The earnings of financial institutions, such as the Bank, are significantly affected by prevailing economic and competitive conditions, particularly changes in interest rates, government monetary and fiscal policies and regulations of various regulatory authorities. Lending activities are influenced by the demand for and supply of single family and commercial properties, competition among lenders, the level of interest rates and the availability of funds. Deposit flows and costs of deposits are influenced by prevailing market rates of interest on competing investments, account maturities and the levels of personal income and savings. The interest rates charged by the FHLB and Federal Reserve Bank (FRB) on advances to the Bank also have a significant impact on the Bank's overall cost of funds.
Outlook
(The following are forward-looking statements; see "Forward-looking information" at the beginning of this section) The Company's management has identified a number of factors which may affect the Company's operations and results in the future. They are as follows:
The recent general economic slowdown, and the softness and declines in the real estate market, may continue. If that is the case, there are a number of adverse effects that we, like other financial institutions, would likely experience such as:
• Loan originations could continue to fluctuate from period to period, along with related interest and fee income.

• A continuing decrease in the value of real estate may occur. Reduced property prices and a soft real estate market could negatively affect the volume of home sales, which, in turn, could affect the construction, residential development, mortgage and home equity loan originations and prepayments.

• A continuation of soft or declining real estate values could also affect the value of the collateral securing our construction, development and mortgage loans. A decrease in value could, in turn, lead to increased losses on loans in the event of foreclosures, which would affect our provisions for loan losses and profitability.

• A general slowdown in the economy or a recession may affect our borrowers' ability to repay their loan obligations, which could lead to increased charge-offs and loan loss provisions and/or less revenue.

• If customer demand for real estate loans decreases, our profits may decrease because our investments, primarily mortgage-related securities, generally earn less income than real estate loans.

• The current unsettled markets may also affect the liquidity and/or value of our real estate-related investments.

We will continue to originate commercial real estate and commercial business loans, both of which can present a higher risk than residential mortgages. Adding personnel to continue to originate these loans in the current environment will increase our costs. However, market conditions and other factors may continue to affect our ability to increase our loan portfolio with these types of loans, and a weak economy could increase the risk that borrowers will not be able to repay these loans.
Critical Accounting Policies
Critical accounting policies are those policies that the Company's management believes are the most important to understanding the Company's financial condition and operating results. The Company has identified the following policies as being critical because they require difficult, subjective, and/or complex judgments that are inherently uncertain. Therefore, actual financial results could differ significantly depending upon the estimates used. Allowance for Loan Losses and Related Provision The allowance for loan losses is based on periodic analysis of the loan portfolio. In this analysis, management considers factors including, but not limited to, specific occurrences of loan impairment, changes in the size of the portfolios, national and regional economic conditions such as unemployment data, loan portfolio composition, loan delinquencies, local construction permits, development plans, local economic growth rates, historical experience and observations made by the Company's ongoing internal audit and regulatory exam processes.

Loans are charged off to the extent they are deemed to be uncollectible. The Company has established separate components of its overall methodology to determine the adequacy of the loan loss allowance for its homogeneous single-family and consumer loan portfolios and its non-homogeneous loan portfolios. The determination of the allowance for the non-homogeneous commercial, commercial real estate, and multi-family loan portfolios involves assigning standardized risk ratings and loss factors that are periodically reviewed. The loss factors are estimated using a combination of the Company's own loss experience and external industry data and are generally assigned to all loans that are on performing status. The Company also performs an individual analysis of impairment on each non-performing loan that is based on the expected cash flows or the value of the assets collateralizing the loans. The determination of the allowance on the homogeneous single-family and consumer loan portfolios is calculated on a pooled basis with individual determination of the allowance of all non-performing loans.
The adequacy of the allowance for loan losses is dependent upon management's estimates of variables affecting valuation, appraisals of collateral, evaluations of performance and status, and the amounts and timing of future cash flows expected to be received on impaired loans. Such estimates, appraisals, evaluations and cash flows may be subject to frequent adjustments due to changing economic prospects of borrowers or properties. The estimates are reviewed periodically and adjustments, if any, are recorded in the provision for loan losses in the periods in which the adjustments become known. The allowance is allocated to individual loan categories based upon the relative risk characteristics of the loan portfolios and the actual loss experience. The Company increases its allowance for loan losses by charging the provision for loan losses against income. The methodology for establishing the allowance for loan losses takes into consideration probable losses that have been identified in connection with specific loans as well as probable losses in the loan portfolio for which specific reserves are not required. Although management believes that based on current conditions the allowance for loan losses is maintained at an adequate amount to provide for probable loan losses inherent in the portfolio as of the balance sheet dates, future conditions may differ substantially from those anticipated in determining the allowance for loan losses and adjustments may be required in the future. Mortgage Servicing Rights
The Company recognizes as an asset the rights to service mortgage loans for others, which are referred to as mortgage servicing rights (MSRs). MSRs are capitalized at the fair value of the servicing rights on the date the mortgage loan is sold and are carried at the lower of the capitalized amount, net of accumulated amortization, or fair value. MSRs are capitalized and amortized in proportion to, and over the period of, estimated net servicing income. Each quarter the Company evaluates its MSRs for impairment in accordance with Statement of Financial Accounting Standards (SFAS) No. 140. Loan type and interest rate are the predominant risk characteristics of the underlying loans used to stratify the MSRs for purposes of measuring impairment. If temporary impairment exists, a valuation allowance is established for any excess of amortized cost over the current fair value through a charge to income. If the Company later determines that all or a portion of the temporary impairment no longer exists, a reduction of the valuation allowance is recorded as an increase to income. The valuation is based on various assumptions, including the estimated prepayment speeds and default rates of the stratified portfolio. Changes in the mix of loans, interest rates, prepayment speeds, or default rates from the estimates used in the valuation of the mortgage servicing rights may have a material effect on the amortization and valuation of MSRs. Management believes that the assumptions used and the values determined are reasonable based on current conditions. However, future economic conditions may differ substantially from those anticipated in determining the value of the MSRs and adjustments may be required in the future. The Company does not formally hedge its MSRs because they are hedged naturally by the Company's origination volume. Generally, as interest rates rise the origination volume declines and the value of MSRs increases and as interest rates decline the origination volume increases and the value of MSRs decreases.
Income Taxes
Deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on

deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. These calculations are based on many complex factors including estimates of the timing of reversals of temporary differences, the interpretation of federal and state income tax laws, and a determination of the differences between the tax and the financial reporting basis of assets and liabilities. Actual results could differ significantly from the estimates and interpretations used in determining the current and deferred income tax liabilities.
The Company adopted FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109 (FIN 48) on January 1, 2007. FIN 48 requires the use of estimates and management's best judgment to determine the amounts and probabilities of all of the possible outcomes that could be realized upon the ultimate settlement of a tax position using the facts, circumstances, and information available. The application of FIN 48 requires significant judgment in arriving at the amount of tax benefits to be recognized in the financial statements for a given tax position. It is possible that the tax benefits realized upon the ultimate resolution of a tax position may result in tax benefits that are significantly different from those estimated.
Net Income (Loss)
The Company's net loss was $7.1 million for the third quarter of 2008, a $9.9 million decrease from net income of $2.8 million for the third quarter of 2007. Diluted loss per common share for the third quarter of 2008 was $1.93, down $2.64 from diluted earnings per share of $0.71 for the third quarter of 2007. The decrease in net income for the quarter is due primarily to a $14.9 million increase in the loan loss provision between the periods as a result of increased commercial loan charge offs. In the third quarter of 2008, the Bank recorded a loan loss provision of $12.0 million related indirectly to the charges of fraud against businessman Tom Petters and the bankruptcy of Petters Company, Inc. (PCI). The Bank issued a commercial loan in April 2003 to a company that in turn loaned money to PCI. The Bank took a security interest in receivables from PCI as collateral for its commercial loan. It now appears that fraudulent misrepresentations were made about the collateral. The loan in question was current prior to the discovery of the apparent fraud, which remains under investigation. The financial capability of the borrower to repay the loan is uncertain due to the pervasive impact that the apparent fraud has had on the borrower's financial position, which raises substantial doubt regarding future collections on the loan. Accordingly, the Bank has recorded a provision for loan losses and a corresponding charge-off of $12.0 million in the third quarter of 2008 relating to this loan. The Bank has additional outstanding loans to borrowers connected with PCI. However, the additional loans are secured by real estate and the Bank currently does not expect any additional losses due to the apparent fraud related to PCI.
The net loss was $7.6 million for the nine-month period ended September 30, 2008, a decrease of $16.0 million compared to net income of $8.5 million for the nine-month period ended September 30, 2007. Diluted loss per common share for the nine-month period in 2007 was ($2.08), down $4.24 from $2.16 of diluted earnings per share for the same period in 2007. The decrease in net income for the first nine months of 2008 is primarily due to a $16.1 million increase in the loan loss provision between the periods as a result of increased commercial loan charge offs. Included in the $16.1 million loan loss provision is the $12.0 million charge off previously discussed related to fraudulent activities related to the collateral of one loan. Net income was also adversely affected by a $3.8 million non-cash goodwill impairment charge and a $4.0 million decrease in net interest income in the first nine-months of 2008 when compared to the same period in 2007.
Net Interest Income
Net interest income was $8.6 million for the third quarter of 2008, a decrease of $1.2 million, or 12.7%, compared to $9.8 million for the third quarter of 2007. Interest income was $16.4 million for the third quarter of 2008, a decrease of $3.9 million, or 19.3%, from $20.3 million for the same period in 2007. Interest income decreased primarily because of a decrease in the average yields earned on loans and investments. The decreased average yields were the result of the 275 basis point decrease in the prime interest rate between the periods. Decreases in the prime rate, which is the rate that banks charge their prime business customers, generally decrease the rates on adjustable rate consumer and commercial loans in the portfolio and on new loans originated. Interest income was also adversely affected by the increase in non-performing loans between the periods. The average yield earned on interest-earning assets was 6.14% for the third quarter of 2008, a decrease of 125 basis points from the 7.39% average yield for the third quarter of 2007.

Interest expense was $7.8 million for the third quarter of 2008, a decrease of $2.7 million, or 25.4%, compared to $10.5 million for the third quarter of 2007. Interest expense decreased primarily because of the lower interest rates paid on money market accounts and certificates of deposits. The decreased rates were the result of the 275 basis point decrease in the federal funds rate that occurred between the periods. Decreases in the federal funds rate, which is the rate that banks charge other banks for short term loans, generally have a lagging effect and decrease the rates banks pay for deposits. The lagging effect of deposit rate changes is primarily due to the Bank's deposits that are in the form of certificates of deposit which do not re-price immediately when the federal funds rate changes. The average interest rate paid on interest bearing liabilities was 3.12% for the third quarter of 2008, a decrease of 93 basis points from the 4.05% average rate paid in the third quarter of 2007.
Net interest margin (net interest income divided by average interest earning assets) for the third quarter of 2008 was 3.21%, a decrease of 37 basis points, compared to 3.58% for the third quarter of 2007.
Net interest income was $25.4 million for the first nine months of 2008, a decrease of $4.0 million, or 13.7%, from $29.4 million for the same period in 2007. Interest income was $50.4 million for the nine-month period ended September 30, 2008, a decrease of $7.8 million, or 13.3%, from $58.2 million for the same period in 2007. Interest income decreased primarily because of a decrease in the average yields earned on loans and investments. The decreased average yields were the result of the 275 basis point decrease in the prime interest rate between the periods. Decreases in the prime rate generally decrease the rates on adjustable rate consumer and commercial loans in the portfolio and on new loans originated. Interest income was also adversely affected by the increase in non-performing loans between the periods. The average yield earned on interest-earning assets was 6.37% for the first nine-months of 2008, a decrease of 108 basis points from the 7.45% average yield for the same period of 2007.
Interest expense was $25.0 million for the nine-month period ended September 30, 2008, a decrease of $3.7 million, or 13.0%, from $28.7 million for the same period in 2007. Interest expense decreased primarily because of the lower interest rates paid on money market accounts and certificates of deposits. The decreased rates were the result of the 275 basis point decrease in the federal funds rate that occurred between the periods. Decreases in the federal funds rate generally have a lagging effect and decrease the rates banks pay for deposits. The lagging effect of deposit rate changes is because many of the Bank's deposits are in the form of certificates of deposit which do not re-price immediately when the federal funds rate changes. The average outstanding brokered deposit balance increased $84.0 million between the periods primarily because brokered deposits were used to replace scheduled escrowed money market withdrawals. The average interest rate paid on interest bearing liabilities was 3.38% for the first nine months of 2008, a decrease of 52 basis points from the 3.90% average rate paid in the same period of 2007.
Net interest margin (net interest income divided by average interest earning assets) for the first nine months of 2008 was 3.21%, a decrease of 56 basis points, compared to 3.77% for the first nine months of 2007.

A summary of the Company' net interest margin for the nine month period ended September 30, 2008 and September 30, 2007 is as follows:

                                                             For the nine month period ended
                                          September 30, 2008                                  September 30, 2007
                               Average           Interest                          Average           Interest
                             Outstanding          Earned/         Yield/         Outstanding          Earned/         Yield/
(Dollars in thousands)         Balance             Paid            Rate            Balance             Paid            Rate
Interest-earning
assets:
Securities available
for sale                     $    145,713            5,438           4.99 %      $    190,231            7,305           5.13 %
Loans held for sale                 2,600              117           6.01               2,368              110           6.23
Mortgage loans, net               164,661            7,703           6.23             142,034            6,531           6.15
Commercial loans, net             635,397           32,325           6.80             593,080           37,530           8.46
Consumer loans, net                84,181            4,428           7.03              84,248            5,461           8.67
Cash equivalents                   17,645              196           1.48              25,516              972           5.09
Federal Home Loan Bank
stock                               6,927              211           4.07               6,940              276           5.32

Total interest-earning
assets                          1,057,124           50,418           6.37           1,044,417           58,185           7.45

Interest-bearing
liabilities:
NOW accounts                      124,869            1,367           1.46             113,733            2,685           3.16
Savings accounts                   41,642              345           1.11              40,654              414           1.36
Money market accounts             127,299            2,323           2.43             222,056            6,314           3.80
Certificates                      244,313            7,373           4.03             235,787            7,815           4.43
Brokered deposits                 277,288            9,536           4.59             193,332            7,278           5.03
Federal Home Loan Bank
advances                          116,209            4,047           4.65             122,817            4,227           4.60

Total interest-bearing
liabilities                       931,620           24,991           3.58             928,379           28,733           4.14

Noninterest checking               54,731                                              55,607
Other noninterest
bearing escrow deposits             1,107                                               1,030

Total interest-bearing
liabilities and
Noninterest bearing
deposits                     $    987,458                                        $    985,016

Net interest income                              $  25,427                                           $  29,452

Net interest rate
spread                                                               2.79 %                                              3.31 %

Net interest margin                                                  3.21 %                                              3.77 %

Provision for Loan Losses
The provision for loan losses is recorded to bring the allowance for loan losses to a level deemed appropriate by management based on factors disclosed in the critical accounting policies previously discussed. The provision for loan losses was $15.8 million for the third quarter of 2008, an increase of $14.9 million, from $921,000 for the third quarter of 2007. As discussed previously, the third quarter provision increased $12.0 million as a result of the full charge off of a loan that was deemed a loss due to the apparent fraudulent activity related to the underlying collateral. The provision for loan losses also increased $3.4 million due to specific reserves established on two residential development loans as a result of obtaining new third party appraisals of the properties during the quarter. The total amount outstanding on these two loans was $15.0 million at September 30, 2008.
The provision for loan losses was $18.5 million for the first nine-months of 2008, an increase of $16.1 million, from $2.4 million for the same nine-month period in 2007. The provision increased $12.0 million as the result of a loan that was charged off in the third quarter of 2008 due to the apparent fraudulent activity related to the underlying collateral. The provision for loan losses also increased $3.6 million due to specific reserves established on three residential development loans as a result of obtaining new appraisals.