Cautionary Statements Regarding Forward-Looking Information

This report contains or incorporates by reference various forward-looking statements concerning the Company's prospects that are based on the current expectations and beliefs of management. Forward-looking statements may also be made by the Company from time to time in other reports and documents as well as in oral presentations. When used in written documents or oral statements, the words "anticipate," "believe," "estimate," "expect," "objective" and similar expressions and verbs in the future tense, are intended to identify forward-looking statements. The statements contained herein and such future statements involve or may involve certain assumptions, risks and uncertainties, many of which are beyond the Company's control, that could cause the Company's actual results and performance to differ materially from what is expected. In addition to the assumptions and other factors referenced specifically in connection with such statements, the following factors could impact the business and financial prospects of the Company:

·        regulatory action requiring maintenance of minimum regulatory capital
         ratios higher than generally applicable minimum ratios; noncompliance
         could result in additional regulatory enforcement action; compliance
         could result in lower future return on equity and dilution for current
         stock holders;


·         adverse changes in the real estate markets;


                    · adverse changes in the securities markets;


  · general economic conditions, either nationally or in our market areas, that
    are worse than expected;


  · inflation and changes in the interest rate environment that reduce our margins
    or reduce the fair value of financial instruments;


      · legislative or regulatory changes that adversely affect our business;


  · our ability to enter new markets successfully and take advantage of growth
    opportunities;


  · significantly increased competition among depository and other financial
    institutions;


  · changes in accounting policies and practices, as may be adopted by the bank
    regulatory agencies and the Financial Accounting Standards Board; and


           · changes in consumer spending, borrowing and savings habits.

See also the factors referred to in reports filed by the Company with the Securities and Exchange Commission (particularly those under the caption "Risk Factors" in Item 1A of the Company's 2008 Annual Report on Form 10-K).

Overview

The following discussion and analysis is presented to assist the reader in the understanding and evaluation of the Company's financial condition and results of operations. It is intended to complement the unaudited consolidated financial statements, footnotes, and supplemental financial data appearing elsewhere in this Form 10-Q and should be read in conjunction therewith. The detailed discussion focuses on the results of operations for the nine and three month periods ended September 30, 2009 and 2008 and the financial condition as of September 30, 2009 compared to the financial condition as of December 31, 2008.

Generally, our results of operations are highly dependent on our net interest income and the provision for loan losses. In recent periods our results of operations have also been negatively impacted by other than temporary impairment of securities available for sale, by increased real estate owned expense and by higher deposit insurance premiums. Net interest income is the difference between the interest income we earn on loans receivable, investment securities and cash and cash equivalents and the interest we pay on deposits and other borrowings. The Company's banking subsidiary, WaterStone Bank SSB ("WaterStone Bank"), formerly Wauwatosa Savings Bank, is primarily a mortgage lender with such loans comprising 97.0% of total loans receivable on September 30, 2009. Further, 82.5% of loans receivable are residential mortgage loans with over four-family loans comprising 35.4% of all loans on September 30, 2009. WaterStone Bank funds loan production primarily with retail deposits and Federal Home Loan Bank advances. On September 30, 2009, deposits comprised 68.5% of total liabilities. Time deposits, also known as certificates of deposit, accounted for 87.0% of total deposits at September 30, 2009. Federal Home Loan Bank advances outstanding on September 30, 2009 totaled $512.0 million, or 29.5% of total liabilities. During the current period of low interest rates and economic weakness, we have determined that an investment philosophy emphasizing short-term liquid investments is prudent and will position the Company to take advantage of the opportunities that will exist as the local and national economies recover from the recession.

During the nine and three month periods ended September 30, 2009, our results of operations continued to be adversely affected by elevated levels of nonperforming loans and real estate owned which have resulted in high provisions for loan losses and loan charge-offs. We have sought to address the deterioration of the real estate market by increasing our provisions for loan losses over the past two years. The continued downturn in the local real estate market requires the Company to continually reevaluate the assumptions used to determine the fair value of collateral related to loans receivable to ensure that the allowance for loan losses continues to be an accurate reflection of management's best estimate of the amount needed to provide for the probable and estimable loss on impaired loans and other inherent losses in the loan portfolio. As a result, the Company determined that a provision for loan losses of $19.1 million was necessary during the nine months ended September 30, 2009 in order to maintain the allowance for loan losses at an appropriate level. Additional information regarding loan quality and its impact on our financial condition and results of operations can be found in the Asset Quality discussion. Our results of operations are also affected by noninterest income and noninterest expense. Noninterest income consists primarily of mortgage banking fee income and service charges. A significant increase in the sale of mortgage loans in the secondary market, resulting from a decline in mortgage interest rates during the period, yielded a $3.5 million increase in mortgage banking income during the nine months ended September 30, 2009 compared to the nine months ended September 30, 2008. In addition to the increase in mortgage banking activity, the increase in noninterest income compared to the prior period resulted from an $885,000 decrease in impairment charge on securities considered to be other than temporarily impaired. Noninterest expense consists primarily of compensation and employee benefits, FDIC insurance premiums, occupancy expenses and real estate owned expense. In 2009 our noninterest expense has been and will continue to be adversely affected by higher deposit insurance premium assessments from the FDIC. FDIC insurance premium expense, which included a $876,000 special assessment during the nine months ended September 30, 2009, has increased $1.7 million compared to the nine months ended September 30, 2008. Our results of operations also may be affected significantly by general and local economic and competitive conditions, governmental policies and actions of regulatory authorities.

Critical Accounting Policies

Critical accounting policies are those that involve significant judgments and assumptions by management and that have, or could have, a material impact on our income or the carrying value of our assets.

Allowance for Loan Losses. WaterStone Bank establishes valuation allowances on loans considered impaired. A loan is considered impaired when, based on current information and events, it is probable that WaterStone Bank will not be able to collect all amounts due according to the contractual terms of the loan agreement. A valuation allowance is established for an amount equal to the impairment when the carrying amount of the loan exceeds the net realizable value of the underlying collateral. WaterStone Bank also establishes valuation allowances based on an evaluation of the various risk components that are inherent in the credit portfolio. The risk components that are evaluated include past loan loss experience; the level of nonperforming and classified assets; current economic conditions; volume, growth, and composition of the loan portfolio; adverse situations that may affect the borrower's ability to repay; the estimated value of any underlying collateral; regulatory guidance; and other relevant factors. The allowance is increased by provisions charged to earnings and recoveries of previously charged-off loans and reduced by charge-offs. The adequacy of the allowance for loan losses is reviewed and approved at least quarterly by the WaterStone Bank board of directors. The allowance reflects management's best estimate of the amount needed to provide for the probable loss on impaired loans and other inherent losses in the loan portfolio, and is based on a risk model developed and implemented by management and approved by the WaterStone Bank board of directors.

Actual results could differ from this estimate and future additions to the allowance may be necessary based on unforeseen changes in loan quality and economic conditions. In addition, state and federal regulators periodically review the WaterStone Bank allowance for loan losses. Such regulators have the authority to require WaterStone Bank to recognize additions to the allowance at the time of their examination.

Income Taxes. The Company and its subsidiaries file a consolidated federal income tax return. The provision for income taxes is based upon income in the consolidated financial statements, rather than amounts reported on the income tax return. Consequently, our federal income tax returns do not include the financial results of our mutual holding company parent. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. 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 as income or expense in the period that includes the enactment date.

Under generally accepted accounting principles, a valuation allowance is required to be recognized if it is "more likely than not" that a deferred tax asset will not be realized. The determination of the realizability of the deferred tax assets is highly subjective and dependent upon judgment concerning management's evaluation of both positive and negative evidence, the forecasts of future income, applicable tax planning strategies, and assessments of current and future economic and business conditions. Positive evidence includes the existence of taxes paid in available carry-back years as well as the probability that taxable income will be generated in future periods, while negative evidence includes the cumulative losses in the current year and prior two years and general business and economic trends. At September 30, 2009 and at December 31, 2008, the Company determined that valuation allowances were necessary, largely based on the cumulative loss during the most recent three-year period caused by the significant loan loss provisions recorded during 2009 and 2008. In addition, general uncertainty surrounding future economic and business conditions have increased the potential volatility and uncertainty of projected earnings. Management is required to re-evaluate the deferred tax asset and the related valuation allowance quarterly.

Positions taken in the Company's tax returns may be subject to challenge by the taxing authorities upon examination. The benefit of uncertain tax positions are initially recognized in the financial statements only when it is more likely than not the position will be sustained upon examination by the tax authorities. Such tax positions are both initially and subsequently measured as the largest amount of tax benefit that is greater than 50% likely of being realized upon settlement with the tax authority, assuming full knowledge of the position and all relevant facts. Interest and penalties on income tax uncertainties are classified within income tax expense in the income statement.

Management believes its tax policies and practices are critical because the determination of the tax provision and current and deferred tax assets and liabilities have a material impact on our net income and the carrying value of our assets. We have no plans to change the tax recognition methodology in the future. If our estimated deferred tax valuation allowance is adjusted it will affect our future results of operations. At September 30, 2009, the Company had a deferred tax valuation allowance of $15.1 million. The net recorded deferred tax asset, after valuation allowance, at September 30, 2009 was $4.5 million. The remaining deferred tax asset was supported by remaining carry-backs of income taxes paid in prior years and available tax planning strategies. The deferred tax asset is also net of deferred tax liabilities associated with net unrealized gains on available for sale investment securities recorded in other comprehensive income. The comparable net deferred tax asset valuation allowance at December 31, 2008 totaled $13.5 million and the net deferred tax asset after valuation allowance was $5.6 million.

Comparison of Operating Results for the Nine Months Ended September 30, 2009 and 2008

General - Net loss for the nine months ended September 30, 2009 totaled $5.8 million, or $0.19 for both basic and diluted loss per share, compared to net loss of $30.1 million, or $0.99 for both basic and diluted loss per share, for the nine months ended September 30, 2008. The nine months ended September 30, 2009 generated an annualized loss on average assets of 0.41% and an annualized loss on average equity of 4.63%, compared to an annualized loss on average assets of 2.21% and an annualized loss on average equity of 20.02% for the comparable period in 2008. The net loss for the nine months ended September 30, 2009 reflects continuing deterioration in asset quality which resulted in a $19.1 million provision for loan losses during the current year. The current year to date provision represents a $15.5 million decrease from the $34.6 million provision for loan losses for the nine months ended September 30, 2008. Increases of $1.4 million in net interest income, $3.5 million in mortgage banking income, an $885,000 decrease in impairment charge on securities considered to be other than temporarily impaired and a decrease of $5.8 million in income tax expense for the first nine months of 2009 over the prior period were FDIC insurance expense increases of $1.7 million (which include the FDIC special assessment) and an increase in compensation expense of $524,000. Loan charge-off activity and specific loan reserves are discussed in additional detail in the Asset Quality section. The net interest margin for the nine months ended September 30, 2009 was 2.34% compared to 2.35% for the nine months ended September 30, 2008.

Total Interest Income - Total interest income decreased $3.4 million, or 4.4%, to $74.5 million during the nine months ended September 30, 2009 from $77.9 million during the nine months ended September 30, 2008.

Interest income on loans decreased $3.2 million, or 4.7%, to $66.3 million during the nine months ended September 30, 2009 from $69.6 million during the nine months ended September 30, 2008. The decrease in interest income was primarily due to a 54 basis point decrease in the average yield on loans to 5.79% for the nine-month period ended September 30, 2009 from 6.23% for the comparable period in 2008. The decrease in interest income attributable to the decrease in the yield on loans was partially offset by a $40.3 million, or 2.7%, increase in the average balance of average loans outstanding to $1.53 billion during the nine months ended September 30, 2009 from $1.49 billion during the comparable period in 2008. In addition to the decrease in interest income due to a decrease in the average yield, $1.5 million of the overall decrease compared to the prior year related to interest income recognized on a loan during the nine months ended September 30, 2008 that had previously been recorded on the cost recovery method. The loan was originated to facilitate the sale of Company owned real estate during 2000 and the $1.5 million represented interest income that was collected but not recognized during the facilitation period. The loan was paid in full during the third quarter of 2008, which resulted in full recognition of interest collected in prior periods. This transaction had the affect of increasing the average yield on interest earning assets by 13 basis points for the nine months ended September 30, 2008. Unrecognized interest income on non-accrual loans totaled $4.9 million during the nine months ended September 30, 2009. This had the effect of reducing the average yield on loans during the same period by 43 basis points. Unrecognized interest income on non-accrual loans totaled $3.2 million during the nine months ended September 30, 2008, effectively reducing the average yield on loans for that period by 28 basis points.

Interest income from mortgage-related securities decreased $176,000, or 3.1%, to $5.5 million during the nine months ended September 30, 2009 from $5.7 million during the nine months ended September 30, 2008. The decrease in interest income was primarily due to a $8.6 million, or 6.2%, decrease in the average balance of mortgage-related securities to $129.3 million for the nine months ended September 30, 2009 from $137.9 million during the comparable period in 2008. The decrease in interest income, reflecting a decrease in average balance, was partially offset by an increase in average yield. The average yield on mortgage-related securities increased 18 basis points to 5.67% for the nine months ended September 30, 2009 from 5.49% for the comparable period in 2008. The decline in the average balance of mortgage-related securities during the nine months ended September 30, 2009 reflects management's decision to deemphasize investments in mortgage-related securities and emphasize more liquid government agency and higher yielding municipal debt securities.

Finally, interest income from debt securities, federal funds sold and short-term investments remained stable at $2.6 million for both the nine months ended September 30, 2009 and 2008. Interest income decreased due to a 109 basis point decline in the average yield on other earning assets to 2.15% for the nine months ended September 30, 2009 from 3.24% for the comparable period in 2008. The decline in average yield provided by these investments reflects the overall interest rate environment as opposed to a shift in investment strategy or product mix. The decrease in average rate was offset by an increase of $53.8 million, or 48.9%, in the average balance of other earning assets to $163.8 million during the nine months ended September 30, 2009 from $110.0 million during the comparable period in 2008. The increase in average balance reflects a strategic shift towards higher levels of liquidity. The Company intends to maintain higher than usual liquidity given the current economic environment and relatively low rates of return available on loans and mortgage related securities. The average balance of debt securities, federal funds sold and short-term investments includes FHLBC stock of $21.7 million and $20.6 million for the nine month-periods ended September 30, 2009 and 2008, respectively. On October 10, 2007, the FHLBC entered into a consensual cease and desist order with its regulator, the Federal Housing Finance Board. Under the terms of the order, dividend declarations are subject to the prior written approval of the Federal Housing Finance Board. The FHLBC has not declared a dividend since it entered into the cease and desist order. At the request of the FHLBC, on July 24, 2008, the Finance Board amended the cease and desist order to allow the FHLBC to redeem incremental purchases of capital stock tied to increased levels of borrowing through advances after repayment of those new advances.

Total Interest Expense - Total interest expense decreased by $4.8 million, or 10.2%, to $42.5 million during the nine months ended September 30, 2009 from $47.3 million during the nine months ended September 30, 2008. This decrease was the result of a decrease of 67 basis points in the cost of funds to 3.27% for the nine months ended September 30, 2008 from 3.94% for the comparable period ended September 30, 2008, partially offset by an increase of $128.5 million, or 8.0%, in average interest bearing deposits and borrowings outstanding to $1.73 billion for the nine months ended September 30, 2009 compared to an average balance of $1.61 billion for the nine months ended September 30, 2008.

Interest expense on deposits decreased $4.4 million, or 13.8%, to $27.4 million during the nine months ended September 30, 2009 from $31.8 million during the comparable period in 2008. This was due to a decrease in the cost of total average deposits of 85 basis points to 3.03% for the nine months ended September 30, 2009 compared to 3.88% for the comparable period during 2008. The decrease in interest expense attributable to the decrease in the cost of deposits was partially offset by an increase of $113.2 million, or 10.3%, in the average balance of other interest bearing deposits to $1.21 billion during the nine months ended September 30, 2009 from $1.1 billion during the comparable period in 2008. The decrease in the cost of deposits reflects the Federal Reserve's reduction of short term interest rates which are typically used by financial institutions in pricing deposit products.

Interest expense on borrowings decreased $469,000, or 3.0%, to $15.1 million during the nine months ended September 30, 2009 from $15.5 million during the comparable period in 2008. The decrease resulted primarily from a 24 basis point decrease in the average cost of borrowings to 3.90% during the nine months ended September 30, 2009 from 4.14% during the comparable period in 2008. The decrease due to rate was partially offset by a $20.2 million, or 4.1%, increase in average borrowings outstanding to $512.2 million during the nine months ended September 30, 2009 from $492.0 million during the comparable period in 2008. The increased use of borrowings as a source of funding during nine months ended September 30, 2009 reflected our assessment that such sources of funds provided favorable rates and terms compared to retail funding sources. The reduction in short term interest rates by the Federal Reserve allowed banks such as WaterStone Bank to borrow funds at lower rates, helping to reduce our cost of funds.

Net Interest Income - Net interest income increased by $1.4 million or 4.6%, to $32.0 million during the nine months ended September 30, 2009 as compared to $30.6 million during the comparable period in 2008. Net interest income continues to be positively affected by a decrease in short and medium term interest rates in 2009, as compared to 2008 and by our interest bearing liabilities repricing at a faster rate than our interest earning assets. The increase in net interest income resulted primarily from a 14 basis point increase in our interest rate spread to 2.18% for the nine month period ended September 30, 2009 from 2.04% for the comparable period in 2008. The 14 basis point increase in the interest rate spread resulted from a 67 basis point decrease in the cost of interest bearing liabilities, which was partially offset by a 53 basis point decrease in the yield on interest earning assets. The increase in net interest income resulting from an increase in our net interest rate spread was partially offset by a decrease in net average earning assets of $43.0 million, or 32.0%, to $91.5 million for the nine months ended September 30, 2009 from $134.5 million from the comparable period in 2008. The decrease in net average earning assets was primarily attributable to an increase in loans transferred to real estate owned. The average balance of real estate owned totaled $37.3 million for the nine months ended September 30, 2009 compared to $13.7 million for the nine months ended September 30, 2008.

Provision for Loan Losses - Our provision for loan losses decreased $15.5 million, to $19.1 million during the nine months ended September 30, 2009, from $34.6 million during the comparable period during 2008. During the third quarter of 2008, the Company received updated appraisals on a number of properties that collateralized nonperforming loans. The decline in value noted in those appraisals, in addition to the continued downturn in the local real estate market, prompted the Company to obtain updated appraisals on a larger number of at risk loans and to reevaluate the assumptions used to determine the fair value of collateral related to both performing and nonperforming loans. This reevaluation contributed to the provision for loan losses of $34.6 million during the nine months ended September 30, 2008. While it has decreased from the prior year, the provision for loan losses remains at historically high levels. The provision for the nine months ended September 30, 2009 was primarily the result of $12.7 million of net loan charge-offs combined with continued weakness in local real estate markets. The increase in charge-offs reflects management's continued evaluation of assumptions used to determine the fair value of collateral supporting nonperforming loans. In addition, compared to prior periods, the Company has observed an increased likelihood of borrowers being unable to resolve ongoing loan defaults prior to completion of a sheriff's sale. As such, charge-offs are generally being recognized earlier in the foreclosure process than they have been in prior periods. See the Asset Quality section for an analysis of charge-offs, nonperforming assets, specific reserves and additional provisions.

Noninterest Income - Total noninterest income increased $3.7 million, or 80.3%, to $8.2 million during the nine months ended September 30, 2009 from $4.6 million during the comparable period in 2008. The increase primarily resulted from an increase in mortgage banking income. Mortgage banking income increased $3.5 million to $6.8 million for the nine months ended September 30, 2009, compared to $3.3 million during the comparable period in 2008. The increase was the result of increased mortgage loan refinancing triggered by declines in mortgage interest rates during the period. During the nine months ended September 30, 2009, the Company sold $515.4 million of mortgage loans into the secondary market, as compared to $229.2 million during the comparable period in 2008.

Noninterest Expense - Total noninterest expense increased $2.1 million, or 8.5%, to $27.0 million during the nine months ended September 30, 2009 from $24.9 million during the comparable period in 2008. The increase was primarily attributable to increased FDIC insurance premiums, including a special assessment charged to income during the second quarter of 2009.

Compensation, payroll taxes and other employee benefit expense increased $524,000, or 4.1%, to $13.3 million during the nine months ended September 30, 2009 compared to $12.8 million during the comparable period in 2008. This increase resulted primarily from an increase in compensation and payroll taxes and health insurance expense, partially offset by a reduction in expense related to the ESOP. Due primarily to an increase in loan sales into the secondary market, total compensation, in the form of commissions, and payroll taxes increased $637,000, or 6.4%, to $10.8 million for the nine months ended September 30, 2009 compared to $10.1 million during the comparable period in 2008. Company paid health insurance expense increased $260,000 to $904,000 during the nine months ended September 30, 2009 compared to $645,000 during the comparable period in 2008. Partially offsetting the increase in compensation and health insurance expense, ESOP expense decreased $471,000, to $195,000 during . . .