431	$	271,076	$	136,100	$	282,231		$	1,088,955

46

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollars in thousands, except share amounts)

(21) Selected Quarterly Financial Data (Unaudited)

	QUARTER ENDED
	MAR 31,		JUNE 30,		SEPT 30,		DEC 31,
	2006		2006		2006		2006
Interest income	$	18,787	$	20,249	$	21,396	$	22,226
Interest expense		9,267		10,561		11,440		12,000
Net interest income		9,520		9,688		9,956		10,226
Provision for loan losses		250		300		300		150
Other income		1,325		1,573		1,616		1,512
Other expense		5,875		6,036		6,349		6,326
Income before provision for income taxes		4,720		4,925		4,923		5,262
Provision for income taxes		1,548		1,598		1,609		1,720
Net income	$	3,172	$	3,327	$	3,314	$	3,542
Earnings per share, basic	$	0.26	$	0.28	$	0.27	$	0.29
Earnings per share, diluted		0.26		0.27		0.27		0.29
	QUARTER ENDED
		MAR 31,		JUNE 30,		SEPT 30,		DEC 31,
		2005		2005		2005		2005
Interest income	$	15,600	$	16,666	$	17,391	$	18,145
Interest expense		6,826		7,515		8,055		8,880
Net interest income		8,774		9,151		9,336		9,265
Provision for loan losses		245		250		250		200
Other income		1,600		1,667		1,564		1,502
Other expense		5,553		5,776		5,672		5,605
Income before provision for income taxes		4,576		4,792		4,978		4,962
Provision for income taxes		1,505		1,577		1,634		1,546
Net income	$	3,071	$	3,215	$	3,344	$	3,416
Earnings per share, basic	$	0.26	$	0.27	$	0.28	$	0.29
Earnings per share, diluted		0.25		0.26		0.27		0.28
	QUARTER ENDED
		MAR 31,		JUNE 30,		SEPT 30,		DEC 31,
		2004		2004		2004		2004
Interest income	$	12,609	$	13,096	$	14,518	$	15,093
Interest expense		5,307		5,250		5,967		6,395
Net interest income		7,302		7,846		8,551		8,698
Provision for loan losses		225		150		150		150
Other income		1,153		1,188		1,238		1,168
Other expense		4,467		5,300		5,005		5,545
Income before provision for income taxes		3,763		3,584		4,634		4,171
Provision for income taxes		1,189		1,300		1,531		1,347
Net income	$	2,574	$	2,284	$	3,103	$	2,824
Earnings per share, basic	$	0.25	$	0.22	$	0.26	$	0.24
Earnings per share, diluted		0.24		0.21		0.26		0.23

47

ANNUAL SHAREHOLDERS’ MEETING

The Annual Shareholders’ meeting will be held at the Everett Golf & Country Club, 1500 52^nd Street SE, Everett, Washington, on Tuesday, April 24, 2007 at 6:30 p.m. Pacific time.

48