Summary of TIMBERLAND BANCORP INC

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following analysis discusses the material changes in the financial condition and results of operations of the Company at and for the three months ended December 31, 2008. This analysis as well as other sections of this report contains certain "forward-looking statements." The Company desires to take advantage of the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995 and is including this statement for the express purpose of availing itself of the protection of such safe harbor with forward looking statements. These forward looking statements may describe future plans or strategies and include the Company's expectations of future financial results. The words "believe," "expect," "anticipate," "estimate," "project," and similar expressions identify forward-looking statements. The Company's ability to predict results or the effect of future plans or strategies is inherently uncertain. Factors which could cause actual results to differ materially, include, but are not limited to, the credit risks of lending activities, including changes in the level and trend of loan delinquencies and charge-offs; changes in the general economic conditions, either nationally or in our market areas; changes in the level of general interest rates, deposit interest rates, our net interest margin and funding sources; fluctuations in the demand for loans, the number of unsold homes and other properties and fluctuations in real estate values in our market areas; results of examinations of the Company by the Federal Reserve and of the Bank by the Federal Deposit Insurance Corporation, the Washington Department of Financial Institutions or other regulatory authorities, including the possibility that any such regulatory authority may, among other things, require us to increase our reserve for loan losses or to write-down assets; our ability to control operating costs and expenses; our ability to implement our branch expansion strategy; our ability to successfully integrate any assets, liabilities, customers, systems, and management personnel we have acquired or may in the future acquire into our operations and our ability to realize related revenue synergies and cost savings within expected time frames and any goodwill charges related thereto; our ability to manage loan delinquency rates; our ability to retain key members of our senior management team; costs and effects of litigation, including settlements and judgments; increased competitive pressures among financial service companies; changes in consumer spending, borrowing and savings habits; legislative or regulatory changes that adversely affect our business; adverse changes in the securities markets; inability of key third-party providers to perform their obligations to us; changes in accounting policies and practices, as may be adopted by the financial institution regulatory agencies or the Financial Accounting Standards Board; war or terrorist activities; other economic, competitive, governmental, regulatory, and technological factors affecting our operations, pricing, products and services and other risks detailed in the Company's reports filed with the Securities and Exchange Commission, including the Annual Report on Form 10-K for the fiscal year ended September 30, 2008. The Company undertakes no responsibility to update or revise any forward-looking statements.

Overview

Timberland Bancorp, Inc., a Washington corporation, was organized on September 8, 1997 for the purpose of becoming the holding company for Timberland Savings Bank, SSB upon the Bank's conversion from a Washington-chartered mutual savings bank to a Washington-chartered stock savings bank ("Conversion"). The Conversion was completed on January 12, 1998 through the sale and issuance of 13,225,000 shares of common stock by the Company. At December 31, 2008, the Company had total assets of $671.59 million and total shareholders' equity of $90.94 million. The Company's business activities generally are limited to passive

investment activities and oversight of its investment in the Bank. Accordingly, the information set forth in this report relates primarily to the Bank.

The Bank was established in 1915 as "Southwest Washington Savings and Loan Association." In 1935, the Bank converted from a state-chartered mutual savings and loan association to a federally-chartered mutual savings and loan association, and in 1972 changed its name to "Timberland Federal Savings and Loan Association." In 1990, the Bank converted to a federally chartered mutual savings bank under the name "Timberland Savings Bank, FSB." In 1991, the Bank converted to a Washington-chartered mutual savings bank and changed its name to "Timberland Savings Bank, SSB." In 2000, the Bank changed its name to "Timberland Bank." The Bank's deposits are insured by the Federal Deposit Insurance Corporation ("FDIC") up to applicable legal limits. The Bank has been a member of the Federal Home Loan Bank System since 1937. The Bank is regulated by the Washington State Department of Financial Institutions, Division of Banks and the FDIC.

The Bank is a community-oriented bank which offers a variety of deposit and loan products to its customers. The Bank operates 21 branches (including its main office in Hoquiam) and a loan production office (which is in the process of being converted to a full service branch) in the following market areas:

* Grays Harbor County
* Thurston County
* Pierce County
* King County
* Kitsap County
* Lewis County

Historically, the principal lending activity of the Bank has consisted of the origination of loans secured by first mortgages on owner-occupied, one- to four-family residences and loans for the construction of one- to four-family residences. Since 2001, the Bank has expanded its business banking capabilities and has emphasized the origination of commercial real estate and commercial business loans.

Critical Accounting Policies and Estimates

The Company has identified two accounting policies that as a result of judgments, estimates and assumptions inherent in those policies, are critical to an understanding of the Company's Consolidated Financial Statements.

Allowance for Loan Losses. The allowance for loan losses is maintained at a level sufficient to provide for probable loan losses based on evaluating known and inherent risks in the portfolio. The allowance is based upon management's comprehensive analysis of the pertinent factors underlying the quality of the loan portfolio. These factors include changes in the amount and composition of the loan portfolio, actual loss experience, current economic conditions, and detailed analysis of individual loans for which the full collectibility may not be assured. The appropriate allowance for loan loss level is estimated based upon factors and trends identified by management at the time consolidated financial statements are prepared.

While the Company believes it has established its existing allowance for loan losses in accordance with accounting principles generally accepted in the United States, there can be no assurance that regulators, in reviewing the Company's loan portfolio, will not request the Company to significantly increase or decrease its allowance for loan losses. In addition, because future events affecting borrowers and collateral cannot be predicted with certainty, there can be no assurance that the existing allowance for loan losses is adequate or that substantial increases will not be necessary should the quality of any loans deteriorate as a result of the factors discussed elsewhere in this document. Although management believes the levels of the allowance as of both

December 31, 2008 and September 30, 2008 were adequate to absorb probable losses inherent in the loan portfolio, a decline in local economic conditions, or other factors, could result in a material increase in the allowance for loan losses and may adversely affect the Company's financial condition and results of operations.

Mortgage Servicing Rights. Mortgage servicing rights ("MSRs") are capitalized when acquired through the origination of loans that are subsequently sold with servicing rights retained and are amortized to servicing income on loans sold in proportion to and over the period of estimated net servicing income. The value of MSRs at the date of the sale of loans is determined based on the discounted present value of expected future cash flows using key assumptions for servicing income and costs and prepayment rates on the underlying loans. The estimated fair value is periodically evaluated for impairment by comparing actual cash flows and estimated cash flows from the servicing assets to those estimated at the time servicing assets were originated. The effect of changes in market interest rates on estimated rates of loan prepayments represents the predominant risk characteristic underlying the MSRs portfolio. The Company's methodology for estimating the fair value of MSRs is highly sensitive to changes in assumptions. For example, the determination of fair value uses anticipated prepayment speeds. Actual prepayment experience may differ and any difference may have a material effect on the fair value. Thus, any measurement of MSRs' fair value is limited by the conditions existing and assumptions as of the date made. Those assumptions may not be appropriate if they are applied at different times.

Comparison of Financial Condition at December 31, 2008 and September 30, 2008

The Company's total assets decreased by $10.29 million, or 1.5%, to $671.59 million at December 31, 2008 from $681.88 million at September 30, 2008, primarily attributable to a decrease in cash equivalents and a decrease in investment and mortgage backed securities.

Total deposits decreased by $21.23 million, or 4.3%, to $477.34 million at December 31, 2008 from $498.57 million at September 30, 2008, primarily attributable to a decrease in money market account balances and jumbo certificate of deposit account balances.

Shareholders' equity increased by $16.10 million, or 21.5%, to $90.94 million at December 31, 2008 from $74.84 million at September 30, 2008. The increase in shareholders' equity was primarily a result of the sale of $16.64 million in senior preferred stock to the U.S. Treasury Department as part of the Treasury's Capital Purchase Program.

A more detailed explanation of the changes in significant balance sheet categories follows:

Cash Equivalents: Cash equivalents decreased by $8.96 million, or 20.9%, to $33.91 million at December 31, 2008 from $42.87 million at September 30, 2008. The decrease was primarily a result of a decrease in federal funds sold. The decrease in liquid assets was primarily a result of a large short-term deposit made by a commercial customer in August 2008 that was withdrawn for business purposes during the three months ended December 31, 2008 and correspondingly reduced the amount that the Bank had been holding in federal funds sold. The Bank also used a portion of its liquid assets to reduce its FHLB advances.

Investment Securities and Mortgage-backed Securities: Investment and mortgage-backed securities decreased by $2.95 million, or 9.4%, to $28.38 million at December 31, 2008 from $31.33 million at September 30, 2008. The decrease was primarily as a result of a $1.17 million other than temporary impairment ("OTTI") charge recorded on 17 private label mortgage-backed securities and regular amortization and prepayments on mortgage-backed securities. The securities, on which the impairments were recognized, were acquired from the in-kind redemption of the Bank's investment in the AMF family of mutual funds in June 2008.

At December 31, 2008, the Company's securities' portfolio was comprised of mortgage-backed securities of $27.41 million (of which $12.86 million were classified as held to maturity), mutual funds of $947,000 and U.S. agency securities of $27,000. For additional information, see Note 3 of the Notes to Condensed Consolidated Financial Statements contained in "Item 1, Financial Statements."

Loans: Net loans receivable remained stable at $557.56 million at December 31, 2008 compared to $557.69 million at September 30, 2008. During the three months ended December 31, 2008, decreases in construction and land development loans and commercial business loans, were offset by increases in commercial real estate loans, land loans, and one-to-four family loans. The decrease in construction loans was primarily reflected in an $8.39 million decrease in multi-family and condominium construction loans, a $3.78 million decrease in speculative construction loans, a $3.34 million decrease in custom and owner / builder construction loans, and a $1.43 million decrease in land development loans; which were partially offset by a $3.42 million increase in commercial real estate loans.

Loan originations decreased to $43.9 million for the three months ended December 31, 2008 compared to $65.5 million for the three months ended December 31, 2007. The reduction in loan volume was primarily a result of lower demand for financing in the Bank's market areas due to a slowing economy and a tightening in the Bank's underwriting standards. However, the demand for single family home refinance loans began to increase significantly during the latter part of December 2008 as a result of historically low interest rates. The Bank continues to sell longer-term fixed rate loans for asset liability management purposes. The Bank sold fixed rate one- to four-family mortgage loans totaling $10.54 million for the three months ended December 31, 2008 compared to $7.41 million for the three months ended December 31, 2007.

For additional information, see Note 5 of the Notes to Condensed Consolidated Financial Statements contained in "Item 1, Financial Statements."

Premises and Equipment: Premises and equipment increased by $485,000, or 2.9%, to $17.37 million at December 31, 2008 from $16.88 million at September 30, 2008. The increase was primarily a result of capitalized construction costs on the Bank's new branch facility being constructed in Lewis County. The new branch is scheduled to open in May 2009.

Goodwill and Core Deposit Intangible: The value of goodwill remained unchanged at $5.65 million at December 31, 2008 from September 30, 2008. The amortized value of the core deposit intangible decreased to $918,000 at December 31, 2008 from $972,000 at September 30, 2008. The decrease is attributable to scheduled amortization of the core deposit intangible.

Deposits: Deposits decreased by $21.23 million, or 4.3%, to $477.34 million at December 31, 2008 from $498.57 million at September 30, 2008. The decrease was primarily a result of a $9.17 million decrease in money market account balances, an $8.83 million decrease in jumbo certificate of deposit account balances, a $1.32 million decrease in N.O.W. checking account balances, and a $1.31 million decrease in savings account balances. The decrease in money market account balances was primarily due to a large short-term deposit made by a commercial customer in the prior quarter that was withdrawn for business purposes during the quarter ended December 31, 2008. The decrease in jumbo certificate of deposit accounts balances was primarily due to the Company's decision to reduce its exposure to county government jumbo CD's in anticipation of receiving proceeds from the sale of preferred stock to the Treasury under the terms of its Capital Purchase Program. The cost of holding these public deposits increased during the quarter as the Federal Reserve decreased the yield on short-term investments through additional rate decreases. Reducing these jumbo certificate of deposit balances eliminated the negative interest carry associated with retaining them on the balance sheet. For additional information, see the section entitled "Deposit Breakdown" included herein.

FHLB Advances and Other Borrowings: FHLB advances and other borrowings decreased by $5.06 million, or 4.8%, to $100.32 million at December 31, 2008 from $105.39 million at September 30, 2008 as the Bank used a portion of it liquid assets to repay a portion of its FHLB advances. For additional information, see "FHLB Advance Maturity Schedule" included herein.

Shareholders' Equity: Total shareholders' equity increased by $16.10 million, or 21.5%, to $90.94 million at December 31, 2008 from $74.84 million at September 30, 2008. The increase was primarily a result of the sale of $16.64 million in senior preferred stock to the U.S. Treasury Department as part of the Treasury's Capital Purchase Program. As part of the transaction, the Company also issued to the Treasury warrants to purchase up to $2.5 million in common stock. The transaction is part of the Treasury's program to encourage qualified financial institutions to build capital to increase the flow of financing to businesses and consumers and to support the U.S. economy.

Also impacting shareholders' equity during the three months ended December 31, 2008 was the payment of $767,000 in cash dividends on common stock and a $446,000 increase in the accumulated other comprehensive loss equity category. These items were partially offset by net income of $361,000 and proceeds from stock option exercises of $284,000.

The Company did not repurchase any shares of its common stock during the three months ended December 31, 2008. As part of the Company's participation in the Treasury's Capital Purchase Program, the existing share repurchase plan announced on February 25, 2008 was suspended indefinitely. For additional information, see Item 2 of Part II of this Form 10-Q.

Non-performing Assets: Non-performing assets consist of non-accrual loans, OREO and other repossessed assets. Non-performing assets to total assets increased to 2.20% at December 31, 2008 from 1.83% at September 30, 2008, as non-accrual loans increased by $1.53 million to $13.52 million at December 31, 2008 from $11.99 million at September 30, 2008 and OREO and other repossessed assets increased by $755,000 to $1.27 million at December 31, 2008 from $511,000 at September 30, 2008.

Total non-accrual loans of $13.52 million at December 31, 2008 were comprised of 44 loans and 27 credit relationships. These 44 loans consisted of 15 single family speculative construction loans totaling $4.40 million (of which the largest has a balance of $395,00), a $2.60 million land development loan in Eastern Washington, a $1.36 million participation interest in a land development loan located in Clark County, 16 individual lot (land ) loans totaling $1.93 million, three commercial real estate loans totaling $1.18 million, a $1.39 million multi-family loan, three single family home loans totaling $328,000, three home equity consumer loans totaling $317,000 and a $31,000 consumer loan.

The Company had net charge-offs totaling $1.20 million for the quarter ended December 31, 2008. The charge-offs were associated with six relationships which primarily involved construction loans. In recognition of a real estate market that reflected lower valuations during the quarter, net charge-off consisted of the following:

* $464,000 to reduce exposure to the speculative construction inventory and land holdings of three contractors.
* $475,000 on one land development loan.
* $250,000 on one of the few unsecured loans in the portfolio.
* $6,000 on one auto loan.

OREO and other repossessed assets totaled $1.27 million at December 31, 2008 and consisted of three single family homes in Pierce County totaling $1.13 million, one single family home in Kitsap County at $102,000, one land parcel in Grays Harbor County at $28,000 and one vehicle at $5,000.

For additional information, see Note 5 of the Notes to Condensed Consolidated Financial Statements contained in "Item 1, Financial Statements."

Deposit Breakdown
-----------------
The following table sets forth the composition of the Company's deposit
balances.
                                                 At                    At
                                        December 31, 2008    September 30, 2008
                                                    (In thousands)

Non-interest bearing                       $  51,775             $  51,955
N.O.W. checking                               89,151                90,468
Savings                                       55,082                56,391
Money market accounts                         61,210                70,379
Certificates of deposit under $100           129,867               130,313
Certificates of deposit $100 and over         64,281                73,107
Certificates of deposit - brokered            25,975                25,959
                                            --------              --------
  Total deposits                           $ 477,341             $ 498,572
                                            ========              ========

FHLB Advance Maturity Schedule
------------------------------
The Bank has short- and long-term borrowing lines with the FHLB of Seattle with
total credit on the lines equal to 30% of the Bank's total assets, limited by
available collateral.  Borrowings are considered short-term when the original
maturity is less than one year.  FHLB advances consisted of the following:

                           At December 31,            At September 30,
                                 2008                       2008
                          Amount      Percent        Amount      Percent
                          -------------------        -------------------
                                       (Dollars in thousands)

Short-term              $     --          --%      $     --          --%
Long-term                 99,609       100.0        104,628       100.0
                          ------       -----        -------       -----
Total FHLB advances     $ 99,609       100.0%      $104,628       100.0%
                          ======       =====        =======       =====

The Bank's FHLB borrowings mature at various dates through September 2017 and bear interest at rates ranging from 3.49% to 5.54%. The weighted average interest rate on FHLB borrowings at December 31, 2008 was 4.17%. Principal reduction amounts due for future years ending September 30 are as follows (in thousands):

Remainder of 2009   $  4,609
2010                  20,000
2011                  20,000
2012                  10,000
2013                      --
Thereafter            45,000
                     -------
Total               $ 99,609
                     =======

A portion of these advances have a putable feature and may be called by the FHLB earlier than the above schedule indicates.

Comparison of Operating Results for the Three Months Ended December 31, 2008 and 2007

The Company's net income decreased by $1.25 million, or 77.6%, to $361,000 for the three months ended December 31, 2008 from $1.62 million for the three months ended December 31, 2007. Diluted earnings per common share decreased 79.2% to $0.05 for the three months ended December 31, 2008 from $0.24 for the three months ended December 31, 2007.

The decrease in net income and diluted earnings per common share was primarily a result of a $1.17 million other than temporary impairment charge on mortgage-backed securities, a $686,000 increase in non-interest expense, a $455,000 decrease in net interest income, and a $115,000 increase in the provision for loan losses. These items were partially offset by a $579,000 increase in non-interest income (excluding the impairment charge).

A more detailed explanation of the income statement categories is presented below.

Net Income: Net income for the quarter ended December 31, 2008 decreased by $1.25 million, or 77.6%, to $361,000 from $1.62 million for the quarter ended December 31, 2007. Earnings per diluted common share for the quarter ended December 31, 2008 decreased to $0.05 from $0.24 for the quarter ended December 31, 2007. The $0.19 decrease in diluted earnings per common share was primarily a result of a $1.17 million ($772,000 net of income tax - $0.12 per diluted common share) other than temporary impairment charge on mortgage-backed securities, a $686,000 ($453,000 net of income tax - $0.07 per diluted common share) increase in non-interest expense, a $455,000 ($300,000 net of income tax
- $0.05 per diluted common share) decrease in net interest income, and a $115,000 ($76,000 net of income tax - $0.01 per diluted common share) increase in the provision for loan losses. These decreases to earnings per common share were partially offset by a $579,000 increase ($382,000 net of income tax - $0.06 per diluted common share) in non-interest income (excluding the impairment charge).

Net Interest Income: Net interest income decreased by $455,000 or 6.6%, to $6.46 million for the quarter ended December 31, 2008 from $6.92 million for the quarter ended December 31, 2007. The decrease in net interest income was primarily attributable to interest rate decreases, which compressed margins, and the reversal of interest on loans placed on non-accrual status. These decreases were, however, partially offset by a larger interest earning asset base. Total interest and dividend income decreased by $1.45 million, or 12.7%, to $10.03 million for the quarter ended December 31, 2008 from $11.48 million for the quarter ended December 31, 2007 as the yield on interest earning assets decreased to 6.50% from 7.62%. Total average interest earning assets increased by $14.65 million to $617.28 million for the quarter ended December 31, 2008 from $602.63 million for quarter ended December 31, 2007. Total interest expense decreased by $997,000, or 21.9%, to $3.56 million for the quarter ended December 31, 2008 from $4.56 million for the quarter ended December 31, 2007 as the average rate paid on interest bearing liabilities decreased to 2.67% for the quarter ended December 31, 2008 from 3.49% for the quarter ended December 31, 2007. Total average interest bearing liabilities increased by $11.99 million to $530.69 million for the quarter ended December 31, 2008 from $518.70 million for the quarter ended December 31, 2007. The net interest margin decreased to 4.19% for the quarter ended December 31, 2008 from 4.59% for the quarter ended December 31, 2007. The margin compression was primarily attributable to significant interest rate decreases by the Federal Reserve which reduced the yield on interest earning assets at a faster pace than the Bank was able to reduce its funding costs. The reversal of interest income on loans placed on non-accrual status also contributed to the margin compression and reduced the net interest margin by approximately 11 basis points during the quarter ended December 31, 2008. For additional information, see the section below entitled "Rate Volume Analysis."

Rate Volume Analysis
The following table sets forth the effects of changing rates and volumes on the
net interest income on the Company.  Information is provided with respect to the
(i) effects on interest income attributable to change in volume (changes in
volume multiplied by prior rate), and (ii) effects on interest income
attributable to changes in rate (changes in rate multiplied by prior volume),
and (iii) the net change (sum of the prior columns).  Changes in rate/volume
have been allocated to rate and volume variances based on the absolute values of
each.
                       Three months ended December 31, 2008
                            compared to three months
                            ended December 31, 2007
                              increase (decrease)
                                    due to
                                    ------
                                             Rate        Volume     Net Change
                                            ------       ------     ----------
                                                   (In thousands)
Interest-earning assets:
  Loans receivable (1)                     ($1,704)        $510        ($1,194)
. . .