Cascade Financial 10K 2008 Annual report | CASB Filing

CASCADE FINANCIAL CORPORATION SELECTED FINANCIAL DATA
(Dollars in thousands, except per share data)
	FOR THE YEARS ENDED DECEMBER 31,
	2008			2007			2006			2005			2004
Interest income	$	92,571		$	93,935		$	82,658		$	67,802		$	55,316
Interest expense		46,686			50,540			43,268			31,276			22,919
Net interest income		45,885			43,395			39,390			36,526			32,397
Provision for loan losses		7,240			1,350			1,000			945			675
Net interest income after provision for loan losses		38,645			42,045			38,390			35,581			31,722
Other income		8,884			7,566			6,026			6,333			4,747
Other expense		28,540			26,682			24,586			22,606			20,317
Other than temporary impairment (OTTI)		17,338			-			-			-			-
Income before provision for income taxes		1,651			22,929			19,830			19,308			16,152
Net income		2,090			15,546			13,355			13,046			10,785
Dividends on preferred stock		216			-			-			-			-
Net income available for common stockholders		1,874			15,546			13,355			13,046			10,785
Earnings per common share, basic (1)		0.16			1.29			1.11			1.09			0.96
Earnings per common share, diluted (1)		0.15			1.27			1.08			1.06			0.93
Book value per common share (1)		10.23			10.15			9.53			8.76			8.06

	AT DECEMBER 31,
	2008			2007			2006			2005			2004
Assets	$	1,637,319		$	1,417,588		$	1,345,254		$	1,211,784		$	1,088,955
Loans, net		1,238,733			1,092,776			996,015			867,049			794,466
Cash and securities		309,658			246,548			282,301			278,747			228,644
Deposits		1,006,782			904,896			855,449			795,768			721,908
Other borrowings		212,365			147,512			121,485			66,270			36,356
FHLB advances		249,000			231,000			243,000			236,000			228,000
Preferred stock		36,616			-			-			-			-
Common stockholders’ equity		123,506			122,096			115,199			105,193			96,250
Total stockholders’ equity		160,122			122,096			115,199			105,193			96,250
Nonperforming loans		40,278			1,523			851			1,987			532

	FINANCIAL RATIOS
	FOR THE YEARS ENDED DECEMBER 31,
	2008			2007			2006			2005			2004
Return on average assets		0.14	%		1.13	%		1.05	%		1.13	%		1.09	%
Return on average equity		1.62			13.23			12.24			13.13			13.22
Return on average common equity		1.49			13.23			12.24			13.13			13.22
Return on average tangible common equity		1.87			16.88			16.08			17.82			16.24
Net interest margin		3.20			3.34			3.26			3.35			3.44
Efficiency ratio (2)		52.11			52.36			54.14			52.75			54.70
Dividend payout ratio		175.19			25.98			28.43			25.66			25.81
Average stockholders’ equity to average assets		8.41			8.58			8.55			8.60			8.25
Total risk-based capital to risk-weighted assets		13.26			10.80			11.22			10.86			11.18
Tier 1 capital to average total assets		10.30			8.90			8.99			8.23			8.14

(1)	Per common share data is retroactively adjusted to reflect all stock splits and stock dividends. December 31, 2008 is calculated using net income available for common stockholders.

(2)	The efficiency ratio calculation excludes the OTTI charge of $17.3 million in 2008.

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

MANAGEMENT DISCUSSION AND ANALYSIS

The following discussion is provided for the consolidated operations of Cascade Financial Corporation (the “Corporation”) as of December 31, 2008. 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.

Certain of the statements contained herein that are not historical facts are 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 Corporation’s actual results may differ materially from those included in the forward-looking statements. Forward-looking statements are typically identified by words or phrases such as “believe,” “expect,” “intend,” “may increase,” “may fluctuate,” and similar expressions or future or conditional verbs such as “will,” “should,” “would,” and “could.” These forward-looking statements involve risks and uncertainties including, but not limited to, economic conditions which have been and continue to be in a recession, portfolio growth, the credit performance of the portfolios, including bankruptcies, higher than expected loan delinquency rates, and seasonal factors; changes in general economic conditions including the performance of financial markets, prevailing inflation and interest rates, realized gains from sales of investments, gains from asset sales, and losses on commercial lending activities; results of various investment activities; the effects of competitors’ pricing policies, of changes in laws and regulations on competition and of demographic changes in target market populations’ savings and financial planning needs; industry changes in information technology systems on which we are highly dependent; failure of acquisitions to produce revenue enhancements or cost savings at levels or within the time frames originally anticipated or unforeseen integration difficulties; the adoption of the Corporation of an FFIEC policy that provides guidance on the reporting of delinquent consumer loans and the timing of associated credit charge-offs for financial institution subsidiaries; and the resolution of legal proceedings and related matters. In addition, the banking industry in general is subject to various monetary and fiscal policies and regulations, which include those determined by the Federal Reserve Board, the Federal Deposit Insurance Corporation, and state regulators, whose policies and regulations could affect the Corporation’s results and are subject to change at any time. 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 the documents the Corporation files from time to time with the Securities and Exchange Commission.

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. The Bank believes 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 collectability of loans; and (2) the impact of a sudden large loss could significantly reduce the allowance and would require increased provisions to replenish the allowance, which would negatively affect earnings.

At December 31, 2008, the Corporation had $25.1 million in goodwill and other intangible assets as a result of a business combination. Goodwill and other intangible assets with indefinite lives are not amortized but instead are periodically tested for impairment. Management performs an impairment analysis periodically, and at least annually. Management determined that there was no impairment as of December 31, 2008. The valuation is determined using discounted cash flows of forecasted earnings, estimated sales price based on recent observable market transactions and market capitalization based on current stock price. If impairment was deemed to exist, a write-down of the asset would occur with a charge to earnings. The impairment analysis requires management to make subjective judgments. Events and factors that may significantly affect the estimates include, among others, competitive forces, customer behaviors and attrition, changes in revenue growth trends, cost structures, technology, changes in discount rates and specific industry and market conditions.

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 potential losses on adversely classified loans, 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 probable and will have a material impact on the Corporation’s consolidated financial statements and results of operation. 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.

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, 2008, 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 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.

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, 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. The Bank also uses Qualitative (“Q”) Factors to analyze the adequacy of the loan loss allowance and determine an unallocated portion of the allowance. Factors such as regional/local economic trends, the health of the real estate market, loan and collateral concentrations, size of borrowing relationships, trends in loan delinquencies and charge-offs and changes in loan classifications are included in the Bank’s analysis of the allowance for loan losses. Loans losses are charged-off against the allowance when management confirms the uncollectability of a loan balance or when the liquidation value of the collateral is less than the amount of the loan. 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 held-for-trading, available-for-sale, or held-to-maturity. Held-for-trading securities are marked to market with the change in value recognized in the income statement. 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 15 of the Notes to Consolidated Financial Statements. Held-to-maturity securities are carried at amortized cost.

Income 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. 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.

Fair Value

Effective January 1, 2007, the Corporation adopted Statement of Financial Accounting Standards (“SFAS”) No. 157, Fair Value Measurements, which among other things, requires enhanced disclosures about financial instruments carried at fair value. SFAS No. 157 establishes a hierarchical disclosure framework associated with the level of pricing observability utilized in measuring financial instruments at fair value. The degree of judgment utilized in measuring the fair value of financial instruments generally correlates to the level of pricing observability. Financial instruments with readily available active quoted prices or for which fair value can be measured from actively quoted prices generally will have a higher degree of pricing observability and a lesser degree of judgment utilized in measuring fair value. Conversely, financial instruments rarely traded or not quoted will generally have little or no pricing observability and a higher degree of judgment utilized in measuring fair value. Pricing observability is impacted by a number of factors, including the type of financial instrument, whether the financial instrument is new to the market and not yet established and the characteristics specific to the transaction. See Note 15 of the Notes to Consolidated Financial Statements for additional information about the level of pricing transparency associated with financial instruments carried at fair value.

FINANCIAL CONDITION

Total Assets

The Corporation’s total assets at December 31, 2008, were $1.6 billion, compared to $1.4 billion at December 31, 2007, an increase of 15.5%. The increase in 2008 is due to internal growth. The Corporation’s total assets at December 31, 2006, were $1.3 billion.

Investment Securities

Total securities held increased by $24.2 million to $256.2 million as of December 31, 2008. Securities designated as available-for-sale increased to $135.6 million at December 31, 2008, versus $94.8 million at December 31, 2007. Securities designated as available-for-sale include $11.9 million in Federal Home Loan Bank (“FHLB”) of Seattle stock at December 31, 2008

and 2007. At December 31, 2008, securities available-for-sale also included $454,000 of Fannie Mae (“FNMA”) and Freddie Mac (“FHLMC”) preferred stock. Securities designated as held-to-maturity decreased to $120.6 million at December 31, 2008, from $137.2 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. There were no investment securities that were backed by subprime loans and all investments received the highest credit rating from at least one of the major rating agencies except for the FNMA and FHLMC preferred stock. For a discussion on the impact of FNMA and FHLMC preferred stock on the Corporation’s results, see the details of the Other Than Temporary Impairment (OTTI) of these securities under Results of Operations – Earnings and Other Expense in the Management Discussion and Analysis and under Investment Securities, Note 3 to the financial statements.

Loan Portfolio

Net loans increased to $1.2 billion at December 31, 2008, a 13.4% increase over $1.1 billion at December 31, 2007. Net loans were $996.0 million at December 31, 2006.

Business banking loans increased from $468.5 million at December 31, 2007, to $485.1 million at December 31, 2008, a 3.5% increase. Growth in this portfolio was the result of our ability to win new borrowing customers in a very competitive market. Cascade has slowed new construction and land development lending but the construction balances have grown as construction draws were made and exceeded payoffs. Construction loans (net of loans in process) increased from $381.8 million to $406.5 million during the year. Commercial real estate loans increased from $120.4 million at December 31, 2007, to $123.0 million at December 31, 2008. The Corporation’s loan focus remains on small businesses in the Puget Sound Region of Washington State. Construction lending is directed toward building single-family housing and land development for single-family housing.

Total single-family residential mortgage loans increased from $98.4 million at December 31, 2007, to $126.1 million at December 31, 2008. The Corporation sells the vast majority of its originations of 30-year fixed-rate loans, its 15-year fixed-rate loans, and many of its conforming intermediate term hybrid adjustable rate mortgages (“ARMs”) in the secondary mortgage market. Multifamily loans outstanding increased from $11.4 million at December 31, 2007, to $86.9 million at December 31, 2008. Multifamily loans increased substantially from a year ago, partly as a result of the reclassifications from multifamily construction as projects were completed.

Consumer loans increased from $27.7 million at December 31, 2007, to $30.8 million at December 31, 2008. The Corporation’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.

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

	DECEMBER 31, 2008						DECEMBER 31, 2007						DECEMBER 31, 2006
(Dollars in thousands)	AMOUNT			PERCENT			AMOUNT			PERCENT			AMOUNT			PERCENT

Business	$	485,060			39	%	$	468,453			42	%	$	442,391			44	%
Construction		406,505			32			381,810			34			295,087			29
Commercial real estate		122,951			10			120,421			11			119,298			12
Residential		126,089			10			98,384			9			91,256			10
Consumer		30,772			2			27,688			3			27,686			2
Multifamily		86,864			7			11,397			1			34,719			3
Total loans		1,258,241			100	%		1,108,153			100	%		1,010,437			100	%
Deferred loan fees, net		(3,069	)					(3,724	)					(3,434	)
Allowance for losses on loans		(16,439	)					(11,653	)					(10,988	)
Loans, net	$	1,238,733					$	1,092,776					$	996,015

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. There is no guarantee that management’s estimate will be sufficient to cover actual loan losses. The allowance for loan losses is maintained at levels based on management’s assessment of various factors affecting the loan portfolio, including analysis of adversely classified loans, delinquencies, trends in credit quality, local economic conditions, growth of the loan portfolio, past loss experience, and the portfolio’s composition. Increases in the allowance for loan losses made through provisions primarily reflect loan growth, loan loss 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 quality 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 over $1.0 million 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, 2008, the allowance for loan losses was $16.4 million (1.31% of total loans) compared to $11.7 million (1.05% of total loans) at December 31, 2007, and $11.0 million

(1.09% of total loans) at December 31, 2006. During 2008, the Corporation added $7.2 million to the allowance compared to $1.4 million in 2007 and $1.0 million in 2006. In 2007, the Bank segregated a valuation reserve against off-balance sheet commitments, such as loans in process. As of December 31, 2008, that valuation reserve account was $93,000 compared to $142,000 at December 31, 2007. Total allowance for loan losses, which includes the allowance for off-balance sheet commitments, was $16.5 million (1.31% of total loans) as of December 31, 2008 compared to $11.8 million (1.06% of total loans) as of December 31, 2007.

The allowance for loan losses increased during the year in terms of dollars and percentage of total loans, due to an increase in nonperforming loans, an increase in adversely classified loans, growth in the loan portfolio and a weakening economy with its negative impact on local real estate, which serves as collateral for a majority of the Corporation’s loans. The allowance for loan losses is discussed in Note 4.

Net loan charge-offs were $2.5 million in 2008 (or 0.21% of average loans outstanding) compared to $543,000 in 2007 (or 0.05% of average loans outstanding). Net charge-offs were $266,000 (or 0.03% of average loans outstanding) for the year ended December 31, 2006. The coverage ratio (the allowance for loan losses to nonperforming loans) was 41% at December 31, 2008, 765% at December 31, 2007, and 1,291% at December 31, 2006. The increase in net charge-offs was driven by the decline in real estate values, especially land held for the development of residential building lots and/or houses. The decrease in the Corporation’s coverage ratio, from the very high levels of 2007 and 2006, was due to an increase in nonperforming loans.

Deposit Accounts

Deposit account balances totaled $1.0 billion at December 31, 2008, an increase of $101.9 million or 11.3% over $904.9 million at December 31, 2007. Deposits totaled $855.4 million at December 31, 2006. Checking account balances grew $48.7 million to $186.8 million as of December 31, 2008, compared to $138.2 million in the prior year. Continued marketing and sales management efforts directed at our High Performance Checking program resulted in dramatic growth in our checking account balances. Personal checking account balances grew by 76% or $44.0 million over the course of the year and business checking balances grew 6% or $4.7 million during the same time period. Money market deposit account balances decreased by 38.8% to $193.4 million. The reductions in money market account balances were primarily from the public sector and the termination of a sweep account agreement with a money center bank. Certificates of deposit increased 40.2% to $616.0 million. As business banking activity increases, management’s goal is 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 objective of the Bank to increase its demand deposit account balances and other low rate accounts.

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, 2008, the Bank had $249.0 million in FHLB advances compared to $231.0 million as of December 31, 2007. For 2008, FHLB advances averaged 16.7% of assets compared to 16.0% in 2007. 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, 2008, the Bank had executed $146.4 million in repurchase agreements compared to $120.6 million a year earlier. The Bank participates in the Federal Reserve term auction facility (TAF) and had an outstanding balance of $ 40.0 million at December 31, 2008. 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 junior subordinated debentures payable. These debentures have a fixed rate of 5.82% for the first 5 years and then float at the three-month LIBOR plus 1.90% for the remaining 25 years. The debentures 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 debentures 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 debentures are callable at par after 5 years. Junior subordinated debentures payable are considered Tier 1 capital by financial institution regulators.

Capital

On November 21, 2008, Cascade completed its $39 million capital raise as a participant in the U.S. Treasury Department’s Capital Purchase Program. Under the terms of the transaction, the Corporation issued 38,970 shares of Series A Fixed-Rate Cumulative Perpetual Preferred Stock, and a warrant to purchase 863,442 shares of the Corporation’s common stock at an exercise price of $6.77 per share.

Banking regulations require the Bank to maintain minimum levels of capital. As of December 31, 2008, the Bank remained a “well-capitalized” institution (the FDIC’s highest rating), under regulatory guidelines, with a Tier 1 capital-to-asset ratio of 10.34% and a risk-based capital-to-asset ratio of 13.32%. The Bank’s regulatory capital ratios are discussed in more detail in Note 12 of the Notes to Consolidated Financial Statements.

Federal Reserve guidelines require the Corporation, on a consolidated basis, to maintain minimum levels of capital as well. At December 31, 2008, the Corporation's total risk-based capital to risk-weighted assets was 13.26%, compared to 10.80% at December 31, 2007, and 11.22% at December 31, 2006. The Corporation has paid its shareholders a cash dividend on a

quarterly basis since 2002. Average shares outstanding, stock options, net income per share and book value per share for all periods presented have been retroactively adjusted to reflect stock splits. In 2008, the Corporation returned $3.3 million in dividends to its shareholders compared to $4.1 million in 2007.

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 of $2.1 million for the year ended December 31, 2008, a decrease of 86.6% from the $15.5 million net income for the year ended December 31, 2007. After dividends on preferred stock, net income available for common stockholders for the year ended December 31, 2008, was $1.9 million. Operating results for the year were below the record-setting earnings from the previous year due to an increase of $5.9 million in the provision for loan losses and the OTTI charge of $17.3 million during the third quarter. Net interest income increased $2.5 million to $45.9 million in 2008 and other income increased $1.3 million to $8.9 million due mostly to a $1.0 million increase in checking service fees. The Corporation earned net income of $13.4 million for the fiscal year ended December 31, 2006.

Return on Average Equity and Average Common Equity

Return on average equity for the year ended December 31, 2008, was 1.62% compared to 13.23% for the same period of 2007. Return on average equity for the fiscal year ending December 31, 2006, was 12.24%. Return on average common equity, which excludes preferred stock, was 1.49% for the year ended December 31, 2008. The decline in return on equity from 2007 was driven by the OTTI charge on FNMA and FHLMC preferred stock and a substantial increase in the Corporation’s provision for loan losses.

Return on Average Tangible Common Equity

Return on average tangible common equity (average equity less average goodwill and preferred stock), was 1.87% for the year ended December 31, 2008, compared to 16.88% in 2007 and 16.08% in 2006. The June 2004 acquisition of Issaquah Bancshares, Inc. (“Issaquah”) generated $26.3 million in goodwill and intangible 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.

A summary of average tangible common equity follows:

(Dollars in thousands)	2008			2007
Net income	$	2,090		$	15,546
Dividends on preferred stock		216			-
Income available for common stockholders		1,874			15,546
Average total equity	$	129,083		$	117,534
Average preferred stock		3,683			-
Average common equity		125,400			117,534
Average goodwill & intangibles		25,149			25,439
Average tangible common equity	$	100,251		$	92,095
Return on average tangible common equity		1.87	%		16.88	%

Net Interest Income

The largest component of the Corporation’s earnings is net interest income. Net interest income is the difference between interest-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 and government policies. The Corporation’s operations may be sensitive to changes in interest rates and the resulting impact on net interest income.

Net interest income for the year ended December 31, 2008, increased by 5.7%, or $2.5 million, to $45.9 million from $43.4 million for the year ended December 31, 2007. The improvement in net interest income was primarily due to the growth in our level of average earning assets of $137.6 million. Net interest income for the fiscal year ended December 31, 2006, was $39.4 million.

Average earning assets increased 10.6% to $1.4 billion for the year ended December 31, 2008, from $1.3 billion for the year ended December 31, 2007. Average earning assets were $1.2 billion for the year ended December 31, 2006.

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, 2008, was 3.20%, compared to 3.34% for the year ended December 31, 2007. Interest reversals associated with loans placed on non-accrual during the year and a 400 basis point drop in interest rates were responsible for the reduction in the net interest margin. The yield on earning assets decreased 79 basis points to 6.45% in 2008. The cost of interest-bearing liabilities decreased 81 basis points to 3.57% for the year.

Average Balances and an Analysis of Average Rates Earned and Paid

The following table shows 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,
	2008								2007								2006
(Dollars in thousands)
	AVERAGE BALANCE			INTEREST AND DIVIDEND		YIELD/ COST			AVERAGE BALANCE			INTEREST AND DIVIDEND		YIELD/ COST			AVERAGE BALANCE			INTEREST AND DIVIDEND		YIELD/ COST
ASSETS
Interest-earning assets (1)
Residential loans	$	107,912		$	6,478		6.00	%	$	94,608		$	5,753		6.08	%	$	98,476		$	5,582		5.67	%
Multifamily loans		48,272			3,367		6.98			18,467			1,416		7.67			42,574			2,863		6.72
Commercial real estate loans		117,510			7,857		6.69			117,952			8,259		7.00			144,094			9,821		6.82
Construction loans		384,410			25,427		6.61			332,467			30,094		9.05			214,290			19,376		9.04
Consumer loans		29,111			1,931		6.63			27,575			2,128		7.72			30,064			2,304		7.66
Business banking loans		475,716			32,881		6.91			455,024			33,908		7.45			426,194			31,158		7.31
Total loans		1,162,931			77,941		6.70			1,046,093			81,558		7.80			955,692			71,104		7.44
Securities available-for-sale		124,875			6,280		5.03			102,613			4,828		4.71			148,917			6,735		4.52
Securities held-to-maturity		140,008			8,213		5.87			88,535			4,527		5.11			96,668			4,563		4.72
Securities held-for-trading		-			-		-			38,614			1,884		4.88			-			-		-
Daily interest-earning deposits		8,939			137		1.54			21,607			1,138		5.27			5,356			256		4.78
Total securities and interest-earning deposits		273,822			14,630		5.34			251,369			12,377		4.92			250,941			11,554		4.60

Total interest-earning assets		1,436,753			92,571		6.44			1,297,462			93,935		7.24			1,206,633			82,658		6.85
Noninterest-earning assets
Office properties and equipment, net		15,420								13,744								12,093
Other noninterest-earning assets		82,285								59,103								56,830

Total assets	$	1,534,458							$	1,370,309							$	1,275,556

LIABILITIES AND EQUITY
Interest-bearing liabilities
Savings accounts	$	10,888		$	53		0.49	%	$	13,261		$	66		0.50	%	$	14,748		$	75		0.51	%
Checking accounts		72,817			1,203		1.65			51,021			747		1.46			45,039			656		1.46
Money market accounts		297,312			7,311		2.46			284,843			12,314		4.32			229,788			8,505		3.70
Certificates of deposit		497,115			18,648		3.75			444,726			22,093		4.97			446,437			19,339		4.33
Total interest-bearing deposits		878,132			27,215		3.10			793,851			35,220		4.44			736,012			28,575		3.88
Other interest-bearing liabilities
FHLB advances		256,898			10,955		4.26			226,124			10,240		4.53			237,888			11,194		4.71
Other interest-bearing liabilities		173,195			8,516		4.92			134,410			5,080		3.78			104,085			3,499		3.36
Total interest-bearing liabilities		1,308,225			46,686		3.57			1,154,385			50,540		4.38			1,077,985			43,268		4.01
Other liabilities		97,150								98,390								88,468
Total liabilities		1,405,375								1,252,775								1,166,453
Stockholders’ equity		129,083								117,534								109,103
Total liabilities and stockholders’ equity	$	1,534,458							$	1,370,309							$	1,275,556
Net interest income (2)				$	45,885							$	43,395							$	39,390
Interest rate spread (3)							2.87	%							2.86	%							2.84	%
Net interest margin (4)							3.20	%							3.34	%							3.26	%
Average interest-earning assets to average interest-bearing liabilities		109.82	%							112.39	%							111.93	%

(1) Does not include interest on nonaccrual 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 and other loans, gains on the sale of securities, and rental income, primarily on space at the building that formerly served as the headquarters of Issaquah Bank. Other income for the year ended December 31, 2008, was $8.9

million compared to $7.6 million for the year ended December 31, 2007. The increase is largely due to the increase in checking fees, which were up $1.0 million to $4.8 million in 2008. Other income for the year ended December 31, 2006, was $6.0 million. The net gain on the fair value of financial instruments, related to the implementation of SFAS No. 159 was $912 and $1.1 million for the years ended December 31, 2008, and 2007, respectively. There were no corresponding gains in 2006.

Other Expense

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

Other expense increased by $19.2 million to $45.9 million for the year ended December 31, 2008, from $26.7 million and $24.6 million for 2007 and 2006, respectively. The Corporation owns preferred shares issued by FNMA ($10.2 million of original book value) and FHLMC ($8.4 million of original book value) with a combined original book value of approximately $18.6 million. Following the placement of these two Government Sponsored Enterprises into conservatorship, and the decline in the market value of these securities, the Corporation recorded a pre-tax OTTI charge of $17.3 million in the third quarter of 2008. This accounted for most of the increase in other expense in the year ended December 31, 2008. Salaries and employee benefits increased overall by $727,000 to $14.5 million during 2008 compared to the prior year. Other expenses increased $1.1 million to $14.0 million during 2008, largely due to FDIC insurance premiums of $633,000 and costs associated with opening the new Burlington branch in May of 2008, compared to $12.9 million and $11.9 million for the years ended December 31, 2007, and 2006, respectively.

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, 2008, 2007, and 2006, the Corporation’s efficiency ratio was 52.11%, 52.36%, and 54.14%, respectively. The efficiency ratio calculation for the year ended December 31, 2008, excludes the OTTI charge of $17.3 million. 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 the Bank. Primary sources of liquidity are cash and cash equivalents, which include highly liquid investments. At December 31, 2008, 2007 and 2006, cash and cash equivalents totaled $53.5 million, $14.5 million, and $42.9 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.

The primary source of borrowings are Federal Home Loan Bank of Seattle (“FHLB-Seattle”) advances, repurchase agreements and starting in 2008, the Term Auction Facility (“TAF”) from the Federal Reserve Bank (“FRB”). At December 31, 2008, $323.9 million of additional borrowing capacity remained under the Bank’s existing credit line from the FHLB-Seattle, which is 35% of the Bank’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, 2008, the Bank had unencumbered eligible collateral of approximately $136.2 million to pledge against the line. In addition, the 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. The Bank tested each of these lines during the year. The Bank also has a $172.4 million line of credit with the Federal Reserve Bank of San Francisco collateralized with commercial and construction loans. As of December 31, 2008, $40.0 million in TAF borrowings were outstanding against this line.

Liquidity management is of critical importance to the Bank in that it significantly relies upon wholesale sources of funds (e.g. FHLB-Seattle advances and Federal Reserve borrowings). 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 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 vast majority of fixed-rate loans have repricing periods with a maximum of five years. The mix of floating- and fixed-rate assets is designed to mitigate the impact of rate changes on the Corporation’s net interest income. Virtually all fixed-rate residential loans are sold into the secondary market. However, the Bank has sought to add prepayment provisions to its newly originated loans with five year fixed and adjustable rates. The Bank has also instituted a required floor on many floating and adjustable rate loans. At the end of December 31, 2008, over one-third of the loans in the floating rate portfolio were at or near their floors.

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, 2008, a 200 basis point increase in rates would increase forecasted net interest income over a 12 month period by approximately 2.2%. A 200 basis point decrease in rates would decrease interest income by 17.3% 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 $5.5 million or 2.8%, a 200 basis point decrease in rates would decrease the fair value of equity by $55.4 million or 28.1%. Both are within the guideline established by the Bank’s Asset/Liability Policy.

The Corporation has maintained a trading account for financial instruments in the past, however there was no activity during 2008. 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, 2008, are shown in the following table.

	INTEREST REPRICING ASSUMPTIONS
(Dollars in thousands)	<1 YEAR		1-3 YEARS		3-5 YEARS		5-10 YEARS		10 YEARS AND UP		TOTAL		FAIR VALUE
Interest-Sensitive Assets
Total loans	$	830,759	$	144,649	$	225,302	$	15,876	$	1,377	$	1,217,963	$	1,239,685
Investments and other
interest-earning assets		267,406		13,907		4,413		12,028		44		297,798		297,894

Interest-Sensitive Liabilities
Checking accounts	$	22,618	$	24,674	$	37,011	$	16,655	$	1,851	$	102,809	$	102,810
Money market accounts		189,597		1,185		1,777		800		89		193,448		193,448
Savings accounts		2,329		2,541		3,811		1,715		191		10,587		10,587
Certificates of deposit		587,094		10,332		8,307		10,171		-		615,904		618,044
Borrowings		101,390		-		80,000		229,000		25,000		435,390		458,911
Junior subordinated debentures payable		-		15,975		-		-		10,000		25,975		22,079

Off-Balance Sheet Arrangements: Credit Commitments

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 had not incurred any losses on its commitments in 2008 or 2007.

A summary of the notional amount of the Bank’s financial instruments with off-balance sheet risk at December 31, 2008 follows:

(Dollars in thousands)	TOTAL
Commitments to extend credit	$	173,680
Standby letters of credit and financial guarantees written		5,116
Unused commitments on bankcards		13,868
Total	$	192,664

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	$	587,094	$	13,571	$	5,068	$	10,171	$	615,904
Federal Home Loan Bank advances		10,000		10,000		70,000		159,000		249,000
Operating lease obligations		820		1,557		1,515		8,314		12,206
Junior subordinated debentures payable		-		-		-		25,975		25,975
	Total				$	597,914			$	25,128

At December 31, 2008, the Corporation’s long-term contractual obligations related to debt totaled $275.0 million. See additional discussion under Notes 7 and 8 to the Consolidated Financial Statements for the year ended December 31, 2008. 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 deterioration in the quality of the loan portfolio. The Corporation’s loan growth has been focused on commercial lending. 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 their 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 the Corporation’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 October 2008, the FASB issued FASB Staff Position (FSP) FAS No. 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active. The FSP clarifies the application of FAS No. 157, Fair Value Measurements, when the market for a financial asset is not active. The FSP was effective upon issuance, including reporting for prior periods for which financial statements have not been issued. The adoption of the FSP for reporting as of December 31, 2008, did not have a material impact on our consolidated financial statements.

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. In addition, the 2008 Proxy Statement and Annual Report are available at http://bnymellon.mobular.net/bnymellon/CASB. 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.

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 (the Corporation) as of December 31, 2008, and 2007, and the related consolidated statements of income, stockholders' equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2008. We also have audited the Corporation’s internal control over financial reporting as of December 31, 2008, 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 included in the accompanying Report of Management on Internal Control over Financial Reporting. Our responsibility is to express an opinion on these financial statements 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 auditing 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 audits of the 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, as well as evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risks. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

A 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, 2008 and 2007, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2008, in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, Cascade Financial Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

/s/ Moss Adams LLP

Everett, Washington

March 12, 2009

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Consolidated Balance Sheets

December 31, 2008, and 2007

	DECEMBER 31,
(Dollars in thousands, except share amounts)	2008			2007
ASSETS
Cash on hand and in banks	$	11,859		$	12,911
Interest-bearing deposits in other financial institutions		10,907			1,619
Fed funds sold		30,700			—
Securities available-for-sale, fair value		123,678			82,860
Securities held-to-maturity, amortized cost		120,594			137,238
Federal Home Loan Bank (FHLB) stock		11,920			11,920
Loans, net		1,238,733			1,092,776
Goodwill		24,585			24,585
Core deposit intangible, net		493			634
Premises and equipment, net		15,463			14,160
Cash surrender value of bank owned life insurance (BOLI)		23,638			22,658
Real estate owned (REO) and other repossessed assets		1,446			—
Deferred tax asset		9,828			1,574
Accrued interest receivable and other assets		13,475			14,653
Total assets	$	1,637,319		$	1,417,588

LIABILITIES AND STOCKHOLDERS’ EQUITY
Liabilities:
Deposits	$	1,006,782		$	904,896
FHLB advances		249,000			231,000
Federal Reserve Bank (FRB) TAF borrowings		40,000			—
Securities sold under agreements to repurchase		146,390			120,625
Junior subordinated debentures payable		15,465			15,465
Junior subordinated debentures payable, fair value		10,510			11,422
Accrued interest payable, expenses, and other liabilities		9,050			12,084
Total liabilities		1,477,197			1,295,492

Stockholders’ equity:
Preferred stock, no par value. Authorized 38,970 shares; Series A (liquidation preference $1,000 per share); issued and Outstanding 38,970 shares at December 31, 2008, and none at December 31, 2007		36,616			—
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 12,071,032 shares at December 31, 2008, and 12,023,685 shares at December 31, 2007		121			120
Additional paid-in capital		40,781			40,322
Retained earnings, substantially restricted		80,875			82,169
Warrants issued to US Treasury		2,389			—
Accumulated other comprehensive loss		(660	)		(515	)
Total stockholders’ equity		160,122			122,096
Total liabilities and stockholders’ equity	$	1,637,319		$	1,417,588

(See accompanying notes to consolidated financial statements.)

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Consolidated Statements of Income

Years ended December 31, 2008, 2007, and 2006

	YEARS ENDED DECEMBER 31,
(Dollars in thousands, except share amounts)	2008			2007			2006
Interest income:
Loans	$	77,941		$	81,558		$	71,104
Securities held-for-trading		—			1,884			—
Securities available-for-sale		5,258			4,756			6,723
Securities held-to-maturity		8,213			4,527			4,563
FHLB dividends		113			72			12
Preferred stock		909			—			—
Interest-bearing deposits		137			1,138			256
Total interest income		92,571			93,935			82,658
Interest expense:
Deposits		27,215			35,220			28,576
FHLB advances		10,955			10,240			11,193
FRB TAF borrowings		375			—			—
Securities sold under agreements to repurchase		6,021			2,960			1,619
Junior subordinated debentures payable		2,120			2,120			1,880
Total interest expense		46,686			50,540			43,268
Net interest income		45,885			43,395			39,390
Provision for loan losses		7,240			1,350			1,000
Net interest income after provision for loan losses		38,645			42,045			38,390
Other income:
Checking service fees		4,848			3,820			3,311
Other service fees		1,092			1,059			1,156
BOLI		1,056			803			769
Gain (loss) on sale of securities available-for-sale, net		285			(435	)		—
Gain on calls of securities held-to-maturity, net		113			—			—
Gain on sale of loans		128			199			483
Gain on fair value of financial instruments, net		912			1,081			—
Gain on FHLB advances, net		—			569			—
Loss on sale of REO and other repossessed assets, net		(3	)		—			(27	)
Other		453			470			334
Total other income		8,884			7,566			6,026
Other expenses:
Salaries and employee benefits		14,544			13,817			12,691
Occupancy		3,986			3,576			3,450
Marketing		1,096			1,182			1,094
B&O tax		1,277			1,373			1,027
Other		7,637			6,734			6,324
Other than temporary impairment (OTTI)		17,338			—			—
Total other expenses		45,878			26,682			24,586
Income before (benefit) provision for income taxes		1,651			22,929			19,830
(Benefit) provision for income taxes		(439	)		7,383			6,475
Net income		2,090			15,546			13,355
Dividends on preferred stock		216			—			—
Net income available for common stockholders	$	1,874		$	15,546		$	13,355
Earnings per common share (EPS), basic	$	0.16		$	1.29		$	1.11
Weighted average number of common shares outstanding, basic		12,053,084			12,047,792			12,060,191
Earnings per common share, diluted	$	0.15		$	1.27		$	1.08
Weighted average number of common shares outstanding, diluted		12,159,174			12,284,854			12,363,198

(See accompanying notes to consolidated financial statements.)

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Consolidated Statements of Stockholders’ Equity and Comprehensive Income

Years ended December 31, 2008, 2007, and 2006

Consolidated Statement of Stockholders’ Equity
(Dollars in thousands, except share amounts)															ACCUMULATED			TOTAL
									ADDITIONAL						OTHER			STOCK-
	PREFERRED		COMMON						PAID-IN			RETAINED			COMPREHENSIVE			HOLDERS’
	STOCK		SHARES			AMOUNT			CAPITAL			EARNINGS			LOSS, NET			EQUITY
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 declared				-			-			-			(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 loss, 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
Adoption of fair value option		-		-			-			-			(4,532	)		-			(4,532	)
Cash dividends declared		-		-			-			-			(4,094	)		-			(4,094	)
Options exercised, including related tax benefit		-		108,818			-			813			-			-			813
Stock compensation expense, net of tax benefit		-		-			-			213			-			-			213
Net income		-		-			-			-			15,546			-			15,546
Shares repurchased		-		(178,832	)		(1	)		(134	)		(2,703	)		-			(2,838	)
Other comprehensive income, net of tax provision of $963		-		-			-			-			-			1,789			1,789
Balances at December 31, 2007		-		12,023,685			120			40,322			82,169			(515	)		122,096
Cash dividends declared
Common stock		-		-			-			-			(3,256	)		-			(3,256	)
Preferred stock		-		-			-			-			(216	)		-			(216	)
Options exercised, including related tax benefit		-		47,347			1			263			123			-			387
Stock compensation expense, net of tax benefit		-		-			-			196			-			-			196
Net income		-		-			-			-			2,090			-			2,090
Issuance of preferred stock		36,581		-			-			-			-			-			36,581
Warrants on issuance of preferred stock		-		-			-			2,389			-			-			2,389
Accretion of discount on preferred stock		35		-			-			-			(35	)		-			-
Other comprehensive loss, net of tax benefit of $(79)		-		-			-			-			-			(145	)		(145	)
Balances at December 31, 2008	$	36,616		12,071,032		$	121		$	43,170		$	80,875		$	(660	)	$	160,122

Consolidated Statement of Comprehensive Income
(Dollars in thousands, except share amounts)	YEARS ENDED DECEMBER 31,
	2008			2007		2006
Net income	$	2,090		$	15,546	$	13,355
Unrealized gain (loss) on securities available-for-sale, netof tax provision (benefit) of $(178), $953, and $(165)		(330	)		1,771		(307	)
Reclassification adjustment for gains on securities included in net income, net of tax provision of $100, $10, and $0		185			18		—
Comprehensive income	$	1,945		$	17,335	$	13,048

(See accompanying notes to consolidated financial statements.)

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Consolidated Statements of Cash Flows

Years ended December 31, 2008, 2007, and 2006

	YEARS ENDED
	DECEMBER 31,
(Dollars in thousands)	2008			2007			2006
Cash flows from operating activities:
Net income	$	2,090		$	15,546		$	13,355
Adjustments to reconcile net income to netcash provided by (used in) operating activities:
Depreciation and amortization of premises and equipment		2,136			1,875			1,917
Provision for losses on loans		7,240			1,350			1,000
Increase in cash surrender value of bank owned life insurance		(980	)		(684	)		(661	)
Amortization of retained servicing rights		39			44			6
Amortization of core deposit intangible		141			141			141
Deferred income taxes		(8,176	)		(1,982	)		178
Deferred loan fees, net		(654	)		290			(9	)
Gain on sale of loans		(128	)		(199	)		(483	)
Stock-based compensation		196			213			287
Excess tax benefits from stock-based compensation		(30	)		(231	)		(314	)
Net change in fair value of financial instruments		(912	)		(1,081	)		—
Purchase of securities held-for-trading		—			(46,413	)		—
Proceeds from sales/calls on securities held-for-trading		—			112,162			—
Net (gain) loss on sales of securities available-for-sale		(285	)		435			—
Net (gain) on calls of securities held-to-maturity		(113	)		—			—
Net (gain) on FHLB advances		—			(569	)		—
Net (gain) on sales of premises and equipment		(4	)		—			—
Net loss (gain) on sale of real estate owned, investment property and other repossessed assets		3			—			27
Net change in accrued interest receivable and other assets		1,308			3,732			(562	)
Net change in accrued interest payable, expenses and other liabilities		(797	)		(733	)		1,764
Impairment on securities available-for-sale (OTTI)		17,338			—			—
Net cash provided by operating activities		18,412			83,896			16,646
Cash flows from investing activities:
Loans originated, net of principal repayments		(154,195	)		(91,242	)		(133,462	)
Purchases of securities held-to-maturity		(81,866	)		(64,034	)		(3,434	)
Proceeds from sales/calls on securities held-to-maturity		96,550			5,000			—
Principal repayments on securities held-to-maturity		2,074			2,658			2,020
Purchases of securities available-for-sale		(149,022	)		(76,198	)		(5,716	)
Proceeds from sales of securities available-for-sale		88,184			66,220			—
Principal repayments on securities available-for-sale		2,743			5,677			15,184
Net purchases of premises and equipment		(3,440	)		(4,047	)		(1,846	)
Proceeds from sales/retirements of premises and equipment		6			15			195
Proceeds from sales/retirements of REO		4,434			—			74
Proceeds from loan participations sold		(4,269	)		(6,818	)		3,988
Change in CRA investment		(1,902	)		(1,890	)		—
Purchase of bank owned life insurance		—			(4,000	)		—

Net cash used in investing activities		(200,703	)		(168,659	)		(122,997	)
Subtotal, carried forward	$	(182,291	)	$	(84,763	)	$	(106,351	)

(See accompanying notes to consolidated financial statements.)

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Consolidated Statements of Cash Flows, Continued

Years ended December 31, 2008, 2007, and 2006

	YEARS ENDED
	DECEMBER 31,
(Dollars in thousands)	2008			2007			2006

Subtotal, brought forward	$	(182,291	)	$	(84,763	)	$	(106,351	)
Cash flows from financing activities:
Proceeds from issuance of common stock		357			582			736
Proceeds from issuance of preferred stock/warrants		38,970			—			—
Dividends paid		(3,794	)		(3,978	)		(3,603	)
Repurchase of common stock		—			(2,838	)		(673	)
Excess tax benefits from stock-based compensation		30			231			314
Net increase in deposits		101,886			49,134			59,681
Net increase (decrease) in FHLB advances		18,000			(11,431	)		7,000
Net increase (decrease) in securities sold under agreements to repurchase		25,765			24,915			44,652
Net proceeds from FRB borrowing		40,000			—			—
Net increase (decrease) in advance payments by borrowers for taxes and insurance
Proceeds from junior subordinated debentures payable		—			—			10,000
Net cash provided by financing activities		221,227			56,414			118,121
Net increase (decrease) in cash and cash equivalents		38,936			(28,349	)		11,770
Cash and cash equivalents at beginning of period		14,530			42,879			31,109
Cash and cash equivalents at end of period		53,466			14,530			42,879

Supplemental disclosures of cash flow information –
Cash paid during the period for:
Interest	$	47,494		$	51,457		$	40,241
Income taxes		7,150			5,600			6,700

Supplemental schedule of non-cash investing activities:
Mark-to-market on securities available-for-sale		223			(2,752	)		472
Retirement of common stock in retained earnings		—			171			142
Dividends declared on common and preferred stock		3,471			4,094			3,706
Cumulative adjustment to equity for SFAS No.159		—			(3,162	)		—
Transfer of loans to REO and other repossessed assets		6,000			—			—

(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 (the “Corporation”) and its sole subsidiary, Cascade Bank (the “Bank”) 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. Material estimates that are particularly susceptible to significant change relates to the determination of the allowance for losses on loans, valuation of real estate acquired in connection with foreclosures or in satisfaction of loans and goodwill. In connection with the determination of the estimated losses on loans and foreclosed assets held-for-sale, management obtains independent appraisals for significant properties. Goodwill and other intangible assets with indefinite lives are not amortized but instead are periodically tested for impairment. Management performs an impairment analysis periodically, and at least annually. Management determined that there was no impairment as of December 31, 2008. The valuation is determined using discounted cash flows of forecasted earnings, estimated sales price based on recent observable market transactions and market capitalization based on current stock price. If impairment was deemed to exist, a write-down of the asset would occur with a charge to earnings. The impairment analysis requires management to make subjective judgments. Events and factors that may significantly affect the estimates include, among others, competitive forces, customer behaviors and attrition, changes in revenue growth trends, cost structures, technology, changes in discount rates, and specific industry and market conditions.

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

(a) Basis of Presentation

The consolidated financial statements include the accounts of the Corporation and the Bank. 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. 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.

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, Fed funds sold and short-term highly liquid investment securities with an original maturity of three months or less to be cash equivalents.

Interest-bearing deposits with other financial institutions are carried at cost and include interest-bearing deposits at the Federal Home Loan Bank.

(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, 2008, and 2007, the Bank has $11.9 million 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

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollars in thousands, except share amounts)

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 $23.1 million and $32.0 million at December 31, 2008, and 2007, respectively.

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, $1.2 million, and $1.1 million for the years ended December 31, 2008, 2007, and 2006, respectively.

(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 stockholders’ equity.

(i) Earnings per Common Share (EPS) Data

The Corporation displays basic and diluted EPS in the consolidated statement of income. Basic EPS is computed by dividing net income available for common stockholders, which is net income less dividends on preferred stock, by the weighted average number of shares outstanding during the year. Diluted EPS is computed by dividing net income available for common stockholders 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 and warrants.

(j) 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, 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 intangible assets consisted of the following at December 31, 2008, and 2007:

	GROSS CARRYING AMOUNT
Intangible assets carrying amount	2008		2007
Goodwill	$	24,585	$	24,585
Core deposit intangible, net		493		634
Total	$	25,078	$	25,219

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollars in thousands, except share amounts)

Carrying amount of the core deposit intangible asset at December 31, 2008 and 2007 was as follows:

	YEARS ENDED DECEMBER 31
Core deposit intangible asset	2008			2007
Gross carrying amount	$	1,127		$	1,127
Accumulated amortization		(634	)		(493	)
Net carrying amount	$	493		$	634

Amortization expense for each of the years ended December 31, 2008, 2007, and 2006 was $141. Estimated existing intangible asset amortization for the next five years is as follows:

Estimated amortization expense
For year ended 12/31/09	$	141
For year ended 12/31/10		141
For year ended 12/31/11		141
For year ended 12/31/12		70
For year ended 12/31/13		—

(k) Loans

Almost all of the Corporation's loans are located in Washington State, primarily in the Puget Sound Region. At December 31, 2008, the Corporation's loans were classified as one-to-four-family residences (10%), multifamily residences (7%), real estate construction (32%), business (39%), consumer (2%), and commercial real estate (10%). Accordingly, the ultimate collectability 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 39% 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, 2008, $29.8 million in commercial and industrial 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 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 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. Approximately 84% of Cascade’s loan portfolio is secured by real estate and a significant decline in real estate market values may require an increase in the provision for loan losses. Over the last two years, there has been deterioration in the residential development market which has led to an increase in nonperforming loans and the allowance for loan losses. A continued deterioration in this market, or deterioration in other segments of the loan portfolio, may lead to additional charges to the allowance for loan losses.

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 loan’s yield over the contractual life of the loan using the interest or straight-line 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.

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 uncollectability 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 collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrowers’ 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.

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollars in thousands, except share amounts)

The allowance consists of specific, general and unallocated components. The specific component relates to loans that are classified as either doubtful or substandard. 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 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.

The allowance for losses on loans is management’s best estimate of potential losses. 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.

(l) Loans Held for Sale

Loans held for sale includes mortgage loans and are reported at the lower of cost or market value. Cost generally approximates market value, given the short duration of these assets. Gains or losses on the sale of loans that are held for sale are recognized at the time of the sale and determined by the difference between net sale proceeds and the net book value of the loans less the estimated fair value of any retained mortgage servicing rights. The Bank held $1.2 million in loans held for sale at December 31, 2008, and $129 in loans held for sale at December 31, 2007. Loans are sold without recourse on a best effort, servicing released basis.

(m) Securities

Debt and equity securities, including mortgage-backed securities (“MBS”), may be classified as held-for-trading, available-for-sale, or held-to-maturity. Securities classified as held-for-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.

(n) 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

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollars in thousands, except share amounts)

charge-offagainst 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. There was $1.4 million of real estate owned at December 31, 2008, and no real estate owned at December 31, 2007.

(o) 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.

(p) Income Taxes

The Corporation accounts for income taxes in accordance with SFAS No. 109 Accounting for Income Taxes (“SFAS No. 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.

(q) Stock-Based Compensation

The Corporation previously accounted for its stock option plan in accordance with the provisions of APB Opinion No. 25, Accounting for Stock Issued to Employees. Effective January 1, 2006, the Corporation adopted SFAS No. 123 (revised 2004), Share-Based Payment, (“SFAS No. 123(R)”) using the modified prospective method. SFAS No. 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 14 to the Consolidated Financial Statements for a further discussion on stock-based compensation.

(r) Interest Rate Swap Agreements

For asset/liability management purposes, the Corporation has used 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 a high correlation between the contract and the underlying item being hedged, both at inception and throughout the hedge period. The Corporation had no interest rate swap agreements at December 31, 2008 or December 31, 2007.

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 marked-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. That 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.

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollars in thousands, except share amounts)

(s) 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.

(t) 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.

(u) Reclassifications

Certain balances have been reclassified to conform to the 2008 presentation.

(v) Recent Accounting Pronouncements

In November 2007, the SEC issued Staff Accounting Bulletin No. 109, Written Loan Commitments Recorded at Fair Value through Earnings (“SAB 109”). SAB 109 provides guidance on the accounting for written loan commitments recorded at fair value under GAAP. Specifically, the SAB revises the Staff’s views on incorporating expected net future cash flows related to loan servicing activities in the fair value measurement of a written loan commitment. SAB 109, which supersedes SAB 105, Application of Accounting Principles to Loan Commitments, requires the expected net future cash flows related to the associated servicing of the loan be included in the measurement of all written loan commitments that are accounted for at fair value through earnings. SAB 109 is effective on January 1, 2008, for the Corporation. Adoption of SAB 109 is not expected to have a material impact on the Corporation’s financial statements.

In December 2007, FASB issued SFAS No. 141 (revised), Business Combinations. SFAS No. 141(R) establishes principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, any noncontrolling interest in the acquiree and the goodwill acquired. SFAS No. 141(R) also establishes disclosure requirements to enable the evaluation of the nature and financial effects of the business combination. This statement applies prospectively to business combinations for which the acquisition date is on or after January 1, 2009. Accordingly, the Corporation will apply SFAS 141(R) to business combinations occurring on or after January 1, 2009.

In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB No. 51. SFAS 160 establishes accounting and reporting standards that require that the ownership interests in subsidiaries held by parties other than the parent be clearly identified, labeled, and presented in the consolidated statement of financial position within equity, but separate from the parent’s equity; the amount of consolidated net income attributable to the parent and to the noncontrolling interest be clearly identified and presented on the face of the consolidated statement of income; and changes in a parent’s ownership interest while the parent retains its controlling financial interest in its subsidiary be accounted for consistently. SFAS 160 also requires that any retained noncontrolling equity investment in the former subsidiary be initially measured at fair value when a subsidiary is deconsolidated. SFAS 160 also sets forth the disclosure requirements to identify and distinguish between the interests of the parent and the interests of the noncontrolling owners. SFAS 160 applies to all entities that prepare consolidated financial statements, except not-for-profit organizations, but will affect only those entities that have an outstanding noncontrolling interest in one or more subsidiaries or that deconsolidate a subsidiary. SFAS 160 is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. Earlier adoption is prohibited. SFAS 160 must be applied prospectively as of the beginning of the fiscal year in which SFAS 160 is initially applied, except for the presentation and disclosure requirements. The presentation and disclosure requirements are applied retrospectively for all periods presented. The Corporation does not have a noncontrolling interest in one or more subsidiaries. Accordingly, the Corporation does not anticipate that the initial application of SFAS 160 will have an impact on our financial statements.

In October 2008, the FASB issued FASB Staff Position (“FSP”) FAS No. 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active. The FSP clarifies the application of FAS No. 157, Fair Value Measurements, when the market for a financial asset is not active. The FSP was effective upon issuance, including reporting for prior periods for which financial statements have not been issued. The adoption of the FSP for reporting as of December 31, 2008, did not have a material impact on the Corporation’s consolidated financial statements.

On January 12, 2009, FASB issued FSP Emerging Issues Task Force (“EITF”) 99-20-1, Amendments to the Impairment Guidance of EITF Issue No. 99-20. FSP EITF 99-20-1 addresses certain practice issues in EITF No. 99-20, Recognition of Interest Income and Impairment on Purchased Beneficial Interests and Beneficial Interests That Continue to Be Held by a Transferor in Securitized Financial Assets, by making its other-than-temporary impairment assessment guidance consistent with SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. FSP EITF 99-20-1 removes the reference to the consideration of a market participant's estimates of cash flows in EITF 99-20, and instead requires an assessment of whether it is probable, based on current information and events, that the holder of the security will be unable to collect all amounts due according to the contractual terms. If it is probable that there has been an adverse change in estimated cash flows, an other-than-temporary impairment is deemed to exist, and a corresponding loss shall be

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollars in thousands, except share amounts)

recognized in earnings equal to the entire difference between the investment’s carrying value and its fair value

at the balance sheet date of the reporting period for which the assessment is made. This FSP is effective for interim and annual reporting periods ending after December 15, 2008, and shall be applied prospectively. The impact of adoption did not have a material impact on the Corporation’s consolidated financial statements.

(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. No deposit was required to be held at the Federal Reserve as of December 31, 2008, and December 31, 2007, due to a reclassification of deposits.

(3) Securities

A summary of securities at December 31, 2008 and December 31, 2007, follows:

	DECEMBER 31, 2008
	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	$	42,250	$	288	$	-	$	(281	)	$	(405	)	$	41,852
Agency notes		81,149		368		-		(145	)		-			81,372
Corporate/other		1,294		-		-		(840	)		-			454
Total	$	124,693	$	656	$	-	$	(1,266	)	$	(405	)	$	123,678

	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	$	20,484	$	195	$	14	$	(139	)	$	(9	)	$	20,545
Agency notes		99,335		442		-		(396	)		-			99,381
Corporate/other		775		-		-		-			-			775
Total	$	120,594	$	637	$	14	$	(535	)	$	(9	)	$	120,701

	DECEMBER 31, 2007
	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	$	26,286	$	2	$	5	$	(71	)	$	(795	)	$	25,427
Agency notes		57,366		67		-		-			-			57,433
Total	$	83,652	$	69	$	5	$	(71	)	$	(795	)	$	82,860

	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	$	22,556	$	28	$	-	$	-		$	(643	)	$	21,941
Agency notes		113,907		67		-		(246	)		(149	)		113,579
Corporate/other		775		-		-		-			-			775
Total	$	137,238	$	95	$	-	$	(246	)	$	(792	)	$	136,295

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollars in thousands, except share amounts)

At December 31, 2008, the Bank had five securities with a gross unrealized loss totaling $405 in our available-for-sale portfolio with a fair value of $10.0 million that had an unrealized loss for greater than one year and two held-to-maturity securities with a gross unrealized loss totaling $9 with a fair value of $2.0 million that have had an unrealized loss for

more than one year. The only impairment on available-for-sale securities was in the MBS category, which accounted for 100% of the total impairment. As of December 31, 2008, the Bank had sixteen available-for-sale and eight held-to-maturity securities included in the temporarily impaired report, compared to fourteen available-for-sale and twenty 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 credit spreads 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.

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 par value with respect to these securities at maturity or sooner in the event of a more favorable market interest rate environment.

On September 7, 2008, the U.S. Treasury, the Federal Reserve and the Federal Housing Finance Agency (“FHFA”) announced that FHFA was placing Fannie Mae and Freddie Mac under conservatorship and would eliminate dividends on FNMA and FHLMC common and preferred stock. On September 9, 2008, Cascade reported that as of June 30, 2008, the Bank owned preferred shares issued by FNMA ($10.2 million book value) and FHLMC ($8.4 million book value) with a combined adjusted book value of approximately $18.6 million. As of September 30, 2008, the fair market value of these securities was $1.3 million. With an amortized cost basis for the securities of $18.6 million, Cascade recorded a pre-tax OTTI charge of $17.3 million, resulting in a charge net of taxes of $11.3 million to third quarter 2008 earnings. As of September 30, 2008, the adjusted book value of these securities was $1.3 million. The fair value as of December 31, 2008, was $454.

As of December 31, 2008, and 2007, the Corporation was required to maintain 89,350 and 81,050 shares, respectively, of $100 par value FHLB stock.

Accrued interest receivable on securities and interest-bearing deposits was $2.7 million and $2.2 million at

December 31, 2008, and 2007, respectively.

Proceeds from the sales of securities available-for-sale and gross realized gains and losses are summarized as follows for the year ended December 31, 2008, 2007, and 2006:

	PROCEEDS		GAINS		LOSSES
Year ended December 31, 2008	$	88,184	$	374	$	(89	)
Year ended December 31, 2007		66,220		55		(490	)
Year ended December 31, 2006		—		—		—

The following table shows the contractual or expected maturities of the Corporation’s securities available-for-sale at December 31, 2008:

	WITHIN ONE YEAR		ONE TO FIVE YEARS		OVER FIVE TO TEN YEARS		OVER TEN YEARS		TOTAL
Amortized Cost
MBS	$	22,517	$	19,733	$	-	$	-	$	42,250
Agency notes		-		-		71,100		10,049		81,149
Corporate/other		-		-		-		1,294		1,294
Total amortized cost	$	22,517	$	19,733	$	71,100	$	11,343	$	124,693
Fair Value
MBS	$	22,345	$	19,507	$	-	$	-	$	41,852
Agency notes		-		-		71,458		9,914		81,372
Corporate/other		-		-		-		454		454
Total fair value	$	22,345	$	19,507	$	71,458	$	10,368	$	123,678

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollars in thousands, except share amounts)

The following table shows the contractual or expected maturities of the Corporation’s securities held-to-maturity at December 31, 2008:

	WITHIN ONE YEAR		ONE TO FIVE YEARS		OVER FIVE TO TEN YEARS		OVER TEN YEARS		TOTAL
Amortized Cost
MBS	$	-	$	-	$	8,660	$	11,824	$	20,484
Agency notes		-		5,000		46,958		47,377		99,335
Corporate/other		-		-		-		775		775
Total amortized cost	$	-	$	5,000	$	55,618	$	59,976	$	120,594
Fair Value
MBS	$	-	$	-	$	8,552	$	11,993	$	20,545
Agency notes		-		5,059		46,944		47,378		99,381
Corporate/other		-		-		-		775		775
Total fair value	$	-	$	5,059	$	55,496	$	60,146	$	120,701

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 was $23.8 million at December 31, 2008, and $36.0 million at December 31, 2007. The fair

value of securities pledged to the FHLB at December 31, 2008, was $23.5 million and $29.1 million at December 31, 2007. The fair value of securities pledged to fund repurchase agreements was $193.8 million at December 31, 2008, and $139.7 million at December 31, 2007. The fair value of securities pledged at the Federal Reserve Bank for treasury tax and loan was $1.5 million at December 31, 2008 and $1.2 million at December 31, 2007. The Bank also had securities pledged with a fair value of $442 at the Federal Reserve Bank at December 31, 2008.

(4) Loans and Allowance for Loan Losses

A summary of loans at December 31, 2008, and 2007, follows:

	DECEMBER 31,			DECEMBER 31,
	2008			2007
Residential	$	126,089		$	98,384
Multifamily		86,864			11,397
Commercial real estate		122,951			120,421
Construction (1)		406,505			381,810
Business banking		485,060			468,453
Consumer		30,772			27,688
Total loans		1,258,241			1,108,153
Deferred loan fees, net		(3,069	)		(3,724	)
Allowance for loan losses		(16,439	)		(11,653	)
Net loans	$	1,238,733		$	1,092,776
Loans serviced for others	$	23,131		$	31,965

(1) Construction loans are net of loans in process.

Accrued interest on loans was $4.9 million and $5.9 million at December 31, 2008, and December 31, 2007, respectively. Loans to officers and directors totaled $1.4 million at December 31, 2008, $301 at December 31, 2007, and $311 at December 31, 2006. Repayments totaling $6, $10, and $6 were received and additional advances of $1.1 million, $0, and $17 were made for the years ended December 31, 2008, 2007, and 2006, respectively.

At December 31, 2008, the composition of the loan portfolio was as follows:

	FIXED		VARIABLE		ADJUSTABLE
Term to maturity	RATE		RATE (1)		RATE
Less than one year	$	43,907	$	319,832	$	5,088
1-3 years		80,915		104,257		4,179
3-5 years		96,231		22,438		100,509
5-10 years		71,095		11,676		241,152
10-20 years		4,954		4,571		28,227
Over 20 years		6,660		13,881		98,669
Total	$	303,762	$	476,655	$	477,824

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

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollars in thousands, except share amounts)

Nonaccrual loans totaled $40.3 million, $1.5 million, and $851, respectively, at December 31, 2008, December 31, 2007, and December 31, 2006. If interest on these loans had been recognized, such income would have been $871, $111, and $27, respectively, for the periods ended December 31, 2008, 2007, and 2006. The Corporation has no commitments to extend additional credit on loans that are nonaccrual. At December 31, 2008, 2007, and 2006, loans totaling $87.3 million, $29.1 million, and $9.4 million, were adversely classified loans. Of the adversely classified loans, $3.5 million, $451, and $223 were in foreclosure at December 31, 2008, 2007, and 2006, respectively. The average balances of adversely classified loans for the years ended December 31, 2008, and December 31, 2007, respectively, were $54.5 million and $9.2 million and the Corporation recognized $2.2 million and $561 of related interest income on such loans during the time they were adversely classified.

At December 31, 2008, 2007, and 2006, impaired loans totaled $83.4 million, $26.2 million, and $7.0 million, respectively. The Corporation conducts an impairment analysis on any loan exceeding $1.0 million when their ability to make all contractual payments in a timely basis is in question. At December 31, 2008, $83.4 million were subjected to impairment analysis. No impairment charges were taken and/or reserves established for $48.5 million of the analyzed loans. However, according to FAS114, the Bank is still required to report these loans as impaired since an impairment analysis was performed. The average balances during the years ended December 31, 2008, 2007, and 2006, were $47.8 million, $6.5 million and $10.0 million, respectively. The allowance for loan losses related to these loans was approximately $2.9 million, $1.2 million, and $932, at December 31, 2008, 2007, and 2006, respectively. Interest collected on impaired loans in cash and included in income was $4.5 million for 2008, $1.8 million for 2007, and $545 for 2006. If interest on these loans had been accrued, the additional amount of such income would have been $871, $111, and $23 at December 31, 2008, 2007, and 2006, respectively.

The Bank had no loans that were 90 days or more past due and still accruing at December 31, 2008. The Bank had three loans that were 90 days or more past due and still accruing totaling $11.6 million at December 31, 2007. These loans were secured by real estate and supported by then current appraised values.

At December 31, 2008, and 2007, respectively, loans of $171.3 million and $29.2 million represent real estate secured loans that have loan-to-value ratios above supervisory guidelines.

At December 31, 2008, the Corporation had outstanding commitments to grant loans of $3.9 million with fixed interest rates and $2.4 million with adjustable rates.

The Corporation had non-mandatory forward commitments totaling $127 and $0 to sell loans into the secondary market at December 31, 2008, and December 31, 2007, 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 losses on its commitments in 2008 or 2007.

At December 31, 2008, and 2007, the following financial instruments with off-balance sheet risk were outstanding:

	2008		2007
Commitments to grant loans	$	6,327	$	45,118
Unfunded commitments under lines of credit/loans in process		167,353		265,118
Standby letters of credit and financial guarantees written		5,116		5,171
Unused commitments on bankcards		13,868		12,840
Total	$	192,664	$	328,247

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollars in thousands, except share amounts)

A summary of the allowance for losses on loans follows:

	YEARS ENDED DECEMBER 31,
	2008			2007			2006
Balances at beginning of year	$	11,653		$	10,988		$	10,254
Off-balance sheet commitments		49			(142	)		—
Provision for loss		7,240			1,350			1,000
Recoveries		1,282			135			148
Charge-offs		(3,785	)		(678	)		(414	)
Balances at end of year	$	16,439		$	11,653		$	10,988

(5) Premises and Equipment

A summary of premises and equipment follows:

	ESTIMATED	DECEMBER 31,			DECEMBER 31,
	USEFUL LIVES	2008			2007
Land	40 years Lease term 2-10 years	$	4,291		$	4,277
Buildings			13,106			11,394
Leasehold improvements			2,420			2,498
Furniture and equipment			13,293			14,066
			33,110			32,235
Accumulated depreciation and amortization			(17,647	)		(18,075	)
Total		$	15,463		$	14,160

Total depreciation and amortization expense was $2.1 million for the year ended December 31, 2008, and $1.9 million for each of the years ended December 31, 2007, and 2006, respectively.

The Bank leases space for various branches. These leases run for a period ranging from 20 months to 10 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, 2008, are as follows:

Years ending December 31,	2009	$	821
	2010		786
	2011		771
	2012		757
	2013		757
	Thereafter		8,315
	Total	$	12,207

Rental expenses charged to operations were approximately $825, $763, and $693 for the years ended December 31, 2008, 2007, and 2006, respectively.

(6) Deposits

Deposits at December 31, 2008, and 2007, are summarized as follows:

	DECEMBER 31,		DECEMBER 31,
	2008		2007
Noninterest-bearing checking accounts	$	84,033	$	87,350
Interest-bearing checking accounts		102,810		50,840
Money market deposit accounts		193,448		315,967
Savings accounts		10,587		11,297
Certificates of deposit		615,904		439,442
Total		1,006,782		904,896

Time deposit accounts in amounts of $100 thousand or more totaled $462.3 million and $271.5 million at December 31, 2008, and December 31, 2007, respectively. Deposits held by executive officers and directors totaled $3.8 million at December 31, 2008, and $4.2 million at December 31, 2007. Included in these totals were $1.6 million and $2.6 million held in business accounts on which six directors have signing authority, at December 31, 2008, and December 31 2007, respectively.

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollars in thousands, except share amounts)

	WEIGHTED AVERAGE INTEREST RATE ON DEPOSITS			DEPOSIT ACCOUNTS WITH BALANCES IN EXCESS OF $100 THOUSAND		ACCRUED INTEREST PAYABLE ON DEPOSITS
December 31, 2008		2.24	%	$	710,863	$	2,925
December 31, 2007		3.78			606,579		4,285

A summary of interest expense on deposits follows:

	YEARS ENDED DECEMBER 31,
	2008		2007		2006
Checking and money market accounts	$	8,514	$	13,061	$	9,160
Savings accounts and time deposits		18,701		22,159		19,416
Total	$	27,215	$	35,220	$	28,576

Maturities of time deposits at December 31, 2008, are as follows:

Years ending December 31,	2009	$	587,094
	2010		10,332
	2011		3,239
	2012		2,153
	2013		2,915
	Thereafter		10,171
	Total		615,904

(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.

The junior subordinated debentures payable will mature on March 1, 2030, unless redeemed prior to such date if certain conditions are met.

In October 2003, the Corporation 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, the Corporation received an 11% fixed-rate and paid a floating-rate of USD-six-month LIBOR-BBA plus 520 basis points. 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, as Cascade Capital Trust II. These debentures have a fixed coupon of 5.82% for the first 5 years and then float at the three-month LIBOR plus 1.90% for the remaining 25 years. The debentures are callable at par after 5 years. These debentures 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, as Cascade Capital Trust III. These debentures have a fixed coupon of 6.50% for the first 5 years and then float, if not called, at the three-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 Trusts II and III incorporate the same structure, for the same purposes as Cascade Capital Trust I.

Effective January 1, 2007, the Corporation elected early adoption of SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, and SFAS No. 157, Fair Value Measurements, both of which were issued in February 2007. The Corporation applied fair value accounting to Cascade Capital Trust I. Upon adoption of SFAS No. 159 and No. 157, the Corporation determined a fair value for Cascade Capital Trust I of approximately 117 or $11.17 million for the $10.0 million in trust preferred securities (junior subordinated debentures). This resulted in charging off the unamortized issuance costs to retained earnings of $654 as required under SFAS No. 159. The $1.17 million fair value premium is the result of the 11% coupon and the 5.5% call premium. This fair value premium should be effectively written down to the $550 premium to call the security on March 1, 2010, which is embedded in its fair value. The fair value option was not selected for variable rate junior subordinated debentures totaling $15.0 million. See Note 15 of the Notes to Consolidated Financial Statements for additional information on SFAS No. 157.

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,
		2008					2007
				WEIGHTED					WEIGHTED
				AVERAGE					AVERAGE
				INTEREST					INTEREST
MATURITY DATE		AMOUNT		RATE			AMOUNT		RATE
At December 31,	2008	$	—		—	%	$	2,000		3.51	%
	2009		10,000		3.62			10,000		3.62
	2010		-		-			-		-
	2011		10,000		3.88			10,000		3.88
	2012		40,000		4.33			40,000		4.33
	2013		30,000		3.61			10,000		5.30
	Thereafter (1)		159,000		4.44			159,000		4.26
		$	249,000		4.27	%	$	231,000		4.27	%

(1)	December 31, 2007 includes $30,000 tied to the three-month Libor.

	YEARS ENDED DECEMBER 31,
	2008		2007
Maximum amount of outstanding FHLB advances at any month-end	$	287,500	$	264,790
Average amount of outstanding FHLB advances during the year		256,898		226,124

The Bank had $249.0 million in fixed-rate advances as of December 31, 2008, and the FHLB has the option to convert these advances to variable-rate advances after a specified period.

At December 31, 2008, the Bank had an unused line of credit from the FHLB-Seattle of $323.9 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 $572.9 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 and cash 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. At December 31, 2008, $10.5 million in cash was held as collateral as securities were called at the end of the year and not yet replaced.

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

						UNDERLYING SECURITIES/CASH
			WEIGHTED			BOOK VALUE,
			AVERAGE			INCLUDING
	BALANCE		INTEREST			ACCRUED		MARKET
	OUTSTANDING		RATE			INTEREST		VALUE
December 31, 2008	$	146,390		5.19	%	$	193,832	$	193,846
December 31, 2007		120,625		3.23			140,523		139,722

Financial data pertaining to repurchase agreements follows:

	YEARS ENDED DECEMBER 31,
	2008		2007
Maximum amount of outstanding agreements at any month-end	$	147,740	$	120,625
Average amount of outstanding agreements during the year		124,211		107,516

The Corporation had $75.0 million of repurchase agreements that adjust to a spread based on a calculation using the three-month LIBOR every three months to maturity and $70 million that are fixed for the remainder of the agreement unless the lender terminates the agreement.

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollars in thousands, except share amounts)

The Bank has Fed funds borrowing lines with three of its correspondent banks. One line is for $15.0 million and

the other two facilities are for $10.0 million each. All three have no maturity dates. 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.

The Bank had an outstanding balance of $40.0 million in TAF borrowings at the Federal Reserve Bank at December 31, 2008, as detailed in the following table:

AMOUNT		INTEREST RATE			ORIGINATION DATE	MATURITY DATE
$	10,000		1.39	%	10/09/08	1/02/09
	20,000		0.60		11/06/08	1/29/09
	10,000		0.28		12/18/08	1/15/09
$	40,000

(10) Income Taxes

Income tax expense (benefits) includes the following components:

	YEARS ENDED
	DECEMBER 31,
	2008			2007			2006
Current	$	7,737		$	9,365		$	6,297
Deferred		(8,176	)		(1,982	)		178
Total	$	(439	)	$	7,383		$	6,475

As required by SFAS No. 109, the Corporation continually reviews 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 No. 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, 2008, the Corporation had $13.1 million of deferred tax assets and net deferred tax assets (after deferred tax liabilities) of $9.8 million related to the U.S. tax jurisdictions whose recoverability is dependent upon future profitability.

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

For the year ended December 31, 2008, the Corporation's effective tax rate was -26.6% compared to 32.2% and 32.7% for the years ended December 31, 2007 and 2006. A decrease in earnings, combined with 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 2008 and 2007.

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, 2008, 2007 and 2006, as a result of the following:

	2008			2007			2006
Computed “expected” tax expense	$	578		$	8,025		$	6,941
Bank owned life insurance (BOLI)		(343	)		(239	)		(231	)
Tax exempt interest		(111	)		(218	)		(341	)
Nondeductible stock-based compensation cost		65			68			101
Dividend on preferred stock		(223	)		-			-
Other, net		(405	)		(253	)		5
Total	$	(439	)	$	7,383		$	6,475

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.

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, 2008, and December 31, 2007:

	DECEMBER 31,			DECEMBER 31,
	2008			2007
Deferred tax assets:
Securities available-for-sale	$	355		$	277
Junior subordinated debentures		279			607
Premises and equipment		788			274
Loans		5,603			3,640
OTTI		6,068			-
Gross deferred tax assets		13,093			4,798
Deferred tax liabilities:
Deferred loan fees		(1,305	)		(1,184	)
Core deposit intangible		(173	)		(222	)
Premises and equipment		—			—
FHLB stock		(1,732	)		(1,732	)
Other		(55	)		(86	)
Gross deferred tax liabilities		(3,265	)		(3,224	)
Net deferred tax asset	$	9,828		$	1,574

A valuation allowance for deferred tax assets was not considered necessary at December 31, 2008, or 2007. Management believes the Corporation will fully realize its total deferred income tax assets as of December 31, 2008, and 2007, based upon its total deferred income tax liabilities, previous taxes paid and its current and expected future levels of taxable income.

The Corporation adopted the provisions of FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, on January 1, 2007. The Corporation had no unrecognized tax benefits which would require an adjustment to the January 1, 2007 beginning balance of retained earnings. The Corporation had no unrecognized tax benefits at December 31, 2007, or December 31, 2008.

The Corporation recognizes interest accrued and penalties related to unrecognized tax benefits in tax expense. During the years ended December 31, 2008, and 2007, the Corporation recognized no interest and penalties.

The Corporation and its subsidiaries file income tax returns in the U.S. Federal jurisdiction. With few exceptions, the Corporation is no longer subject to U.S. federal or state/local income tax examinations by tax authorities for years before 2005.

(11) Earnings per Common Share

The following table presents EPS information:

	YEARS ENDED DECEMBER 31,
	2008		2007		2006
Net income	$	2,090	$	15,546	$	13,355
Dividends on preferred stock		216		-		-
Net income available for common stockholders		1,874		15,546		13,355
Weighted average number of common shares outstanding, basic		12,053,084		12,047,792		12,060,191
Effect of dilutive stock options		106,090		237,062		303,007
Weighted average number of common shares outstanding, diluted		12,159,174		12,284,854		12,363,198

EPS, basic	$	0.16	$	1.29	$	1.11
EPS, diluted		0.15		1.27		1.08

For purposes of calculating basic and diluted earnings per common share, the numerator of net income available for common stockholders is the same. There were outstanding options to purchase 399,385; 174,810; and 196,554 shares of common stock at December 31, 2008, December 31, 2007, and December 31, 2006, 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. Also as of December 31, 2008, the warrant issued to the U.S. Treasury to purchase up to 863,442 shares of common stock in the fourth quarter of 2008 was not included in the computation of diluted EPS because the warrant’s exercise price was greater than the average market price of common shares.

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollars in thousands, except share amounts)

(12) 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). In November 2008, the Corporation issued preferred stock to the U.S. Treasury. As a provision of that issuance, the Corporation cannot increase its current cash dividend, currently 0.045 per quarter, without prior approval of the U.S. Treasury for three years or until November 2011.

(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.

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, 2008, and 2007, 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.

At December 31, 2008, 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, 2008, the Bank was in compliance with the regulatory requirements for well-capitalized institutions.

As of December 31, 2008, 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.

	ACTUAL					MINIMUM REQUIREMENTS FOR CAPITAL ADEQUACY					WELL-CAPITALIZED REQUIREMENTS
CASCADE BANK	AMOUNT		RATIO			AMOUNT		RATIO			AMOUNT		RATIO
December 31, 2008:
Total risk-based capital to risk-weighted assets (1)	$	177,318		13.32	%	$	106,493		8.00	%	$	133,116		10.00	%
Tier I (core) capital to risk-weighted assets		160,786		12.08			53,247		4.00			79,870		6.00
Tier I (core) capital to average total assets		160,786		10.34			62,215		4.00			77,769		5.00
December 31, 2007:
Total risk-based capital to risk-weighted assets (1)	$	135,345		10.91	%	$	99,248		8.00	%	$	124,059		10.00	%
Tier I (core) capital to risk-weighted assets		123,550		9.96			49,624		4.00			74,436		6.00
Tier I (core) capital to average total assets		123,550		9.00			54,901		4.00			68,626		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.

	ACTUAL					MINIMUM REQUIREMENTS FOR CAPITAL ADEQUACY					WELL-CAPITALIZED REQUIREMENTS
CASCADE FINANCIAL CORP	AMOUNT		RATIO			AMOUNT		RATIO			AMOUNT		RATIO
December 31, 2008:
Total risk-based capital to risk-weighted assets (1)	$	176,681		13.26	%	$	106,579		8.00	%	$	133,224		10.00	%
Tier I (core) capital to risk-weighted assets		160,149		12.02			53,290		4.00			79,934		6.00
Tier I (core) capital to average total assets		160,149		10.30			62,208		4.00			77,760		5.00
December 31, 2007:
Total risk-based capital to risk-weighted assets (1)		134,174		10.80	%	$	99,361		8.00	%	$	124,201		10.00	%
Tier I (core) capital to risk-weighted assets		122,379		9.85			49,681		4.00			74,521		6.00
Tier I (core) capital to average total assets		122,379		8.90			55,032		4.00			68,790		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.

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollars in thousands, except share amounts)

(13) Mortgage Servicing Rights

A summary of capitalized mortgage servicing rights, included in other assets at December 31, 2008, and December 31, 2007, follows:

	DECEMBER 31,
	2008			2007
Balance at beginning of year		130		$	174
Additions		—			—
Amortization		(39	)		(44	)
Balance at end of year	$	91		$	130

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

(14) 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 $382, $336, and $313 to the plan for the years ended December 31, 2008, 2007, and 2006, respectively.

(b) 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 effectively 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.

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 504,559 and 597,566 shares available for grant at December 31, 2008, and 2007, respectively.

Accounting for Stock Options

On January 1, 2006, the Corporation adopted SFAS No.123(R), applying the modified prospective method. SFAS No. 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.

Net compensation cost charged against income for stock-based compensation expense was $196 for 2008, and $213 for 2007. The total income tax benefit recognized in the income statement for stock based compensation arrangements was $30 for 2008, and $231 for 2007.

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.

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollars in thousands, except share amounts)

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

	YEARS ENDED DECEMBER 31,
	2008			2007			2006
Risk-free interest rate		2.50	%		4.75	%		4.50	%
Expected life in years		6			5			5
Expected volatility		24	%		24	%		24	%
Dividend yield		2.90	%		2.00	%		2.03	%

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, 2008 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, 2007		595,567		$	9.87		5.13	$	2,580,240
Granted		97,382			12.61
Exercised		(25,677	)		6.13
Forfeited/Cancelled		(10,389	)		10.37
Outstanding as of December 31, 2008		656,883		$	10.41		5.07	$	153,385

Exercisable as of December 31, 2008		441,658		$	8.70		3.72	$	153,385

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, 2008, and December 31, 2007, 441,658 and 384,696 shares, respectively, were fully exercisable.

The weighted average fair values of options granted under the Corporation's stock option plan were $2.59, $4.04, and $3.77, respectively for the years ended December 31, 2008, December 31, 2007, and December 31, 2006. The total intrinsic value of options exercised were $133, $1.1 million and $1.3 million, respectively, during the years ended December 31, 2008, 2007, and 2006. Total unrecognized compensation cost related to stock options was $233 as of December 31, 2008, $210 as of December 31, 2007, and $466 as of December 31, 2006. That cost is expected to be recognized over a weighted average period of 1.8 years. Cash received from options exercised under all share-based payment arrangements were $157, $576, and $670 for the years ended December 31, 2008, 2007 and 2006, respectively.

Deferred Compensation Plan

In December 2004, the Board adopted the Cascade Bank Deferred Compensation Plan. The purpose of this Plan is to provide specified benefits to a select group of management or highly compensated employees who contribute materially to the continued growth, development and business success of the Bank. The Plan was inactive in 2007 and has been replaced with a new plan effective February 1, 2008.

On January 16, 2008, the Cascade Bank Non-Qualified Deferred Compensation Plan was adopted. During 2007, one of the major projects of the Compensation Committee was to develop and recommend a plan to the Board of Directors that would provide specified benefits to a select group of management and highly compensated employees. Participants may contribute up to 50 percent of salary and 100 percent of their incentive to the Plan. In addition, the Compensation Committee has the authority to authorize an employer contribution to the Plan for these same employees. There were no employer contributions made for the year ended December 31, 2008. The contribution will be based upon the performance of the Bank as well as the individual performance of each employee. The Non-Qualified Deferred Compensation Plan will also be available to Directors. Each Director may contribute up to 100 percent of their director compensation to the Plan. No Corporation contributions will be made for Directors.

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollars in thousands, except share amounts)

Employment Agreement

The Bank entered into an employment agreement with Carol K. Nelson dated November 27, 2007, which replaced a previous agreement dated July 12, 2005. This agreement replaced a prior agreement dated March 26, 2002, and extended on January 27, 2004. The current agreement may be terminated upon 90 days written notice.

(15) 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,
	2008				2007
	CARRYING		ESTIMATED		CARRYING		ESTIMATED
	VALUE		FAIR VALUE		VALUE		FAIR VALUE
Financial assets:
Cash and cash equivalents	$	53,466	$	53,466	$	14,530	$	14,530
Securities available-for-sale		123,678		123,678		82,860		82,860
Securities held-to-maturity		120,594		120,701		137,238		136,295
FHLB stock		11,920		11,920		11,920		11,920
Loans, net		1,238,733		1,260,455		1,092,776		1,110,897
Financial liabilities:
Deposit accounts	$	1,006,782	$	997,826	$	904,896	$	895,449
Borrowings		435,390		458,911		351,625		364,499
Junior subordinated debentures payable		15,465		11,569		15,465		14,649
Junior subordinated debentures payable, at fair value		10,510		10,510		11,422		11,422

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 when available or through the use of alternate approaches, such as matrix or model pricing, when market quotes are not readily available.

Loans

Fair values are estimated using current market interest rates to discount future cash flows for each of the 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 (FHLB advances and securities sold under agreements to repurchase)

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

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. There were no swaps as of December 31, 2008 or 2007.

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollars in thousands, except share amounts)

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.

Fair Value Accounting

SFAS No. 159 generally permits the measurement of selected eligible financial instruments at fair value at specified election dates. Upon adoption of SFAS No. 159, the Corporation selected fair value measurement for certain available-for-sale and held-to-maturity investment securities, FHLB advances and Cascade Capital Trust I (junior subordinated debentures payable), which had fair values of approximately $68.1 million, $46.7 million and $12.1 million, respectively, on January 1, 2007. The Corporation also selected fair value measurement for an interest rate swap on a certificate of deposit with a notional value of $10.0 million and a fair value loss of $312 on January 1, 2007. SFAS No. 157 defines fair value, establishes a framework for measuring fair value under GAAP, and expands disclosures about fair value measurement.

Upon adoption of SFAS No. 157, there was no cumulative effect adjustment to beginning retained earnings and no impact on the financial statements, other than in conjunction with the adoption of SFAS No. 159, in the year ended December 31, 2007.

Initial Fair Value Adjustment on Adoption of SFAS 159
	JANUARY 1, 2007
	AMORTIZED COST		FAIR MARKET VALUATION ADJUSTMENT			BASIS AT FMV		RELATED DEFERRED TAXES			CUMULATIVE EFFECT OF ADOPTION
Assets
Securities available-for-sale (AFS) reclassified to fair value	$	54,721	$	(2,056	)	$	52,665	$	720		$	(1,336	)
Securities held-to-maturity (HTM) reclassified to fair value		15,984		(554	)		15,430		194			(360	)
Deferred origination costs on junior subordinated debentures		654		(654	)		-		227			(427	)
	$	71,359	$	(3,264	)	$	68,095	$	1,141		$	(2,123	)
Liabilities
FHLB advances	$	45,000	$	1,654		$	46,654	$	(579	)	$	1,075
Junior subordinated debentures payable		10,310		1,740			12,050		(609	)		1,131
Interest rate swap on CD		-		312			312		(109	)		203
	$	55,310	$	3,706		$	59,016	$	(1,297	)	$	2,409

Total adjustment								$	2,438		$	(4,532	)
Less transfer from other comprehensive loss to retained earnings									(738	)	$	1,370
Cumulative adjustment of deferred tax asset and equity on adoption of SFAS 159								$	1,700		$	(3,162	)

Following the initial election, changes in the value of financial instruments recorded at fair value are recognized as gains or losses in subsequent financial reporting periods. As a result of the adoption of SFAS No. 159 and changes in the fair value measurement of the financial assets and liabilities noted above, the Corporation recorded a cumulative net gain of $1.1 million ($703 after tax) for the year ended December 31, 2007.

Fair Value Gains (Losses)
PAR VALUE			TOTAL NET INCOME
$	10,000	Interest rate swap	$	57
	45,000	FHLB advances		(70	)
	70,000	Investment securities HFT		518
	10,000	Junior subordinated debentures		576
		Total	$	1,081
		Adjusted for taxes	$	703

Fair values determined by Level 1 inputs utilize quoted prices (unadjusted) in active markets for identical assets or liabilities that the Corporation has the ability to access. Fair values determined by Level 2 inputs utilize inputs other

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollars in thousands, except share amounts)

than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs include quoted prices for similar assets and liabilities in active markets, and inputs other than quoted prices that are observable for the asset or liability, such as interest rates and yield curves that are observable at commonly quoted intervals. Level 3 inputs are unobservable inputs for the asset or liability, and include situations where there is little, if any, market activity for the asset or liability.

Available-for-sale securities are priced using quoted prices (unadjusted) for identical assets in active markets

(Level 1) or through matrix pricing based on securities’ relationship to other benchmark quoted prices (Level 2).

Junior subordinated debentures payable are priced using discounted cash flows to the next available redemption date on the date of valuation based on recent issuances or quotations for comparable bank holding companies and are considered a Level 3 input method. At December 31, 2008, the Corporation had $10.5 million in junior subordinated debentures measured at fair value on a recurring basis.

Fair value adjustments to impaired collateral dependent loans are sometimes recorded to reflect partial write-downs based on the current appraised value of the collateral or internally developed models which contain management’s assumptions.

Fair value adjustments to real estate owned (REO) and other repossessed assets are recorded at the lower of carrying amount of the loan or fair value less selling costs. Any write-downs based on the asset’s fair value at the date of acquisition are charged to the allowance for loan losses. After foreclosure, management periodically performs valuations such that the real estate is carried at the lower of its new cost basis or fair value, net of estimated costs to sell.

The following table presents the balances of assets and liabilities measured at fair value on a recurring basis at December 31, 2008, and the total gains from these fair value adjustments for the year ended December 31, 2008.

	Fair Value at December 31, 2008								Year Ended December 31, 2008
Assets	Level 1		Level 2		Level 3		Total		Total Gains
Available-for-sale securities	$	454	$	123,224	$	-	$	123,678	$	285
Total	$	454	$	123,224	$	-	$	123,678	$	285
Liabilities
Junior subordinated debentures payable	$	-	$	-	$	10,510	$	10,510	$	912
Total	$	-	$	-	$	10,510	$	10,510	$	912

The change in fair market value of the junior subordinated debentures payable is recorded as a component of non-operating income.

The following table presents the balance of assets measured at fair value on a nonrecurring basis at December 31, 2008, and the total impairment resulting from these fair value adjustments for the year ended December 31, 2008.

	Fair Value at December 31, 2008								Year Ended December 31, 2008
Description	Level 1		Level 2		Level 3		Total		Total Impairment
Impaired loans	$	-	$	-	$	83,368	$	83,368	$	2,874
REO and other repossessed assets		-		-		1,446		1,446		-
Total	$	-	$	-	$	84,814	$	84,814	$	2,874

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

Derivative Financial Instruments

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.

An interest rate swap agreement used to hedge junior subordinated debentures payable (trust preferred securities), with a notional amount of $10.0 million was terminated in December 2006 at a loss of $150.

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollars in thousands, except share amounts)

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

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

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. The unrealized (loss) relating to the interest rate swap of $(312) was marked to market as an adjustment to equity with the implementation of SFAS No. 159 effective January 1, 2007. The swap was terminated in April 2007 at a net loss of $4.

Risk management results for the year ended December 31, 2006, 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 $127 and $0 to sell loans into the secondary market at December 31, 2008, and December 31, 2007, respectively.

(17) 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.

(18) Subsequent Event

In January 2009, Cascade was informed by the Washington Public Deposit Protection Commission (WPDPC) that the failure of a bank in Washington State had resulted in a $15.1 million shortfall in deposits held by Washington State municipalities. To prevent losses to public entities, Washington State requires that all financial institutions that receive public deposits must pledge collateral to the WPDPC and participate in a collateral pool established to protect public deposits that are not covered by FDIC insurance or the assets of the failed bank. In February, Cascade was informed by the WPDPC that its share of the shortfall would be $368.

Subsequent to year end the FDIC voted to amend the restoration plan for the Deposit Insurance Fund (DIF). The FDIC took action to ensure the continued strength of the insurance fund by imposing a special assessment on insured institutions of 20 basis points, implementing changes to the risk-based assessment system and setting rates beginning the second quarter of 2009. The Company has not completed a full evaluation of the impact but believes its deposit insurance premium assessments will increase substantially from current levels.

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollars in thousands, except share amounts)

(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, 2008		DECEMBER 31, 2007
Assets:
Cash	$	287	$	267
Investment in subsidiary		185,759		148,267
Other assets		1,292		2,011
	$	187,338	$	150,545
Liabilities and stockholders’ equity:
Other liabilities	$	1,241	$	1,562
Junior subordinated debentures payable		25,975		26,887
Preferred stock		36,616		—
Common stockholders’ equity		123,506		122,096
	$	187,338	$	150,545

INCOME STATEMENT	FOR THE YEARS ENDED DECEMBER 31,
	2008			2007			2006
Equity in undistributed net income of the subsidiary	$	3,071		$	16,745		$	14,836
Interest income – junior subordinated debentures payable		64			64			58
Net gain on fair value of junior subordinated debentures payable		912			576			—
Operating expenses		(366	)		(364	)		(460	)
Interest expense – junior subordinated debentures payable		(2,120	)		(2,120	)		(1,880	)
Income before benefit from income taxes		1,561			14,901			12,554
Benefit from income taxes		529			645			801
Net income	$	2,090		$	15,546		$	13,355

STATEMENT OF CASH FLOWS	FOR THE YEARS ENDED DECEMBER 31,
	2008			2007			2006
Cash flows from operating activities:
Net income	$	2,090		$	15,546		$	13,355
Adjustments to reconcile net income to net cash used in operating activities:
Equity in net income of subsidiaries		(3,071	)		(16,745	)		(14,836	)
Increase (decrease) in other assets		719			(31	)		936
Decrease in other liabilities		(911	)		(629	)		(287	)
Net cash used in operating activities		(1,173	)		(1,859	)		(832	)
Cash flows from investing activities:
Dividends received from subsidiaries		4,600			7,300			4,250
Investment in subsidiary		(38,970	)		—			(10,000	)
Net cash (used in) provided by investing activities		(34,370	)		7,300			(5,750	)
Cash flows from financing activities:
Repurchase of common stock		—			(2,838	)		(673	)
Proceeds from exercise of stock options		387			813			1,050
Dividends paid		(3,794	)		(3,978	)		(3,603	)
Proceeds from preferred stock/warrants		38,970			—			—
Proceeds from junior subordinated debentures payable		—			—			10,000
Net cash provided by (used in) financing activities		35,563			(6,003	)		6,774
Net increase (decrease) in cash and cash equivalents		20			(562	)		192
Cash and cash equivalents:
Beginning of year		267			829			637
End of year	$	287		$	267		$	829

CASCADE FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Dollars in thousands, except share amounts)

(20) Lines of Business

The Corporation and the Bank are managed by a legal entity and not by lines of business. The Bank’s operations include commercial banking services, such as lending activities, deposit products and other cash management services. The performance of the Bank as a whole is reviewed by the Board of Directors and Management Committee.

The Management Committee, which is the senior decision making group of the Bank, is comprised of six members including the President/CEO. Segment information is not necessary to be presented in the notes to the consolidated financial statements because operating decisions are made based on the performance of the Corporation as a whole.

(21) Selected Quarterly Financial Data (Unaudited)

	QUARTER ENDED
	MAR 31,		JUNE 30,		SEPT 30,			DEC 31,
	2008		2008		2008			2008
Interest income	$	23,014	$	22,793	$	24,345		$	22,419
Interest expense		12,539		11,348		11,508			11,291
Net interest income		10,475		11,445		12,837			11,128
Provision for loan losses		2,390		1,200		1,250			2,400
Other income		2,454		2,217		2,323			1,890
Other expense		6,935		7,251		24,500			7,193
Income (loss) before provision for income taxes		3,604		5,211		(10,590	)		3,425
Provision (benefit) for income taxes		990		1,577		(3,971	)		964
Net income (loss)	$	2,614	$	3,634	$	(6,619	)	$	2,461
Dividends on preferred stock		-		-		-			216
Income available for common stock holders	$	2,614	$	3,634	$	(6,619	)	$	2,245
Earnings (loss) per common share, basic	$	0.22	$	0.30	$	(0.55	)	$	0.19
Earnings (loss) per common share, diluted		0.21		0.30		(0.55	)		0.19


	QUARTER ENDED
	MAR 31,		JUNE 30,		SEPT 30,			DEC 31,
	2007		2007		2007			2007
Interest income	$	22,631	$	23,789	$	23,378		$	24,137
Interest expense		12,354		12,798		12,568			12,820
Net interest income		10,277		10,991		10,810			11,317
Provision for loan losses		250		250		350			500
Other income		2,051		1,834		1,942			1,739
Other expense		6,423		6,548		6,724			6,987
Income before provision for income taxes		5,655		6,027		5,678			5,569
Provision for income taxes		1,890		2,044		1,892			1,557
Net income	$	3,765	$	3,983	$	3,786		$	4,012
Earnings per share, basic	$	0.31	$	0.33	$	0.32		$	0.33
Earnings per share, diluted		0.30		0.32		0.31			0.33


	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

ANNUAL SHAREHOLDERS’ MEETING

The Annual Shareholders’ Meeting will be held at the Everett Golf & Country Club, 1500 52nd Street SE, Everett, Washington, on Tuesday, April 28, 2009, at 6:30 p.m. Pacific Time.

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Cascade Financial (CASB) Inactive 10-K2008 FY Annual report

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