FORM 10-K

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

þ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2005.

¨	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission file number 0-25286

CASCADE FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

Washington		91-1661954
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer I.D. Number)

2828 Colby Avenue, Everett, Washington		98201
(Address of principal executive offices)		(Zip Code)

Registrant’s telephone number, including area code:		(425) 339-5500

Securities registered pursuant to Section 12(b) of the Act:		None

Securities registered pursuant to Section 12(g) of the Act:		Common Stock, par value $0.01 per share

Indicate by check mark if the registrant is a well-known seasoned issuer as defined in Rule 405 of the Securities Act.

YES ¨ NO þ

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. YES ¨ NO þ

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨

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

Large Accelerated Filer ¨ Accelerated Filer þ Non-Accelerated Filer ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

YES ¨ NO þ

DOCUMENTS INCORPORATED BY REFERENCE

1.	Portions of Annual Report to Stockholders for the year ended December 31, 2005, including the Selected Financial Data and the Management Discussion and Analysis attached as Exhibit 13 (the “Annual Report”) (Part I, II & IV).

2.	Portions of registrant’s Definitive Proxy Statement for the Annual Meeting of Stockholders (the “Proxy Statement”) (Part III).

Cascade Financial Corporation

FORM 10-K

December 31, 2005

TABLE OF CONTENTS

	PART I	Page

Item 1.	Description of Business	4
	Loan Portfolio	6
	Asset and Liability Management Activities	14
	Investment Portfolio	16
	Deposits	17
	Return on Equity and Assets	18
	Borrowings	18
	Regulation	19
	Taxation	24
Item 1A.	Risk Factors	25
Item 1B.	Unresolved Staff Comments	26
Item 2.	Properties	26
Item 3.	Legal Proceedings	27
Item 4.	Submission of Matters to a Vote of Security Holders	27

	PART II

Item 5.	Market for Registrant’s Common Equity and Related Stockholder Matters	28
Item 6.	Selected Financial Data	29
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	29
Item 7A.	Quantitative and Qualitative Disclosures About Market Risk	29
Item 8.	Financial Statements and Supplementary Data	29
Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
Item 9A.	Controls and Procedures	29
Item 9B.	Other Information	30

	PART III

Item 10.	Directors and Executive Officers of the Registrant	31
Item 11.	Executive Compensation	32
Item 12.	Security Ownership of Certain Beneficial Owners and Management and related Stockholder Matters
Item 13.	Certain Relationships and Related Transactions	32
Item 14.	Principal Accountant Fees and Services	32

	PART IV

Item 15.	Exhibits and Financial Statement Schedules	33

FORWARD LOOKING STATEMENTS

In addition to historical information, this Form 10-K contains certain "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995 ("PSLRA"). This statement is included for the express purpose of availing Cascade Financial Corporation of the protections of the safe harbor provisions of the PSLRA. The forward-looking statements contained herein are subject to factors, risks, and uncertainties that may cause actual results to differ materially from those projected.

The following items are among the factors that could cause actual results to differ materially from the forward-looking statements: higher than expected loan delinquency rates; general economic conditions, including their impact on capital expenditures; business conditions in the banking industry; recent world events and their impact on interest rates, businesses and customers; the regulatory environment; new legislation; vendor quality and efficiency; employee retention factors; rapidly changing technology and evolving banking industry standards; competitive standards; competitive factors, including increased competition with community, regional, and national financial institutions; fluctuating interest rate environments; and similar matters. Readers are cautioned not to place undue reliance on these forward-looking statements, which reflect management's analysis only at the date of the statement. The Corporation undertakes no obligation to publicly revise or update these forward-looking statements to reflect events or circumstances that arise after the date of this report. Readers should carefully review the risk factors described in this and other documents the Corporation files from time to time with the Securities and Exchange Commission. There can be no assurance that any of the strategies described in this Form 10-K will be implemented, or if implemented, achieve the amounts described or within the time periods currently estimated. Sentences containing words such as “may,” “will,” “expect,” “anticipate,” “believe,” “estimate,” “should,” “projected,” or similar words may constitute such forward-looking statements.

Item 1. Description of Business

General

Cascade Financial Corporation (the “Corporation”) is a bank holding company incorporated in the state of Washington that was formed in 1994. The consolidated entity includes the Corporation and its wholly owned subsidiaries. At December 31, 2005, the Corporation’s wholly-owned subsidiaries were Cascade Bank (“Cascade” or the “Bank”), Cascade Capital Trust I and Capital Trust II. The executive offices of the Corporation are located at 2828 Colby Avenue, Everett, Washington 98201. The telephone number is (425) 339-5500 and the web site is www.CascadeBank.com. Information on the website is not part of this Report.

The Bank has been serving the people of Snohomish and King Counties since 1916 when it was organized as a mutual savings and loan association. On September 15, 1992, the Bank completed its conversion from a federal mutual to a federal stock savings bank. In July 2001, the Bank converted from a federal stock savings bank to a Washington state commercial bank.

The Corporation was organized on August 18, 1994, for the purpose of becoming the holding company for Cascade Bank. The reorganization was completed on November 30, 1994, on which date the Bank became the wholly-owned subsidiary of the Corporation, and the stockholders of the Bank became stockholders of the Corporation. Subsequent to the acquisition of Cascade, the primary activity of the Corporation has been holding the stock of the Bank. Accordingly, the information set forth in this report, including financial statements and related data, relates primarily to the Bank.

In July of 2001, the Corporation elected to be treated as a financial holding company under the supervision of the Federal Reserve Board. In May of 2003, the Corporation transferred its state of domicile from Delaware, which it had maintained since its formation as a holding company in 1994, to Washington. Following this conversion, the Corporation changed its fiscal year end from June 30 to December 31 to align its reporting period with those of its commercial bank peers.

In June of 2004, the Corporation completed the acquisition of Issaquah Bancshares (“Issaquah”). Issaquah Bank, the only operating subsidiary of Issaquah, was merged into Cascade Bank.

The Corporation conducts its business from its main office in Everett, Washington, and eighteen other full service offices in the greater Puget Sound region. At December 31, 2005, the Corporation had total assets of $1.2 billion, total deposits of $795.8 million and stockholders’ equity of $105.2 million.

The Bank, a full-service commercial bank, offers a wide range of products and services. The deposits of the Bank are insured by the Federal Deposit Insurance Corporation (“FDIC”), up to the limits specified by law.

Market Area

Headquartered in Everett, Washington, the Corporation serves its customers from nineteen full service offices, twelve in Snohomish County and seven in King County. Located in the center of the western Washington region, Snohomish and King counties have experienced significant growth in recent years. The rebound in commercial aircraft orders and the success of Boeing’s new 787 has helped fuel an increase in economic activity in Snohomish County.

Our market area in King County includes the growing cities east of Seattle and Lake Washington. This area’s economy has been dominated by Microsoft and the Boeing Company, with other high technology companies playing an important role. The housing market has been particularly strong due to population growth in the region and the lack of affordable housing within Seattle itself.

Everett is the home port of the Navy’s carrier battle ship, the USS Abraham Lincoln. The contribution that the Navy makes to the economy is not as dependent on other trends. The economy in the Corporation’s market area has become more dependent upon the health care and biotechnology industries. Snohomish County and Northeast King County are home to numerous biotechnology companies.

As a gateway to Asia, the Bank’s market area has also benefited from the expansion of world trade. Economic weakness in either the United States or Asia could reduce that trade. Such slowdowns in the international flow of goods and services could prove detrimental to the economy of the market area and potentially the quality of our loan portfolios.

Business Strategy

The Corporation’s business plan is to increase the Bank’s emphasis on commercial banking. The Corporation is pursuing the following strategies:

·	Increasing the percentage of its assets consisting of business, construction, and commercial real estate loans with higher risk-adjusted returns, shorter maturities and rates more sensitive to interest rate fluctuations.

·	Increasing deposits by attracting lower cost transaction accounts (such as checking, savings and money market accounts) through an enhanced branch network, customer service center and online banking.

·	Maintaining cost-effective operations by efficiently offering products and services.

·	Maintaining its capital position at or above the “well-capitalized” (as defined for regulatory purposes) level.

·	Exploring prudent means to grow the business internally and through acquisitions.

·	Diligently searching for additional sources of fee-based revenue.

The primary objectives of these strategies are to: enhance shareholder value measured through increasing returns, and to increase the opportunity for quality earning asset growth, deposit generation, and fee-based income activities. However, the shift in emphasis to commercial banking does inherently contain additional risks (See “LOAN PORTFOLIO” below).

Competition

The Bank competes for both loans and deposits. The Puget Sound metropolitan area has a high density of financial institutions, including major national banks, several local community banks, and credit unions.

The Bank’s primary focus for loans is small to medium sized businesses, builders and developers, and real estate investors in the Puget Sound area. The major competitors for the Bank are large commercial and community banks. The large banks often compete on the basis of competitive pricing, while the community banks compete on the basis of local decision-making, loan structuring flexibility, and promises of a higher level of service.

The Bank’s competitors for residential loans and consumer business are numerous, including banks, mortgage bankers, captive finance subsidiaries of auto companies, etc. Cascade has made a conscious decision to de-emphasize consumer lending in that intense competition has led to very low margins combined with relatively high credit risk.

Geographic location is still the primary factor in choosing a bank for the checking account relationship. As a result, the Bank’s competition for checking deposits comes primarily from the large institutions with a broad network of locations. Online banking continues to be an important convenience service to attract checking customers from larger banks. In addition, Cascade has made an arrangement with US Bank to allow customers to use US Bank ATMs without a surcharge. Community banks, savings institutions, as well as other non-banking financial institutions, provide the greatest competition for the various savings vehicles such as money market deposit accounts and certificates of deposit.

In addition to competition from other banking institutions, the Bank continues to experience increased competition from non-banking companies such as credit unions, financial services companies and brokerage firms. Recent amendments to the federal banking laws to eliminate certain barriers between banking and commercial firms are expected to result in even greater competition in the future.

The Corporation anticipates continuing opportunities to arise from the effects of substantial consolidation among financial institutions in Washington that has occurred to date. Federal law allows mergers or other combinations, relocations of a bank’s main office and branching across state lines. Several other financial institutions, which have greater resources than the Bank, compete for banking business in the Bank’s market area. Among the advantages of some of these institutions are their ability to make larger loans, finance extensive advertising and promotion campaigns, access international money markets and allocate their investment assets to regions of highest yield and demand.

LOAN PORTFOLIO

General. The Bank originates business, real estate and consumer loans. Total loans, which are net of loan in process, equaled $880.7 million at December 31, 2005. Total loans were adjusted by deferred loan fees and the allowance for loan losses for a net loan balance of $867.0 million. At December 31, 2005, $394.0 million or 44.8% of total loans consisted of business loans; $166.0 million or 18.8% were real estate construction loans; $141.1 million or 16.0% of loans consisted of commercial real estate; $32.2 million or 3.7% were consumer loans; $95.4 million or 10.8% of the Bank’s loans consisted of loans secured by one-to-four family residential properties; and $52.1 million or 5.9% consisted of multifamily loans. Total loans secured by first liens on residential real estate was $147.5 million or 16.8% of total loans. The Bank sells almost all its 30 year fixed-rate loans and the vast majority of its 15 year fixed-rate loans in the secondary mortgage market. The Bank had non-mandatory forward commitments totaling $157,000 and $784,000 to sell loans into the secondary market at December 31, 2005, and December 31, 2004, respectively.

Loan Portfolio Analysis. The following table sets forth the Bank’s loan portfolio by type of loan and by type of collateral at the dates indicated.

						At December 31,
	2005					2004					2003
	Amount		Percent			Amount		Percent			Amount		Percent
Type of Loan						(Dollars in thousands)
Real estate mortgage
One-to-four family ⁽¹⁾	$	95,429		10.83	%	$	105,975		13.14	%	$	105,565		18.3	%
Multifamily		52,057		5.91			92,372		11.45			87,212		15.12
Commercial		141,109		16.02			178,704		22.15			83,856		14.53
Construction		165,957		18.84			107,431		13.32			62,742		10.87
Business		394,034		44.75			292,117		36.21			204,446		35.43
Consumer ⁽²⁾		32,160		3.65			30,125		3.73			33,163		5.75
Total loans	$	880,746		100.00	%	$	806,724		100.00	%	$	576,984		100.00	%
Less:
Deferred loan fees, net		3,443					2,695					2,179
Allowance for loan losses		10,254					9,563					7,711
Total loans, net	$	867,049				$	794,466				$	567,094

Type of Collateral
Real estate mortgage
One-to-four family ⁽²⁾	$	279,652		31.76	%	$	231,504		28.7	%	$	190,168		32.96	%
Multifamily		52,057		5.91			92,372		11.45			87,212		15.12
Commercial		141,109		16.02			178,704		22.15			83,856		14.53
Land loans		6,007		0.68			3,546		0.44			1,786		0.31
Other		401,921		45.63			300,598		37.26			213,962		37.08
Total loans	$	880,746		100.00	%		806,724		100.00	%		576,984		100.00	%
Less:
Deferred loan fees, net		3,443					2,695					2,179
Allowance for loan losses		10,254					9,563					7,711
Total loans, net	$	867,049				$	794,466				$	567,094

	At December 31,
	2002					2001
	Amount		Percent			Amount		Percent
	(Dollars in thousands)
Type of Loan
Real estate mortgage
One-to-four family ⁽¹⁾	$	122,561		22.04	%	$	152,727		26.1	%
Multifamily		94,245		16.96			109,733		18.76
Commercial		63,108		11.36			62,938		10.76
Construction		84,229		15.16			75,911		12.98
Business		142,273		25.6			125,342		21.42
Consumer ⁽²⁾		49,331		8.88			58,381		9.98
Total loans	$	555,747		100.00	%	$	585,032		100.00	%
Less:
Deferred loan fees, net		2,198					2,502
Allowance for loan losses		6,872					6,304
Total loans, net	$	546,677				$	576,226

		At December 31,
			2002				2001
	Amount			Percent			Amount	Percent
		(Dollars in thousands)
Type of Collateral
Real estate mortgage
One-to-four family ⁽²⁾		$	241,805	43.5	%	$	267,721	45.75	%
Multifamily			94,245	16.96			109,733	18.76
Commercial			63,108	11.36			62,938	10.76
Land loans			1,720	0.31			2,546	0.44
Other			154,869	27.87			142,094	24.29
Total loans		$	555,747	100.00	%	$	585,032	100.00	%
Less:
Deferred loan fees, net			2,198				2,502
Allowance for loan losses			6,872				6,304
Total loans, net		$	546,677			$	576,226

⁽¹⁾ Includes construction loans converted to permanent loans and land loans.

⁽²⁾ Includes home equity loans and HELOCs.

At December 31, 2005, deferred fees were $3.4 million and the allowance for loan losses was $10.3 million.

Business Loans. Business loans increased from $292.1 million at December 31, 2004, to $394.0 million at December 31, 2005. Unsecured business loans totaled $13.2 million at December 31, 2005, compared to $11.5 million as of December 31, 2004. The Bank’s business loan portfolio consists primarily of commercial business loans to small and medium sized businesses operating in Snohomish and King counties. These loans are secured by real estate, receivables, equipment, other assets of the business and personal property, and the personal guarantee of the borrower. These loans typically have variable-rate terms or fixed-rates with maturities of up to five years. The Bank also offers secured and unsecured operating lines of credit. Business loans are underwritten by the Bank on the basis of the borrower's cash flow, ability to service debt from earnings, and the underlying collateral value. The borrower is generally required to provide the Bank with financial statements, tax returns, current financial information on any and all guarantors, and other reports that show trends in their financial condition; and to update this information annually. Business loans also include owner occupied real estate loans with terms comparable to the Bank’s commercial real estate loans. In addition, as the business banking activity increases, the Bank expects to expand its lower cost deposit franchise through the growth of commercial checking as a source of funding.

Business loans are inherently sensitive to conditions in the economy. The collateral securing other loans may depreciate over time, may be difficult to appraise and may fluctuate in value based on the success of the business. In the case of loans secured by accounts receivable, the availability of funds for the repayment of such loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers. Accordingly, the repayment of a business loan depends primarily on the successful operation of the borrower's business and creditworthiness of the borrower (and any guarantors), while liquidation of collateral is a secondary and potentially insufficient source of repayment.

Construction Loans. The Bank originates construction loans on one-to-four family homes either to borrowers as custom construction loans or to builders as speculative construction loans. Construction loans generally have maturities of 12-18 months. The interest rates charged on construction loans are typically indexed to the prime rate and vary depending on the characteristics of the loan, particularly the credit risk inherent in the project and/or the financial strength of the borrower. All construction loans require approval by various levels of Bank personnel, depending on the size of the loan. The Bank has increased its construction loan portfolio because these loans have relatively high margins, floating interest rates and short-term maturities. The historically strong housing market in the Puget Sound area has made construction lending attractive. At December 31, 2005, and December 31, 2004, the Corporation’s construction loans were $166.0 million or 18.8% of the total loan portfolio and $107.4 million or 13.3% of the total loan portfolio, respectively. The construction loans are net of loans in process of $86.7 million at December 31, 2005 and $49.7 million at December 31, 2004. Of the total net construction loans, $161.0 million was to builders and developers, including $42.3 million for land acquisition and development, and $5.0 million was to individuals for custom home construction. The strength of the local housing market led to a rapid turnover in this portfolio as builders were able to quickly sell new homes. The Bank’s maximum outstanding commitment to one builder at December 31, 2005 totaled $18.8 million involving five construction projects, all of which are performing in accordance with their respective loan terms.

Construction loans often involve higher credit risks because loan funds are advanced upon the security of the project under construction that is of uncertain value before completion. The Bank’s risk of loss on a construction loan is dependent largely upon the accuracy of the initial estimate of the property’s value at completion of construction or development and the estimated cost (including interest) of the construction. If the estimate of construction costs proves to be inaccurate, the Bank may be required to advance additional funds to complete the development. If upon completion of the project, the estimate of the marketability of the property is inaccurate, the borrower may be unable to sell the completed project in a timely manner or obtain adequate proceeds to repay the loan. Delays may arise from labor problems, material shortages and other unpredictable contingencies in completing the project. Furthermore, if the estimate of value of a completed project is inaccurate, the Bank may be confronted with a project with a value that is insufficient to assure full repayment. As a result, these loans may involve the disbursement of substantial funds with repayment dependent, in part, on the success of the ultimate project rather than the ability of the borrower or guarantor to repay principal and interest.

Commercial Real Estate Loans. Commercial real estate loans totaled $141.1 million or 16.0% of the Bank’s total loans at December 31, 2005, compared to $178.7 million or 22.2% of the portfolio at December 31, 2004. A major reason for the drop in commercial real estate loans during the year was the reclassification of $35 million in loans acquired in the merger with Issaquah in June 2004. These loans were initially classified as commercial real estate but were reclassified as business banking loans. All commercial real estate loans are secured by properties in western Washington, mainly in the Puget Sound region. Improved property including office buildings and small commercial business properties, such as strip shopping centers, secure the Bank’s commercial real estate loans. These loans are primarily fixed-rate with a maximum reset on the interest rate of five years. At December 31, 2005, the largest commercial real estate loan in the Bank’s portfolio was $11.3 million, which was performing according to its terms at that date.

Commercial real estate loans are also sensitive to local economic conditions. An economic recession can lead to increased vacancies that would lower the borrower’s ability to service the debt. Commercial real estate loans also have a degree of interest rate risk in that if rates fall borrowers may refinance, if rates rise the Bank could experience a squeeze on net interest margin if the Bank does not properly fund these loans, which often have a fixed-rate for the initial five years of the loan.

Multifamily Loans. Multifamily loans totaled $52.1 million or 5.9% of the total loan portfolio at December 31, 2005. The multifamily portfolio is principally comprised of small to medium-size apartment projects with loan-to-value ratios usually up to 75%. All new loan originations are in the Puget Sound region and have adjustable interest rates.

Multifamily residential and commercial real estate lending affords the Bank an opportunity to receive interest at rates higher than those generally available from one-to-four family mortgage loans. However, loans secured by such properties usually are greater in amount and may involve a greater degree of risk than one-to-four family residential mortgage loans. Because payments on loans secured by multifamily residential and commercial properties are often dependent on the successful operation and management of the properties, repayment of such loans may be affected by adverse conditions in the real estate market or the economy. In addition, the low interest rate environment and robust housing market has induced many erstwhile renters to purchase houses. This has led to higher vacancy rates in some areas.

One-to-Four Family Residential Loans. At December 31, 2005, residential loans totaled $95.5 million or 10.8% of the total loan portfolio. Residential lending consists primarily of first mortgage loans secured by single-family residential properties located principally in Snohomish and King Counties. The Bank originates both fixed-rate and adjustable-rate mortgages (“ARMs”) with maturities up to 30 years. ARM loans are generally held in the Bank’s portfolio. Newly originated ARMs have interest rates that adjust based on the One Year Constant Maturity Treasury Index after an initial fixed-rate period. Borrower demand for ARMs versus fixed-rate mortgage loans is a function of the level of interest rates, the shape of the yield curve, and the differences between the interest rates and loan fees offered for fixed-rate mortgage loans and the rates and loan fees for ARMs.

Fixed-rate residential loans are generally sold and the servicing released to one of the Bank’s correspondents. The loans are sold on a “best efforts” basis. The Bank no longer packages its loans to sell as mortgage backed securities. The Bank had $539,000 in loans held for sale at December 31, 2005, and no loans held for sale at December 31, 2004. Loans held for sale are not material and therefore the Bank does not include them as a separate line item on the balance sheet. The Bank has greatly reduced its emphasis on mortgage banking and mortgage lending in the past five years.

The Bank’s conforming residential loans meet the Federal Home Loan Mortgage Corporation's underwriting standards with respect to credit, borrower debt ratios and documentation. The Bank’s nonconforming residential loans are those that do not conform to agency underwriting guidelines, due to the size of the loan, as a result of credit histories, debt-to-income ratios, reliance on the borrower's stated income, non-owner occupied property, rural property, or other exceptions from agency guidelines.

Consumer Loans. The Bank’s consumer loan activities take two forms: home equity loans or lines of credit, and installment loans. Home equity loans are secured by a junior lien in priority on the borrower's home. Such loans may have a combined loan-to-value ratio of up to 90% of the value of the home securing the loan. Home equity loans are fixed amount loans, which may have fixed or floating interest rates. Home equity lines of credit can be drawn upon at any time by the customer up to a specific amount. These loans are at a floating-rate with a floor on that rate. The balance outstanding for both types of home equity loans increased to $24.3 million at December 31, 2005, as compared to $21.6 million at December 31, 2004. At December 31, 2005 and December 31, 2004, the total amount of unused lines of credit were $22.6 million and $22.7 million, respectively. The second category of consumer loans are installment loans in which boats, automobiles, and recreational vehicles serve as collateral. This portfolio was $7.9 million at December 31, 2005, as compared to $8.5 million outstanding at December 31, 2004. Although boat loans total $2.8 million of the Bank’s installment loans at December 31, 2005, the Bank has significantly decreased its origination of boat loans and expects this amount to decline further in the future. Since installment loans are secured by depreciating assets, any repossessed collateral for a defaulted loan may not provide an adequate source of repayment of the outstanding loan balance. The remaining deficiency often does not warrant further substantial collection efforts against the borrower. Consumer loan collections are dependent on the borrower’s continuing financial ability, and are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy.

The Loan Maturity Table

The following table sets forth information at December 31, 2005 regarding the dollar amount of loans maturing in the Bank’s portfolio based on their contractual terms to maturity, but does not include scheduled payments or potential prepayments. Loan balances do not include deferred loan fees. Construction loans are net of loans in process.

		Due in one year or less		Due in one to five years		Due after five years		Total		With variable or adjustable rate (for maturities of more than one year)		With fixed rate (for maturities of more than one year)
	(Dollars in thousands)
Business	$	70,241	$	133,360	$	190,433	$	394,034	$	130,642	$	193,151
Construction		63,861		84,580		17,516		165,957		101,873		223
Commercial Real Estate		1,166		11,448		128,495		141,109		126,451		13,492
Multifamily		-		2,199		49,858		52,057		49,276		2,781
Home Equity/Consumer		3,243		1,211		27,706		32,160		20,964		7,953
Residential		577		5,252		89,600		95,429		83,977		10,786

Asset Quality

Banking regulations require that each insured institution review and classify its assets regularly. In addition, bank examiners have the authority to identify problem assets and, if appropriate, require them to be adversely classified. There are three classifications for problem assets: substandard, doubtful and loss. Substandard assets must have one or more defined weaknesses and are characterized by the distinct possibility that the insured institution will sustain some loss if the deficiencies are not corrected. Doubtful assets have sufficient weaknesses that make collection or payment in full, based on currently existing facts, conditions and values, questionable. There is a high possibility of loss. An asset classified “loss” is considered uncollectible and of such little value that its continuance as an asset of the institution is not warranted. Assets classified as “substandard” or “doubtful” require the institution to establish general allowances for loan losses. If an asset, or portion thereof, is classified loss, the insured institution must either establish specific allowances for loan losses in the amount of 100% of the portion of the asset classified loss or charge-off such amounts. The Bank uses two other asset classification categories for potential problem loans. They are watch and special mention. Borrowers with declining earnings, strained cash flow, increasing leverage and/or weakening market fundamentals that indicate above average risk are classified as watch. Loans on special mention represent borrowers who exhibit potential credit weaknesses or trends deserving bank management’s close attention.

Cascade established the Credit Administration Division in 2001, to help assure that the Bank maintains the quality of its loan portfolio. Management has comprehensive monthly and annual review procedures for identifying and classifying assets for weaknesses. Reserves are maintained for assets classified as substandard or doubtful. The objective of these review procedures is to identify any trends and determine the levels of loss exposure to evaluate the need for an adjustment to the reserve accounts.

Delinquencies. A report containing delinquencies of all loans is reviewed monthly by the Asset Review Committee and periodically by the Board of Directors. Procedures taken with respect to delinquent loans differ depending on the particular circumstances of each loan. The Bank’s general procedures provide that when a loan becomes delinquent, the borrower is contacted, usually by phone, within 15 to 30 days. When the loan is over 30 days delinquent, the borrower is usually contacted in writing. Typically, the Bank will initiate foreclosure or other corrective action against the borrower when principal and interest become 90 days or more delinquent. In any event, interest income is reduced by the full amount of accrued and uncollected interest on loans once they become 90 days delinquent, go into foreclosure or are otherwise determined to be uncollectible. Once interest has been paid to date or management considers the loan fully collectable, it is returned to accrual status. An allowance for loss is established when, in the opinion of management, the fair value less sales costs of the property collateralizing the loan is less than the outstanding principal and the collectibility of the loan’s principal becomes uncertain. It is intended that the Bank’s allowance for loan losses be adequate to cover known potential and reasonably estimated unknown losses. At December 31, 2005 and December 31, 2004, the Bank had $2.0 million and $532,000, respectively, of loans accounted for on a non-accrual basis.

Allowance for Loan Losses/Non-Performing Assets

Management provides for possible loan losses by maintaining an allowance. The level of the allowance is determined based upon judgments regarding the size and nature of the loan portfolio, historical loss experience, the financial condition of borrowers, the level of non-performing loans, and anticipated general economic conditions. Additions to the allowance are charged to expense. Loans are charged against the allowance when management believes the collection of principal is unlikely. Increases in the allowance for loan losses made through provisions were primarily a result of loan growth, awareness of the greater risk inherent in business lending and the impact of the economic climate on the loan portfolio.

Management measures the reasonableness of the allowance for loan losses by utilizing a loan grading system to determine risk in the loan portfolio and by considering the results of credit reviews. The loan portfolio is separated by quality and then by loan type. Loans of acceptable quality are evaluated as a group, by loan type, with a loss rate assigned to the total loans in each type, but unallocated to any individual loan. Adversely classified loans may be individually analyzed to determine an estimated loss amount. A loss rate is also assigned to these adversely classified loans, but at a higher rate due to the greater risk of loss. Past due and impaired loans are actively managed to minimize the potential loss. Although management has allocated a portion of the allowance to the loan categories using the method described above, the adequacy of the allowance must be considered as a whole. Loan concentrations, quality, terms, and basic underlying assumptions remained substantially unchanged during the period.

The following table presents information with respect to the Bank’s non-performing assets and restructured loans at the dates indicated.

	December 31,
	2005			2004			2003
	(Dollars in thousands)
Non-performing loans:
Commercial loans
Business	$	958		$	—		$	128
Commercial real estate		842			488			—
		1,800			488			128
Residential		187			34			1,704
Consumer loans		—			10			89
Total non-performing loans		1,987			532			1,921
Other real estate and repossessed assets		101			868			474
Total non-performing assets	$	2,088		$	1,400		$	2,395
Restructured loans	$	1,467		$	95		$	3,467
Total non-performing loans to net loans		.23	%		.07	%		.34	%
Total non-performing loans to total assets		.16			.05			.22
Total non-performing assets to total assets		.17			.13			.27

The Bank’s non-performing assets at December 31, 2005, consisting of non-performing loans and other real estate, totaled $2.1 million or 0.17% of total assets. This is an increase from $1.4 million or 0.13% of total assets at December 31, 2004, and a decrease from $2.4 million or 0.27% of total assets at December 31, 2003.

Loans are generally placed on non-accrual when they become past due over 90 days or when the collection of interest or principal is considered unlikely. Loans past due over 90 or 120 days, that are not on non-accrual status, must be well secured by tangible collateral and in the process of collection. The Bank does not return a loan to accrual status until it is brought current with respect to both principal and interest and future principal and interest payments are no longer in doubt.

Non-performing loans increased to $2.0 million at December 31, 2005, compared to $532,000 at December 31, 2004, and $1.9 million at December 31, 2003. The increase in non-performing loans from December 31, 2004, to December 31, 2005 is due to increases in non-performing commercial loans. Management believes that the allowance for losses on loans is adequate to provide for losses that may be incurred on non-performing loans.

Other real estate owned includes property acquired by the Bank through foreclosure. Other real estate is carried at the lower of the estimated fair value or the principal balance of the foreclosed loans. Non-performing other real estate was $0 at December 31, 2005, $868,000 at December 31, 2004, and $474,000 at December 31, 2003. At December 31, 2005, the Bank owned two repossessed boats totaling $101,000.

Interest income that would have been recognized for the years ended December 31, 2005, December 31, 2004, and December 31, 2003, had non-accrual loans been current in accordance with their contractual terms, amounted to $81,500, $2,000, and $90,000, respectively.

The following tables set forth information regarding changes in the Bank’s allowance for loan losses for the most recent three years (dollars in thousands).

	Years Ended December 31,
	2005			2004			2003
Balance at beginning of period	$	9,563		$	7,711		$	6,872
Issaquah Bank balance at June 2004		—			1,395			—
Charge-Offs
Business		1			310			295
Commercial Real Estate		—			—			95
Single-Family Residential		116			34			59
Consumer and other		403			97			302
Recoveries:		(266	)		(223	)		(315	)
Net charge-offs (recoveries):		254			218			436
Provision for loan losses		945			675			1,275
Balance at end of period		10,254			9,563			7,711
Average loans outstanding	$	854,684		$	691,372		$	565,453

Ratio of net charge-offs during the period to average loans outstanding		.03	%		.03	%		.08	%

Ratio of allowance for loan losses to average loans outstanding		1.20			1.38			1.36

A material estimate that is particularly susceptible to significant change relates to the determination of the allowance for losses on loans and the valuation of real estate acquired in connection with foreclosures or in satisfaction of loans. In connection with the determination of the estimated losses on loans and foreclosed assets held for sale, management obtains independent appraisals for significant properties.

While management uses available information to recognize losses on loans, further reductions in the carrying amounts of loans may be necessary based on changes in local economic conditions. In addition, regulatory agencies, as an integral part of their examination process, periodically review the estimated losses on loans. Such agencies may require the Bank to recognize additional losses based on their judgment about information available to them at the time of their examination.

Certain loans may meet the criteria of troubled debt restructuring as defined in Statement of Financial Accounting Standards (“SFAS”) No. 114 and No. 118, “Accounting by Creditors for Impairment of a Loan,” and “Accounting by Creditors for Impairment of a Loan-Income Recognition and Disclosures,” respectively.

The following tables set forth information concerning the Bank’s allocation of the allowance for loan losses and the percentage of loans by category at the dates indicated (dollars in thousands).

	December 31,
	2005					2004					2003
	Amount		%*			Amount		%*			Amount		%*
Business	$	5,773		44.75	%	$	4,181		36.21	%	$	2,833		35.43	%
Commercial Real Estate		3,020		16.02			583		22.15			787		14.53
Single-Family Residential		337		10.83			432		13.14			745		18.3
Multifamily		275		5.91			616		11.45			245		15.12
Real Estate Construction		543		18.84			1,295		13.32			642		10.87
Consumer and Other		306		3.65			513		3.73			444		5.75
Unallocated		—		—			1,943		—			2,015		—
Total allowance for loan losses	$	10,254		100.00	%	$	9,563		100.00	%	$	7,711		100.00	%

* Percent of loans in each category to total loans.

The provision for loan losses for the year ended December 31, 2005, totaled $945,000 compared to $675,000 for the year ended December 31, 2004, and $1,275,000 for the year ended December 31, 2003. The increase in the provision for loan losses for the twelve month period ended December 31, 2005, was due to the increase in actual adversely classified loans (which includes the substandard and doubtful categories) under the Bank’s loan classification system. Adversely classified loans increased to $18.0 million at December 31, 2005, from $9.3 million at December 31, 2004.

ASSET AND LIABILITY MANAGEMENT ACTIVITIES

The Bank’s asset/liability management activity is the responsibility of the Asset/Liability Management Committee (ALCO) to measure and monitor interest rate risk, liquidity, and capital adequacy. The Bank uses a variety of tools to measure, monitor, and manage interest rate risk. The Audit and Finance Committee of the Board of Directors reviews the interest rate risk management activities of the Bank on a regular basis and has established policies and guidelines on the amount of risk deemed appropriate. The Bank’s net interest income and the fair value of its capital are measured under different interest rate scenarios. The Board, through the Asset/Liability Management Policy, has established targets for maximum negative impact that changes in interest rates have on the Bank’s net interest income, the fair value of equity and adjusted capital/asset ratios under certain interest rate shock scenarios. Cascade uses a simulation model to measure rate risk and the impact on net interest income, the fair value of equity, and the fair value capital/asset ratio. In general, the Bank seeks to manage its rate risk through its balance sheet. The Bank focuses on originating more interest rate sensitive assets, such as floating-rate loans, while reducing its long-term, fixed-rate assets through the sale of long-term residential mortgages in the secondary market. The vast majority of the loans that the Bank keeps in its portfolio have rate repricing periods of five years or less. The Bank often uses FHLB advances to fund its intermediate term assets. Cascade also uses repurchase agreements to provide inexpensive funding.

Using standard interest rate shock methodology (an instantaneous uniform change in interest rates at all maturities), the Bank is well within the guidelines established by the Board of Directors for the changes in fair value of equity and the adjusted capital/asset ratios. The Bank’s fair value of equity decreases 20.8% in an up 200 bp shock scenario and decreases 5.0% in a down 200 bp shock, within the established guideline of a maximum 30% decline. The adjusted capital/asset ratio is 8.4% in the up 200 bp scenario and 9.6% in the down 200 bp scenario, both above the 5% minimum established guideline. The net interest income decreases 1.0% in the up 200 bp scenario. In the down 200 bp shock scenario, the Bank’s net income increases 0.4%, well within the guideline of a 10% decline.

To manage the rate risk in the investment portfolio, limits have been established on the final maturity of securities and limits have been initiated on the price volatility of mortgage-backed securities (MBS) (including collateralized mortgage obligations (CMOs)). Additionally, the Bank extends the maturities of its liabilities by offering long-term deposit products to customers, and obtaining longer term FHLB advances. As of December 31, 2005, $231 million of the $236 million in advances had original maturities greater than one year and $213 million have remaining maturities greater than one year.

The Bank has used interest rate swaps and has used caps and floors in the past to control the amount of its interest rate risk. During the third quarter of 2004, the Bank implemented two $25 million interest rate swaps to reduce its exposure to increasing interest rates. The first of these swaps was a 5 year pay-fixed instrument used as a cash flow hedge to offset increases in LIBOR in a $25 million FHLB advance. The second swap was a 10 year, pay-fixed instrument, originally accounted for as a fair value hedge to offset changes in value of $26 million of the Bank’s available-for-sale investment portfolio. Both of these swaps were terminated in March 2005 as the Bank sought less costly vehicles to mitigate its interest rate risk.

Another major component of asset/liability management is liquidity management. The Board of Directors has also established liquidity parameters that seek to assure that the Bank will have sufficient liquidity to meet all its customer needs for funding and/or deposit withdrawals. Liquidity levels are monitored by the ALCO with liquidity analysis reports presented to the Board on a regular basis. The ALCO also monitors and reports to the Board on the capital position of the Bank and the Corporation. Both seek to remain “well-capitalized” under FDIC and Federal Reserve guidelines.

The balance sheets and the section of Management’s Discussion and Analysis titled “Average Balances and an Analysis of Average Rates Earned and Paid” contained in the Annual Report are incorporated herein by reference.

Rate/Volume Analysis. The following table sets forth the effects of changing rates and volumes on net interest income of the Bank. Information is provided with respect to (i) effects on interest income attributable to changes in volume (changes in volume multiplied by prior rate); (ii) effects on interest income attributable to changes in rate (changes in rate multiplied by prior volume); and (iii) changes in rate/volume mix (change in rate multiplied by change in volume).

	Year Ended December 31,												Year Ended December 31,
	2005 Compared to Year Ended December 31, 2004 Increase (Decrease) Due to												2004 Compared to Year Ended December 31, 2003 Increase (Decrease) Due to
	(Dollars in thousands)
	Rate			Volume			Mix			Net			Rate			Volume			Mix			Net
Interest-earning assets
Single-family loans ⁽¹⁾	$	(258	)	$	(82	)	$	3		$	(337	)	$	(873	)	$	(406	)	$	48		$	(1,231	)
Multifamily loans ⁽¹⁾		172			(1,071	)		(31	)		(930	)		(733	)		317			(37	)		(453	)
Commercial real estate loans ⁽¹⁾		193			2,808			69			3,070			(521	)		3,456			(340	)		2,595
Construction loans ⁽¹⁾		1,168			2,854			598			4,620			393			632			55			1,080
Consumer loans ⁽¹⁾		4			(47	)		—			(43	)		—			(533	)		—			(533	)
Business loans ⁽¹⁾		641			6,115			238			6,994			48