-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, Q0uXC4yf37AjNnwQfl7iJT8f26UAJYGunmxrjk3v50wx2nrmUnpsg2oBdlnts9Gh JBMtF6vf+FkOQ1Ta8IpJtg== 0001140361-07-004461.txt : 20070228 0001140361-07-004461.hdr.sgml : 20070228 20070227202940 ACCESSION NUMBER: 0001140361-07-004461 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 12 CONFORMED PERIOD OF REPORT: 20061231 FILED AS OF DATE: 20070228 DATE AS OF CHANGE: 20070227 FILER: COMPANY DATA: COMPANY CONFORMED NAME: FRONTIER FINANCIAL CORP /WA/ CENTRAL INDEX KEY: 0000716457 STANDARD INDUSTRIAL CLASSIFICATION: STATE COMMERCIAL BANKS [6022] IRS NUMBER: 911223535 STATE OF INCORPORATION: WA FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: 1934 Act SEC FILE NUMBER: 000-15540 FILM NUMBER: 07654963 BUSINESS ADDRESS: STREET 1: 332 SW EVERETT MALL WAY CITY: EVERETT STATE: WA ZIP: 98204 BUSINESS PHONE: 4255140700 10-K 1 form10-k.htm FRONTIER FINANCIAL CORPORATION 10-K 12-31-2006 Frontier Financial Corporation 10-K 12-31-2006
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K
 
T ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the Fiscal Year Ended December 31, 2006
OR
£ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from _________________ to __________________

Commission File Number 000-15540

Frontier Financial Corporation
(Exact Name of registrant as specified in its charter)
 
Washington
91-1223535
(State of incorporation or organization)
(IRS Employer Identification Number)
   
332 S.W. Everett Mall Way
  
P. O. Box 2215
  
Everett, Washington
98213
(Address of Principal Executive Office)
(Zip Code)
 
Registrant’s telephone number, including area code: (425) 514-0700

Securities registered pursuant to Section 12(g) of the Act:
 
Title of each class
  
Name of each exchange on which registered
Common Stock (no par value)
  
The NASDAQ Stock Market LLC

Securities registered pursuant to Section 12(g) of the Act: None
 
Indicate by a check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Yes T No £ 
 
Indicate by a check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
Yes £ No T 
 
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 12 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 T No £
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of the 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 a check mark whether the registrant is large accelerated filer, an accelerated filer, or a nonaccelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
 
Large accelerated filer T
Accelerated Filer £
Non-accelerated Filer £
 
Indicate by a check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes £ No T
 
As of February 21, 2007, 42,205,057 of the registrant’s common stock were outstanding. The aggregate market value of shares of common stock held by nonaffiliates at February 21, 2007 was $993,425,622 (based upon the closing sales price of $27.17 per share).
 
 
DOCUMENTS INCORPORATED BY REFERENCE
 
Portions of the Annual Report to Shareowners for the fiscal year ended December 31, 2006 - Parts I and II.
 
Portions of the Definitive Proxy Statement to be filed with the Securities and Exchange Commission, relating to the 2007 Annual Meeting of Shareowners, to be held on April 18, 2007 - Part III.
 
 
To Our Shareowners, Employees, and Customers
 
Message From the Chairman
 
Once again, I am pleased to report record earnings and outstanding growth for Frontier Financial Corporation during 2006. Since our founding in 1978, it has been our pleasure to report record earnings during 27 of the 28 years.
 
Frontier Bank’s expansion continued during 2006, and on January 31, we closed our merger with NorthStar Financial Corporation, acquiring offices in Ballard and Fremont, two new markets for the bank.
 
Our 45th office, located in Bellevue, opened on December 20, 2006. We are looking at further expansion, and plan to open an office in Bremerton in the second or third quarter of this year, followed by an office in Gig Harbor during the second half of 2007. This will give us 47 locations throughout Western Washington, stretching from Whatcom County to Pierce County, and west to Clallam County.
 
In August, the Board of Directors declared a 3-for-2 stock split to shareowners of record as of September 12, 2006. Shareowners received one additional share for every two shares of stock they owned. This was equivalent to a 50% stock dividend. This marks the eighth time that Frontier has had a stock split since our opening in 1978. As a result of those eight splits and our 17 stock dividends paid since inception, an original shareowner in 1978 with 100 shares, would now own 113,040 shares, providing no shares were sold during that time.
 
Directors continued to increase the cash dividend on our stock in each successive quarter during the year. The dividend of 15.5¢ per share, paid in January 2007, marked the 29th consecutive quarter in which the cash dividend has been increased. During 2006 our shareowners were rewarded with a total return of 39%, which includes stock price appreciation and the dividend return.
 
The economy in our region continues to be resilient, and the housing market shows strength due to strong job and population growth. The Puget Sound region seems to have avoided the housing downturn we have seen in other areas of the country, and because of this, we look to continued growth and success in the coming year.
 
For the past year, our results were enviable:
 
•  Our net income for the year was $68.9 million, an increase of 33.6% over 2005 earnings of $51.6 million. Diluted earnings per share of $1.52 reflected an increase of $.31 or 25.6% over the $1.21 earned in 2005, split adjusted. The principal driver of earnings growth was an increase in net interest income of $36.1 million.
 
•  At year-end 2006, Frontier’s total assets were $3.24 billion, and deposits totaled $2.45 billion, an increase of 22.7% and 19.0%, respectively. Net loans of $2.87 billion and investments of $114.7 million reflected an increase of 21.7% and 3.7%, respectively.

 
•  Return on average assets for the year was 2.27% compared to 2.09% for 2005 and return on shareowners’ equity was 18.91% compared to 18.75% in the prior year. Frontier’s efficiency ratio was 38% compared to 41% last year. This ratio reflects the cost of producing a dollar of revenue, and a lower ratio reflects a more productive organization. Based on the above ratios, Frontier continues to be among the top performing financial holding companies in the nation.
 
•  Nonperforming assets were .27% of total assets
 
at year-end 2006 compared to .19% a year ago. Nonaccruing loans increased to $8.7 million at year-end compared to $4.9 million at December 31, 2005. For the years ended December 31, 2006 and 2005, net charge-offs amounted to $2.9 million, compared to a net recovery of $147 thousand, respectively. The loan loss reserve stood at $40.6 million, or 1.40% of total loans at year-end, compared to $33.8 million, or 1.41% of total loans at the end of the prior year-end. Frontier considers the provision for loan losses adequate to cover losses inherent in the portfolio at December 31, 2006. The bank did not have any other real estate owned (foreclosed properties) on the books during either of the last two year-ends.
 
We sincerely thank our Board of Directors for their leadership during 2006, and we thank our employees for their dedication in providing outstanding service to our customers and to our communities. Many thanks to you, our loyal shareowners, for your continued support of our bank.
 
To those customers that are featured throughout this year’s Annual Report, and to the hundreds of others with whom we have built loyal relationships over the past many years, we say “thank you” for your business and for referring others to Frontier Bank. You continue to “make the difference” in our success.
 
Sincerely,
 
Robert J. Dickson
 
Chairman
 
 
TABLE OF CONTENTS

Item Number
 
Form 10-K
Page
  
Annual
Shareowners’
Report
Page
  
Proxy
Statement
Page
PART I
            
1 - 15
        
15 - 22
        
22
        
 
23
        
34
        
34
        
34
        
PART II
            
35
  
20 - 23, 43
    
37
        
   
31 - 48
    
28 - 31
  
36 - 39
    
38
        
38
        
38 - 39
        
39
        
PART III
            
40
        
40
        
41
        
41
        
41
        
PART IV
            
42
        
 
43 - 44
        

i

PART I

This report includes a number of forward-looking statements that reflect the Company’s current views with respect to future events and financial performance. Please refer to the section addressing forward-looking information on page 14 for further discussion. In this report, “we,” “our,” and “us” refer to Frontier Financial Corporation and subsidiaries, unless otherwise noted or context otherwise indicates.
 
ITEM 1 - BUSINESS

(a)
General Development of Business.
 
Frontier Financial Corporation (“FFC”, “Frontier” or “the Corporation”) is a Washington corporation which was incorporated in 1983 and is registered as a financial holding company under the Bank Holding Company Act of 1956. As part of a plan of reorganization consummated following the close of business September 30, 1983, FFC acquired all of the stock of Frontier Bank (the “Bank”), issuing its common stock in an exchange for the Bank’s common stock on a share-for-share basis. FFC has two subsidiaries: the Bank, which is engaged in a general banking business and in businesses related to banking, and FFP, Inc., a nonbank corporation which leases property to the Bank. As of December 31, 2006, Frontier had total assets of approximately $3.24 billion, net loans receivable of approximately $2.87 billion, total deposits of approximately $2.45 billion and shareowner’s equity of approximately $395.3 million.
 
The Bank
 
Frontier Bank is a Washington state-chartered commercial bank that is a nonmember with its headquarters located in Everett, Snohomish County, Washington. It was founded in September 1978 by Robert J. Dickson and local business persons. The Bank is an “insured bank” as defined in the Federal Deposit Insurance Act.

(b)
Financial Information About Industry Segments
 
Not applicable.
 
(c)
Narrative Description of Business.
 
Location of Principal Market Areas

The Bank engages in general banking business in the State of Washington, including the acceptance of demand, time and savings deposits and the making of loans. Headquartered in Everett, Washington, Frontier serves its customers from forty-five full service offices in 2006. In Snohomish County, four offices are located in Everett, and one office each is located in Arlington, Edmonds, Lake Stevens, Marysville, Mill Creek, Monroe, Lynnwood, Smokey Point, Snohomish, and Stanwood. Seven offices are located in Pierce County in the cities of Buckley, Edgewood-Milton, Orting, Puyallup, Sumner, Tacoma and University Place. Frontier has thirteen branches in King County, one each in Ballard (Seattle), Bellevue, Bothell, Duvall, Fremont (Seattle), Kent, Kirkland, Lake City (Seattle), Redmond, Renton, Seattle, Totem Lake (Kirkland) and Woodinville. In addition, the following eleven branches are located in Clallam, Jefferson, Kitsap, Skagit and Whatcom Counties: two branches each in Bellingham and Poulsbo, and one each in Bainbridge Island, Lynden, Mount Vernon, Port Angeles, Port Townsend, Sequim and Silverdale.

In February 2004, the Bank opened a full service banking office downtown Seattle, its only office in downtown Seattle. In April 2004, the Bank opened a real estate lending office in Tacoma, Pierce County, which makes commercial and construction loans. In 2005, the Bank opened a second full service office in downtown Bellingham, a Renton Office in King County and an office in Lynden, Whatcom County. As of February 1, 2006, Frontier completed its merger with NorthStar Financial Corporation and acquired two offices in the Ballard and Fremont communities of Seattle. Two additional offices were opened in 2006: a University Place Office in Pierce County and a Bellevue Office in King County for a total of 45 offices.

On February 1, 2006, FFC completed the acquisition of NorthStar Financial Corporation and its subsidiary, NorthStar Bank, a privately held financial institution headquartered in Seattle, Washington, with two banking offices in the Ballard and Fremont communities north of downtown Seattle. The shareowners of NorthStar received 1,513,707 shares of FFC common stock in exchange for all of the outstanding shares of NorthStar. The transaction was accounted for under the purchase method of accounting.

-1-

Banking Services

The Bank provides a full range of consumer banking services including savings accounts, checking accounts, installments and commercial lending, safe deposit facilities, time deposits and other consumer and business related financial services. In addition to consumer-oriented activities, the Bank maintains a strong commercial lending program, servicing individuals and businesses headquartered in the Bank’s principal market area.

Frontier's loan portfolio consists of primarily of loans secured by real estate, although importance is also placed on commercial and agriculture loans, consumer installment loans and bankcard loans. At December 31, 2006, real estate category loans comprised 84.7% of the net loan portfolio, while commercial and agriculture loans made up 13.1% of the portfolio and installment and bankcard loans were 2.2%. Loans totaled $2.91 billion, and were 119% of deposits. Almost all of these loans were to borrowers within the Bank's principal market areas. See page 25 for loan category amounts for the last five years.

Commercial and Agriculture Loans

This category of loans includes both commercial and agriculture loans used to provide working capital or for specific purposes, such as to finance the purchase of fixed assets, equipment or inventory. Commercial loans include lines of credit and term loans. Lines of credit are extended to businesses based on the financial strength and integrity of the borrower and generally (with some exceptions) are collateralized by short-term assets such as accounts receivable and have a maturity of one year or less. Such lines of credit bear an interest rate that floats with our base rate or another established index. Commercial term loans are typically made to finance the acquisition of fixed assets, refinance short-term debt originally used to purchase fixed assets or, in rare cases, to finance a businesses purchase. Commercial term loans generally mature within one to five years. They may be collateralized by the asset being acquired or other available assets. These term loans will generally bear interest that either floats with our base rate or another established index or is fixed for the term of the loan. Agricultural loans consist of farm related credits used to finance operating expenses. These loans generally have terms of one year and bear interest that either floats with our base rate or is fixed for the term of the loan. These loans are generally collateralized by farm related assets including land, equipment, crops or livestock.

Real Estate Loans

Real estate loans represent the largest share of our loan portfolio. These loans are comprised of construction and land development loans, real estate commercial term loans and home mortgages. The construction and land development loan portfolio is comprised of three types:

 
·
Loans for construction of residential and commercial income-producing properties that generally have terms of less than two years and typically bear an interest rate that floats with the base rate.
 
·
Loans for construction of single-family spec and owner-occupied properties that generally have terms of one year or less and typically bear an interest rate that floats with the base rate.
 
·
Land development used for either residential or commercial purposes. These loans generally have terms of one year or less and typically bear an interest rate that floats with the base rate.

Our real estate commercial term loans finance the purchase and/or ownership of income producing properties. These loans are generally mature in one to ten years with a payment amortization schedule ranging from 15 to 25 years. Interest rates may be fixed or variable. The interest rate on fixed rate loans typically reprice between the first and fifth year.

Mortgages loans include various types of loans for which real property is held as collateral. These loans, collateralized by one to four family residences, will typically have maturities between one and five years with payment amortization schedules ranging from 10 to 20 years. Mortgage loans will be written with both fixed and variable rates.

-2-

In addition to home mortgages held in our portfolio, the Bank is active in originating and selling mortgages into the secondary market. The Bank offers a variety of products for refinancing and purchases and is approved to originate FHA and VA loans. The majority of loans originated in 2006 were fixed rate single-family loans. Total loans sold in 2006 were approximately $111.7 million. Servicing is sold with the loan. Funding requirements for these loans is very minimal as few of these loans originated through this operation are retained for investment.

Installment Loans

We provide loans for personal use including: auto loans, boat loans, home improvement loans, revolving lines of credit, VISA credit cards and other loans typically made by banks to individual borrowers. These loans generally have terms ranging from one to five years, with up to 20-year amortizations and are written with both fixed and variable rates.

Investments

From time to time, the Bank acquires investment securities when funds acquired through deposit activities exceed loan demand. When excess funds are considered temporary in nature by management, they are typically placed in federal funds sold on an overnight basis to correspondent banks, approved by the Board of Directors. This type of investment is not considered desirable, as the interest rate earned on these funds is minimal in nature. When funds are considered longer term, they are generally invested in securities purchased in the open market. At December 31, 2006, the Bank had investments totaling $105.2 million at amortized cost. U.S. Agency bonds comprised 47.5% of the portfolio, equities comprised 27.6%, corporate bonds made up 17.3%, municipals made up 3.6% and U.S. Treasury bonds made up 4.0%. Please see Note 3, page 13 of our 2006 Annual Report for details on the makeup of the portfolio. The Bank has an investment policy that generally permits purchasing securities rated only in one of the four highest rating categories by a nationally recognized credit rating organization. The policy also provides for maturity patterns, diversification of investments and avoidance of concentrations within the portfolio.

Deposit Activities

The Bank's primary source of funds has historically been customer deposits. The Bank offers a variety of accounts designed to attract both short-term and long-term deposits from its market area. These accounts include NOW, money market, sweep, savings and certificates of deposit. Interest rates paid on these account vary from time to time and are based on competitive factors and liquidity needs. One of the goals of management is to maintain noninterest-bearing deposits at the highest level possible. These are low cost funds and help to increase the net interest margin. Noninterest-bearing accounts comprised for 16.6% of total deposits at the end of 2006.

Other Funding Sources/FHLB Advances

The Bank has other funding sources such as FHLB advances, federal funds purchased and repurchase agreements. The major source of funds in this area is advances from the FHLB of Seattle. Although this source of funding can be more costly than deposit activities, large portions of funds are available very quickly for meeting loan commitments. The Bank's line of credit with the FHLB is 19% of qualifying assets and is collateralized by qualifying first mortgage loans, qualifying commercial real estate and government agency securities. The Bank, as of December 31, 2006, had FHLB advances totaling $282.0 million (please refer to page 17 of the Annual Report to Shareowners for detail regarding these advances). These advances were collateralized with $597.8 million in qualifying first mortgages, other certain assets, a blanket filing on our commercial real estate portfolio and the remainder was secured by stock in FHLB. No commercial real estate or government securities were pledged at year-end. The unused portion of this credit line at December 31, 2006 was $247.8 million.
 
-3-
 
Business Strategy
 
Frontier is attempting to pursue 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 greater sensitivity 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 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) levels; and
 
 
·
exploring prudent means to grow the business internally and/or through acquisitions.
 
A source of future growth may be through acquisitions, although no assurance can be given that acquisition activity will continue in the future. See “Risk Factors”.
 
Facilities
 
Frontier owns its administrative offices and operations centers in Everett, and 24 of its branches, through its wholly-owned bank premises holding corporation subsidiary, FFP, Inc., which leases the properties to the Bank. Owned offices range in size from 1,000 to 45,000 square feet and have a total net book value at December 31, 2006, including leasehold improvements, furniture, fixtures and equipment of $30.0 million.
 
Other Financial Services
 
The Bank offers other financial services complementary to banking including an insurance and investment center that markets annuities, life insurance products, and mutual funds to Bank customers and the general public, a trust department that offers a full array of trust services, and a private banking office to provide personal service to high net worth customers.
 
Competition. The banking industry is highly competitive. The Bank faces strong competition in attracting deposits and in originating loans. The most direct competition for deposits has historically come from other commercial banks, saving institutions and credit unions located in the primary market area. As with all banking organizations, FFC also has competition from nonbanking sources, including mutual funds, corporate and governmental debt securities and other investment alternatives. FFC expects increasing competition from other financial institutions and nonbanking sources in the future. Many of FFC’s competitors have more significant financial resources, larger market share and greater name recognition than FFC. The existence of such competitors may make it difficult for FFC to achieve its financial goals.
 
Competition has further increased as a result of Washington banking laws that permit statewide branching of Washington domiciled financial institutions and acquisitions of Washington-based financial institutions by out-of-state bank holding companies.
 
Management believes that the principal competitive factors affecting FFC’s markets include interest rates paid on deposits and charged on loans, the range of banking products available, and customer service and support. Although management believes that the Bank’s products currently compete favorably with respect to these factors, there can be no assurance that FFC can maintain its competitive position against current and potential competitors, especially those with significantly greater financial resources.
 
The Bank’s competition for loans comes principally from other commercial banks, savings institutions, credit unions and mortgage banking companies. The Bank competes for loans principally through the efficiency and quality of the services it provides borrowers, real estate brokers and home builders, and the interest rates and loan fees it charges.

-4-

 
The Bank competes for deposits by offering depositors a wide variety of checking accounts, savings accounts, certificates and other services. The Bank’s ability to attract and retain deposits depends on its ability to provide deposit products that satisfy the requirements of customers as to interest rates, liquidity, transaction fees, risk of loss of deposit, convenience and other factors. Deposit relationships are actively solicited through a sales and service system.
 
Changes in technology, mostly from the growing use of computers and computer-based technology, present competitive challenges to FFC. Large banking institutions typically have the ability to devote significant resources to developing and maintaining technology-based services such as on-line banking and other banking products and services over the Internet, including deposit services and mortgage loans. Some new banking competitors offer all of these services online. Customers who bank by computer or by telephone may not need to go to a branch location in person. FFC’s high service philosophy emphasizes face-to-face contact with tellers, loan officers and other employees. FFC believes a personal approach to banking is a competitive advantage, one that will remain popular in the communities that it serves. However, customer preferences may change, and the rapid growth of online banking could, at some point, render the Bank’s personal, branch-based approach obsolete. FFC believes that it has reduced this risk by offering on-line banking services to its customers, and by continuing to provide 24-hour banking services. There can be no assurance that these efforts will be successful in preventing the loss of customers to competitors.

Employees

At December 31, 2006, the Bank had 721 full time equivalent employees. None of the Bank’s employees are covered by a collective bargaining agreement. The Bank considers its relations with employees to be good.

REGULATION AND SUPERVISION
 
The following discussion is only intended to provide summaries of significant statutes and regulations that affect the banking industry and is therefore not complete. Changes in applicable laws or regulations, and in the policies of regulators, may have a material effect on our business and prospects. We cannot accurately predict the nature or extent of the effects on our business and earnings that fiscal or monetary policies, or new federal or state laws, may have in the future.
 
General
 
We are extensively regulated under federal and state law. These laws and regulations are primarily intended to protect depositors, not shareholders. The discussion below describes and summarizes certain statutes and regulations. These descriptions and summaries are qualified in their entirety by reference to the particular statute or regulation. Changes in applicable laws or regulations may have a material effect on our business and prospects. Our operations may also be affected by changes in the policies of banking and other government regulators. We cannot accurately predict the nature or extent of the possible future effects on our business and earnings of changes in fiscal or monetary policies, or new federal or state laws and regulations.
 
Compliance
 
In order to assure that we are in compliance with the laws and regulations that apply to our operations, including those summarized below, we employ a compliance officer, and we engage an independent compliance auditing firm. We are regularly reviewed by the Federal Reserve, the Federal Deposit Insurance Corporation, or FDIC, and the Washington Department of Financial Institutions, Division of Banks, or DFI, during which reviews such agencies assess our compliance with applicable laws and regulations. Based on the assessments of our outside compliance consultants and the FDIC, we believe that we materially comply with all of the laws and regulations that apply to our operations.
 
-5-
 
Federal Bank Holding Company Regulation
 
General. Frontier Financial Corporation, Inc. is a registered financial holding company as defined in the Bank Holding Company Act of 1956, as amended, or the Bank Holding Company Act, and is therefore subject to regulation, supervision and examination by the Federal Reserve. In general, the Bank Holding Company Act limits the business of bank holding companies to owning or controlling banks and engaging in other activities closely related to banking. FFC must file reports with the Federal Reserve and must provide it with such additional information as it may require.
 
The Federal Reserve may require FFC to terminate an activity or terminate control or liquidate or divest certain subsidiaries, affiliates or investments when the Federal Reserve believes the activity or the control of the subsidiary or affiliates constitutes a significant risk to the financial safety, soundness or stability of any of its banking subsidiaries.
 
The Federal Reserve also has the authority to regulate provisions of certain bank holding company debt, including the authority to impose interest ceilings and reserve requirements on such debt. Under certain circumstances, FFC must file written notice and obtain Federal Reserve approval prior to purchasing or redeeming its equity securities. Additionally, FFC is required by the Federal Reserve to maintain certain levels of capital. See “Capital Adequacy” below for a discussion of the applicable federal capital requirements.
 
Financial Holding Company Status. Under the Financial Services Modernization Act of 1999, a bank holding company may apply to the Federal Reserve to become a financial holding company, and thereby engage (directly or through a subsidiary) in certain activities deemed financial in nature. FFC’s election of financial holding company status was effective October 28, 2000.
 
As a financial holding company, FFC may affiliate with securities firms and insurance companies and engage in other activities that are financial in nature or are incidental or complementary to activities that are financial in nature. “Financial in nature” activities include:
 
 
•
securities underwriting;
 
 
•
dealing and market making;
 
 
•
sponsoring mutual funds and investment companies;
 
 
•
insurance underwriting and brokerage;
 
 
•
merchant banking; and
 
 
•
activities that the Federal Reserve, in consultation with the Secretary of the Treasury, determines from time to time to be so closely related to banking or managing or controlling banks as to be a proper incident thereto.
 
In order to become or remain a financial holding company, the Bank must be well capitalized, well managed, and, except in limited circumstances, in satisfactory compliance with the Community Reinvestment Act. Failure to sustain compliance with such requirements or correct any non-compliance within a fixed time period could lead to divesture of subsidiary banks or require us to conform all of our activities to those permissible for a bank holding company. A bank holding company that is not also a financial holding company can only engage in banking and such other activities determined by the Federal Reserve to be so closely related to banking or managing or controlling banks as to be a proper incident thereto.
 
We do not believe that the Financial Services Modernization Act will negatively affect our operations in the short term. However, to the extent the legislation permits banks, securities firms and insurance companies to affiliate, the financial services industry may experience further consolidation. This consolidation could result in a growing number of larger financial institutions that offer a wider variety of financial services than we currently offer, and these companies may be able to aggressively compete in the markets we currently serve.
 
-6-

Acquisition of Banks. The Bank Holding Company Act requires every bank holding company to obtain the Federal Reserve Board’s prior approval before:
 
•
acquiring direct or indirect ownership or control of any voting shares of any bank if, after the acquisition, the bank holding company will directly or indirectly own or control more than 5% of the bank’s voting shares;
 
 
•
acquiring all or substantially all of the assets of any bank; or
 
 
•
merging or consolidating with any other bank holding company.
 
Additionally, the Bank Holding Company Act provides that the Federal Reserve Board may not approve any of these transactions if it would result in or tend to create a monopoly, substantially lessen competition or otherwise function as a restraint of trade, unless the anti-competitive effects of the proposed transaction are clearly outweighed by the public interest in meeting the convenience and needs of the community to be served. The Federal Reserve Board is also required to consider the financial and managerial resources and future prospects of the bank holding companies and banks concerned and the convenience and needs of the community to be served. The Federal Reserve Board’s consideration of financial resources generally focuses on capital adequacy, which is discussed below.
 
Restrictions on Ownership of FFC. The Bank Holding Company Act requires any “bank holding company” (as defined in that Act) to obtain the approval of the Board of Governors of the Federal Reserve System prior to acquiring more than 5% of FFC’s outstanding common stock. Any person other than a bank holding company is required to obtain prior approval of the Federal Reserve Board to acquire 10% or more of FFC’s outstanding common stock under the Change in Bank Control Act. Any holder of 25% or more of FFC’s outstanding common stock, other than an individual, is subject to regulation as a bank holding company under the Bank Holding Company Act.
 
Holding Company Control of Nonbanks. With some exceptions, the Bank Holding Company Act also prohibits a bank holding company from acquiring or retaining direct or indirect ownership or control of more than 5% of the voting shares of any company which is not a bank or bank holding company, or from engaging directly or indirectly in activities other than those of banking, managing or controlling banks, or providing services for its subsidiaries. The principal exceptions to these prohibitions involve certain non-bank activities which, by statute or by Federal Reserve regulation or order, have been identified as activities closely related to the business of banking or of managing or controlling banks.
 
Transactions with Affiliates. Subsidiary banks of a bank holding company are subject to restrictions imposed by the Federal Reserve Act on extensions of credit to the holding company or its subsidiaries, on investments in their securities and on the use of their securities as collateral for loans to any borrower. These regulations and restrictions may limit FFC’s ability to obtain funds from the Bank for its cash needs, including funds for payment of dividends, interest and operational expenses.
 
Tying Arrangements. We are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit, sale or lease of property or furnishing of services. For example, with certain exceptions, neither FFC nor the Bank may condition an extension of credit to a customer on either (i) a requirement that the customer obtain additional services provided by us or (ii) an agreement by the customer to refrain from obtaining other services from a competitor.
 
Support of Subsidiary Banks. Under Federal Reserve policy, FFC is expected to act as a source of financial and managerial strength to the Bank. This means that FFC is required to commit, as necessary, resources to support the Bank. Any capital loans a bank holding company makes to its subsidiary banks are subordinate to deposits and to certain other indebtedness of those subsidiary banks.
 
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Federal and State Regulation of the Bank
 
General. The Bank is a Washington chartered commercial bank with deposits insured by the FDIC. As a result, the Bank is subject to supervision and regulation by the Washington DFI and the FDIC. These agencies have the authority to prohibit banks from engaging in what they believe constitute unsafe or unsound banking practices.
 
Lending Limits. Washington banking law generally limits the amount of funds that a bank may lend to a single borrower to 20% of stockholders’ equity.
 
Control of Financial Institutions. The acquisition of 25% or more of a state chartered bank’s voting power by any individual, group or entity, is deemed a change in control under Washington banking law, requiring notice and application and prior approval of the DFI.
 
Community Reinvestment. The Community Reinvestment Act requires that, in connection with examinations of financial institutions within their jurisdiction, the FDIC evaluate the record of the financial institution in meeting the credit needs of its local communities, including low and moderate income neighborhoods, consistent with the safe and sound operation of the institution. These factors are also considered in evaluating mergers, acquisitions and applications to open a branch or facility.
 
Insider Credit Transactions. Banks are also subject to certain FDIC restrictions on extensions of credit to executive officers, directors, principal shareholders or any related interests of such persons (i.e., insiders). Extensions of credit (i) must be made on substantially the same terms and pursuant to the same credit underwriting procedures as those for comparable transactions with persons who are neither insiders nor employees, and (ii) must not involve more than the normal risk of repayment or present other unfavorable features. Banks are also subject to certain lending limits and restrictions on overdrafts to insiders. A violation of these restrictions may result in regulatory sanctions on the bank or its insiders.
 
Regulation of Management. Federal law sets forth circumstances under which officers or directors of a bank may be removed by the institution’s federal supervisory agency. Federal law also prohibits management personnel of a bank from serving as a director or in a management position of another financial institution whose assets exceed a specified amount or which has an office within a specified geographic area.
 
Safety and Soundness Standards. Federal law imposes upon banks certain non-capital safety and soundness standards. These standards cover internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, compensation and benefits. Additional standards apply to asset quality, earnings and stock valuation. An institution that fails to meet these standards must develop a plan acceptable to its regulators, specifying the steps that the institution will take to meet the standards. Failure to submit or implement such a plan may subject the institution to regulatory sanctions. Under Washington state law, if the stockholders’ equity of a Washington state-chartered bank becomes impaired, the Commissioner of the Washington DFI will require the bank to make the impairment good. Failure to make the impairment good may result in the Commissioner’s taking possession of the bank and liquidating it.
 
Dividends. The principal source of FFC’s cash reserves will be dividends received from the Bank. Washington law limits the Bank’s ability to pay cash dividends. Under these restrictions, a bank may not declare or pay any dividend greater than its retained earnings without approval of the Washington DFI. The Washington DFI has the power to require any state-chartered bank to suspend the payment of any and all dividends.
 
In addition, a bank may not pay cash dividends if doing so would reduce its capital below minimum applicable federal capital requirements. See “Capital Adequacy” below for a discussion of the applicable federal capital requirements.
 
Other Regulations. The loan operations of the Bank are subject to state usury laws and federal laws concerning interest rates.
 
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Federal Laws Applicable to Credit Transactions. The loan operations of the Bank are also subject to federal laws applicable to credit transactions, such as the:
 
 
•
Truth-In-Lending Act, governing disclosures of credit terms to consumer borrowers;
 
 
•
Home Mortgage Disclosure Act of 1975, requiring financial institutions to provide information to enable the public and public officials to determine whether a financial institution is fulfilling its obligation to help meet the housing needs of the community it serves;
 
 
•
Equal Credit Opportunity Act, prohibiting discrimination on the basis of race, creed or other prohibited factors in extending credit;
 
 
•
Fair Credit Reporting Act of 1978, governing the use and provision of information to credit reporting agencies;
 
 
•
Fair Debt Collection Practices Act, governing the manner in which consumer debts may be collected by collection agencies;
 
 
•
Servicemembers Civil Relief Act, which amended the Soldiers’ and Sailors’ Civil Relief Act of 1940, governing the repayment terms of, and property rights underlying, secured obligations of persons in military service; and
 
 
•
the rules and regulations of the various federal agencies charged with the responsibility of implementing these federal laws.
 
Federal Laws Applicable to Deposit Operations. The deposit operations of the Bank are subject to:
 
 
•
the Right to Financial Privacy Act, which imposes a duty to maintain confidentiality of consumer financial records and prescribes procedures for complying with administrative subpoenas of financial records; and
 
 
•
the Electronic Funds Transfer Act and Regulation E issued by the Federal Reserve Board to implement that act, which govern automatic deposits to and withdrawals from deposit accounts and customers’ rights and liabilities arising from the use of automated teller machines and other electronic banking services.
 
Check Clearing for the 21st Century Act. On October 28, 2003, President Bush signed into law the Check Clearing for the 21st Century Act, also known as Check 21. The new law gives “substitute checks,” such as a digital image of a check and copies made from that image, the same legal standing as the original paper check. Some of the major provisions include:
 
 
•
allowing check truncation without making it mandatory;
 
 
•
demanding that every financial institution communicate to accountholders in writing a description of its substitute check processing program and their rights under the law;
 
 
•
legalizing substitutions for and replacements of paper checks without agreement from consumers;
 
 
•
retaining in place the previously mandated electronic collection and return of checks between financial institutions only when individual agreements are in place;
 
 
•
requiring that when accountholders request verification, financial institutions produce the original check (or a copy that accurately represents the original) and demonstrate that the account debit was accurate and valid; and
 
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•
requiring recrediting of funds to an individual’s account on the next business day after a consumer proves that the financial institution has erred.
 
This new legislation will likely affect bank capital spending as many financial institutions assess whether technological or operational changes are necessary to stay competitive and take advantage of the new opportunities presented by Check 21.
 
Federal Home Loan Bank System. The Federal Home Loan Bank system, of which the Bank is a member, consists of 12 regional FHLBs governed and regulated by the Federal Housing Finance Board, or FHFB. The FHLBs serve as reserve or credit facilities for member institutions within their assigned regions. They are funded primarily from proceeds derived from the sale of consolidated obligations of the FHLB system. They make loans (i.e., advances) to members in accordance with policies and procedures established by the FHLB and the boards of directors of each regional FHLB.
 
As a system member, Frontier Bank is entitled to borrow from the FHLB of its region and is required to own a certain amount of capital stock in the FHLB. The Bank is in compliance with the stock ownership rules described above with respect to such advances, commitments and letters of credit and home mortgage loans and similar obligations. All loans, advances and other extensions of credit made by the FHLB to the Bank are secured by a portion of its mortgage loan portfolio, certain other investments and the capital stock of the FHLB held by the Bank.
 
Mortgage Banking Operations. The Bank is subject to the rules and regulations of FHA, VA, FNMA, FHLMC and GNMA with respect to originating, processing, selling and servicing mortgage loans and the issuance and sale of mortgage-backed securities. Those rules and regulations, among other things, prohibit discrimination and establish underwriting guidelines which include provisions for inspections and appraisals, require credit reports on prospective borrowers and fix maximum loan amounts, and, with respect to VA loans, fix maximum interest rates. Mortgage origination activities are subject to, among others, the Equal Credit Opportunity Act, Federal Truth-in-Lending Act and the Real Estate Settlement Procedures Act and the regulations promulgated thereunder which, among other things, prohibit discrimination and require the disclosure of certain basic information to mortgagors concerning credit terms and settlement costs.
 
Commercial Real Estate Guidance. The FDIC and the Federal Reserve Board issued joint Guidance on Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices on December 6, 2006. The Guidance provides supervisory criteria, including the following numerical indicators, to assist bank examiners in identifying banks with potentially significant commercial real estate loan concentrations that may warrant greater supervisory scrutiny: (1) commercial real estate loans exceed 300% of capital and increased 50% or more in the preceding three years, or (2) construction and land development loans exceed 100% of capital. The Guidance does not limit banks’ levels of commercial real estate lending activities. The Guidance applies to the Bank, based on our current loan portfolio. We believe that our loan portfolio has been subject to rigorous examination by banking regulators and that we have taken appropriate precautions to address the risks associated with our concentrations in commercial real estate lending. We do not expect the Guidance to adversely affect our operations or our ability to execute our growth strategy.
 
Privacy
 
Federal banking rules limit the ability of banks and other financial institutions to disclose non-public information about consumers to nonaffiliated third-parties. Pursuant to these rules, financial institutions must provide:
 
 
•
initial notices to customers about their privacy policies, describing the conditions under which they may disclose nonpublic personal information to nonaffiliated third-parties and affiliates;
 
 
•
annual notices of their privacy policies to current customers; and
 
 
•
a reasonable method for customers to “opt out” of disclosures to nonaffiliated third-parties.
 
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These privacy provisions affect how consumer information is transmitted through diversified financial companies and conveyed to outside vendors. We have implemented privacy policies in accordance with the law.
 
Interstate Banking And Branching
 
The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (“Interstate Act”) permits nationwide interstate banking and branching under certain circumstances. This legislation generally authorizes interstate branching and relaxes federal law restrictions on interstate banking. Currently, bank holding companies may purchase banks in any state, and states may not prohibit these purchases. Additionally, banks are permitted to merge with banks in other states, as long as the home state of neither merging bank has opted out under the legislation. The Interstate Act requires regulators to consult with community organizations before permitting an interstate institution to close a branch in a low-income area.
 
FDIC regulations prohibit banks from using their interstate branches primarily for deposit production. The FDIC has implemented a loan-to-deposit ratio screen to ensure compliance with this prohibition.
 
Washington enacted “opting in” legislation in accordance with the Interstate Act, allowing banks to engage in interstate merger transactions, subject to certain “aging” requirements. Until recently, Washington restricted out-of-state banks from opening de novo branches; however, in 2005, Washington interstate branching laws were amended so that an out-of-state bank may, subject to the DFI’s approval, open de novo branches in Washington or acquire an in-state branch so long as the home state of the out-of-state bank has reciprocal laws with respect to de novo branching or branch acquisitions. Once an out-of-state bank has acquired a bank within Washington, either through merger or acquisition of all or substantially all of the bank’s assets or through authorized de novo branching, the out-of-state bank may open additional branches within the state.
 
Deposit Insurance
 
The Bank’s deposits are currently insured to a maximum of $100,000 per depositor through the Bank Insurance Fund administered by the FDIC. The Bank is required to pay deposit insurance premiums, which are assessed semiannually and paid quarterly. The premium amount is based upon a risk classification system established by the FDIC. Banks with higher levels of capital and a low degree of supervisory concern are assessed lower premiums than banks with lower levels of capital or a higher degree of supervisory concern.
 
The FDIC is also empowered to make special assessments on insured depository institutions in amounts determined by the FDIC to be necessary to give it adequate assessment income to repay amounts borrowed from the U.S. Treasury and other sources or for any other purpose the FDIC deems necessary.
 
Legislative reforms to modernize the Federal Deposit Insurance System, including merging the Bank Insurance Fund and the Savings Association Insurance Fund into a new Deposit Insurance Fund, were approved by Congress on February 15, 2006. In addition to merging the insurance funds, the legislation:
 
 
•
raised the deposit insurance limit on certain retirement accounts to $250,000 and indexes that limit for inflation;
 
 
•
requires the FDIC and National Credit Union Administration boards, starting in 2010 and every succeeding five years, to consider raising the standard maximum deposit insurance; and
 
 
•
eliminated the current fixed 1.25 percent Designated Reserve Ratio and provides the FDIC with the discretion to set the DRR within a range of 1.15 to 1.50 percent for any given year.
 
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Capital Adequacy
 
Regulatory Capital Guidelines. Federal bank regulatory agencies use capital adequacy guidelines in the examination and regulation of bank holding companies and banks. The guidelines are “risk-based,” meaning that they are designed to make capital requirements more sensitive to differences in risk profiles among banks and bank holding companies.
 
Tier I and Tier II Capital. Under the guidelines, an institution’s capital is divided into two broad categories, Tier I capital and Tier II capital. Tier I capital generally consists of common stockholders’ equity, surplus and undivided profits. Tier II capital generally consists of the allowance for loan losses, hybrid capital instruments, and subordinated debt. The sum of Tier I capital and Tier II capital represents an institution’s total capital. The guidelines require that at least 50% of an institution’s total capital consist of Tier I capital.
 
Risk-based Capital Ratios. The adequacy of an institution’s capital is gauged primarily with reference to the institution’s risk weighted assets. The guidelines assign risk weightings to an institution’s assets in an effort to quantify the relative risk of each asset and to determine the minimum capital required to support that risk. An institution’s risk weighted assets are then compared with its Tier I capital and total capital to arrive at a Tier I risk-based ratio and a total risk-based ratio, respectively. The guidelines provide that an institution must have a minimum Tier I risk-based ratio of 4% and a minimum total risk-based ratio of 8%.
 
Leverage Ratio. The guidelines also employ a leverage ratio, which is Tier I capital as a percentage of total assets less intangibles, to be used as a supplement to risk-based guidelines. The principal objective of the leverage ratio is to constrain the maximum degree to which a bank holding company may leverage its equity capital base. The minimum leverage ratio is 3%; however, for all but the most highly rated bank holding companies and for bank holding companies seeking to expand, regulators generally expect an additional cushion of at least 1% to 2%.
 
Prompt Corrective Action. Under the guidelines, an institution is assigned to one of five capital categories depending on its total risk-based capital ratio, Tier I risk-based capital ratio, and leverage ratio, together with certain subjective factors. The categories range from “well capitalized” to “critically undercapitalized.” Institutions that are deemed to be “undercapitalized,” depending on the category to which they are assigned, are subject to certain mandatory supervisory corrective actions.
 
State Corporate Law Restrictions
 
As a Washington corporation, FFC is subject to certain limitations and restrictions under applicable Washington corporate law. For example, state law restrictions in Washington include limitations and restrictions relating to indemnification of directors; distributions to shareholders; transactions involving directors, officers, or interested shareholders; maintenance of books, records, and minutes; and observance of certain corporate formalities.
 
Corporate Governance and Accounting Legislation
 
Sarbanes-Oxley Act of 2002. On July 30, 2002, the Sarbanes-Oxley Act of 2002, or SOX, was signed into law to address corporate and accounting fraud. SOX establishes a new accounting oversight board that will enforce auditing standards and restricts the scope of services that accounting firms may provide to their public company audit clients. Among other things, SOX also (i) requires chief executive officers and chief financial officers to certify to the accuracy of periodic reports filed with the SEC; (ii) imposes new disclosure requirements regarding internal controls, off-balance-sheet transactions, and pro forma (non-GAAP) disclosures; (iii) accelerates the time frame for reporting of insider transactions and periodic disclosures by public companies; and (iv) requires companies to disclose whether or not they have adopted a code of ethics for senior financial officers and whether the audit committee includes at least one “audit committee financial expert.”
 
Under SOX, the SEC is required to regularly and systematically review corporate filings, based on certain enumerated factors. To deter wrongdoing, SOX (i) subjects bonuses issued to top executives to disgorgement if a restatement of a company’s financial statements was due to corporate misconduct; (ii) prohibits an officer or director from misleading or coercing an auditor; (iii) prohibits insider trades during pension fund “blackout periods”; (iv) imposes new criminal penalties for fraud and other wrongful acts; and (v) extends the period during which certain securities fraud lawsuits can be brought against a company or its officers.
 
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As a public reporting company, we are subject to the requirements of SOX and related rules and regulations issued by the SEC and NASDAQ. We anticipate that we will incur additional expense as a result of the Act, but we do not expect that such compliance will have a material impact on our business.
 
Anti-terrorism Legislation
 
USA Patriot Act of 2001. On March 9, 2006, President Bush signed the renewal of the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism, or the Patriot Act, of 2001. Among other things, the Patriot Act (i) prohibits banks from providing correspondent accounts directly to foreign shell banks; (ii) imposes due diligence requirements on banks opening or holding accounts for foreign financial institutions or wealthy foreign individuals; (iii) requires financial institutions to establish an anti-money-laundering compliance program; and (iv) eliminates civil liability for persons who file suspicious activity reports. The Patriot Act also increases governmental powers to investigate terrorism, including expanded government access to account records. The Department of the Treasury is empowered to administer and make rules to implement the Patriot Act. While we believe the Patriot Act may, to some degree, affect our recordkeeping and reporting expenses, we do not believe that it will have a material adverse effect on our business and operations.
 
Effects of Government Monetary Policy
 
Our earnings and growth are affected not only by general economic conditions, but also by the fiscal and monetary policies of the federal government, particularly the Federal Reserve. The Federal Reserve can and does implement national monetary policy for such purposes as curbing inflation and combating recession. The nature and impact of future changes in monetary policies and their impact on us cannot be predicted with certainty.
 
Nonbank Subsidiary
 
Our non-bank subsidiary, FFP, Inc., a Washington corporation, is subject to the laws and regulations of both the federal government and the state in which it conducts business.
 
(d) Financial Information About Foreign and Domestic Operations and Export Sales.
 
Not applicable.
 
(e) Available Information of the Registrant.
 
We make available through our Internet website, free of charge, copies of our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or Section 15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after filing such material electronically or otherwise furnishing it to the Securities and Exchange Commission. These filings can be accessed under “Investor Relations” found on the homepage of our website at www.frontierbank.com. Our Code of Ethics for Senior Financial Officers, which includes a code of ethics applicable to our accounting and financial employees, including our Chief Executive Officer and Chief Financial Officer, is also available on our website under “Investor Relations.” These filings are also accessible on the SEC’s website at www.sec.gov. The public may read and copy any materials we file with the SEC at the SEC’s Public Reference Room at 100 F Street, N.E., Washington, D.C. 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. Further, each of these documents is also available in print (at no charge) to any shareholder upon request, addressed to Investor Relations, Frontier Financial Corporation, 332 S.W. Everett Mall Way, P.O. Box 2215, Everett, WA 98213. Our website and the information contained therein or connected thereto are not incorporated by reference into this Form 10-K.

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FFP, Inc.

On April 4, 1988, the Corporation formed a new subsidiary corporation called FFP, Inc. The purpose of this corporation is to purchase and lease improved real property to the Bank and acquire future branch sites. For further details, please see page 34 of this Form 10-K Report, "Properties." It is intended that future purchases of real property will be made by FFP, Inc. At this time, it is not anticipated that FFP, Inc. will engage in any other type of business.

Recent Stock Purchase

In December 2004, the Corporation purchased 4.95% of the common stock of Skagit State Bank, headquartered in Burlington, Washington, which is approximately 44 miles north of Everett in Skagit County. Subsequent to this investment, the Corporation applied to the Board of Governors of the Federal Reserve System to purchase up to 20% of Skagit State. Approval was received in February 2005 and the Corporation made additional purchases raising total ownership to 11.3% as of December 31, 2005. In January 2006, the Corporation purchased an additional 5,022 shares for $653 thousand, bringing total ownership to 12.62%.
 
Share Repurchase Program

In January 2001, the Board announced the adoption of a stock repurchase program authorizing the Corporation to repurchase up to 5% of its outstanding stock in the open market. On October 17, 2001 and 2002, September 16, 2004 and August 16, 2006 the Board of Directors authorized four plans that permitted purchases of 5% of the outstanding common stock under the repurchase program. The current repurchase program expires in August 2008. There were 2,263,323 shares remaining under the current plan at December 31, 2006. Subsequent to year-end, the Corporation repurchased 218,940 shares at an average cost of $26.85 through February 21, 2007.

Treatment of Goodwill

The Corporation has goodwill which was recorded in connection with acquisitions over the years. Prior to January 1, 2002, the Corporation amortized goodwill over 20 years. Upon the implementation of Statement of Financial Standards No. 142 (SFAS 142), Goodwill and Other Intangible Assets, on January 1, 2002, the Company ceased amortization of goodwill. SFAS 142 requires the Corporation to test the goodwill for impairment at least annually. The Corporation tested its goodwill and found no impairment during 2006. The Corporation uses the fair market value approach to determine if there has been any impairment.

Forward-Looking Statements

The Annual Report on Form 10-K contains certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. In addition, the Corporation may make certain statements in future SEC filings, in press releases, and in oral and written statements made with the Corporation’s approval that are not statements of historical fact and may constitute forward-looking statements. Forward-looking statements may relate to, without limitation the Corporation’s financial condition, results of operations, plans, objectives, future performance or business.

Forward-looking statements are identified by the fact that they do not relate only to historical or current facts. Sentences containing words such as “may”, “will”, “expect”, “anticipate”, “believe”, “estimate”, “should”, “projected”, or similar words may constitute forward-looking statements, but are not the only means to identify these statements. The Corporation may have used these statements to describe expectations and estimates in various areas, including, but not limited to: changes in the economy of the markets in which it operates; interest rate movements; future acquisition and growth strategies; system conversions and integration activities; the impact of competitive products, services and pricing; and legislative, regulatory and accounting changes affecting the banking and financial service industry.

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•
Forward-looking statements are subject to risks and uncertainties that may cause actual future results to differ materially from estimated or projected results. Factors that could cause this difference—many of which are beyond the Corporation’s control—include the following, without limitation: changes in general economic conditions, either nationally or in Washington state;
 
 
•
inflation, interest rate, market and monetary fluctuations;
 
 
•
changes in consumer spending habits and savings habits;
 
 
•
increases in competitive pressures among financial institutions and businesses offering similar products and services;
 
 
•
higher defaults on our loan portfolio than we expect;
 
 
•
changes in management’s estimate of the adequacy of the allowance for loan losses;
 
 
•
risks associated with our growth strategy and related costs;
 
 
•
increased lending risks associated with our high concentrations of real estate loans, including construction and land development loans;
 
 
•
legislative or regulatory changes or changes in accounting principles, policies or guidelines;
 
 
•
technological changes; and
 
 
•
regulatory or judicial proceedings.
 
Given these risks and uncertainties, you are cautioned not to place undue reliance on such forward-looking statements. The forward-looking statements included or incorporated by reference into this report are made only as of the date hereof. We do not undertake and specifically decline any obligation to update any such statements or to publicly announce the results of any revisions to any such statements to reflect future events or developments.
 
ITEM 1A. RISK FACTORS
 
An investment in our common shares is subject to risks inherent to our business. The material risks and uncertainties that management believes affect us are described below. Before making an investment decision, one should carefully consider the risks and uncertainties described below as well as the other information contained in this report or incorporated by reference, including the consolidated financial statements and the notes thereto and “Management Discussion and Analysis of Financial Condition and Results of Operations.” The risks and uncertainties described below are not the only ones we face. Although we have significant risk management policies, procedures and verification processes in place, additional risks and uncertainties that management is not aware of or focused on or that management currently deems immaterial may also impair our business operations. This report is qualified in its entirety by these risk factors.
 
If any of the following risks actually occur, our financial condition and results of operations could be materially and adversely affected. If this were to happen, the value of our common shares could decline, perhaps significantly, and you could lose all or part of your investment. Investments in shares of bank stock are not government guaranteed.

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Risks Related To Our Business 

We Are Subject To Interest Rate Risk
 
Our earnings and cash flows are largely dependent upon our net interest income. Net interest income is the difference between interest income earned on interest-earning assets such as loans and securities and interest expense paid on interest-bearing liabilities such as deposits and borrowed funds. Interest rates are highly sensitive to many factors that are beyond our control, including but not limited to general economic conditions and policies of various governmental and regulatory agencies and, in particular, the Federal Reserve Board. Changes in monetary policy, including changes in interest rates, could influence not only the amount of interest we receive on loans and securities and the amount of interest we pay on deposits and borrowings, but such changes could also affect our ability to originate loans and obtain deposits as well as the fair value of our financial assets and liabilities. If the interest we pay on deposits and other borrowings increases at a faster rate than the interest we receive on loans and other investments, our net interest income, and therefore earnings, could be adversely affected. Earnings could also be adversely affected if the interest we receive on loans and other investments fall more quickly than the interest we pay on deposits and other borrowings.
 
Although management believes it has implemented effective asset and liability management strategies to reduce the potential effects of changes in interest rates on our results of operations, any substantial, unexpected and/or prolonged change in market interest rates could have a material adverse effect on our financial condition and results of operations.

We Are Subject To Credit Risk, Particularly With Respect To Our High Concentration of Construction, Land Development and Other Real Estate Loans
 
There are inherent risks associated with our lending and trading activities. These risks include, among other things, the impact of changes in interest rates and changes in the economic conditions in the markets where we operate and the customers we serve. Increases in interest rates and/or weakening economic conditions could adversely impact the ability of borrowers to repay outstanding loans or the value of the collateral securing these loans. We also are subject to various laws and regulations that affect our lending activities. Failure to comply with applicable laws and regulations could subject us to regulatory enforcement action that could result in the assessment against us of civil money or other penalties.
 
As of December 31, 2006, approximately 84.7% of our loan portfolio consisted primarily of loans secured by real estate, including commercial, construction, land development and mortgage loans. Approximately 45.5% of these real estate loans as of December 31, 2006 consisted of real estate construction and land development loans, which generally have a higher degree of risk than long-term financing of existing properties because repayment depends on the completion of the project and usually on the sale of the property. A downturn in the real estate market could increase loan delinquencies, defaults and foreclosures, and significantly impair the value of our collateral and our ability to sell the collateral upon foreclosure. The real estate collateral in each case provides an alternate source of repayment in the event of default by the borrower and may deteriorate in value during the time the credit is extended. If real estate values decline, it is also more likely that we would be required to increase our allowance for loan losses. If during a period of reduced real estate values we are required to liquidate the property collateralizing a loan to satisfy the debt or to increase our allowance for loan losses, it could materially reduce our profitability and adversely affect our financial condition. Although we closely monitor and manage risk concentrations and utilize various portfolio management practices, our loan portfolio contains a number of real estate loans with relatively large balances. The deterioration of one or a few of these loans could cause a significant increase in nonperforming loans, and an increase in overall nonperforming loans could result in a net loss of earnings, an increase in the provision for probable loan losses and an increase in loan charge-offs, all of which could have a material adverse effect on our financial condition and results of operations. Additional information regarding credit risk is included in Management’s Discussion and Analysis of Financial Condition and Results of Operations on page 44 and 45 of Frontier Financial Corporation’s 2006 Annual report to Shareowners.
 
Various Factors May Cause Our Allowance For Loan Losses To Increase

We maintain an allowance for loan losses, which is a reserve established through a provision for loan losses charged to expense, which represents management’s estimate of losses within the existing portfolio of loans. The allowance, in the judgment of management, is necessary to reserve for estimated loan losses and risks inherent in the loan portfolio. The level of the allowance reflects management’s continuing evaluation of industry concentrations; specific credit risks; loan loss experience; current loan portfolio quality; present and future economic, political and regulatory conditions; and unexpected losses inherent in the current loan portfolio. The determination of the appropriate level of the allowance for loan losses inherently involves a degree of subjectivity and requires that we make significant estimates of current credit risks and future trends, all of which may undergo material changes. Changes in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of our control, may require an increase in the allowance for loan losses. In addition, bank regulatory agencies and our independent auditors periodically review our allowance for loan losses and may require an increase in the provision for loan losses or the recognition of further loan charge-offs, based on judgments that can differ somewhat from those of our own management. In addition, if charge-offs in future periods exceed the allowance for loan losses, we will need additional provisions to increase the allowance for loan losses, which should they become necessary, would result in a decrease in net income and capital, and may have a material adverse effect on our financial condition and results of operations. Additional information regarding the allowance for loan losses is included in the section Allowance for Loan Losses on pages 34 and 35 of the Management’s Discussion and Analysis of Financial Condition and Results of Operations section of Frontier Financial Corporation’s 2006 Annual Report to Shareowners.

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We Are Subject To Liquidity Risk
 
Market conditions or other events could negatively affect the level or cost of liquidity, affecting our ongoing ability to accommodate liability maturities and deposit withdrawals, meet contractual obligations, and fund asset growth and new business transactions at a reasonable cost, in a timely manner and without adverse consequences. Management has implemented strategies to maintain sufficient and diverse sources of funding to accommodate planned as well as unanticipated changes in assets and liabilities under both normal and adverse conditions. However, substantial, unexpected and/or prolonged changes in the level or cost of liquidity could have a material adverse effect on our financial condition and results of operations. Additional information regarding liquidity risk is included in the section captioned “Liquidity” beginning on page 41of the Management’s Discussion and Analysis of Financial Condition and Results of Operations section of Frontier Financial Corporation’s 2006 Annual Report to Shareowners.

We Are Subject To Operational Risk
 
We, like all businesses, are subject to operational risk, which represents the risk of loss resulting from human error, inadequate or failed internal processes and systems, and external events. Operational risk also encompasses compliance (legal) risk, which is the risk of loss from violations of, or noncompliance with, laws, rules, and regulations, prescribed practices or ethical standards. Although we seek to mitigate operational risk through a system of internal controls, losses resulting from operational risk could take the form of explicit charges, increased operational costs, harm to our reputation or forgone opportunities, any and all of which could have a material adverse effect on our financial condition and results of operations.

Our Profitability Depends Significantly On Economic Conditions In The Geographic Regions In Which We Operate
 
Our success depends on the general economic conditions of the markets in which we operate. The regional economic conditions in the areas have an impact on the demand for our products and services as well as the ability of our customers to repay loans, the value of the collateral securing loans and the stability of our deposit funding sources. A significant decline in general economic conditions, caused by inflation, recession, acts of terrorism, outbreak of hostilities or other international or domestic occurrences, unemployment, changes in securities markets or other factors could also impact these regional economies and, in turn, have a material adverse effect on our financial condition and results of operations.

We Operate In A Highly Competitive Industry And Market Areas
 
We face substantial competition in all areas of our operations from a variety of different competitors, many of which are larger and may have more financial resources. Such competitors primarily include national and super-regional banks as well as smaller community banks within the various markets in which we operate. However, we also face competition from many other types of financial institutions, including without limitation: savings associations, credit unions, mortgage banking companies, finance companies, mutual funds, insurance companies, investment management firms, investment banking firms, broker-dealers and other local, regional and national financial services firms. The financial services industry could become even more competitive as a result of legislative, regulatory and technological changes and continued consolidation. Also, technology has lowered barriers to entry and made it possible for nonbanks to offer products and services traditionally provided by banks.

-17-
 
Our ability to compete successfully depends on a number of factors, including, among other things:

 
·
Our ability to develop and execute strategic plans and initiatives.

 
·
Our ability to develop, maintain and build upon long-term customer relationships based on quality service, high ethical standards and safe, sound assets.

 
·
Our ability to expand our market position.

 
·
The scope, relevance and pricing of the products and services we offer to meet customer needs and demands.

 
·
The rate at which we introduce new products and services relative to our competitors.

 
·
Industry and general economic trends.

 
·
Our ability to attract and retain qualified employees.

 
·
Our ability to respond to and resolve unexpected legal, regulatory or other compliance issues.
 
Failure to perform in any of these areas could significantly weaken our competitive position, which could adversely affect our growth and profitability and have a material adverse effect on our financial condition and results of operations.

We are Subject to Extensive Government Regulation and Supervision

We are subject to extensive regulation by federal, state and local governmental authorities and are subject to various laws and judicial and administrative decisions imposing requirements and restrictions on part or all of our operations. Because our business is highly regulated, the laws, rules and regulations applicable to us are subject to regular modification and change. For example, the FDIC and the Federal Reserve Board recently issued joint Guidance on Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices, that sets forth supervisory criteria to assist bank examiners in identifying banks with potentially significant commercial real estate loan concentrations that may warrant greater supervisory scrutiny. The Guidance applies to the Bank, based on our current loan portfolio, and we expect that our business and operations will be subject to enhanced regulatory review for the foreseeable future. Our failure to comply with applicable laws and regulations, or changes to the existing regulatory structure, could adversely affect our business, financial condition, results of operations or cash flows.

We Could Be Held Responsible For Environmental Liabilities of Real Estate Acquired Through Foreclosure

In the event we foreclose on a defaulted real estate loan to recover our investment, we may be subject to environmental liabilities in connection with the underlying real property, which could exceed the value of the real property. Although we exercise due diligence to discover potential environmental liabilities prior to acquiring any property through foreclosure, hazardous substances or wastes, contaminants, pollutants, or their sources may be discovered on properties during our ownership or after a sale to a third party. There can be no assurance that we would not incur full recourse liability for the entire cost of any removal and clean-up on an acquired property, that the cost of removal and clean-up would not exceed the value of the property, or that we could recover any of the costs from any third party.

Our Controls And Procedures May Fail Or Be Circumvented
 
Management regularly reviews and updates our internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of our controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on our business, financial condition and results of operations.

-18-

We Rely On Dividends From Our Subsidiaries For Most Of Our Revenue
 
Frontier Financial Corporation is a legal entity separate and distinct from its subsidiaries. It receives substantially all of its revenue from dividends from its subsidiaries. These dividends are the principal source of funds to pay dividends on our common shares. Various laws and regulations limit the amount of dividends that Frontier Bank may pay to Frontier Financial Corporation. In the event Frontier Bank is unable to pay dividends to Frontier Financial Corporation, we may not be able pay dividends on our common shares. The inability to receive dividends from Frontier Bank could have a material adverse effect on our business, financial condition and results of operations. Additional information regarding dividend restrictions is included in the section captioned “Regulation and Supervision” in Item 1, Business, on page 8 of this report.
 
Potential Acquisitions May Disrupt Our Business And Dilute Shareowner Value
 
Acquiring other banks or financial institutions or financial service companies involves various risks commonly associated with acquisitions, including, among other things:

 
•
Potential exposure to unknown or contingent liabilities of the acquired company.

 
•
Exposure to potential asset quality issues of the acquired company.

 
•
Difficulty and expense of integrating the operations and personnel of the acquired company.

 
•
Potential disruption to our business.

 
•
Potential diversion of our management’s time and attention.

 
•
The possible loss of key employees and customers of the acquired company.

 
•
Difficulty in estimating the value (including goodwill) of the acquired company.

 
•
Difficulty in estimating the fair value of acquired assets, liabilities and derivatives of the acquired company.

 
•
Potential changes in banking or tax laws or regulations that may affect the acquired company.
 
We regularly evaluate merger and acquisition opportunities and conduct due diligence activities related to possible transactions with other financial institutions. As a result, merger or acquisition discussions and, in some cases, negotiations may take place and future mergers or acquisitions involving cash, debt or equity securities may occur at any time. Acquisitions typically involve the payment of a premium over book and market values, and, therefore, some dilution of our tangible book value and net income per common share may occur in connection with any future transaction. Furthermore, failure to realize the expected revenue increases, cost savings, increases in geographic or product presence or market share, and/or other projected benefits from an acquisition could have a material adverse effect on our financial condition and results of operations.

We May Not Be Able To Attract And Retain Skilled People
 
Our success depends, in large part, on our ability to attract and retain key people. Competition for the best people in most activities in which we are engaged can be intense and we may not be able to hire or retain the people we want and/or need. The unexpected loss of services of one or more of our key personnel could occur, and such events may have a material adverse impact on our business because of the difficulty of promptly finding qualified replacement personnel and the loss of the employee’s skills, knowledge of our market, years of industry experience.

-19-
 
Our Information Systems May Experience An Interruption Or Breach In Security
 
We rely heavily on communications and information systems to conduct our business. Any failure, interruption or breach in security of these systems could result in failures or disruptions in our customer relationship management, general ledger, deposit, loan and other systems. While we have policies and procedures designed to prevent or limit the effect of the possible failure, interruption or security breach of our information systems, there can be no assurance that any such failures, interruptions or security breaches will not occur or, if they do occur, that they will be adequately addressed. The occurrence of any failures, interruptions or security breaches of our information systems could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our financial condition and results of operations.
 
We Continually Encounter Technological Change
 
The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology-driven products and services. The effective use of technology increases efficiency and enables financial institutions to better serve customers and to reduce costs. Our future success depends, in part, upon our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands, as well as to create additional efficiencies in our operations. Our largest competitors have substantially greater resources to invest in technological improvements. We may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to our customers. Failure to successfully keep pace with technological change affecting the financial services industry could have a material adverse impact on our business and, in turn, our financial condition and results of operations.
 
We Are Subject To Claims And Litigation
 
From time to time, customers and/or vendors may make claims and take legal action against us. Whether these claims and legal action are founded or unfounded, if such claims and legal actions are not resolved in our favor they may result in significant financial liability and/or adversely affect how the market perceives us and our products and services as well as impact customer demand for those products and services. Any financial liability or reputation damage could have a material adverse effect on our business, which, in turn, could have a material adverse effect on our financial condition and results of operations.
 
Our Earnings May Be Affected By Changes In Accounting Principles And In Tax Laws
 
Changes in U.S. generally accepted accounting principles could have a significant adverse effect on Frontier Financial Corporation’s reported financial results. Although these changes may not have an economic impact on our business, they could affect our ability to attain targeted levels for certain performance or regulatory measures.
 
We are subject to tax laws, rules and regulations. Changes to tax laws, rules and regulations, including changes in the interpretation or implementation of tax laws, rules and regulations by the Internal Revenue Service or other governmental bodies, could affect us in substantial and unpredictable ways. Such changes could subject us to additional costs, among other things. Failure to appropriately comply with tax laws, rules and regulations could result in sanctions by regulatory agencies, civil money penalties and/or reputation damage, which could have a material adverse effect on our business, financial condition and results of operations.
 
Severe Weather, Natural Disasters, Acts Of War Or Terrorism And Other External Events Could Significantly Impact Our Business
 
Severe weather, natural disasters, acts of war or terrorism and other adverse external events could have a significant impact on our ability to conduct business. Such events could affect the stability of our deposit base, impair the ability of borrowers to repay outstanding loans, impair the value of collateral securing loans, cause significant property damage, result in loss of revenue, interrupt our information systems, and/or cause us to incur additional expenses. For example, during 2005, hurricanes Katrina and Rita caused extensive flooding and destruction along the coastal areas of the Gulf of Mexico which severely impacted the operations of many financial institutions. While we were not adversely affected by the impact of these specific disasters, other severe weather or natural disasters, acts of war or terrorism or other adverse external events may occur in the future that would have an effect on our business. Although management has established disaster recovery plans and procedures, the occurrence of any such event could have a material adverse effect on our business, which, in turn, could have a material adverse effect on our financial condition and results of operations.

-20-
 
Risks Associated With Our Common Shares 
 
Our Share Price Can Be Volatile
 
Share price volatility may make it more difficult to resell our common stock when desired or at prices deemed statisfactory. Our share price can fluctuate significantly in response to a variety of factors including, among other things:

 
·
Actual or anticipated variations in quarterly results of operations.

 
·
Recommendations by securities analysts.

 
·
Operating and stock price performance of other companies that investors deem comparable to our business.

 
·
News reports relating to trends, concerns and other issues in or affecting the financial services industry.

 
·
Perceptions of us and/or our competitors in the marketplace.

 
·
New technology used, or services offered, by our competitors, or ourselves.

 
·
Significant acquisitions or business combinations, strategic partnerships, joint ventures or capital commitments entered into by us or our competitors.

 
·
Failure to integrate acquisitions or realize anticipated benefits from acquisitions.

 
·
Changes in government regulations.

 
·
Geopolitical conditions such as acts or threats of terrorism or military conflicts.
 
General market fluctuations, industry factors and general economic and political conditions and events, such as economic slowdowns or recessions, interest rate changes or credit loss trends, could also cause our share price to increase or decrease regardless of operating results.

An Investment In Our Common Shares Is Not Insured or An Insured Deposit
 
Our common stock is not a bank deposit and, therefore, is not insured against loss by the FDIC, any other deposit insurance fund or by any other public or private entity. Investment in our common stock is inherently risky for the reasons described in this “Risk Factors” section and elsewhere in this report and is subject to many of the same market forces that affect the price of common stock in any company. As a result, acquisition of our common shares may result in a loss of some or all of an investment in our shares.

Our Articles Of Incorporation, Regulations And Shareowners Rights Plan As Well As Certain Banking Laws May Have An Anti-Takeover Effect
 
Provisions of our articles of incorporation and regulations, federal banking laws, including regulatory approval requirements, could make it more difficult for a third party to acquire us, even if doing so would be perceived to be beneficial to our shareowners. The combination of these provisions may inhibit a non-negotiated merger or other business combination, which, in turn, could adversely affect the market price of our common shares.

-21-
 
Risks Associated With Our Industry 
 
The Earnings Of Financial Services Companies Are Significantly Affected By General Business And Economic Conditions
 
Our operations and profitability are impacted by general business and economic conditions in the United States and abroad. These conditions include short-term and long-term interest rates, inflation, money supply, political issues, legislative and regulatory changes, fluctuations in both debt and equity capital markets, broad trends in industry and finance, and the strength of the U.S. economy and the local economies in which we operate, all of which are beyond our control. Deterioration in economic conditions could result in an increase in loan delinquencies and nonperforming assets, decreases in loan collateral values and a decrease in demand for our products and services, among other things, any of which could have a material adverse impact on our financial condition and results of operations.
 
Financial Services Companies Depend On The Accuracy And Completeness Of Information About Customers And Counterparties
 
In deciding whether to extend credit or enter into other transactions, we may rely on information furnished by or on behalf of customers and counterparties, including financial statements, credit reports and other financial information. We may also rely on representations of those customers, counterparties or other third parties, such as independent auditors, as to the accuracy and completeness of that information. Reliance on inaccurate or misleading financial statements, credit reports or other financial information could have a material adverse impact on our business and, in turn, our financial condition and results of operations.
 
Consumers May Decide Not To Use Banks To Complete Their Financial Transactions
 
Technology and other changes are allowing parties to complete financial transactions through alternative methods that historically have involved banks. For example, consumers can now maintain funds in brokerage accounts or mutual funds that would have historically been held as bank deposits. Consumers can also complete transactions such as paying bills and/or transferring funds directly without the assistance of banks. The process of eliminating banks as intermediaries, known as “disintermediation,” could result in the loss of fee income, as well as the loss of customer deposits and the related income generated from the use of those deposits. The loss of these revenue streams and the lower cost deposits as a source of funds could have a material adverse effect on our financial condition and results of operations.

ITEM 1B. UNRESOLVED STAFF COMMENTS
 
There are no unresolved SEC staff comments.
 
-22-

STATISTICAL DISCLOSURE INDEX

The schedules listed below set forth the statistical information relating to Frontier Financial Corporation and subsidiaries (unless otherwise stated) in accordance with Guide 3. This information should be read in conjunction with the consolidated financial statements.
 
I.
Distribution of Assets, Liabilities and Shareowners' Equity; Interest Rates and Interest Differential:
Form 10-K
Page
  
Annual
Report 
Page
           
 
A.
Consolidated Average Balance Sheets/Interest Income and Expense/Rates
    
47
 
B.
Changes in Net Interest Income and Expense due to Rate and Volume
    
48
           
II.
Investment Portfolio
 
A.
Analysis of Investment Securities at Year-end
24
  
13
           
 
B.
Maturity Distribution of Investment Securities
24
  
14
           
III.
Loan Portfolio
     
 
  
 
 
A.
Types of Loans
25
  
15
 
B.
Loan Maturities and Sensitivity to Changes in Interest Rates
25
  
15, 36, 38 - 40, 42
 
C.
Risk Elements
26 - 27
    
 
D.
Concentrations of Credit
32
    
           
IV
. Summary of Loan Loss Experience
 
A.
Analysis
30
    
 
B.
Allocation of Allowance for Possible Loan Losses
31
    
     
 
    
V.
Deposits
           
 
Average Interest and Noninterest Bearing Deposit Balances
 
  
47
     
 
    
VI.
Return on Equity and Assets
           
 
Significant Financial Ratios
37
    
           
VII.
Short-term Borrowings
34
    
 
-23-

Analysis of Investment Securities

The aggregate amortized cost of investment securities at December 31 are as follows:

(In Thousands)
  
2006
Amoritized
Cost
  
2005
Amortized
Cost
  
2004
Amortized
Cost
  
U.S. Treasuries
  
$
4,204
  
$
7,232
  
$
15,704
  
U.S. Agencies
    
50,004
   
49,621
   
49,738
 
Municipal Bonds
    
3,753
   
4,231
   
6,051
 
Corporate Bonds
    
18,198
   
19,326
   
44,214
 
Equities
    
29,052
   
23,400
   
32,518
 
 
  
$
105,211
  
$
103,810
  
$
148,225
  

Maturity Distribution of Investment Securities

The following table sets forth the maturities of investment securities at amortized cost as of December 31, 2006. Taxable equivalent values are used in calculating weighted average yields assuming a tax rate of 35%.
 
(In Thousands)
  
Within
1 Year/
Yield
  
After 1 Yr
But Within
5 Years/
Yield
  
After 5 Yrs
But Within
10 Years/
Yield
  
After
10 Years/
Yield
  
Totals &
Weighted
Average
Yield
  
U.S. Treasury
  
$
3,954
    
-
 
$
250
    
-
 
$
4,204
  
     
5.00
%
  
-
   
7.16
%
  
-
   
5.13
%
                                 
U.S. Agencies
    
10,504
 
$
39,500
    
-
   
-
   
50,004
 
     
3.04
%
  
3.53
%
  
-
   
-
   
3.43
%
                                 
Municipal Bonds
    
1,007
   
2,716
   
-
 
$
30
    
3,753
 
 
    
6.63
%
  
6.60
%
  
-
   
7.77
%
  
6.63
%
                                 
Corporate Bonds
    
1,022
   
13,133
   
-
   
4,043
   
18,198
 
     
3.65
%
  
4.05
%
  
-
   
10.20
%
  
5.39
%
                               
Equities
    
29,052
   
-
   
-
   
-
   
29,052
 
     
3.35
%
  
-
   
-
   
-
   
3.35
%
 
  
$
45,539
  
$
55,349
  
$
250
  
$
4,073
  
$
105,211
  
     
3.52
%
  
3.80
%
  
7.16
%
  
10.19
%
  
3.93
%

As of December 31, 2006 and 2005, the Corporation held FHLB bonds that had a book value of $35.0 million and $34.0 million and a market value of $34.4 million and $33.2 million, respectively.

-24-

Types of Loans

Major classifications of loans, excluding loans held for resale, net of deferred loan fees, at December 31 are as follows:

(In Thousands)
  
2006
  
2005
  
2004
  
2003
  
2002
  
                       
Commercial and agriculture
  
$
380,940
  
$
321,303
  
$
301,961
  
$
268,963
  
$
272,440
  
Real estate commercial
    
897,717
   
859,251
   
848,737
   
809,307
   
758,826
 
Real estate construction and land development
    
1,323,906
   
967,335
   
608,421
   
507,872
   
443,461
 
Real estate mortgage
    
235,168
   
188,772
   
165,063
   
143,420
   
127,976
 
Installment
    
63,049
   
46,852
   
50,057
   
40,201
   
47,217
 
 
  
$
2,900,780
  
$
2,383,513
  
$
1,974,239
  
$
1,769,763
  
$
1,649,920
  

Loan Maturities and Sensitivity to Changes in Interest Rates

The following table shows the contractual maturity amounts and maturity analysis of loans outstanding as of December 31, 2006. Also, the amounts are classified as to fixed and variable rate sensitivity for amounts due after one year.

   
Maturity
  
(In Thousands)
  
Within
1 Year
  
1 - 5
Years
  
After
5 Years
  
Total
  
Commercial and agriculture
  
$
219,942
  
$
136,070
  
$
24,928
  
$
380,940
  
Real estate commercial
    
94,416
   
473,063
   
330,238
   
897,717
 
Real estate construction and land development
    
1,230,744
   
82,221
   
10,941
   
1,323,906
 
Real estate mortgage
    
94,285
   
90,969
   
49,914
   
235,168
 
Installment
    
11,638
   
15,853
   
35,558
   
63,049
 
 
  
$
1,651,025
  
$
798,176
  
$
451,579
  
$
2,900,780
  

Loans maturing after one year with:

   
1 - 5
Years
  
After
5 Years
  
Fixed Rates
  
$
638,560
  
$
56,385
  
Variable Rates
    
159,616
   
395,194
 
 
  
$
798,176
  
$
451,579
  

Expected maturities will differ from contractual maturities because borrowers may have the right to prepay loans with or without prepayment penalties. It is also not uncommon to rollover loans at the maturity period, provided that the rate and terms of the loan conform to the current policy.

Loan Administration

The credit approval process at the Bank provides for the prompt and thorough underwriting and approval or decline of loan requests. The method used is a step process based on assigned lending limits. Approval process includes authority assigned to individual officers and an internal loan committee. Lending authority is also assigned to the Bank’s Directors’ Loan Committee to approve the Bank’s largest credit relationships up to the legal lending limit of the Bank.

-25-

Credit Review personnel conduct continuous reviews to ensure the loan portfolio remains in compliance with our lending policies and safe and sound practices. They provide ongoing reporting to management regarding credit weakness and policy exceptions and economic and portfolio trends. Quarterly reports are prepared for submission to Senior Management and the Director’s Audit Committee, which details the levels of exceptions and follow-up corrective actions.

Certain problem loans are placed on a nonaccrual basis in conformance with defined policy. The Loan Committee and other administrative personnel regularly review information reports on adversely classified and delinquent loans. Comparative summaries of delinquent loans are also provided on a regular basis to senior management and to the Board of Directors.

Management performs and in depth analysis of the loan loss reserve four times a year and closely monitors the adequacy of the loan loss reserve. Management’s analysis is reviewed each quarter by the Board of Directors. The allowance is maintained at a level deemed sufficient to meet estimated potential losses.

The reviews, examinations and actions described above are in addition to the periodic examinations by federal and state regulatory agencies, as well as the Bank's internal audit department and the Bank's outside public accounting firm.

RISK ELEMENTS - IMPAIRED ASSETS

Nonaccruing/Impaired Loans

Loans are placed on nonaccrual status when, in the opinion of management, the collection of interest is doubtful or when the loan becomes 90 or more days past due. When a loan is placed on nonaccrual status, all interest previously accrued, but not collected, is reversed and charged against interest income. Income on nonaccrual loans is then recognized only to the extent cash is received and where the future collection of principal is probable. Accruals are resumed only when the loan is brought current, and when, in the opinion of management, the borrower has demonstrated the ability to resume payments of principal and interest. Interest income on restructured loans is recognized pursuant to the terms of the new loan agreement. Interest income on other impaired loans is monitored and based upon the terms of the underlying loan agreement. However, the recorded net investment in impaired loans, including accrued interest, is limited to the present value of the expected cash flows of the impaired loan or the observable fair market value of the loan or the fair market value of the loan's collateral.

A loan is considered impaired when management determines it is probable that all contractual amounts of principal and interest will not be paid as scheduled in the loan agreement. These loans include all loans in nonaccrual, loans restructured, and other loans that management considers to be at risk.

This assessment for impairment occurs when and while such loans are on nonaccrual, or the loan has been restructured. When a loan with unique risk characteristics has been identified as being impaired, the amount of impairment will be measured by the Corporation. If the current value of the impaired loan is less than the recorded investment in the loan an impairment is recognized by creating or adjusting an existing allocation of the allowance for loan losses.

Restructured Loans

In cases where a borrower experiences financial difficulties and the Corporation makes certain concessionary modifications to the contractual terms, the loan is classified as a restructured (accruing) loan. Loans restructured at a rate equal to or greater than that of a new loan with comparable risk at the time of the contract is modified may be excluded from the impairment assessment and may cease to be considered impaired.

Delinquent and Problem Loans

Delinquent and problem loans are a part of any lending enterprise. When a borrower fails to make payments, the Bank implements collection activities commencing with simple past due notices. Collection activities progress to phone calls and letters, followed by legal action when and if necessary. At one month past due, the loan is tracked and reported as delinquent.

-26-

It is the Bank's practice to discontinue accruing interest on all loans that are delinquent 90 days or more regardless of risk of loss, collateral, etc. Some problem loans which are less than 90 days delinquent are also placed into nonaccrual status if the success of collecting additional interest is in doubt and some loans will remain in nonaccrual even after improved performance until a consistent timely payment pattern is exhibited and/or timely performance is considered to be reliable.

Levels of, and Trends in, Delinquencies and Nonaccruals

Nonperforming loans and other real estate increased in 2006 to $8.7 million, from $4.9 million in 2005. Management monitors delinquencies monthly and reports are reviewed by the Board of Directors. Delinquencies for the commercial, personal, real estate and credit lines categories are charted separately. One loan totaling $7.1 million makes up 82.5% of the nonaccrual balance.

The dollar amount of loans past due 90 days or more nonaccruing and other real estate owned as a percentage of total loans was .30%, .21%, and .71%, at year-end 2006, 2005, and 2004, respectively. These loans have or had a variety of situations, some of which may lead to foreclosure or involve a bankruptcy case and while some of these loans are in active legal collection processes, others are under active repayment plans and may continue payment as the borrower’s financial situation improves.

Loans delinquent due 90 days or more or other nonaccruing, restructured and other real estate owned (OREO) on which the accrual of interest has been discontinued as of December 31st are as follows:

(In Thousands)
                      
 
  
2006
  
2005
  
2004
  
2003
  
2002
  
Commercial and agriculture
  
$
574
  
$
4,939
    
-
 
$
120
  
$
909
  
Real estate commercial
    
-
   
-
 
$
6,847
    
6,187
   
6,898
 
Real estate construction and land development
    
7,190
   
-
   
356
   
-
   
1,783
 
Real estate mortgage
    
889
   
-
   
6,904
   
344
   
2,291
 
Installment
    
-
   
10
   
-
   
43
   
554
 
Total nonaccruing loans
    
8,653
   
4,949
   
14,107
   
6,694
   
12,435
 
Other real estate owned
    
-
   
-
   
-
   
4,162
   
6,532
 
Total nonperforming assets
  
$
8,653
  
$
4,949
  
$
14,107
  
$
10,856
  
$
18,967
  
Restructured
    
-
   
-
   
-
 
$
6,178
  
$
6,178
  
Total loans at end of period (1)
  
$
2,908,000
  
$
2,389,224
  
$
1,978,052
  
$
1,771,716
  
$
1,658,684
  
Total assets at end of period
  
$
3,238,464
  
$
2,640,275
  
$
2,243,396
  
$
2,075,393
  
$
1,943,727
  
Total nonperforming assets
                                
to total loans
    
0.30
%
  
0.21
%
  
0.71
%
  
0.61
%
  
1.14
%
Total nonperforming assets to total assets
    
0.27
%
  
0.19
%
  
0.63
%
  
0.52
%
  
0.98
%
Total impaired assets to total assets
    
0.27
%
  
0.19
%
  
0.63
%
  
0.82
%
  
1.29
%
(1) Includes loans held for resale
 
-27-

There are certain amounts of interest collected on nonaccrual loans that is included in income, and amounts that have not been accrued which are indicated in the following table:

(In Thousands)
                      
At December 31,
  
2006
  
2005
  
2004
  
2003
  
2002
  
                       
Additional interest income which would have been recorded during the period under original terms of loans above
  
$
761
  
$
67
  
$
925
  
$
443
  
$
1,400
  
                                 
Interest collected and included in net income for the period
  
$
344
  
$
327
  
$
350
  
$
429
  
$
774
  
                                 
Commitments for additional funds related to loans above
    
-0-
    
-0-
    
-0-
    
-0-
    
-0-
  

Loan Charge Off's

It is the Bank's policy to aggressively review questionable loans for charge-off. The Bank adheres to all regulatory, accounting, and legal requirements in writing off loans. 

Other Real Estate Owned (OREO)

OREO is carried at the lesser of book value or market value. The costs related to completion, repair, maintenance, or other costs of such properties, are generally expensed with any gains or shortfalls from the ultimate sale of OREO being shown as other income or expense.
 
The Bank had no OREO totals to report at year-end December 31, 2006 and 2005.
 
Certain other loans, currently in nonaccrual, are in the process of foreclosure and there is a likelihood these foreclosures will be completed and the loans will then become OREO. This is viewed as an ordinary part of the collection process and efforts are constantly underway to reduce and minimize such nonperforming assets.
 
The table below shows the carrying value of OREO at December 31st of the past five years:

(In Thousands)
  
2006
  
2005
  
2004
  
2003
  
2002
  
Other real estate owned
    
-
   
-
   
-
 
$
4,162
  
$
6,532
  

Allowance For Loan Losses - Qualitative Factors

The allowance for loan losses was $40.6 million, or 1.40% of loans at December 31, 2006. This compares to $33.8 million, or 1.41% at December 31, 2005, and $30.4 million, or 1.54% at December 31, 2004. Net charge-off’s as a percentage of average loans was .11% in 2006, a net recovery of (.01%) in 2005 and a net charge-off of .02% in 2004. An improving economy, and positive credit performance trends, is reflected in year-end 2006 and 2005 reserves of 1.40% and 1.41%, respectively. An uncertain economic environment and increasing delinquencies supported the higher loan loss reserve percentages for year-end 2004.
 
The allowance for loan losses is the amount, which, in the opinion of management, provides adequate protection in the event of loan losses. This analysis is performed quarterly and reviewed by senior management to determine the adequacy of the reserve. The analysis takes into consideration current economic trends both on a national and local level. It includes careful consideration of delinquency rates and trends for all loan categories including commercial, personal and real estate related loans by geographic location.

-28-
 
Management and the Board review policies and procedures at least annually, and changes are made to reflect the current operating environment integrated with regulatory requirements. Partly out of these policies has evolved an internal credit risk review process. During this process the quality grade of loans are reviewed and loans are assigned a dollar value of the loan loss reserve by degree of risk. This analysis is performed quarterly and reviewed by senior management who makes the determination if the risk is reasonable, and if the reserve is adequate. This quarterly analysis is then reviewed by the Board of Directors.
 
Another consideration is the volume and terms of loans. Management reviews the growth and terms of loans so that the allowance can be adjusted for current and anticipated future losses.

Quantitative Factors

The allowance for loan losses is the amount which, in the opinion of management, is necessary to absorb loan losses. Management’s evaluation of the adequacy of the allowance is based on the market area served, local and national economic conditions, the growth and composition of the loan portfolio and the related risk characteristics, by continual review by management of the quality of the portfolio.

The Corporation has an active ongoing credit review function. When a loan has degradation in quality its internal rating is downgraded. An assessment of these loans is performed to determine whether it is appropriate to establish a specific allocation reserve or write down as directed by FAS 114, Accounting by Creditors for Impairment of a Loan. If appropriate, such allocation reserve or write down is made. For the remainder of these loans that which no specific allocation reserve or write down is necessary a background reserve is established. The background reserves are also reviewed quarterly to determine if the background reserve percentages are appropriate.

All other loans which have not been identified with degradation in quality have background reserves based upon our experience and information concerning actual industry losses by loan types.

Every quarter certain qualitative factors are evaluated to determine if certain adjustments are indicated for any of the background reserves established. This is accomplished through an internal narrative and the tracking of statistics including but not limited to unemployment rates, historical charge offs, job growth, effects of changing interest rates, housing starts, trends in volume and terms of loans, levels of, and trends in, delinquencies and nonaccruals, and other real estate owned trends.

Loan concentrations, quality, terms and basic underlying assumptions remained substantially unchanged during the period. The actual loan loss reserve as a percentage of total loans has declined over the last two years, mainly due to improvement in quality and performance of the loan portfolio.
 
-29-

Summary of Loan Loss Experience

The following table provides an analysis of the allowance for loan losses and the net losses by loan type for the last five years at December 31:

(In Thousands)
  
2006
  
2005
  
2004
  
2003
  
2002
  
Balance at beginning of year
  
$
37,075
  
$
32,728
  
$
29,556
  
$
28,175
  
$
26,358
  
                                 
Provision charged to operating expense
    
7,500
   
4,200
   
3,500
   
4,250
   
6,300
 
                                 
Loans charged-off:
                                
Commercial and agriculture
    
(2,283
)
  
(342
)
  
(612
)
  
(1,617
)
  
(2,564
)
Real estate commercial
    
-
   
(4
)
  
-
   
(1,486
)
  
(1,774
)
Real estate construction and land development
    
(855
)
  
-
   
-
   
(48
)
  
(23
)
Real estate mortgage
    
-
   
(116
)
  
(387
)
  
(120
)
  
(211
)
Installment
    
(156
)
  
(244
)
  
(413
)
  
(351
)
  
(537
)
Total charged-off loans
    
(3,294
)
  
(706
)
  
(1,412
)
  
(3,622
)
  
(5,109
)
Less recoveries:
                                
Commercial and agriculture
    
353
   
623
   
741
   
620
   
482
 
Real estate commercial
    
-
   
-
   
176
   
6
   
-
 
Real estate construction and land development
    
-
   
142
   
60
   
-
   
49
 
Real estate mortgage
    
-
   
27
   
51
   
62
   
22
 
Installment
    
60
   
61
   
56
   
65
   
73
 
Total recoveries
    
413
   
853
   
1,084
   
753
   
626
 
Net (charge-offs) recoveries
    
(2,881
)
  
147
   
(328
)
  
(2,869
)
  
(4,483
)
Balance before portion identified for undisbursed loans
    
41,694
   
37,075
   
32,728
   
29,556
   
28,175
 
Reserve acquired in merger
    
2,501
   
-
   
-
   
-
   
-
 
Portion of reserve identified for undisbursed loans
    
(3,546
)
  
(3,270
)
  
(2,307
)
  
(1,768
)
  
(1,555
)
                                 
Balance at end of year
  
$
40,649
  
$
33,805
  
$
30,421
  
$
27,788
  
$
26,620
  
                                 
Total loans at
                                
end of period (1)
  
$
2,908,000
  
$
2,389,224
  
$
1,978,052
  
$
1,771,716
  
$
1,658,684
  
Daily average loans
  
$
2,731,257
  
$
2,200,344
  
$
1,887,528
  
$
1,691,051
  
$
1,601,037
  
                                 
Ratio of net charged-off loans during period to average loans outstanding
    
0.11
%
  
-0.01
%
  
0.02
%
  
0.17
%
  
0.28
%
Loan loss reserve as a percentage of total loans
    
1.40
%
  
1.41
%
  
1.54
%
  
1.57
%
  
1.60
%
 
(1) Includes loans held for resale
 
-30-

Allocation of Allowance for Loan Losses

Based on certain characteristics of the portfolio, potential losses can be anticipated for major loan categories. In the following table, the allowance for loan losses at year-end, for the last five years, has been allocated among major loan categories based primarily on their historical net charge-off experience, along with consideration of factors such as quality, volume, anticipated economic conditions and other business considerations.

(In Thousands, except percentages)
                                      
   
2006
Reserve
  
Loan
Category
Percent
  
2005
Reserve
  
Loan
Category
Percent
  
2004
Reserve
  
Loan
Category
Percent
  
2003
Reserve
  
Loan
Category
Percent
  
2002
Reserve
  
Loan
Category
Percent
  
   
 
      
 
      
 
                      
Commercial and agriculture
  
$
9,726
    
13.1
%
$
11,061
    
14.6
%
$
9,658
    
15.3
%
$
13,465
    
15.2
%
$
14,728
    
16.4
%
Real estate commercial
    
11,400
   
30.9
%
  
12,884
   
39.4
%
  
11,489
   
43.0
%
  
8,948
   
45.7
%
  
7,472
   
45.8
%
Real estate construction land development
    
4,932
   
45.5
%
  
2,203
   
35.4
%
  
1,668
   
30.8
%
  
937
   
28.6
%
  
813
   
26.7
%
Real estate mortgage
    
8,368
   
8.3
%
  
4,733
   
8.4
%
  
4,341
   
8.4
%
  
2,084
   
8.2
%
  
1,631
   
8.2
%
Installment
    
1,012
   
2.2
%
  
724
   
2.2
%
  
461
   
2.5
%
  
376
   
2.3
%
  
235
   
2.9
%
Unallocated
    
5,211
         
2,200
         
2,804
         
1,978
         
1,741
       
     
40,649
         
33,805
         
30,421
         
27,788
         
26,620
       
Standby and letters of credit
    
216
         
240
         
215
         
157
         
138
       
Undisbursed
    
3,330
   
 
    
3,030
   
 
    
2,092
   
 
    
1,611
   
 
    
1,417
   
 
  
 
  
$
44,195
    
100.0
%
$
37,075
    
100.0
%
$
32,728
    
100.0
%
$
29,556
    
100.0
%
$
28,175
    
100.0
%

Historical net charge-offs are not necessarily accurate indicators of future losses since net charge-offs vary from period to period due to economic conditions and other factors that cannot be accurately predicted. Thus, an evaluation based on historical loss experience within individual loan categories is only one of many factors considered by management in evaluating the adequacy of the overall allocation.

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 change the allowance based upon their judgment at the time of their examination. It is the Bank's policy to be in compliance with all accounting and regulatory standards related to loan loss reserves and all accounting policies promulgated by GAAP.

Loan concentrations, quality, terms and basic underlying assumptions remained substantially unchanged during the period. The actual loan loss reserve as a percentage of total loans has declined over the last five years, mainly due to loan portfolio quality and performance improvements.

Effects of Changing Interest Rates

A review of the past 12 months shows that the tax equivalent net interest margin began year 2006 at 5.80% (quarter ended December 31, 2005). The margin then declined to 5.61% for the first quarter and then increased to 5.66% in the second quarter. The increase continued in the third quarter to 5.82% and decreased slightly to 5.81% in the fourth quarter. The Corporation increased its key lending index 25 basis points in January, March, May, and June. The movement in the net interest margin was attributed to these rate increases. During 2005, the Corporation increased its index eight times. In 2004, the Corporation increased its key lending index 25 basis points in August, September, November and December.

-31-

Concentrations of Credit

The most significant portion of the loan portfolio consists of real estate construction and land development loans. Total loans within this category grew by $356.6 million or 37%, in 2006. Continued demand for housing and favorable interest rates continued to fuel this growth. Real estate construction loans are generally composed of commitments to customers within our market area for construction purposes. Loans within this category are used for construction projects that range from residential and commercial land development to residential and commercial building projects. They are generally secured by first trust deeds with well-defined repayment sources following project completion. Maturities are set to match the time required for project completion, which typically run from 12 to 18 months depending on complexity. While the Bank has significant balances within this lending category, management believes that its lending policies and underwriting standards are sufficient to minimize risk even during these uncertain economic times. Management closely monitors the effects of current and expected market conditions and other factors that may influence the repayment of these loans.

The following chart indicates the amount of those loans, net of deferred fees, and as a percent of total loans for the period:
 
(In Thousands)
                      
At December 31,
  
2006
  
2005
  
2004
  
2003
  
2002
  
Real estate commercial
  
$
897,717
  
$
859,251
  
$
848,737
  
$
809,307
  
$
758,826
  
Real estate construction and land development
    
1,323,906
   
967,335
   
608,421
   
507,872
   
443,461
 
Total loans at end of period
  
$
2,908,000
  
$
2,389,224
  
$
1,978,052
  
$
1,771,716
  
$
1,658,684
  
Real estate commercial loans as a percent of total loans
    
30.9
%
  
36.0
%
  
42.9
%
  
45.7
%
  
45.7
%
Real estate construction loans as a percent of total loans
    
45.5
%
  
40.5
%
  
30.8
%
  
28.7
%
  
26.7
%

Trends in Volume and Terms of Loans

Average loans for the year 2006 were $2.73 billion, representing an increase of $530.9 million, or 24.1% over the average balance for 2005. Average loans for the year 2005 were $2.20 billion, representing an increase of $312.8 million, or 16.6% over the average balance for 2004. Average loans for the year 2004 were $1.89 billion, representing an increase of $196.5, or 11.6% over the average balance for 2003. In 2006, the rate of growth increased over prior year’s increases due to favorable market conditions and additional lending staff. Terms of loans have remained competitive and within policy guidelines.

Conclusion of Qualitative Factors

The allowance for loan losses is the amount, which, in the opinion of management, is necessary to absorb inherent loan losses regardless of source. Management’s evaluation of the adequacy of the allowance is based on the market area served, local economic conditions, the growth and mix of the portfolio and their related risk characteristics. Our analysis included important subjective factors that cause us to believe the reserve is adequate to absorb anticipated and known losses.

Off Balance Sheet Arrangements

In the ordinary course of business, Frontier has entered into off-balance sheet financial instruments consisting of commitments for the extension of credit, credit card commitments, letter of credit commitments, home equity lines and standby letters of credit. These instruments are recorded in the financial statements only when they are funded or related fees are incurred or received. The following table summarizes the amount of commitments as of December 31, 2006:

-32-

(In Thousands)
      
Standby letters of credit
  
$
27,035
  
Credit card arrangements
    
37,051
  
Commitments to fund loans secured by real estate
    
902,701
  

Commitments to extend credit and letters of credit are written for one year, or have a call in one year. The fair value of these commitments is not material since they are for a short period of time and subject to customary credit terms. A fee is charged for all commitments to lend. Due to the Bank's underwriting policies, there have been no losses associated with these commitments.

Deposits

For the average amount of deposits and rates paid on such deposits for years ended December 31, 2006, 2005, and 2004 please refer to page 47 of 2006 Annual Report to Shareowners.

Maturities of time certificates of deposit $100,000 and over at year-end 2006 are shown below:

In Thousands
      
3 months or less
  
$
184,560
  
Over 3 months through 6 months
    
133,308
  
6 months through 12 months
    
144,510
  
Over 12 months
    
82,795
  
   
$
545,173
  

The following table represents the noninterest and interest-bearing deposit accounts that will mature or reprice in one year or less as compared to the past year:

(In Thousands)
  
2006
  
2005
  
Dollar
Change
  
Percent
Change
  
                   
Demand deposits
  
$
406,621
  
$
395,852
  
$
10,769
    
2.7
%
Now, money market and sweep accounts
    
683,948
   
322,283
   
361,665
   
112.2
%
Savings
    
305,669
   
495,108
   
(189,439
)
  
-38.3
%
Time deposits
    
906,406
   
611,553
   
294,853
   
48.2
%


Although 86% of our time deposit portfolio will mature within the next year, we feel that cash flows are sufficient to support operations for the foreseeable future. Over the past year, we have had the ability to retain and grow each category of our deposit accounts. If liquidity was needed going forward, sources would consist of maturing securities, increased customer deposits or loan maturities. If need be, lines of credit are available or we could issue additional capital stock. Cash flows from operations also contribute significantly to liquidity needs.

-33-

Borrowings

Short-Term Borrowings
  
(In Thousands)
                          
At December 31,
  
2006
  
Weighted
Average
Interest
Rate
  
2005
  
Weighted
Average
Interest
Rate
  
2004
  
Weighted
Average
Interest
Rate
  
Year-end balance:
  
$
81,673
    
5.24
%
$
20,813
    
2.72
%
$
10,205
    
1.71
%
                                       
Highest month end balance during the period:
  
$
81,673
        
$
52,444
        
$
39,906
        

For information regarding average balances and yields, please refer to page 47 of 2006 Annual Report to Shareowners.

ITEM 2 - PROPERTIES

Our principal office is located in a forty-five thousand square foot facility in Everett, Washington. Our data processing and operations center are located in a sixteen thousand square foot facility located in Everett, Washington. In addition to our principal and administrative facilities, we operate 45 branches in Western Washington.

FFP, Inc., a real estate holding subsidiary, owns the properties and buildings housing our principal office, data processing and operations center, and 27 of our branch facilities, including the branch in our principal office. FFP, Inc. also owns the buildings in which 2 of our branches are located in while the land is leased. We lease the land and buildings for 16 of our branch offices. The leases on our branch offices have expiration dates ranging from 2007 to 2021.

The aggregate monthly rental on our leased properties is $152 thousand.

We are in the early stages of construction of a forty-five thousand square foot office facility adjacent to our principal office which will be used to consolidate our administrative functions. We plan to occupy this new space in late 2008.

ITEM 3 - LEGAL PROCEEDINGS

The Corporation is involved in ordinary routine litigation arising in the normal course of business. In the opinion of management, liabilities (if any) arising from such claims will not have a material effect on the business, results of operations or financial condition of the Corporation.

ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SHAREOWNERS

No matters were submitted to shareowners during the fourth quarter of 2006.

-34-

PART II

ITEM 5 - MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED SHAREOWNER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

(a) Frontier Financial Corporation’s common stock is traded on the Nasdaq Stock Market LLC under the symbol “FTBK”. The table below indicates the high/low trading range of Frontier stock over the last eight quarters:

   
 High
  
Low
  
 
          
1st quarter 2005
  
$
17.78
  
$
16.22
  
2nd quarter 2005
    
17.38
    
15.66
 
3rd quarter 2005
    
20.17
    
16.88
  
4th quarter 2005
    
22.33
    
17.33
  
               
1st quarter 2006
  
$
22.43
  
$
20.38
  
2nd quarter 2006
    
23.96
    
20.82
  
3rd quarter 2006
    
28.00
    
21.78
  
4th quarter 2006
    
31.33
    
25.36
  

(b) Frontier Financial Corporation has only one class of stock outstanding, which is common stock. At February 21, 2007 there were 45,205,057 shares outstanding and there were 3,556 holders of record of our common stock. The principal market for our common stock is The NASDAQ Stock Market LLC.


(c) The table below indicates the cash dividends paid on each share of its common stock over the last two years:


Dividend Declared
  
Record Date
  
Payment Date
$.091
  
January 10, 2005
  
January 25, 2005
.093
  
April 11, 2005
  
April 25, 2005
.107
  
July 11, 2005
  
July 25, 2005
.110
  
October 11, 2005
  
October 24, 2005
         
.113
  
January 9, 2006
  
January 24, 2006
.117
  
April 11, 2006
  
April 24, 2006
.12
  
July 10, 2006
  
July 24, 2006
.15
  
October 10, 2006
  
October 24, 2006

(d) During the quarter ended December 31, 2006, there were no issuer repurchases of its equity securities. Subsequent to year-end, the Corporation repurchased 218,940 shares at an average cost of $26.85 through February 21, 2007.
 
-35-

Five-Year Stock Performance Graph
Total Cumulative return to Shareowners

The graph below provides an indicator of cumulative shareowner returns for the Corporation as compared with the Nasdaq Bank Index and the S&P 500 Index.
 
 
Index
12/31/02
12/31/03
12/31/04
12/31/05
12/31/06
Frontier Financial Corporation
100.11
132.65
157.33
199.34
276.54
NASDAQ Bank Index
102.40
131.73
150.75
147.28
165.26
S&P 500 Index
77.56
99.84
110.79
114.11
132.13

The above presentation assumes $100 was invested on December 31, 2001, in the Corporation’s common stock and each of the above indexes.

-36-

ITEM 6 - SELECTED FINANCIAL DATA

FINANCIAL HIGHLIGHTS
 
In Thousands
                          
AT YEAR-END
  
2006
  
2005
  
2004
  
2003
  
2002
  
% Change
2006-2005
  
Total assets
  
$
3,238,464
  
$
2,640,275
  
$
2,243,396
  
$
2,075,393
  
$
1,943,727
    
22.7
%
Net loans
    
2,867,351
   
2,355,419
   
1,945,324
   
1,742,160
   
1,630,509
   
21.7
%
Investment securities
    
114,711
   
110,617
   
153,451
   
187,915
   
140,037
   
3.7
%
Deposits
    
2,453,632
   
2,061,380
   
1,795,842
   
1,667,017
   
1,560,876
   
19.0
%
Shareowners' equity
    
395,283
   
296,097
   
254,230
   
219,406
   
198,863
   
33.5
%
                                       
FOR THE YEAR
                                      
Interest income
  
$
250,144
  
$
178,886
  
$
140,228
  
$
135,201
  
$
138,859
    
39.8
%
Interest expense
    
86,942
    
51,736
    
34,939
    
37,829
    
45,581
    
68.0
%
Net interest income
    
163,202
    
127,150
    
105,289
    
97,372
    
93,278
    
28.4
%
Securities gains (losses)
    
(25
)
  
(211
)
  
(44
)
  
190
   
(480
)
  
NM
  
Provision for loan losses
    
7,500
    
4,200
    
3,500
    
4,250
    
6,300
    
78.6
%
Net income
    
68,910
    
51,584
    
43,045
    
39,607
    
36,014
    
33.6
%
Basic earnings per share
  
$
1.53
  
$
1.21
  
$
1.03
  
$
0.95
  
$
0.84
    
26.4
%
Diluted earnings per share
  
$
1.52
  
$
1.21
  
$
1.02
  
$
0.94
  
$
0.83
    
25.6
%
Cash dividends declared per common share
  
$
0.50
  
$
0.40
  
$
0.34
  
$
0.31
  
$
0.27
    
25.0
%
Dividend payout ratio
    
32.9
%
  
33.1
%
  
33.3
%
  
33.0
%
  
32.5
%
      
Return on Average
                                  
 
Assets
    
2.27
%
  
2.09
%
  
1.98
%
  
1.96
%
  
1.94
%
  
 
Equity
    
18.91
%
  
18.75
%
  
18.35
%
  
19.23
%
  
18.36
%
  
 
Avg. equity/avg. assets
    
11.98
%
  
11.16
%
  
10.76
%
  
10.21
%
  
10.57
%
  
 
Efficiency Ratio
    
38
%
  
41
%
  
42
%
  
41
%
  
40
%
      
                                       

ITEM 7 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION RESULTS AND OF OPERATIONS

Please see 2006 Annual Report to Shareowners, page 31 through 48.

ITEM 7A - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Please see 2006 Annual Report to Shareowners, pages 35-39.
Please see this Form 10-K, pages 28-32.

-37-

ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

INDEX TO FINANCIAL STATEMENTS

 
Form
10-K Page
  
Annual
Report to
Shareowners
Page
Report of Independent Registered Public Accounting Firm
    
1
       
Consolidated Balance Sheet at December 31, 2006 and 2005
    
2
       
Consolidated Statement of Income for the years Ended December 31, 2006, 2005 and 2004
    
3
       
Consolidated Statement of Shareowners’ Equity
    
4
       
Consolidated Statement of Cash Flows for the Years ended December 31, 2006, 2005 and 2004
    
5
       
Condensed Balance Sheet (Parent Only) at December 31, 2006 and 2005
    
27
       
Condensed Statement of Income (Parent Only) for the Years Ended December 31, 2006, 2005 and 2004
    
27
       
Condensed Statement of Cash Flows (Parent Only)for Years Ended December 31, 2006, 2005 and 2004
    
28
       
Notes to Consolidated Financial Statements
   
6 - 30

ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

None.

ITEM 9A - CONTROLS AND PROCEDURES

The Corporation’s management, including the Corporation’s Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of its disclosure controls and procedures as of December 31, 2006. Based on this evaluation, the Chief Executive Officer and the Chief Financial Officer each concluded that as of December 31, 2006, the Corporation maintained effective disclosure controls and procedures in all material respects, including those to ensure that information required to be disclosed in reports filed or submitted with the SEC is recorded, processed, and reported within the time periods specified by the SEC, and is accumulated and communicated to management, including the Chief Executive Officer and the Chief Financial Officer, as appropriate to allow for timely decisions regarding required disclosure.

There has been no change in the Corporation’s internal control over financial reporting in the period covered by this report that have materially affected, or are reasonably likely to affect, the Corporation’s internal control over financial reporting.

-38-

MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

Management of Frontier Financial Corporation and its subsidiaries (“the Corporation”) is responsible for establishing and maintaining adequate internal control over financial reporting, and for performing an assessment of the effectiveness of internal control over financial reporting as of December 31, 2006. The Corporation’s internal control over financial reporting is a process designed under the supervision of the Corporation’s management, including the Chief Executive Officer and Chief Financial Officer, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America.

The Corporation’s system of internal control over financial reporting includes policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect transactions and dispositions of assets of the Corporation; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States, and that receipts and expenditures of the Corporation are being made only in accordance with authorizations of Management and Directors of the Corporation; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Corporation’s assets that could have a material effect on the financial statements.

Management recognizes that there are inherent limitations in the effectiveness of any system of internal control, and accordingly, even effective internal control can provide only reasonable assurance with respect to financial statements preparation and fair presentation. Further, because of changes in condition, the effectiveness of internal control may vary over time.

Under the supervision and with the participation of the Corporation’s management, including the Corporation’s Chief Executive Officer and Chief Financial Officer, the Corporation performed an assessment of the effectiveness of the Corporation’s internal control over financial reporting as of December 31, 2006 based upon criteria in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Based on this assessment, Management determined that the Corporation’s internal control over financial reporting was effective as of December 31, 2006.

The Corporation’s independent registered public accounting firm, Moss Adams LLP who audits the Corporation’s consolidated financial statements, have issued an attestation report on Management’s assessment and on the effectiveness of the Corporation’s internal control over financial reporting.

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON INTERNAL CONTROL OVER FINANCIAL REPORTING

See Report of Independent Registered Public Accounting Firm on page 1 of Annual Report to Shareowners.

ITEM 9B - OTHER INFORMATION

Not applicable.

-39-

PART III

ITEM 10 - DIRECTORS AND EXECUTIVE OFFICERS OF FRONTIER FINANCIAL CORPORATION

Biographical and business experience information about the directors and director nominees of FFC included in Frontier Financial Corporation’s Proxy Statement for the Annual Meeting of Shareowners to be held on April 18, 2007 (the Proxy Statement) under the caption “Election of Directors” and the information incorporated by reference pursuant to Item 13 below are hereby incorporated herein by reference. Information on FFC’s executive officers is also included in the Proxy Statement.

Information regarding FFC’s Audit Committee included under the caption “Directors’ Meetings, Committees and Compensation” of the Proxy Statement is hereby incorporated herein by reference.

Information regarding late filings under Section 16(a) of the Securities Exchange Act of 1934 included in the Proxy Statement under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” is hereby incorporated herein by reference.

FFC’s Code of Ethics for Senior Executive Officers (“Code of Ethics”) is available at www.frontierbank.com, as discussed in “Available Information” above. FFC intends to disclose any amendments or waivers with respect to its Code of Ethics on its website at www.frontierbank.com.

ITEM 11 - EXECUTIVE COMPENSATION

Information regarding compensation of directors and executive officers included under the caption “Compensation of Executives” of the Proxy Statement is hereby incorporated herein by reference. However, the information provided in the Proxy Statement under the headings “Report of the Compensation Committee of the Board of Directors on Executive Compensation” and “Five Year Performance Comparison” shall not be deemed to be “soliciting material” or to be “filed” with the Securities and Exchange Commission, subject to Regulation 14A or 14C, other than as provided in Item 402 of Regulation S-K, or subject to liabilities of Section 18 of the Securities Exchange Act of 1934.

Equity Compensation Plans

The following table sets forth information regarding outstanding options and shares reserved for issuance under the Corporation’s plans:

   
Number of securities
to be issued upon
exercise of outstanding
options, warrants andrights
  
Weighted-average
exercise price of
outstanding options,
warrants and rights
  
Number of securities
remaining available for
future issuance under
equity compensation plans
(excluding securities)
reflected in first column)
  
               
Equity compensation plans approved by security holders (A)
    
1,349,128
 
$
17.78
    
4,997,711
 
                     
Equity compensation plans not approved by security holders (B)
    
45,000
   
N/A
    
37,787
 
     
1,394,128
         
5,035,498
 

(A) Consists of FFC Incentive Stock Options Plan
(B) Consists of FFC 1999 Employee Stock Award Plan

-40-

ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED SHAREOWNER MATTERS

The information set forth under the caption “Share Ownership Information” in the Proxy Statement is hereby incorporated herein by reference.

ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

The information set forth in the Proxy Statement under the caption “Related Party Transactions and Business Relationships” is hereby incorporated herein by reference.

ITEM 14 - PRINCIPAL ACCOUNTANT FEES AND SERVICES

The information set forth in the Proxy Statement under the caption “Independent Registered Public Accounting Firm” is hereby incorporated herein by reference.

-41-

PART IV

ITEM 15 - EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

(a)(1) Financial Statements.
 
Financial statements required by Item 8 of this report are incorporated by reference, from the 2006 Annual Report to Shareowners.
 
(a)(2) Financial Statement Schedules.
 
All financial schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and therefore have been omitted.
 
(a)(3) Exhibits.
 
See Exhibit Index on page 45.
 
-42-

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

   
FRONTIER FINANCIAL CORPORATION
February 21, 2007
  
/s/ John J. Dickson
   
John J. Dickson
   
President and Chief Executive Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated:

February 21, 2007
  
/s/ John J. Dickson
  
 
  
John J. Dickson
  
   
President and Chief Executive Officer
  
   
(Principal Executive Officer)
  
       
February 21, 2007
  
/s/ Carol E. Wheeler
  
   
Carol E. Wheeler
  
   
Chief Financial Officer
  
   
(Principal Financial and Accounting Officer)
  
       
February 21, 2007
  
/s/ George E. Barber
  
   
George E. Barber, Director
  
       
February 21, 2007
  
/s/ Michael J. Clementz
 
   
Michael J. Clementz, Director
  
       
February 21, 2007
  
/s/ David M. Cuthill 
  
   
David M. Cuthill, Director
  
       
February 21, 2007
  
/s/ Lucy DeYoung
 
   
Lucy DeYoung, Director
  
       
February 21, 2007
  
/s/ John J. Dickson
  
   
John J. Dickson, Director
  
       
February 21, 2007
  
/s/ Robert J. Dickson
  
   
Robert J. Dickson, Chairman of the Board
  
       
February 21, 2007
  
/s/ Patrick M. Fahey
  
   
Patrick M. Fahey, Director
  
       
February 21, 2007
  
/s/ Edward D. Hansen
  
   
Edward D. Hansen, Director
  
       
February 21, 2007
  
/s/ William H. Lucas
  
   
William H. Lucas, Director
  
       
February 21, 2007
  
/s/ James H. Mulligan
 
   
James H. Mulligan, Director
  
       
February 21, 2007
  
/s/ William J. Robinson
 
   
William J. Robinson, Director
  
       
February 21, 2007
  
/s/ Edward C. Rubatino
  
   
Edward C. Rubatino, Director
  
       
February 21, 2007
  
/s/ Darrell J. Storkson
  
   
Darrell J. Storkson, Director
  
       
February 21, 2007
  
/s/ Mark O. Zenger
 
   
Mark O. Zenger, Director
  

-43-
 
EXHIBIT INDEX
(3)(a)
Articles of Incorporation of Frontier Financial Corporation are incorporated herein by reference to Appendix A to the registrant’s definitive Proxy Statement on Schedule 14A filed on March 20, 1998 (File No. 000-15540).
   
(3)(b)
By-Laws of Frontier Financial Corporation are incorporated herein by reference to Exhibit 3(ii) to Form 10Q filed on October 29, 2003.
   
*(10)(a)
Amended and Restated Frontier Financial Corporation Incentive Stock Option Plan incorporated by reference to Exhibit 99.1 to Registration Statement on Form S-8, filed March 27, 1998 (File No. 333-48805).
   
*(10)(b)
Frontier Financial Corporation 1999 Employee Stock Award Plan is incorporated herein by reference to Exhibit 99.1 to Registration Statement on Form S-8, filed March 2, 1999 (File No. 333-73217).
   
*(10)(c)
Frontier Financial Corporation 2001 Stock Award Plan, is incorporated herein by reference to Exhibit 99.1 to Registration Statement on Form S-8, filed January 26, 2001, (File No. 333-54362).
   
*(10)(d)
Frontier Financial Corporation Employee Stock Option Plan and Interbancorp, Inc. Director Stock Option Plan, is incorporated herein by reference to Exhibit 10.1 to Registration Statement on Form S-8, filed January 26, 2001 (File No. 333-37242).
   
*(10)(e)
Interbancorp, Inc. Employee Stock Option Plan and Interbancorp, Inc. Director Stock Option Plan, is incorporated herein by reference to Exhibit 10.1 to Registration Statement on Form S-8, filed February 13, 2001 (File No. 333-50882).
   
*(10)(f)
Frontier Financial Corporation Employee Stock Option Plan and NorthStar Bank Employee Stock Option Plan, NorthStar Bank 1994 Employee Stock Option Plan, and NorthStar Bank Director Nonqualified Stock Option Plan, is incorporated herein by reference to Exhibit 10.1 to Registration Statement on Form S-8, filed March 16, 2006 (File No. 333-132487).
   
*(10)(g)
Frontier Financial Corporation 2006 Stock Incentive Plan, is incorporated herein by reference to Exhibit 99.1 to Registration Statement on Form S-8, filed August 4, 2006, (File No. 333-136298).
   
*(10)(h)
Change of Control Agreement with John J. Dickson is incorporated by reference to Exhibit 10.1 to Current Report on Form 8-K, filed January 19, 2006 (File No. 000-15540).
   
Form of Change of Control Agreement with other Executive Officers.
   
Statement Regarding Computation of Earnings Per Share.
   
Portions of the Annual Report to Shareowners for the year ended December 31, 2006, are incorporated by reference herein.
   
Code of Ethics for Senior Financial Officers.
   
Subsidiaries of Registrant.
   
Consent of Moss Adams LLP, independent registered public accounting firm.
   
Certification of Chief Executive Officer.
   
Certification of Chief Financial Officer.
   
Certification pursuant to 28 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act
 
* Compensatory plan or arrangement.
 
 
-44-
 EX-10.I 2 ex10_i.htm EXHIBIT 10.(I) Exhibit 10.(i)
Exhibit (10)(i)
 
FRONTIER BANK
CHANGE OF CONTROL AGREEMENT

This CHANGE OF CONTROL AGREEMENT (this “Agreement”) is made by and between FRONTIER FINANCIAL CORPORATION and FRONTIER BANK (hereinafter jointly referred to as the “Bank”), and __________________(hereinafter referred to as “Executive”). The Bank and Executive are sometimes referred to herein as “the Parties.”
 
WHEREAS, Executive has rendered valuable services to the Bank, and the Board of Directors of the Bank (the “Board”) desires to be assured that Executive will continue rendering such services to the Bank; and
 
WHEREAS, the Board wishes to assure the Bank of continuity of management in the event of a Change of Control of the Bank; and
 
WHEREAS, Executive desires assurance that Executive will be protected in the event of any Change of Control;
 
NOW, THEREFORE, in consideration of the mutual covenants and promises herein, the Parties agree as follows:
 
 1.    Severance Benefits. The Bank agrees that if there is a Change of Control of the Bank and the Bank terminates Executive’s employment other than for Cause, as defined below, or Executive terminates this Agreement for Good Reason, as defined below, within twenty-four (24) months after such Change of Control, Executive shall receive the benefits provided in Paragraphs 1.1 and 1.2 (the “Severance Benefit”):
 
          1.1    Executive shall receive a lump sum payment equal to two (2) times Executive’s W-2 compensation before salary deferrals (excluding any gains from stock-based compensation) over the twelve (12) months prior to the effective date of the Change of Control, less statutory payroll deductions on the first day of the seventh calendar month following the discontinuance of Executive’s employment due to a Change of Control; and
          
          1.2    Executive shall continue to be covered by all of the Bank’s medical and dental plans for twenty-four (24) months following discontinuance of Executive’s employment due to a Change of Control.
 
 2.    Termination Before Change of Control. If Executive’s employment is involuntarily terminated (other than for Cause, as defined below) or Executive dies or terminates employment due to disability as defined below on or after the date of the press release announcing the entering into of an agreement that will result in a Change of Control of the Bank, Executive shall be entitled to the Severance Benefits described in Section 1, said benefits to be paid after the Change of Control actually occurs but no earlier than the first day of the seventh calendar month following the discontinuance of Executive’s employment due to a Change of Control. For purposes of this paragraph, “disability” shall be determined using the definition of that term in the Bank’s long-term disability plan in effect at the time of the disability, or if no such plan is then in effect, the definition of “disability” contained in such other plan providing a disability benefit. If there is no such plan then in effect, the definition of “disability” found in Internal Revenue Code Section 22(e), as may be amended from time to time, shall apply.
- 1 -
 
                 3.      Consideration.
 
          3.1    The amounts paid to Executive hereunder shall be considered severance pay in consideration of the past services Executive has rendered to the Bank and in consideration of Executive’s continued service from the date hereof to the date of Executive’s entitlement to such payments, and in further consideration for the covenant not to compete/non-solicitation, as described in Section 13.
 
          3.2    Executive shall have no duty to mitigate the amount of any payment under this Agreement by seeking other employment. Should Executive actually receive earnings from any such other employment, the payments called for hereunder shall not be reduced or offset by any such future earnings.
 
     4.    Change of Control.“Change of Control” as used herein will be deemed to have occurred when there is a Change in the Ownership of the Bank. For purposes of this Agreement, a Change in the Ownership of the Bank shall be deemed to occur when any one person, or more than one person acting as a group, acquires ownership of the Bank stock that, together with stock held by such person or group, constitutes more than fifty percent (50%) of the total fair market value or total voting power of the Bank. A Change in Ownership of the Bank will not occur when any one person, or more than one person acting as a group, owning more than fifty percent (50%) of the total fair market value or total voting power of the stock of the Bank acquires additional stock. For the purposes of this section, an increase in the percentage of stock owned by any one person, or more than one person if acting as a group, as a result of a transaction in which the Bank acquires its stock in exchange for property will be treated as an acquisition of stock.
 
     5.    Cause. For purposes of this Agreement, “Cause” shall mean:
 
          5.1    The willful breach or habitual neglect of assigned duties related to the Bank, including compliance with the Bank’s policies, and such breach or neglect is materially detrimental to the Bank;
 
          5.2    Conviction (including any plea of nolo contendere) of Executive of any felony or crime involving dishonesty or moral turpitude;
          
          5.3    Any act of personal dishonesty knowingly taken by Executive in connection with Executive’s responsibilities as an employee and intended to result in personal enrichment of Executive or any other person;
 
          5.4     Bad faith conduct that is materially detrimental to the Bank;
 
          5.5    Inability of Executive to perform Executive’s duties due to alcohol or illegal drug use;

- 2 -
          
          5.6    Executive’s failure to comply with any material legal written directive of the Board; or
 
          5.7    Any act or omission of Executive which is of substantial detriment to the Bank because of Executive’s intentional failure to comply with any statute, rule or regulation, except any act or omission believed by Executive in good faith to have been in or not opposed to the best interest of the Bank (without intent of Executive to gain, directly or indirectly, a profit to which Executive was not legally entitled) and except that Cause shall not mean bad judgment or negligence other than habitual neglect of duty.
 
 6.    Good Reason. For purposes of this Agreement, “Good Reason” means any one or more of the following: reduction of Executive’s base compensation without Executive’s consent (other than as part of an overall program applied uniformly to all members of senior management of the Bank); assignment of Executive to a position which provides Executive with significantly less responsibility; or the relocation or transfer of Executive’s principal place of employment to a different location in excess of thirty (30) miles of Executive’s then existing principal job location.
 
 7.    Effect on Other Benefits. The arrangements called for by this Agreement are not intended to have any effect on Executive’s participation in any other benefits available to executive personnel or to preclude other compensation or additional benefits as may be authorized by the Board from time-to-time.
 
 8.    Voluntary Retirement. In the event Executive, after attaining age 60, voluntarily retires within twelve (12) months following a Change of Control of the Bank, Executive shall receive as a Severance Benefit a lump sum payment equal to one (1) times Executive’s W-2 compensation before salary deferrals (excluding any gains from stock-based compensation) over the twelve (12) months prior to the effective date of the Change of Control. Such payment shall be made on the first day of the seventh calendar month after the discontinuance of Executive’s employment. In addition, Executive shall continue to be covered by all of the Bank’s medical and dental plans for twelve (12) months after the discontinuance of Executive’s employment.
 
 9.    Golden Parachute (FDIC). The Bank shall not be obligated to make, and Executive shall not be entitled to, any payment under this Agreement if such payment would constitute a “golden parachute” payment prohibited by 12 U.S.C. 1828(k) or 12 CFR 359.0 et seq. The Bank shall have no liability to Executive under or in relation to this payment should any payment be deemed a prohibited “golden parachute” payment.
 
10.         Golden Parachute (IRS). Executive is aware that under this Agreement payments made to Executive may constitute an “excess parachute payment” under Section 280G of the Internal Revenue Code, as amended, and thus would subject Executive to the Excise Tax under Internal Revenue Code Section 4999, as amended.
 
11.         Binding Effect. This Agreement shall be binding and shall inure to the benefit of the respective successors, assigns, legal representative and heirs of the Parties.
 
12.         Miscellaneous. If any provision of this Agreement shall be held by a court of competent jurisdiction to be invalid or unenforceable, the remaining provisions shall continue to be fully effective. No provision of this Agreement may be modified or waived unless such waiver or modification is agreed to in writing by Executive and the Board. This is the entire agreement between the Parties and replaces any prior agreement regarding Change of Control. This Agreement shall be governed under the laws of the State of Washington.

- 3 -
 
13.         Covenant Not to Compete/Non-Solicitation. Executive agrees that if Executive receives a Severance Benefit under this Agreement, the following shall apply:
 
                             13.1    Executive shall not, for a period of two (2) years after termination of employment with the Bank, directly or indirectly become interested in, as a principal shareholder, director, or officer, any financial institution, now existing or organized hereafter, that competes or will compete with the Bank, including any successor, or any of the Bank’s affiliates within any county in which the Bank does business; provided, that Executive shall not be deemed a “principal shareholder” unless (i) Executive’s investment in such an institution exceeds 2% of the institution’s outstanding voting securities or (ii) Executive is active in the organization, management or affairs of such institution. The provisions restricting competition by Executive may be waived by action of the Board. Executive recognizes and agrees that any breach of this covenant by Executive will cause immediate and irreparable injury to the Bank, and Executive hereby authorizes recourse by the Bank to injunction and/or specific performance, as well as to the other legal or equitable remedies to which the Bank may be entitled.
 
                              13.2    During the non-competition period described in Paragraph 13.1, Executive shall not solicit or attempt to solicit any other employee of the Bank or its affiliates to leave the employ of those companies, or in any way interfere with the relationship between the Bank and any other employee of the Bank.
 
                14.    Dispute Resolution. The Parties agree to attempt to resolve all disputes arising out of this Agreement by mediation. Any party desiring mediation may begin the process by giving the other party a written Request to Mediate, describing the issues involved and inviting the other party to join with the calling party to name a mutually agreeable mediator and a timeframe for the mediation meeting. The Parties and mediator may adopt any procedural format that seems appropriate for the particular dispute. The contents of all discussions during the mediation shall be confidential and non-discoverable in subsequent arbitration or litigation, if any. If the Parties can, through the mediation process, resolve the dispute(s), the agreement reached by the Parties shall be reduced to writing, signed by the Parties, and the dispute shall be at an end.
 
If the result of the mediation is a recognition that the dispute cannot be successfully mediated, or if either party believes mediation would be unproductive or too slow, then either party may seek to resolve the dispute in accordance with the procedures established by Judicial Arbitration and Mediation Services, Inc.
 
The award rendered by the arbitrator (whether through Judicial Arbitration and Mediation Services, Inc. or otherwise) shall be final, and judgment may be entered upon it in accordance with applicable law in any court having jurisdiction thereof.

- 4 -
 
The arbitrator shall allocate the costs charged by Judicial Arbitration and Mediation Services, Inc., or other arbitrator as the case may be, for the arbitration between the Parties in a manner which the arbitrator considers equitable. It is agreed that the arbitrator shall award to the prevailing or substantially prevailing party all fees incurred by such party with regard to such arbitration, including reasonable legal and accounting fees. If the arbitrator determines that there is no prevailing or substantially prevailing party, the legal and accounting fees shall be the responsibility of each party.
 
Notwithstanding the above, if Executive violates Section 13 above, the Bank will be entitled, in addition to the rights set forth heretofore, to commence legal action in a court of competent jurisdiction to obtain a temporary, primary and permanent injunction in order to prevent or restrain the breach of Section 13, and the Bank will not be required to post a bond as a condition to the granting of any such relief.
 
15.    Independent Legal Counsel. Executive acknowledges that they have had the opportunity to review and consult with their own personal legal counsel regarding this Agreement.
 
16.    Termination. This Agreement shall terminate immediately and without notice (1) upon the voluntary or involuntary termination of Executive’s employment, death or disability (as defined in Section 2) occurring prior to the date of the press release announcing the entering into an agreement that will result in a Change of Control of the Bank; or (2) if Executive’s employment with the Bank is reduced to part time (defined for purposes of this Agreement as less than thirty (30) hours per work week) other than due to short-time disability or medical leave; or (3) upon written notice to Executive if Executive’s duties and responsibilities are reduced significantly as determined by the Personnel Committee of the Board of Directors.
 
17.    Compliance with Internal Revenue Code Section 409A. Where required, the provisions of this Agreement are intended to comply with the requirements of Section 409A of the Internal Revenue Code. Notwithstanding any other provision of this Agreement, this Agreement shall be interpreted and administered in accordance with the requirements of Section 409A of the Internal Revenue Code.
 
IN WITNESS WHEREOF, the Parties have signed this Agreement this 3rd day of January, 2007.
 
FRONTIER FINANCIAL CORPORATIONFRONTIER BANK
  
EXECUTIVE
     
By:
      
 
John Dickson, President
    
 
 
- 5 -
 EX-11 3 ex11.htm EXHIBIT 11 Exhibit 11
Exhibit 11

FRONTIER FINANCIAL CORPORATION
COMPUTATION OF BASIC AND DILUTED EARNINGS PER SHARE

   
2006
  
2005
  
2004
  
               
Net Income (in thousands)
  
$
68,910
  
$
51,584
  
$
43,045
  
                     
Computation of average shares outstanding:
                    
                     
Shares outstanding at beginning of year
    
42,657
   
42,177
   
41,738
 
                     
Average shares issued pursuant to merger
    
1,514
   
-
   
-
 
                     
Shares issued or repurchased during the year times average time outstanding during the year
    
839
   
305
   
189
 
Basic average shares outstanding
    
45,010
   
42,482
   
41,927
 
Average number of dilutive shares assumed to be outstanding (1)
    
475
   
261
   
279
 
                     
Average dilutive shares outstanding
    
45,485
   
42,743
   
42,206
 
                     
Basic earnings per share
  
$
1.53
  
$
1.21
  
$
1.03
  
                     
Diluted earnings per share
  
$
1.52
  
$
1.21
  
$
1.02
  
 
 
EX-13 4 ex13.htm EXHIBIT 13 Exhibit 13

FRONTIER FINANCIAL CORPORATION
AND SUBSIDIARIES
 
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM


To the Board of Directors and Shareowners
Frontier Financial Corporation

We have audited the accompanying consolidated balance sheet of Frontier Financial Corporation and subsidiaries (Corporation) as of December 31, 2006 and 2005, and the related consolidated statements of income, shareowners' equity and cash flows for the three years in the period ended December 31, 2006. We also have audited management's assessment included in the accompanying Management Report on Internal Control over Financial Reporting that the Corporation maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Corporation’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on these financial statements, an opinion on management's assessment, and an opinion on the effectiveness of the Corporation’s internal control over financial reporting based on our audits.

We conducted our audits in accordance with auditing standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

The Corporation's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America. A Corporation’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Corporation; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Corporation are being made only in accordance with authorizations of management and Directors of the Corporation; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Corporation's assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Frontier Financial Corporation and subsidiaries as of December 31, 2006 and 2005, and the results of their operations and cash flows for each of the three years ended December 31, 2006, in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, management's assessment that Frontier Financial Corporation and subsidiaries maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Furthermore, in our opinion, Frontier Financial Corporation and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.


Everett, Washington
February 27, 2007
 
The accompanying notes are an integral part of these financial statements.
- 1 -

FRONTIER FINANCIAL CORPORATION
AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEET
(In Thousands, except for number of shares)

   
DECEMBER 31,
  
ASSETS
  
2006
  
2005
  
Cash and due from banks
  
$
104,222
  
$
85,631
  
Federal funds sold
    
18,673
   
733
 
Investment securities
              
Available for sale, at fair value
    
111,112
   
104,904
 
Held to maturity (fair value 2006: $3,623; 2005: $5,919)
    
3,599
   
5,713
 
Total investment securities
    
114,711
   
110,617
 
 
              
Loans for resale
   
7,220
   
5,711
 
Loans
    
2,900,780
   
2,383,513
 
Less allowance for loan losses
    
(40,649
)
  
(33,805
)
               
Net loans
    
2,867,351
   
2,355,419
 
               
Premises and equipment, net
    
30,026
   
29,769
 
Intangible assets
    
41,227
   
6,476
 
Federal Home Loan Bank (FHLB) stock
    
15,030
   
14,154
 
Bank owned life insurance
    
22,198
   
18,136
 
Other assets
    
25,026
   
19,340
 
               
Total assets
  
$
3,238,464
  
$
2,640,275
  
               
LIABILITIES
              
Deposits
              
Noninterest bearing accounts
  
$
406,621
  
$
395,852
  
Interest bearing accounts
    
2,047,011
   
1,665,528
 
               
Total deposits
    
2,453,632
   
2,061,380
 
               
Federal funds purchased and securities sold under agreements to repurchase
    
81,673
   
20,813
 
Federal Home Loan Bank advances
    
282,017
   
240,000
 
Junior subordinated debentures
    
5,156
   
-
 
Other liabilities
    
20,703
   
21,985
 
Total liabilities
    
2,843,181
   
2,344,178
 
COMMITMENTS AND CONTINGENCIES (Note 16)
              
               
SHAREOWNERS' EQUITY
              
               
Preferred stock, no par value; 10,000,000 shares authorized
    
-
   
-
 
Common stock, no par value; 100,000,000 shares authorized; 45,350,316 and 42,657,225 shares issued and outstanding in 2006 and 2005, respectively
    
183,982
   
131,695
 
Retained earnings
    
205,126
   
159,978
 
Accumulated other comprehensive income, net of tax
    
6,175
   
4,424
 
Total shareowners' equity
    
395,283
   
296,097
 
Total liabilities and shareowners' equity
  
$
3,238,464
  
$
2,640,275
  


The accompanying notes are an integral part of these financial statements.

- 2 -

FRONTIER FINANCIAL CORPORATION
AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF INCOME
(In Thousands, except for number of shares and per share amounts) 

   
YEAR ENDED DECEMBER 31,
  
   
2006
 
2005
 
2004
 
INTEREST INCOME
              
Interest and fees on loans
  
$
244,493
  
$
173,753
  
$
133,232
  
Interest on federal funds sold
    
1,448
   
361
   
170
 
Interest on investment securities
                   
Taxable
    
3,998
   
4,497
   
6,351
 
Exempt from federal income tax
    
205
   
275
   
475
 
Total interest income
    
250,144
   
178,886
   
140,228
 
INTEREST EXPENSE
                    
Interest on deposits
    
73,526
   
40,714
   
26,418
 
Interest on FHLB advances
    
12,195
   
10,434
   
8,365
 
Interest on federal funds purchased and securities sold under agreements to repurchase
    
1,221
   
588
   
156
 
Total interest expense
    
86,942
   
51,736
   
34,939
 
NET INTEREST INCOME
    
163,202
   
127,150
   
105,289
 
PROVISION FOR LOAN LOSSES
    
(7,500
)
  
(4,200
)
  
(3,500
)
Net interest income after provision for loan losses
    
155,702
   
122,950
   
101,789
 
NONINTEREST INCOME
                    
Provision for loss on equity investment
    
-
   
(211
)
  
-
 
Loss on sale of securities
    
(25
)
  
-
   
(44
)
Gain on sale of secondary market loans
    
1,491
   
1,249
   
1,028
 
Service charges
    
4,214
   
4,365
   
4,926
 
Other
    
9,943
   
7,672
   
8,034
 
Total noninterest income
    
15,623
   
13,075
   
13,944
 
NONINTEREST EXPENSE
              
Salaries
    
29,935
   
26,718
   
23,403
 
Employee benefits
    
12,050
   
9,825
   
8,509
 
Occupancy
   
9,108
   
7,654
   
7,035
 
State business taxes
    
2,213
   
1,798
   
1,751
 
Other
    
13,740
   
12,117
   
10,027
 
Total noninterest expense
    
67,046
   
58,112
   
50,725
 
INCOME BEFORE PROVISION FOR INCOME TAX
    
104,279
   
77,913
   
65,008
 
PROVISION FOR INCOME TAX
    
(35,369
)
  
(26,329
)
  
(21,963
)
NET INCOME
  
$
68,910
  
$
51,584
  
$
43,045
  
Weighted average number of shares
                    
outstanding for the period
    
45,009,526
   
42,481,644
   
41,926,625
 
BASIC EARNINGS PER SHARE
  
$
1.53
  
$
1.21
  
$
1.03
  
                     
Weighted average number of diluted
                    
shares outstanding for the period
    
45,484,987
   
42,742,551
   
42,205,634
 
DILUTED EARNINGS PER SHARE
  
$
1.52
  
$
1.21
  
$
1.02
  
 
The accompanying notes are an integral part of these financial statements.

- 3 -

FRONTIER FINANCIAL CORPORATION
AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF SHAREOWNERS’ EQUITY
(In Thousands, except number of shares)

CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY
AND COMPREHENSIVE INCOME

                   
Accumulated
      
                   
Other
      
                   
Comprehensive
      
   
Common Stock
  
Comprehensive
  
Retained
  
Income/
      
   
Shares
  
Amount
  
Income
  
Earnings
  
(Loss)
  
Total
  
Balance, December 31, 2003
    
18,550,060
 
$
118,693
        
$
97,221
  
$
3,492
  
$
219,406
  
                                       
Comprehensive Income:
                                      
Net income for 2004
    
-
   
-
 
$
43,045
    
43,045
   
-
   
43,045
 
Other comprehensive income,
Unrealized gain (loss) on available for sale securities, net of tax $(51)
    
-
   
-
   
(95
)
  
-
   
(95
)
  
(95
)
Total comprehensive income
              
$
42,950
                    
Stock options exercised
    
104,755
   
2,393
         
-
   
-
   
2,393
 
Stock award plan
    
15,995
   
528
         
-
   
-
   
528
 
Issuance of common shares
    
74,375
   
3,003
                   
3,003
 
Tax benefit from stock options
    
-
   
-
         
698
   
-
   
698
 
Cash dividends declared (34¢ per share)
    
-
   
-
         
(14,748
)
  
-
   
(14,748
)
                                       
Balance, December 31, 2004
    
18,745,185
   
124,617
         
126,216
   
3,397
   
254,230
 
                                       
Comprehensive Income:
                                      
Net income for 2005
    
-
   
-
 
$
51,584
    
51,584
   
-
   
51,584
 
Other comprehensive income,
Unrealized gain on available for sale
securities, net of tax $554
    
-
   
-
   
1,027
   
-
   
1,027
   
1,027
 
Total comprehensive income
              
$
52,611
                    
Stock options exercised
    
154,791
   
2,549
         
-
   
-
   
2,549
 
Stock award plan
    
22,584
   
601
         
-
   
-
   
601
 
Issuance of common shares
    
143,438
   
3,928
                   
3,928
 
Tax benefit from stock options
    
-
   
-
         
205
   
-
   
205
 
Three for two stock split
    
9,372,152
   
-
                         
Cash dividends declared (40¢ per share)
    
-
   
-
         
(18,027
)
  
-
   
(18,027
)
                                       
Balance, December 31, 2005
    
28,438,150
   
131,695
         
159,978
   
4,424
   
296,097
 
                                       
Comprehensive Income:
                                      
Net income for 2006
    
-
   
-
 
$
68,910
    
68,910
   
-
   
68,910
 
Other comprehensive income,
Unrealized gain on available for sale securities, net of tax $943
    
-
   
-
   
1,751
   
-
   
1,751
   
1,751
 
Total comprehensive income
              
$
70,661
                    
Stock options exercised
    
275,283
   
4,218
         
-
   
-
   
4,218
 
Stock award plan
    
20,542
   
1,156
         
-
   
-
   
1,156
 
Three for two stock split
    
15,102,634
   
-
                     
-
 
Tax benefit from stock options
                      
1,205
         
1,205
 
Merger
    
1,513,707
   
46,913
                     
46,913
 
Stock option expense
                      
73
         
73
 
Cash dividends declared (50¢ per share)
    
-
   
-
         
(25,040
)
  
-
   
(25,040
)
Balance, December 31, 2006
    
45,350,316
 
$
183,982
        
$
205,126
  
$
6,175
  
$
395,283
  


The accompanying notes are an integral part of these financial statements.

- 4 -

FRONTIER FINANCIAL CORPORATION
AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF CASH FLOWS
(In Thousands)

   
YEAR ENDED DECEMBER 31,
  
   
2006
  
2005
  
2004
  
CASH FLOWS FROM OPERATING ACTIVITIES
              
Net income
  
$
68,910
  
$
51,584
  
$
43,045
  
Adjustments to reconcile net income to net cash provided by operating activities
              
Depreciation and amortization
    
4,010
   
2,704
   
2,501
 
Provision for loan losses
    
7,500
   
4,200
   
3,500
 
Gain on sale of other real estate owned
    
-
   
(25
)
  
(512
)
Gain (loss) on sale of premises and equipment
    
(2,445
)
  
31
   
(9
)
Gain (loss) on sale of securities
    
25
   
-
   
44
 
Gain on sale of secondary market loans
    
(1,491
)
  
(1,249
)
  
(1,028
)
Provision for loss on equity investment
    
-
   
211
   
-
 
Deferred taxes
    
(1,721
)
  
(1,633
)
  
(199
)
Stock award plan compensation
    
1,156
   
601
   
528
 
Stock option expense
    
73
   
-
   
-
 
Excess tax benefits associated with equity-based compensation
    
(1,205
)
  
(205
)
  
(698
)
Dividend income from Federal Home Loan Bank
    
-
   
(58
)
  
(397
)
Increase in cash surrender value of BOLI
    
(888
)
  
(736
)
  
(574
)
Changes in operating assets and liabilities
              
Income taxes payable
    
(1,950
)
  
1,964
   
(726
)
Interest receivable
    
(3,780
)
  
(3,005
)
  
359
 
Interest payable
    
4,513
   
3,033
   
290
 
Proceeds from sales of mortgage loans
    
111,720
   
91,293
   
65,847
 
Origination of mortgage loans held for sale
    
(111,736
)
  
(93,191
)
  
(67,707
)
Other operating activities
    
(2,127
)
  
1,984
   
2,900
 
Net cash provided by operating activities
    
70,564
   
57,503
   
47,164
 
CASH FLOWS FROM INVESTING ACTIVITIES
              
Net change in federal funds sold
    
(17,940
)
  
5,213
   
(5,938
)
Proceeds from maturities of available for sale securities
    
20,515
   
90,294
   
78,368
 
Proceeds from maturities of held to maturity securities
    
2,114
   
1,176
   
4,646
 
Proceeds from sales of available for sale securities
    
-
   
1,852
   
1,086
 
Purchase of investment securities available for sale
    
(17,324
)
  
(58,923
)
  
(47,127
)
Acquisition of bank
    
7,121
   
-
   
-
 
Net cash flows from loan activities
    
(517,267
)
  
(409,274
)
  
(204,804
)
Purchases of premises and equipment
    
(3,927
)
  
(3,193
)
  
(3,052
)
Proceeds from the sale of other real estate owned
    
-
   
25
   
5,721
 
Proceeds from the sale of premises and equipment
    
3,443
   
147
   
91
 
Other investing activities
    
(3,069
)
  
(633
)
  
(1,065
)
Net cash used by investing activities
    
(526,334
)
  
(373,316
)
  
(172,074
)
CASH FLOWS FROM FINANCING ACTIVITIES
              
Net change in core deposit accounts
    
182,986
   
(13,360
)
  
77,995
 
Net change in certificates of deposit
    
209,266
   
278,898
   
50,830
 
Stock options exercised
    
4,218
   
2,549
   
2,393
 
Cash dividends paid
    
(22,358
)
  
(17,021
)
  
(14,337
)
Net change in federal funds purchased and securities sold under agreements to repurchase
    
60,860
   
10,608
   
(190
)
Advances from the Federal Home Loan Bank
    
111,756
   
110,000
   
55,000
 
Repayments to the Federal Home Loan Bank
    
(69,739
)
  
(45,088
)
  
(50,016
)
Excess tax benefits associated with equity-based compensation
    
1,205
   
205
   
698
 
Other financing activities
    
(3,833
)
  
3,802
   
(1,164
)
Net cash provided by financing activities
    
474,361
   
330,593
   
121,209
 
INCREASE (DECREASE) IN CASH AND DUE FROM BANKS
    
18,591
   
14,780
   
(3,701
)
CASH AND DUE FROM BANKS AT BEGINNING OF YEAR
    
85,631
   
70,851
   
74,552
 
CASH AND DUE FROM BANKS AT END OF YEAR
  
$
104,222
  
$
85,631
  
$
70,851
  
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
                    
Cash paid during the year for interest
  
$
82,157
  
$
48,703
  
$
34,649
  
Cash paid during the year for income taxes
  
$
36,595
  
$
26,000
  
$
22,505
  
                     
SUPPLEMENTAL INFORMATION ABOUT NONCASH INVESTING AND FINANCING ACTIVITIES              
Other real estate acquired in settlement of loans in 2004 was $1.0 million.
              
Purchase of investment through issuance of common shares in 2005 and in 2004 were $3.9 million and $3.0 million, respectively.
        
 
The accompanying notes are an integral part of these financial statements.

- 5 -

FRONTIER FINANCIAL CORPORATION
AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS 

NOTE ONE - Basis of Presentation, Nature of Operations and Summary of Significant Accounting Policies

Basis of Presentation - The consolidated financial statements include the accounts of Frontier Financial Corporation (the Corporation or FFC), a financial holding company, and its wholly owned subsidiaries, Frontier Bank (the Bank), and FFP, Incorporated (FFP). FFP owns certain real property, which is leased to the Bank for use in its operations. Significant inter-company account balances and transactions have been eliminated in consolidation. Assets held by the Bank in an agency or fiduciary capacity, are not included in the accompanying financial statements.

Variable Interest Entities - The Trusts were formed in December 2004 for the exclusive purpose of issuing trust preferred securities and using the $5.2 million in proceeds from the issuance to fund future asset growth in the Bank (Note 10). The Trusts are considered a variable interest entity as defined in FASB Interpretation No. 46R, Consolidation of Variable Interest Entities (revised December 2003), which are: (1) the entity has equity that is insufficient to permit the entity to finance its activities without additional subordinated financial support from other parties, or (2) the entity has equity investors that cannot make significant decisions about the entity’s operations or that do not absorb the expected losses or receive the expected returns of the entity.

The Corporation has a significant variable interest in the Trusts, however it is not consolidated because the Corporation is not the beneficiary.

Nature of Operations - The Corporation is primarily engaged in providing a full range of banking and mortgage services to individual and corporate customers through the Bank. The Bank also provides other services such as trust services and insurance and financial service brokerage activities. The Corporation is subject to competition from other financial institutions and to regulation by certain federal and state agencies and undergoes periodic examinations by those regulatory authorities.

Stock Split - On August 16, 2006 the Corporation announced a three-for-two stock split paid on September 26, 2006 to shareowners of record on September 12, 2006. Accordingly, all shares and per share amounts have been adjusted to reflect the split.

Summary of Significant Accounting Policies
 
Investment Securities- Certain debt securities that management has the positive intent and ability to hold to maturity are classified as held to maturity (HTM) and recorded at amortized cost. Trading securities are recorded at fair value with changes in fair value included in earnings. Securities not classified as held to maturity or trading, including equity securities with readily determinable fair values, are classified as available for sale (AFS) and recorded at fair value, with unrealized gains and losses excluded from earnings and reported in other comprehensive income.

Purchase premiums and discounts are recognized in interest income using the interest method over the terms of the securities. Declines in the fair value of held to maturity and available for sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses. In determining whether other than temporary impairment exists, management considers many factors, including: (1) the length of time and the extent to which the fair value has been less than cost; (2) the financial condition and near-term prospects of the issuer; and (3) the intent and ability of the Corporation to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. Gains and losses on the sale of securities are recorded on the trade date and determined using the specific identification method.

- 6 -

NOTE ONE - Basis of Presentation, Nature of Operations and Summary of Significant Accounting Policies (continued)

(b)    Federal Home Loan Bank (FHLB) Stock - The Bank’s investment in Federal Home Loan Bank stock is carried at par value ($100 per share), which reasonably approximates its fair value. As a member of the FHLB system, the Bank is required to maintain a minimum level of investment in FHLB stock based on specific percentages of its outstanding FHLB advances. The FHLB announced in December 2004, that it would not repurchase any stock until further notice. On April 5, 2005, the FHLB of Seattle submitted a proposed business and capital plan to its regulator, the Federal Housing Finance Board (“Finance Board”). In May 2005, the Finance Board accepted the Seattle Bank’s three-year plan. To meet the Finance Board’s conditions under the three-year plan, the Seattle Bank’s board adopted a resolution that suspends dividends on all classes of stock going forward. In December 2006, the FHLB of Seattle declared a $0.10 per share cash dividend and in January 2007 announced that its regulator, the Finance Board, has terminated its written plan. The termination of the written plan does not affect the resolution adopted by the Seattle Bank’s Board of Directors to continue its restrictions on Class B stock repurchases and limit dividends to 50 percent of year-to-date GAAP net income, except with the prior written approval of the Finance Board’s Director of the Office of Supervision. The dividend income shown on the statement of cash flows represents dividends declared in 2004, but not paid until 2005.

(c)    Loans and Related Income - Loans that management has the intent and ability to hold for the foreseeable future, or until maturity or payoff are reported at their outstanding principal, adjusted for unearned discounts, net of unamortized nonrefundable fees and related direct loan origination costs. Interest income is accrued as earned.

Net deferred fees and costs are generally amortized into interest income over the life of the loan as an adjustment to the loan yield using the interest method. Expenses deferred (principally personnel expense) and recognized in the yield adjustment result in a reduction in noninterest expense.

Nonrefundable fees related to lending activities other than direct loan origination or purchase are recognized as credit related fees and included in noninterest income during the period the related service is provided. These include standby letter of credit and loan commitment fees.

Loans are placed on nonaccrual status when, in the opinion of management, the collection of additional interest is doubtful or when the loan becomes 90 or more days past due. When a loan is placed on nonaccrual status, all interest previously accrued, but not collected, is reversed and charged against interest income. Income on nonaccrual loans is then recognized only to the extent cash is received and where the future collection of principal is probable. Accruals are resumed only when the loan is brought current, and when, in the opinion of management, the borrower has demonstrated the ability to resume payments of principal and interest. Interest income on restructured loans is recognized pursuant to the terms of the new loan agreement. Interest income on other impaired loans is monitored and based upon the terms of the underlying loan agreement. However, the recorded net investment in impaired loans, including accrued interest, is limited to the present value of the expected cash flows of the impaired loan or the observable fair market value of the loan or the fair market value of the loan's collateral.

(d)    Allowance for Loan Losses - The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.
 
The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectibility of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.

- 7 -

NOTE ONE - Basis of Presentation, Nature of Operations and Summary of Significant Accounting Policies (continued)

The allowance consists of specific, general and unallocated components. The specific component relates to loans that are classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers nonclassified loans and is based on historical loss experience adjusted for qualitative factors. An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimated specific and general losses in the portfolio.

A loan is considered impaired when, based on current information and events, it is probable that the Corporation will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan-by-loan basis for commercial and construction loans by either the present value of the expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent.

(e)    Loans Held For Sale - Mortgage loans originated and designated as held for sale are carried at the lower of cost or estimated fair value, as determined by quoted market prices, in aggregate. Net unrealized losses are recognized in a valuation allowance by charges to income. Gains or losses on the sale of such loans are based on the specific identification method.

(f)    Premises and Equipment - Premises, leasehold improvements and equipment are shown at cost and depreciated using the straight-line method. Depreciation expense is computed over the following estimated useful lives:

Premises
7 to 40 years
Furniture, fixtures and equipment
3 to 7 years

(g)    Other Real Estate Owned - Other real estate owned consists principally of properties acquired through foreclosure and is stated at the lower of cost or estimated market value. Losses arising from the acquisition of property, in full or partial satisfaction of loans, are charged to the allowance for loan losses.

Subsequent to the transfer to foreclosed assets held for sale, these assets continue to be recorded at the lower of cost or fair value (less estimated costs to sell), based on periodic evaluations. Generally, legal and professional fees associated with foreclosures are expensed as incurred. Costs incurred to improve property prior to sale are capitalized, however, in no event are recorded costs allowed to exceed fair value. Subsequent gains, losses, or expenses recognized on the sale of these properties are included in noninterest income or expense.

(h)    Income Tax - The Corporation reports income and expenses using the accrual method of accounting and files a consolidated tax return. Deferred taxes are determined using the asset-liability method and are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes. Deferred taxes result from temporary differences in recognition of certain income and expense amounts between the Bank's financial statements and its tax returns.

- 8 -

NOTE ONE - Basis of Presentation, Nature of Operations and Summary of Significant Accounting Policies (continued)

(i)    Retirement Plan - The Corporation has a profit sharing and salary deferral plan that covers eligible employees. The Corporation's contributions to the plan were $4.3 million in 2006, $3.2 million in 2005, and $2.5 million in 2004. Contributions to the profit sharing plan are discretionary with a minimum of 6% of employee compensation. Employer contributions are funded during the period in which it is committed by the Board of Directors.

(j)    Advertising Costs - The Corporation expenses advertising costs as they are incurred and such costs are not considered to be material.

(k)   Financial Instruments - In the ordinary course of business, the Bank has entered into off-balance sheet financial instruments consisting of commitments to extend credit, commitments under credit card arrangements, commercial letters of credit, and standby letters of credit. Such financial instruments are recorded in the financial statements when they are funded or related fees are incurred or received.

(l)    Equity-Based Compensation  - - At December 31, 2006, the Corporation has a stock-based employee compensation plan, which is described more fully in Note 13. Prior to January 1, 2006, the Corporation accounted for stock plans in accordance with the recognition and measurement provisions of Accounting Principles Board Opinion (APB) No. 25, Accounting for Stock Issued to Employees, and related interpretations, as permitted by FASB Statement No. 123, Accounting for Stock-Based Compensation. No stock-based compensation expense was recognized in the Consolidated Statement of Income for the years ended December 31, 2005 or 2004, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. Effective January 1, 2006, the Corporation adopted the fair value recognition provisions of SFAS No. 123R, Share-Based Payment (Revised 2004) using the modified-prospective-transition method. Under that transition method, compensation cost recognized in 2006 includes: (a) compensation cost for all share-based payments granted prior to, but not yet vested as of January 1, 2006, based on the grant-date fair value estimated in accordance with the original provisions of Statement 123, and (b) compensation cost for all share-based payments granted subsequent to January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of Statement 123R. Results for prior periods have not been restated.

As a result of adopting Statement 123R on January 1, 2006, the Corporation’s income before income taxes and net income for the year ended December 31, 2006 are $73 thousand and $47 thousand lower, respectively, than if it had continued to account for share-based compensation under Opinion 25. Basic and diluted earnings per share for the year ended December 31, 2006 would have been $1.53 and $1.52, respectively, if the Corporation had not adopted Statement 123R, compared to the reported basic and diluted earning per share of $1.53 and $1.52, respectively.

Prior to adoption of Statement 123R, the Corporation presented all tax benefits of deductions resulting from the exercise of stock options as operating cash flows in the Consolidated Statement of Cash Flows. Statement 123R requires the cash flows resulting from the tax benefits resulting from tax deductions in excess of the compensation cost recognized for those options (excess tax benefits) to be classified as financing cash flows. The $1.2 million excess tax benefit classified as a financing cash inflow would have been classified as an operating cash inflow if the company had not adopted Statement 123R.

The following table illustrates the effect on net income and earnings per share if the company had applied the fair value recognition provisions of Statement 123 to options granted under the Corporation’s stock option plans in all periods presented. For purposes of this pro forma disclosure, the value of options is estimated using a Black-Sholes option-pricing formula and amortized to expense over the options’ vesting periods.

- 9 -

NOTE ONE - Basis of Presentation, Nature of Operations and Summary of Significant Accounting Policies (continued)

In Thousands, except for per share amounts
  
Years Ended December 31,
  
 
  
2005
  
2004
  
           
Net income as reported
  
$
51,584
  
$
43,045
  
   Add: Stock-based Employee compensation expense included in reported net income, net of related tax effects
     -     -  
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects
    
(1,098
)  
(1,091
) 
Pro forma net income
  
$
50,486
  
$
41,954
  
Earnings per share
              
Basic - as reported
  
$
1.21
  
$
1.03
  
Basic - Pro forma
  
$
1.18
  
$
1.00
  
Diluted - As reported
  
$
1.21
  
$
1.02
  
Diluted - Pro forma
  
$
1.18
  
$
0.99
  


(m)    Earnings Per Share - Basic earnings per share amounts are computed based on the weighted average number of shares outstanding during the period after giving retroactive effect to stock dividends and stock splits. Diluted earnings per share are computed by determining the number of additional shares that are deemed outstanding due to stock options under the treasury stock method.

(n)    Cash Equivalents - For purposes of reporting cash flows, cash and cash equivalents include cash on hand, and amounts due from banks. Cash and cash equivalents have an original maturity of three months or less.

(o)    Use of Estimates - The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

Material estimates that are particularly susceptible to significant change, relate to the determination of the allowance for loan losses, deferred income taxes, valuation of stock options, and the valuation of real estate acquired in connection with foreclosures or in satisfaction of loans. In connection with the determination of the allowance for loan losses and the valuation of foreclosed assets held for sale, management obtains independent appraisals for significant properties.

(p)    Tranfer of Financial Assets - Transfers of financial assets are accounted for as sales, when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when: (1) the assets have been isolated from the Corporation; (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets; and (3) the Corporation does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity.
 
(q)    Comprehensive Income - Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Certain changes in assets and liabilities, such as unrealized gains and losses on available-for-sale securities, are reported as separate component of the equity section of the balance sheet, and such items, along with net income, are components of comprehensive income.

- 10 -

NOTE ONE - Basis of Presentation, Nature of Operations and Summary of Significant Accounting Policies (continued)
 
The components of comprehensive income and related tax effects are as follows:
  
               
In Thousands
  
Years Ended December 31,
  
   
2006
  
2005
  
2004
  
Unrealized holding gains on available-for-sale securities
  
$
9,500
  
$
6,807
  
$
5,226
  
Tax effect
    
(3,325
)
  
(2,383
)
  
(1,829
)
 
  
$
6,175
  
$
4,424
  
$
3,397
  

The components of accumulated other comprehensive income, included in shareowners' equity, are as follows:
  
           
In Thousands
  
December 31,
  
   
2006
  
2005
  
Net unrealized gain (loss) on securities available-for-sale
  
$
2,694
  
$
1,581
  
Tax effect
    
(943
)
  
(554
)
   
$
1,751
  
$
1,027
  
 
(r)    Business Combinations - Statement of Financial Accounting Standards (SFAS) No. 141, Business Combinations, (SFAS 141), requires that all business combinations initiated after June 30, 2001 be accounted for using the purchase method. The purchase method of accounting requires that the cost of an acquired entity be allocated to the assets acquired and liabilities assumed based on their estimated fair values at the date of acquisition. The difference between the fair values and the purchase price is recorded to Goodwill. Also, under SFAS 141, identified intangible assets acquired in a purchase business combination must be separately valued and recognized on the balance sheet if they meet certain requirements. See Note 2 of the consolidated financial statements for further discussion.
 
(s)    Reclassifications - Certain amounts in prior years' financial statements have been reclassified to conform to the 2006 presentation. These classifications have not had an effect on previously reported income.

NOTE TWO - Acquisition

On February 1, 2006, the Corporation acquired 100 percent of the outstanding shares of NorthStar Financial Corporation (NorthStar). NorthStar’s results of operations were included in the Corporation’s results beginning in 2006. NorthStar had two full service offices in the Seattle communities of Ballard and Fremont. The purchase of NorthStar provided Frontier the opportunity to fill in branches within its market area. The aggregate purchase price was $46.9 million.

The acquisition was accounted for as a purchase in accordance with SFAS 141. Accordingly the purchase price was allocated to the assets acquired and the liabilities assumed based on their estimated fair values at the acquisition date as summarized in the following table:

- 11 -

NOTE TWO - Acquisition (continued)

In Thousands
          
           
Total value of the Corporation's common stock exchanged
  
$
44,656
        
Value of stock options assumed
    
2,257
       
Total Purchase Price
          
46,913
 
               
Allocation of purchase price
              
NorthStar's shareowner equity
          
11,931
 
Estimated adjustments to reflect assets acquired and liabilities assumed at fair value:
              
Loan
          
278
 
Core deposit intangible
          
681
 
Federal Home Loan Bank advances
          
159
 
Junior subordinated debentures
          
52
 
Estimated fair value of net assets acquired
          
13,101
 
               
Goodwill resulting from acquisition
        
$
33,812
  

The acquired core deposit intangible assets has a useful life of approximately 5 years. The $33.8 million of goodwill acquired was assigned to the NorthStar business segment and none of it is deductible for tax purposes.

The fair value of assets and liabilities of NorthStar at the date of acquisition are presented below:
      
       
Cash
  
$
3,481
  
Securities available-for-sale
    
8,176
 
Federal funds sold and interest bearing deposits at banks
    
8,003
 
Loans, net of allowance for loan losses of $2,501
    
150,099
 
Premises and equipment, net
    
178
 
BOLI
    
3,174
 
Other assets
    
2,521
 
Investment in Trust I and Trust II
    
156
 
Goodwill
    
33,812
 
Total assets
    
209,600
 
Deposits
    
(145,172
)
Federal Home Loan Bank advances
    
(11,152
)
Junior subordinated debentures
    
(5,104
)
Other liabilities
    
(1,259
)
Net assets acquired
  
$
46,913
  

The following unaudited pro forma condensed consolidated financial information presents the results of operations of the Corporation had the acquisition taken place at January 1, 2005:

In Thousands, except per share amounts
  
For the years ended December 31,
 
   
2006
  
2005
  
           
Net interest income
  
$
163,806
  
$
134,868
  
Provision for loan losses
    
7,515
   
(4,990
)
Noninterest income
    
15,644
   
14,181
 
Noninterest expense
    
67,238
   
63,025
 
Income before income tax
    
101,697
   
81,034
 
Net income
    
69,190
   
53,646
 
Per common share information:
              
Basis earnings per share
  
$
1.54
  
$
1.20
  
Diluted earnings per share
  
$
1.52
  
$
1.19
  
Average common shares issued and outstanding
    
45,009,526
   
44,664,107
 
Average diluted common shares issued and outstanding
    
45,484,987
   
45,030,953
 
 
- 12 -

NOTE THREE - Acquisition (continued)

The pro forma results presented in the previous table include amortization of purchase premiums of approximately $241 thousand for the years ended December 31, 2006 and 2005. Excluded from the pro forma results are acquisition related expenses of approximately $2.5 million paid for by NorthStar prior to the acquisition date.

NOTE THREE - Investments

Investments in federal funds sold are made with major banks, which are approved by the Board of Directors. The Bank has an investment policy that generally permits holding securities rated only in one of the four highest rating categories by a nationally recognized credit rating organization.

The aggregate amortized cost and fair values of investment securities at December 31 are as follows:
 
In Thousands
                      
2006
  
Amortized
Cost
  
Gross
Unrealized
Gains
  
Less than
12 months
Gross
Unrealized
Losses
  
12 months
or more
Gross
Unrealized
Losses
  
Fair
Value
  
Available for sale
                      
U.S. Treasury bonds
  
$
4,204
  
$
48
    
($4
)
  
-
 
$
4,248
  
U.S. Agency bonds
    
50,004
   
76
   
(23
)
  
($850
)
  
49,207
 
Municipal securities
    
1,680
   
-
   
(16
)
  
(1
)
  
1,663
 
Corporate bonds
    
16,672
   
54
   
(7
)
  
(232
)
  
16,487
 
Equities
    
29,052
   
10,804
   
(91
)
  
(258
)
  
39,507
 
     
101,612
   
10,982
   
(141
)
  
(1,341
)
  
111,112
 
Held to maturity
                              
Municipal securities
    
2,073
   
35
   
-
   
-
   
2,108
 
Corporate bonds
    
1,526
   
-
   
(11
)
  
-
   
1,515
 
     
3,599
   
35
   
(11
)
  
-
   
3,623
 
Total Securities
  
$
105,211
  
$
11,017
    
($152
)
  
($1,341
)
$
114,735
  

2005
  
Amortized
Cost
  
Gross
Unrealized
Gains
  
Less than
12 months
Gross
Unrealized
Losses
  
12 months
or more
Gross
Unrealized
Losses
  
Fair
Value
  
Available for sale
                      
U.S. Treasury bonds
  
$
7,232
  
$
57
    
($1
)
  
-
 
$
7,288
  
U.S. Agency bonds
    
49,621
   
109
   
(26
)
  
($1,179
)
  
48,525
 
Municipal securities
    
45
   
-
   
-
   
-
   
45
 
Corporate bonds
    
17,799
   
336
   
(147
)
  
(135
)
  
17,853
 
Equities
    
23,400
   
8,366
   
(198
)
  
(375
)
  
31,193
 
     
98,097
   
8,868
   
(372
)
  
(1,689
)
  
104,904
 
Held to maturity
                              
Municipal securities
    
4,186
   
84
   
-
   
(5
)
  
4,265
 
Corporate bonds
    
1,527
   
127
   
-
   
-
   
1,654
 
     
5,713
   
211
   
-
   
(5
)
  
5,919
 
Total Securities
  
$
103,810
  
$
9,079
    
($372
)
  
($1,694
)
$
110,823
  
 
- 13 -

NOTE THREE - Investments (continued)
 
Certain investment securities shown above currently have fair values less than amortized cost and therefore contain unrealized losses. The Corporation has evaluated these securities and has determined that the decline in value is temporary, and is not related to any company or industry specific event. There are 22 investment securities with unrealized losses at December 31, 2006. The Corporation anticipates full recovery of amortized cost with respect to these securities at maturity or sooner in the event of a more favorable market interest rate environment.

Contractual maturities of investment securities as of December 31, 2006 are shown below. Expected maturities will differ from contractual maturities because issuers may have the right to call or prepay obligations with or without prepayment penalties.

In Thousands
  
Available for Sale
  
Held to Maturity
  
   
Amortized
Cost
  
Fair
Value
  
Amortized
Cost
  
Fair
Value
  
Maturity
                  
Less than one year
  
$
44,823
  
$
55,197
  
$
715
  
$
720
  
One to five years
    
53,991
   
53,023
   
1,358
   
1,388
 
Five to ten years
    
251
   
299
   
-
   
-
 
Over ten years
    
2,547
   
2,593
   
1,526
   
1,515
 
                           
   
$
101,612
  
$
111,112
  
$
3,599
  
$
3,623
  

Investments in state and political subdivisions represent purchases of municipal bonds, with localities principally in western Washington. Investments in corporate bonds are made in companies located and doing business throughout the United States. Approximately 67% and 70% of the investments in corporate bonds at December 31, 2006 and 2005, respectively, consisted of investments in companies doing business in the financial services sector. Approximately 33% and 30% of the investments in corporate bonds at December 31, 2006 and 2005, respectively, consisted of investments in companies doing business in the industrial sector.

As of December 31, 2006 and 2005, the Corporation held FHLB bonds that had a book value of $35.0 million and $34.0 million and a market value of $34.4 million and $33.2 million, respectively.

Proceeds from sales of available for sale securities were $1.9 million in 2005 and $1.1 million in 2004. Gross realized losses on sales of securities were $25 thousand in 2006 and $44 thousand in 2004. Investment securities, with an amortized cost of $32.2 million and $32.3 million with fair values of $31.0 and $31.6 million in 2006 and 2005, respectively, were pledged to secure public deposits and securities sold under agreements to repurchase as required by law.

NOTE FOUR - Loans

The Bank originates commercial, real estate mortgage, construction and land development and installment loans primarily in Clallam, Island, Jefferson, King, Kitsap, Pierce, Skagit, Snohomish, and Whatcom Counties. Although the Bank has a diversified loan portfolio, local economic conditions may affect borrowers' ability to meet the stated repayment terms. Collateral for each loan is based on a credit evaluation of the customer, and such collateral may, depending on the loan, include accounts receivable, inventory, equipment, real estate or other collateral. Loans are originated at both fixed, adjustable, and variable interest rates.
 
Major classifications of loans at December 31 are as follows:

- 14 -

NOTE FOUR - Loans (continued)
 
In Thousands
  
2006
 
2005
 
           
Commercial and agriculture
  
$
381,800
  
$
321,980
  
Real estate commercial
    
901,098
   
860,826
 
Real estate construction and land development
    
1,334,051
   
978,120
 
Real estate mortgage
    
236,344
   
191,137
 
Installment
    
63,116
   
46,825
 
               
     
2,916,409
   
2,398,888
 
Less deferred loan fees
    
(15,629
)
  
(15,375
)
               
   
$
2,900,780
  
$
2,383,513
  
 
Contractual maturities of loans, net of deferred fees, as of December 31, 2006 are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to prepay loans with or without prepayment penalties.
 
In Thousands
  
Within
1 Year
  
1-5
Years
  
After
5 Years
  
Total
  
                   
Commercial and agriculture
  
$
219,942
  
$
136,070
  
$
24,928
  
$
380,940
  
Real estate commercial
    
94,416
   
473,063
   
330,238
   
897,717
 
Real estate construction and land development
    
1,230,744
   
82,221
   
10,941
   
1,323,906
 
Real estate mortgage
    
94,285
   
90,969
   
49,914
   
235,168
 
Installment
    
11,638
   
15,853
   
35,558
   
63,049
 
                         
   
$
1,651,025
  
$
798,176
  
$
451,579
  
$
2,900,780
  
                           
Loans maturing after one year with:
          
1-5
Years
    
After
5 Years
        
                           
Fixed rates
        
$
638,560
  
$
56,385
        
Variable rates
          
159,616
   
395,194
       
                           
         
$
798,176
  
$
451,579
        
 
LOAN LOSS RESERVE

Changes in the allowance for loan losses for the year ended December 31 are summarized below:
 
In Thousands
  
2006
 
2005
 
2004
 
               
Balance at beginning of year
  
$
37,075
  
$
32,728
  
$
29,556
  
Provision charged to operating expense
    
7,500
   
4,200
   
3,500
 
Merger
    
2,501
   
-
   
-
 
                     
Loans charged-off
    
(3,294
)
  
(706
)
  
(1,412
)
Less recoveries
    
413
   
853
   
1,084
 
                     
Net recoveries (charge-offs)
    
(2,881
)
  
147
   
(328
)
                     
Balance before portion identified for undisbursed loans
    
44,195
   
37,075
   
32,728
 
Portion of reserve identified for undisbursed loans
                    
and reclassified as a liability
    
(3,546
)
  
(3,270
)
  
(2,307
)
Balance at end of period
  
$
40,649
  
$
33,805
  
$
30,421
  
 
- 15 -

NOTE FOUR - Loans (continued)
 
The Bank had loans amounting to $8.7 at December 31, 2006, $4.9 million at December 31, 2005, and $14.1 million at December 31, 2004 that were specifically classified as impaired with an average balance during the year of $8.7 million, $5.0 million, and $14.1 million, respectively. The allowance for loan losses related to these loans was approximately $914 thousand in 2006, $247 thousand in 2005, and $3.6 million in 2004. Interest collected on these loans in cash and included in income amounted to $344 thousand in 2006, $327 thousand in 2005, and $350 thousand in 2004. If interest on these loans had been accrued the additional amount of such income would have approximated $761 thousand in 2006, $67 thousand in 2005, and $925 thousand in 2004. At December 31, 2006 there were no commitments to lend additional funds to borrowers whose loans were classified as impaired.
 
NONPERFORMING ASSETS
 
The Bank’s nonperforming assets (NPA’s) (includes loans in nonaccrual and other real estate owned) totaled 0.27% and 0.19% of total assets at December 31, 2006 and 2005, respectively.

OTHER REAL ESTATE OWNED
 
From time-to-time management has written-off various parcels of other real estate owned due to unresolved issues relating to permitting, zoning and wetlands. Management is attempting to work through the above-mentioned issues to be able to effectively market these properties. Contingent gains could be realized, should the above issues be favorably resolved.

NOTE FIVE - Premises and Equipment
 
Premises and equipment at December 31 are comprised of the following:
 
In Thousands
  
2006
 
2005
 
Premises
  
$
28,153
  
$
27,440
  
Furniture, fixtures and equipment
    
19,896
   
18,280
 
Land
    
9,830
   
9,601
 
Construction in progress
    
1,702
   
578
 
     
59,581
   
55,899
 
Less accumulated depreciation and amortization
    
(29,555
)
  
(26,130
)
   
$
30,026
  
$
29,769
  
 
Depreciation expense on premises and equipment totaled $2.9 million in 2006, $2.7 million in 2005, and $2.5 million in 2004.

NOTE SIX - Interest Bearing Deposits

The major classifications of interest bearing deposits at December 31 are as follows:

In Thousands
  
2006
 
2005
 
Money market, sweep and NOW accounts
  
$
683,948
  
$
322,283
  
Savings
    
305,669
   
495,108
 
Time deposits, $100,000 and over
    
545,173
   
471,726
 
Other time deposits
    
512,221
   
376,411
 
   
$
2,047,011
  
$
1,665,528
  
 
- 16 -

NOTE SIX - Interest Bearing Deposits (continued)

At December 31, 2006, the scheduled maturities of time deposits are as follows:

In Thousands
          
     
2007
  
$
906,406
  
     
2008
    
67,835
 
     
2009
    
37,088
 
     
2010
    
27,272
 
     
2011
    
17,489
 
 
     Thereafter     
1,304
 
               
         
$
1,057,394
  

NOTE SEVEN - Credit Arrangements

The Bank is a member of the Federal Home Loan Bank (FHLB) of Seattle. As a member, the Bank has a committed line of credit up to 19% of total assets, or $597.8 million. At December 31, 2006 committed lines of credit agreements totaling approximately $85.0 million were available to the Bank from unaffiliated banks and there were no outstanding balances as of December 31, 2006. Such lines generally provide for interest at the lending bank's federal funds rate or other money market rates.

NOTE EIGHT - Federal Home Loan Bank (FHLB) Advances

Contractual maturities of FHLB advances as of December 31, 2006 and 2005, are shown below. Expected maturities will differ from contractual maturities because FHLB has the right to call without penalties:

   
2006
  
2005
  
In Thousands
  
Amount
  
Interest
Rates
  
Amount
  
Interest
Rates
  
Within one year
  
$
41,368
    
2.76%-6.04%
 
$
15,000
    
3.05%-4.84%
 
Two through three years
    
82,791
   
3.46%-5.58%
 
  
82,500
   
3.55%-6.04%
 
Four through nine years
    
97,858
   
3.53%-6.77%
 
  
122,500
   
3.53%-6.77%
 
Ten through fifteen years
    
60,000
   
4.03%-4.66%
 
  
20,000
   
3.87%
 
   
$
282,017
        
$
240,000
        
 
Advances from FHLB are collateralized by qualifying first mortgage loans, qualifying commercial real estate, and government agency securities as required by the agreement with FHLB.

The maximum and average outstanding balances and average interest rates on advances from FHLB were as follows for the year ended December 31:

In Thousands
  
2006
 
2005
 
           
Maximum outstanding at any month-end
  
$
282,017
  
$
240,075
  
Average outstanding
    
258,604
   
221,392
 
Weighted average interest rates:
              
Annual
    
4.72
%
  
4.71
%
End of year
    
4.69
%
  
4.70
%
 
- 17 -

NOTE NINE - Securities Sold Under Agreements to Repurchase
 
The Bank has sold certain securities of the U.S. Government and its agencies and other approved investments under agreements to repurchase on a short-term basis. The securities underlying the agreements were held by a safekeeping agent. Securities sold under agreements to repurchase are reflected at the amount of cash received in connection with the transaction. The Corporation may be required to provide additional collateral based on the fair value of the underlying securities.

Securities sold under agreement to repurchase were $11.1 million in 2006 and $7.8 million in 2005. The average daily balance of outstanding agreements during the period was $8.5 million in 2006 and $6.9 million in 2005, with maximum outstanding agreements at any month-end of $10.0 million and $8.9 million, respectively.

NOTE TEN - Junior Subordinated Debentures

On February 1, 2006, the Corporation acquired 100 percent of the outstanding shares of NorthStar Financial Corporation (Note 2). As part of the transaction, the Corporation acquired two statutory business trusts which had been formed in December of 2004. NorthStar Financial Corporation Statutory Trust I (Trust I) and NorthStar Financial Corporation Statutory Trust II (Trust II), the Trusts, were formed for the exclusive purposes of issuing and selling capital securities and utilizing the proceeds to acquire junior subordinated debt.

The Trusts raised $5.2 million in cash through the issuance of $5.0 million of Trust Preferred Securities (“trust preferred securities”) and $156 thousand of common stock. The trust preferred securities are owned by third parties and the common stock is owned by the Corporation. The proceeds from the sale of the trust preferred securities and the common stock was invested by the Trusts in $5.2 million of junior subordinated debentures issued by NorthStar Financial Corporation and assumed by the Corporation in the acquisition. In the December 31, 2006, balance sheet of the Corporation, the $5.2 million of junior subordinated debentures is reflected as a liability and the $156 thousand of common stock of the Trusts is included in other assets. There were $5.0 million in trust preferred securities outstanding at December 31, 2006.

The Trusts accrue interest and make cash distributions on the trust preferred securities periodically at rates specified in the trust preferred securities. The interest rate on Trust I trust preferred securities is fixed at 6%. The interest rate on Trust II trust preferred securities is the Three-Month Libor rate plus 2%, and is adjusted quarterly. As of December 31, 2006, the interest rate on Trust II trust preferred securities was 7.37%. The Corporation pays interest on the junior subordinated debentures to the Trusts equal to the rate at which the Trusts accrue and pay interest on their trust preferred securities. Interest expense incurred on the junior subordinated debt of $311 thousand was recorded on the Corporation’s Consolidated Statement of Income in 2006.

The junior subordinated debentures mature in February 2033. The Trust’s trust preferred securities are subject to mandatory redemption, in whole or in part, upon repayment of the debentures. In the event of certain changes or amendments to regulatory requirements or federal tax rules, the Trust’s trust preferred securities are redeemable by the Corporation in whole before February 23, 2010, at 100% of the liquidation amount. Upon approval of the Federal Reserve, the Corporation may redeem the Trust’s trust preferred securities in whole or in part on or after February 23, 2010, at 100% of the liquidation amount. The Trust’s trust preferred securities are fully and unconditionally guaranteed by the Corporation. As of December 31, 2006, $5.0 million of the Trust’s preferred securities qualify as Tier I capital under the guidelines of the Federal Reserve.

- 18 -

NOTE ELEVEN - Income Tax

The components of the provision for income tax are as follows:

In Thousands
  
2006
 
2005
 
2004
 
               
Current
  
$
37,090
  
$
27,962
  
$
22,162
  
Deferred
    
(1,721
)
  
(1,633
)
  
(199
)
                     
   
$
35,369
  
$
26,329
  
$
21,963
  

The following table shows the nature and components of the Corporation's net deferred tax assets, established at an estimated tax rate of 35% at December 31:

In Thousands
  
2006
 
2005
 
           
Deferred tax assets
              
Allowance for possible loan losses,in excess of tax reserves
  
$
15,341
  
$
12,976
  
Other deferred tax assets
    
1,684
   
739
 
               
Total deferred tax assets
    
17,025
   
13,715
 
               
Deferred tax liabilities
              
FHLB stock dividends
    
(2,522
)
  
(2,468
)
Deferred loan fees
    
(2,276
)
  
(1,494
)
Unrealized gain on available-for-sale securities
    
(3,325
)
  
(2,382
)
Other deferred tax liabilities
    
(1,601
)
  
(848
)
               
Total deferred tax liabilities
    
(9,724
)
  
(7,192
)
               
Net deferred tax assets
  
$
7,301
  
$
6,523
  
 
The Corporation believes, based upon available information, that all deferred assets will be realized in the normal course of operations. Accordingly, these assets have not been reduced by a valuation allowance.
 
A reconciliation of the effective income tax rate with the federal statutory tax rate is as follows:

   
2006
  
2005
  
2004
  
In Thousands
  
Amount
  
Rate
  
Amount
  
Rate
  
Amount
  
Rate
  
                           
Income tax provision at statutory rate
  
$
36,498
    
35%
 
$
27,270
    
35%
 
$
22,753
    
35%
 
                                 
Effect of nontaxable interest income
    
(1,129)
 
  
(1%)
 
  
(740)
 
  
(1%)
 
  
(576)
 
  
(1%)
 
                                       
Other
    
-
   
-
    
(201)
 
  
-
    
(214)
 
  
-
  
   
$
35,369
    
34%
 
$
26,329
    
34%
 
$
21,963
    
34%
 
 
- 19 -

NOTE TWELVE - Shareowners’ Equity and Regulatory Matters

In addition to 100 million shares of common stock authorized, the Corporation is authorized to issue up to 10 million shares of preferred stock with no par value. The Board of Directors has the authority to determine the rights and privileges to be granted to holders of preferred stock. There are no preferred shares issued and outstanding.

In December 2006, the Board of Directors declared a $0.15 ½ per share cash dividend to shareowners of record as of January 9, 2007, and payable on January 24, 2007.
 
On August 16, 2006 the Board announced the adoption of a stock repurchase program authorizing the Corporation to repurchase up to 5% of its outstanding stock in the open market. The plan expires in August of 2008. There were 2,263,323 shares available to repurchase under the current plan at December 31, 2006. Subsequent to year end, the Corporation repurchased 218,940 shares at an average cost per share of $26.85 through February 21, 2007.

During 2005 and 2004 the Corporation made a purchase of Skagit State Bank stock through the issuance of common shares with a market value of $3.9 million and $3.0 million, and cash of $3.2 million and $2.5 million, respectively. See Note 16 for additional discussion. No purchases were made in 2006.

The Corporation and Bank are subject to various regulatory capital requirements administered by the federal and state banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possible additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Corporation's financial statements. Under capital adequacy guidelines in the regulatory framework for prompt corrective action, the Bank must meet specific capital adequacy guidelines that involve quantitative measures of each entity's assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.

Quantitative measures established by regulation to ensure capital adequacy require maintenance of minimum amounts and ratios (set forth in the following table). Tier I capital includes common stock, surplus, retained earnings and undivided profits less goodwill. Total capital includes Tier I capital and a portion of the loan loss reserve. Tier I capital to average risk weighted assets is referred to as the Tier I ratio. Management believes, as of December 31, 2006 and 2005, that the Corporation and Bank meet the capital adequacy requirements to which they are subject.

As of the most recent notification from the Bank's primary regulator, the Bank was categorized as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Bank must maintain minimum total risk-based, Tier I risk-based, and Tier I leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed this category.

- 20 -

NOTE TWELVE - Shareowners’ Equity and Regulatory Matters (continued)

In Thousands
  
Actual
  
To Be Well
Capitalized Under
Prompt Corrective
Action Provisions
  
For Capital
Adequacy Purposes
  
2006
  
Amount
  
Ratio
  
Amount
  
Ratio
  
Amount
  
Ratio
  
                           
Total Capital (to risk weighted assets)
                                      
Consolidated
  
$
390,752
    
12.85
%
  
N/A
    
N/A
  
$
243,324
    
8.00
%
Frontier Bank
    
360,051
   
11.92
%
  
302,158
   
10.00
%
  
241,726
   
8.00
%
                                       
Tier I Capital (to risk weighted assets)
                                      
Consolidated
    
352,656
   
11.59
%
  
N/A
    
N/A
    
121,662
   
4.00
%
Frontier Bank
    
322,202
   
10.66
%
  
181,295
   
6.00
%
  
120,863
   
4.00
%
                                     
Tier I Capital (to average assets)
                                      
Consolidated
    
352,656
   
11.32
%
  
N/A
    
N/A
    
124,638
   
4.00
%
Frontier Bank
    
322,202
   
10.47
%
  
153,894
   
5.00
%
  
123,115
   
4.00
%
2005
                                      
Total Capital (to risk weighted assets)
                                      
Consolidated
  
$
316,902
    
12.37
%
  
N/A
    
N/A
  
$
204,891
    
8.00
%
Frontier Bank
    
289,801
   
11.39
%
  
254,470
   
10.00
%
  
203,576
   
8.00
%
                                       
Tier I Capital (to risk weighted assets)
                                      
Consolidated
    
284,825
   
11.12
%
  
N/A
    
N/A
    
102,445
   
4.00
%
Frontier Bank
    
257,947
   
10.14
%
  
152,682
   
6.00
%
  
101,788
   
4.00
%
                                     
Tier I Capital (to average assets)
                                      
Consolidated
    
284,825
   
10.99
%
  
N/A
    
N/A
    
103,654
   
4.00
%
Frontier Bank
    
257,947
   
10.07
%
  
128,081
   
5.00
%
  
102,465
   
4.00
%

Under federal regulations, the Bank is limited, unless previously approved, as to the amount it may loan the holding company and other affiliates to 10% of its capital stock (approximately $6.8 million at December 31, 2006 and $5.6 million at December 31, 2005).

Federal Reserve Board regulations require maintenance of certain minimum reserve balances on deposit with the Federal Reserve Bank. The average amount of such balances was $27.4 million in 2006 and $22.3 million in 2005.

NOTE THIRTEEN - Benefit Plans

On December 31, 2006, The Corporation had two share-based compensation plans, which are described below. The compensation cost that has been charged against income for those plans was $73 thousand in 2006. There were no compensations costs charged against income in 2005 or 2004 for those plans. The total income tax benefit recognized in the income statement for share-based compensation arrangements was $26 thousand in 2006. There was no income tax benefit recognized in the income statement for share-based compensation arrangements in 2005 or 2004.

- 21 -

NOTE THIRTEEN - Benefit Plans (continued)

On February 17, 1999, the Corporation adopted the 1999 Employee Stock Award Plan to recognize, motivate, and reward eligible employees for longstanding performance with the Corporation and its subsidiaries. Employees eligible to receive stock awards under this plan must have been employees of the Corporation for at least 20 years, or some other tenure as determined from time to time by the Board of Directors. The maximum number of shares that may be issued is 45,000 and is adjusted to reflect future common share dividends, splits, recapitalization or reorganization. During the year 2006, there were 813 shares with a fair value of $17 thousand awarded and vested to employees. In 2005, and 2004, there were 1,502 and 1,778 shares with fair values of $25 thousand and $24 thousand, respectively, awarded and vested under this plan. Through December 31, 2006, there have been 7,222 shares issued under this plan. The stock awards vest immediately when granted. The plan is effective for ten years from adoption. There are currently 37,778 shares remaining under this plan.

In 2006, the Shareowners of the Corporation approved a Stock Incentive Plan (the Plan) to promote the best interest of the Corporation, its subsidiaries and its shareowners, by providing an incentive to those key employees who contribute to the operating success of the Corporation. The plan allows for incentive stock options, stock grants and stock appreciation rights to be awarded. The maximum number of shares that may be issued under the Plan is 5,250,000 common shares of the Corporation. Shares issued and outstanding are adjusted to reflect common stock dividends, splits, recapitalization, or reorganization. The Board of Directors make available sufficient shares for each award granted. Options are granted at fair market value, generally vest over three years, and expire ten years from the date of grant. Dividends are paid on stock grants and are not paid on incentive stock options. Certain options provide for accelerated vesting if there is a change in control.

The fair value of each option award is estimated on the date of grant using the Black-Scholes option valuation model that uses the assumptions noted in the following table. Expected volatilities are based on historical volatility of the Corporation’s stock. The Corporation uses historical data to estimate option exercise and employee termination within the valuation model; separate groups of employees that have similar historical exercise behavior are considered separately for valuation purposes. The expected term of options granted is derived from the output of the option valuation model and represents the period of time that options granted are expected to be outstanding; the range given below results from certain groups of employees exhibiting different behavior. The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant.

The following table presents the assumptions used in the fair value calculation:

   
Years Ended December 31,
  
   
2006
  
2005
  
2004
  
Risk-free interest rate
   
4.60
%
  
5.25
%
  
3.25
%
Expected dividends
   
1.68
%
  
2.20
%
  
2.20
%
Volatility
   
35.61
%
  
23.34
%
  
35.51
%
Expected term (in years)
   
3.2
   
3.4
   
3.1
 

A summary of option activity under the Plan as of December 31, 2006, and changes during the year then ended is as follows:

- 22 -

NOTE THIRTEEN - Benefit Plans (continued)

           
Weighted
          
   
Shares of Common Stock
  
Average of
          
           
Exercisable
  
Weighted
  
Aggregate
  
           
Price
  
Average
  
Intrinsic
  
   
Available for
  
Under
  
of Shares
  
Contractual
  
Value
  
   
Award
  
Plans
  
Under Plans
  
Term
  
(Thousands)
  
                       
Outstanding, December 31, 2005
    
3,776
   
952,123
 
$
24.75
              
New plan
    
3,500,000
                         
Merger
    
148,401
   
148,401
   
10.93
             
Three-for-two stock split
    
1,583,637
   
415,910
                   
Granted
    
(122,163
)
  
122,163
   
29.83
             
Exercised
          
(275,283
)
  
11.21
             
Forfeited/Expired
    
14,186
   
(14,186
)
  
20.65
             
Outstanding, December 31, 2006
    
5,127,837
   
1,349,128
 
$
17.78
    
7.6
 
$
15,533
  
Exercisable at December 31, 2006
          
1,226,965
 
$
16.57
    
7.4
 
$
15,533
  
 
The numbers of shares under award for the plans represent 3.0% of the total shares outstanding as of December 31, 2006. The following table summarizes information concerning currently outstanding and exercisable awards:
 
       
Awards Outstanding
  
Awards Exercisable
Range of
Exercise
Prices
  
Number
Outstanding
  
Weighted
Average
Remaining
Contractual
Life
  
Weighted
Exercise
Average
Price
  
Number
Exercisable
  
Weighted
Average Exercise
Price
                     
$ 1-10
  
57,924
 
3.72
 
$7.65
 
57,924
 
$7.65
10-15
  
479,446
 
6.08
 
12.88
 
479,446
 
12.88
15-20
  
298,560
 
7.95
 
17.78
  
298,560
 
17.78
20-30
  
513,198
 
9.20
 
23.50
  
391,035
 
21.50

The weighted-average grant-date fair value of options granted during the years 2006, 2005, and 2004 was $8.06, $3.86, and $4.13, respectively. The total intrinsic value of options exercised during the years ended December 31, 2006, 2005, and 2004 was $4.8 million, $1.7 million, and $1.6 million, respectively.

A summary of the status of the Corporation’s nonvested shares as of December 31, 2006, and changes during the year ended December 31, 2006, is presented in below:

   
Shares
  
Weighted
Average
Grant-Date
Fair Value
  
Nonvested at January 1, 2006
    
-
   
-
 
               
Granted
    
131,464
 
$
29.76
  
Vested
    
(813
)
  
20.91
 
Forfeited
    
(525
)
  
29.83
 
               
Outstanding, December 31, 2006
    
130,126
 
$
29.83
  
 
- 23 -

NOTE THIRTEEN - Benefit Plans (continued)

As of December 31, 2006, there was $4.9 million of total unrecognized compensation cost related to nonvested share-based compensation arrangements granted under the Plan. That cost is expected to be recognized over a weighted-average period of 3.2 years. The fair value of shares vested during the year was $17 thousand.

Cash received from option exercise under all share-based payment arrangements for the years ended December 31, 2006, 2005, and 2004 was $4.2 million, $2.5 million, and $2.4 million, respectively. The actual tax benefit realized for the tax deductions from option exercise of the share-based payment arrangements totaled $1.2 million, $205 thousand, and $698 thousand, respectively, for the years ended December 31, 2006, 2005, and 2004.
 
NOTE FOURTEEN - Earnings per Share
 
The numerators and denominators of basic and fully diluted earnings per share are as follows:

In Thousands, except for number of shares and per share amounts
      
               
   
2006
  
2005
  
2004
  
Net income (numerator)
  
$
68,910
  
$
51,584
  
$
43,045
  
                     
Shares used in the calculation
                    
(denominator)
                    
Weighted average shares outstanding
    
45,009,526
   
42,481,644
   
41,926,625
 
Effect of dilutive stock options
    
475,461
   
260,907
   
279,009
 
Diluted shares
    
45,484,987
   
42,742,551
   
42,205,634
 
Basic Earnings per share
  
$
1.53
  
$
1.21
  
$
1.03
  
Diluted Earnings per share
  
$
1.52
  
$
1.21
  
$
1.02
  
 
NOTE FIFTEEN - Related Party Transactions
 
Loans to directors, executive officers and their affiliates are subject to regulatory limitations. Such loans had aggregate balances and activity during 2006, 2005 and 2004 as follows and were within regulatory limitations:
 
In Thousands
  
2006
  
2005
  
2004
  
               
Balance at beginning of year
  
$
72,700
  
$
55,762
  
$
49,496
  
New loans or advances
    
23,342
   
35,322
   
22,804
 
Repayments
    
(10,765
)
  
(18,384
)
  
(16,538
)
               
Balance at end of year
  
$
85,277
  
$
72,700
  
$
55,762
  
 
Total deposits beneficially owned by related parties were $6.4 million, $4.8 million, and $4.5 million at December 31, 2006, 2005, and 2004, respectively.

- 24 -
 
NOTE SIXTEEN - Commitments and Contingent Liabilities

The Bank leases various branch offices under agreements, which expire between 2007 and 2021. The agreements contain various renewal options and generally require the Bank to maintain the properties.

The total future minimum lease commitments through 2011 and thereafter are as follows:

In Thousands
          
           
Year ending December 31,
   
2007
  
$
1,824
  
     
2008
    
1,756
 
     
2009
    
1,488
 
     
2010
    
1,050
 
     
2011
    
894
 
 
    
Thereafter
    
2,421
 
               
         
$
9,433
  

Rental expense charged to operations was $1.6 million in 2006, $1.6 million in 2005, and $1.3 million in 2004.

The Bank is a party to financial instruments with off-balance sheet risk in the normal course of business to meet financing needs of its customers. These financial instruments include commitments to extend credit, standby letters of credit and financial guarantees. Those instruments involve, to varying degrees, elements of credit and interest-rate risk in excess of the amount recognized in the balance sheet. The contract amount of those instruments reflect the extent of the Bank's involvement in particular classes of financial instruments.

The Bank's exposure to credit loss in the event of nonperformance by the other party to the instrument for commitments to extend credit, standby letters of credit, and financial guarantees written is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Bank's experience has been that approximately 49 percent of loan commitments are drawn upon by customers. While approximately 100 percent of commercial letters of credit are utilized, a significant portion of such utilization is on an immediate payment basis. The Bank evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if it is deemed necessary by the Bank upon extension of credit, is based on management's credit evaluation of the borrower. Collateral held varies but may include accounts receivable, inventory, property, plant, and equipment, and income-producing commercial properties.

Standby letters of credit and financial guarantees written are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements, bond financing, and similar transactions. The Bank underwrites its standby letters of credit using its policies and procedures applicable to loans in general. Standby letters of credit are made on an unsecured and secured basis. The Bank has not been required to perform on any financial guarantees during the past two years. The Bank has not incurred any significant losses on its commitments in 2006, 2005, or 2004.

A summary of the notional amount of the Bank’s financial instruments with off-balance sheet risk at December 31, 2006 follows:

- 25 -

NOTE SIXTEEN - Commitments and Contingent Liabilities (continued)

In Thousands
  
Amount
  
       
Commitments to extend credit
  
$
902,701
  
Credit card arrangements
    
37,051
 
Standby letters of credit
    
27,035
 
 
The Corporation is a defendant in certain claims and legal actions arising in the ordinary course of business. In the opinion of management, after consultation with legal counsel, the ultimate disposition of these matters is not expected to have a material adverse effect on the Corporation’s financial condition or results of operations.

In December 2004, the Corporation entered into an agreement to purchase a total of 80,000 shares Skagit State Bank (SSB) stock, headquartered in Burlington, Washington. An initial purchase of 35,000 shares representing 4.95% of SSB total outstanding shares was made in December 2004, through an issuance of common shares with a market value of $3.0 million and cash of $2.5 million. A second purchase of 22,500 shares was made in February 2005 through the issuance of common shares with a market value of $1.8 million and cash of $1.6 million for a cumulative ownership percentage of 8.13%. In July 2005, a third installment of 22,500 shares was made through the issuance of common shares with a market value of $2.1 million and cash of $1.6 million for a cumulative ownership of 11.3%. In January 2006, the Corporation purchased 5,022 shares, from a separate party, for $653 thousand, bringing total ownership to 12.62%.

NOTE SEVENTEEN - Fair Value of Financial Instruments

The following disclosure of the estimated fair value of financial instruments is made in accordance with the requirements of SFAS No. 107, Disclosures About Fair Value of Financial Instruments. The estimated fair value amounts have been determined by the Corporation using available market information and appropriate valuation methodologies. However, considerable judgment is necessary to interpret market data in the development of the estimates of fair value. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value.

(a)    Cash equivalents and federal funds sold - For these short-term instruments, the carrying amount is a reasonable estimate of fair value.

(b)    Investment securities - For investment securities fair values are based on quoted market prices or dealer quotes, if available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities.

(c)    Loans - The fair value of loans generally is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. For certain homogeneous categories of loans, such as Small Business Administration guaranteed loans, fair value is estimated using the quoted market prices for securities backed by similar loans, adjusted for differences in loan characteristics.

(d)    Deposits and federal funds purchased - The fair value of demand deposits, savings accounts, certain money market deposits, and federal funds purchased, is the amount payable on demand at the reporting date. The fair value of fixed-maturity certificates of deposit is estimated by discounting the future cash flows using the rates currently offered for deposits of similar remaining maturities.

(e)    FHLB advances and securities sold under agreements to repurchase- Fair value is determined by discounting future cash flows using rates currently available to the Bank for debt with similar terms and remaining maturities.

- 26 -

NOTE SEVENTEEN - Fair Value of Financial Instruments (continued)

(f)    Off-Balance sheet financial instruments - Commitments to extend credit and letters of credit represent the principal categories of off-balance sheet financial instruments (see Note 16). The fair value of these commitments is not material.

The estimated fair values at December 31 are as follows:
 
In Thousands
  
2006
  
2005
  
Assets
  
Carrying
Value
  
Fair
Value
  
Carrying
Value
  
Fair Value
  
Cash and due from banks
  
$
104,222
  
$
104,222
  
$
85,631
  
$
85,631
  
Federal funds sold
    
18,673
   
18,673
   
733
   
733
 
Investment securities
                          
Available for sale
    
111,112
   
111,112
   
104,904
   
104,904
 
Held to maturity
    
3,599
   
3,623
   
5,713
   
5,919
 
Net loans
    
2,867,351
   
2,883,518
   
2,355,419
   
2,355,206
 
                   
Liabilities
                          
                           
Noninterest bearing deposits
    
406,621
   
406,621
   
395,852
   
395,852
 
Interest bearing deposits
    
2,047,011
   
2,047,748
   
1,665,528
   
1,666,295
 
Federal funds purchased and securities sold under agreements to repurchase
    
81,673
   
81,673
   
20,813
   
20,813
 
Subordinated debt
    
5,156
   
5,123
   
-
   
-
 
FHLB Advances
    
282,017
   
277,450
   
240,000
   
238,521
 

NOTE EIGHTEEN - Parent Company (Only) Financial Information
 
Condensed balance sheets for Frontier Financial Corporation (only) at December 31 are as follows:
 
 
2006
  
2005
  
ASSETS
          
Cash
  
$
1,357
  
$
306
  
Investment in subsidiaries:
              
Bank
    
321,626
   
259,621
 
Nonbank
    
9,314
   
9,343
 
Investment securities
          
Available for sale, at fair value
    
35,213
   
27,470
 
Other assets
    
40,247
   
4,350
 
               
   
$
407,757
  
$
301,090
  
LIABILITIES
              
Other liabilities
  
$
12,474
  
$
4,993
  
               
SHAREOWNERS' EQUITY
              
Common stock
    
183,982
   
131,695
 
Retained earnings
    
205,126
   
159,978
 
Accumulated other comprehensive income, net of tax
    
6,175
   
4,424
 
               
Total Shareowners' equity
    
395,283
   
296,097
 
               
   
$
407,757
  
$
301,090
  
 
- 27 -
 
NOTE EIGHTEEN - Parent Company (Only) Financial Information (continued)

Condensed statements of income for the years ended December 31 are as follows:
 
In Thousands
  
2006
  
2005
  
2004
  
Income
              
Dividends from Bank
  
$
23,846
  
$
16,416
  
$
12,322
  
Dividend from FFP
    
1,100
   
900
   
1,200
 
Other dividends
    
526
   
367
   
214
 
Other income
    
32
   
95
   
14
 
Interest
    
186
   
167
   
187
 
                     
Total income
    
25,690
   
17,945
   
13,937
 
Expenses
                    
Personnel
    
677
   
910
   
688
 
Depreciation and amortization
    
267
   
35
   
25
 
Other
    
1,934
   
1,362
   
804
 
                     
Total expenses
    
2,878
   
2,307
   
1,517
 
                     
Income before equity in undistributed income of subsidiaries and benefit equivalent to income tax
    
22,812
   
15,638
   
12,420
 
                     
Benefit equivalent to income tax
    
800
   
622
   
438
 
                     
Income before equity in undistributed income of subsidiaries
    
23,612
   
16,260
   
12,858
 
                     
Equity in undistributed income of subsidiaries
    
45,298
   
35,324
   
30,187
 
               
Net income
  
$
68,910
  
$
51,584
  
$
43,045
  
 
Condensed statements of cash flows for the years ended December 31:
 
In Thousands
  
2006
  
2005
  
2004
  
Cash flows from operating activities
              
Net income
  
$
68,910
  
$
51,584
  
$
43,045
  
Adjustments to reconcile net income to net cash provided by operating activities
                    
Equity in undistributed income of subsidiaries
    
(45,298
)
  
(35,324
)
  
(30,187
)
Depreciation and amortization
    
267
   
35
   
25
 
Excess tax benefits associated with equity-based compensation
    
(1,205
)
  
(205
)
  
(698
)
Other operating activities
    
486
   
714
   
543
 
Net cash flows from operating activities
    
23,160
   
16,804
   
12,728
 
                     
Cash flows from investing activities
                    
Purchase of available for sale securities
    
(5,496
)
  
(3,196
)
  
(2,485
)
Other investment activities
    
(390
)
  
79
   
452
 
Net cash flows from investing activities
    
(5,886
)
  
(3,117
)
  
(2,033
)
                     
Cash flows from financing activities
                    
Stock options exercised
    
4,218
   
2,549
   
2,393
 
Cash dividends paid to shareowners
    
(22,358
)
  
(17,021
)
  
(14,337
)
Excess tax benefits associated with equity-based compensation
    
1,205
   
205
   
698
 
Other financing activities
    
712
   
(13
)
  
-
 
Net cash flows from financing activities
    
(16,223
)
  
(14,280
)
  
(11,246
)
                     
Increase (decrease) in cash
    
1,051
   
(593
)
  
(551
)
Cash at beginning of year
    
306
   
899
   
1,450
 
Cash at end of year
  
$
1,357
  
$
306
  
$
899
  
 
- 28 -
 
NOTE NINETEEN - Recent Accounting Pronouncements

In July 2006, the FASB issued Interpretation (FIN) No. 48, Accounting for Uncertainty in Income Taxes - an Interpretation of SFAS No. 109, Accounting for Income Taxes. FIN 48 defines the threshold for recognizing the benefits of tax return positions in the financial statements as "more-likely-than-not" to be sustained by a taxing authority. The term "more-likely-than-not" means a likelihood of more than 50 percent. FIN 48 is effective as of Jan. 1, 2007, with early application permitted. Any impact from the adoption of FIN 48 will be recorded directly to the beginning balance of retained earnings and reported as a change in accounting principle. Management does not expect that the provision of FIN 48 will materially impact the Corporation’s results of operations or financial condition.

In September 2006, the Financial Accounting Standards Board released Statement No. 157, Fair Value Measurements which defines fair value, establishes a framework for measuring fair value in GAAP, and enhances disclosures about fair value measurements. This Statement applies when other accounting pronouncements require fair value measurements; it does not require new fair value measurements. This Statement is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those years. Management is currently evaluating the effect of the impact of this interpretation on the Corporation.

In September 2006, the Financial Accounting Standards Board issued SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106 and 132-R.” SFAS No. 158 requires an entity to recognize in its statement of financial condition the funded status of its defined benefit pension and postretirement plans, measured as the difference between the fair value of the plan assets and the benefit obligation. SFAS No. 158 also requires an entity to recognize changes in the funded status of a defined benefit pension and postretirement plan within accumulated other comprehensive income, net of tax, to the extent such changes are not recognized in earnings as components of periodic net benefit cost. SFAS No. 158 is effective as of the end of the first fiscal year ending after December 15, 2006. The Corporation will adopt SFAS No. 158 as of the end of 2007. The Corporation does not expect that the adoption of SFAS No. 158 will have a material effect on its financial condition, results of operations or cash flows.

Prior to January 1, 2006, the Corporation accounted for shared-based compensation to employees under the intrinsic value method in Accounting Principal Board (APB) Option No. 25, Accounting for Stock Issued to Employees. At January 1, 2006, the Corporation began recognizing compensation expense for stock options with the adoption of SFAS No. 123 (Revised), Share-Based Payment, as described in Note 13.

- 29 -

NOTE TWENTY- Unaudited Quarterly Financial Data - Condensed Consolidated Statement of Income
 
   
2006 Quarter Ended
  
In Thousands
  
(Unaudited)
  
   
December 31
  
September 30
  
June 30
  
March 31
  
Interest income
  
$
67,377
  
$
66,201
  
$
61,346
  
$
55,220
  
Interest expense
    
24,327
   
23,533
   
21,166
   
17,916
 
Net interest income
    
43,050
   
42,668
   
40,180
   
37,304
 
Provision for loan losses
    
(2,300
)
  
(1,700
)
  
(1,000
)
  
(2,500
)
Net interest income after provision for loan losses
    
40,750
   
40,968
   
39,180
   
34,804
 
Non interest income
    
3,403
   
3,466
   
3,438
   
5,316
 
Non interest expense
    
17,601
   
16,408
   
16,269
   
16,768
 
Income before income tax
    
26,552
   
28,026
   
26,349
   
23,352
 
Provision for income tax
    
(9,001
)
  
(9,500
)
  
(8,944
)
  
(7,924
)
Net income
 
$
17,551
  
$
18,526
  
$
17,405
  
$
15,428
  
Basic earnings per share
  
$
0.39
  
$
0.41
  
$
0.39
  
$
0.35
  
Diluted earnings per share
  
$
0.38
  
$
0.40
  
$
0.38
  
$
0.35
  
Weighted average basic shares outstanding
    
45,328,840
   
45,276,225
   
45,202,309
   
44,215,528
 
Weighted average diluted shares outstanding
    
45,866,921
   
45,743,603
   
45,573,583
   
44,685,555
 

   
2005 Quarter Ended
  
In Thousands
  
(Unaudited)
  
Interest income
  
$
50,569
  
$
46,763
  
$
43,204
  
$
38,350
  
Interest expense
    
15,082
   
13,633
   
12,497
   
10,524
 
Net interest income
    
35,487
   
33,130
   
30,707
   
27,826
 
Provision for loan losses
    
(900
)
  
(1,400
)
  
(1,050
)
  
(850
)
Net interest income after provision for loan losses
    
34,587
   
31,730
   
29,657
   
26,976
 
Non interest income
    
3,042
   
3,417
   
3,474
   
3,142
 
Non interest expense
    
16,020
   
14,571
   
13,848
   
13,673
 
Income before income tax
    
21,609
   
20,576
   
19,283
   
16,445
 
Provision for income tax
    
(7,308
)
  
(6,998
)
  
(6,485
)
  
(5,538
)
Net income
  
$
14,301
  
$
13,578
  
$
12,798
  
$
10,907
  
Basic earnings per share
  
$
0.34
  
$
0.32
  
$
0.30
  
$
0.26
  
Diluted earnings per share
  
$
0.33
  
$
0.32
  
$
0.30
  
$
0.26
  
Weighted average basic shares outstanding
    
42,639,612
   
42,558,987
   
42,415,247
   
42,308,258
 
Weighted average diluted shares outstanding
    
42,960,444
   
42,832,271
   
42,625,095
   
42,545,471
 
 
- 30 -

FRONTIER FINANCIAL CORPORATION
AND SUBSIDIARIES

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATION 
 
The information contained in this section should be read in conjunction with the Consolidated Financial Statements and accompanying Notes to the Consolidated Financial Statements.
 
Frontier Financial Corporation (“the Corporation”) a Washington corporation, is a financial holding company owning all of the equity of its wholly owned subsidiaries, Frontier Bank (the "Bank") and FFP, Inc., a bank premises holding company.
 
FINANCIAL HIGHLIGHTS
 
Frontier Financial Corporation’s performance in 2006 reflects another year of record earnings, continued asset growth, and good credit quality.
 
Net income was up 33.6%, totaling $68.9 million, or $1.52 per diluted share, which compares to $51.6 million, $1.21 per diluted share, in 2005 and $43.0 million, or $1.02 per diluted share in 2004. Net income in 2006 was influenced by a favorable increase in net interest income which improved 28.4% to $163.2 million in 2006 from $127.2 million in 2005. This was similar to the improvement in 2005 when our net interest income increased 20.8% from $105.3 million.
 
Contributing to our record earnings for 2006 was the growth in total assets, which increased $598.2 million, or 22.7% and increased $393.6 million, or 17.5% in 2005. By comparison, the increase in assets in 2004 was $168.0 million, or 8.1%. In all three years the growth in our assets occurred principally in the loan portfolio. Portfolio loans (loans receivable) in 2006 increased to $2.90 billion, or 21.7% and in 2005 increased to $2.39 billion, a growth of 20.8% from the 2004 balance of $1.98 billion.
 
Nonperforming assets were .27% of total assets at December 31, 2006, up from .19% at December 31, 2005 which was less than the .63% at year-end 2004. Nonaccruing loans increased to $8.7 million at year-end, up from $4.9 million at December 31, 2005. In the year ended 2004 the amount was $14.1 million and was up from $6.7 million at year-end 2003. For the years ended December 31, 2006, 2005 and 2004, net loan charge offs amounted to $2.9 million, a net recovery of $.1 million and a net charge-off of $.3 million, respectively. This represents a loss of 11 basis points for 2006, a recovery of 1 basis point for 2005 and a loss of 2 basis points for 2004 of average loans outstanding. The total allowance for loan losses stood at $40.6 million, or 1.40% of total loans outstanding in 2006 compared to $33.8 million, or 1.41% of total loans outstanding in 2005, and $30.4 million or 1.54% of total loans at year-end 2004.
 
During the year 2006 cash dividends of $22.4 million were paid to shareowners and the Corporation did not purchase any common stock in the open market under the stock repurchase program. There were no shares repurchased in 2006, 2005 and 2004. Subsequent to year-end, the Corporation repurchased 218,940 shares at an average cost per share of $26.85 through February 21, 2007.
 
RESULTS OF OPERATIONS
 
Net Interest Income
 
Net interest income is the Corporation’s principal source of revenue and is comprised of interest income on earning assets, less interest expense on interest bearing liabilities. The net interest margin is net interest income expressed as a percent of average earning assets and represents the difference between the yield on earning assets and the composite interest rate paid on all sources of funds.
 
Net interest income is adjusted to a taxable equivalent basis to present income earned on taxable and tax-exempt assets on a comparable basis. Reference to net interest income and net interest margin (NIM), in this discussion, represents taxable equivalent (TE) amounts using a tax rate of 35%, and applies only to loans and investments as no other assets or liabilities are affected by the adjustment.

- 31 -
 
The level of growth in our earning assets and the repricing characteristics of our assets and liabilities influenced net interest income, which increased 28.4% from the prior year. The latter, repricing of assets and liabilities, is in turn influenced by the direction of interest rates. In 2006, we benefited from FRB’s four rate increases totaling 100 basis points during the first six months of the year. These increases caused the yield on assets to increase, while the cost on interest bearing liabilities lagged. The tables on pages 47 and 48 include a breakdown of the change in earning assets and liabilities, referred to as "volume," and the repricing of assets and liabilities labeled "rate."
 
Average earning assets rose $532.3 million, or 22.8%, in 2006, following increases of 13.1% and 8.4% in 2005 and 2004, respectively. The growth over the past year in earning assets has come from the increase in the loan portfolio. Average loans rose $530.9 million, or 24.1% this past year, $312.8 million, or 16.6%, in 2005 and $196.5 million or 11.6% in 2004. Average investments decreased $15.7 million, or 12.8% for the year and decreased $40.7 million, or 24.9% in 2005 and increased $2.8 million, or 1.8% in 2004. The increase in earning assets contributed $46.4 million to net interest income in 2006. In 2005 and 2004 the growth in assets increased net interest income by $21.3 million and $14.4 million, respectively. The increase in income from the change in interest rates on average earning assets totaled $25.0 million for the year and an increase of $17.4 million and a reduction of $9.6 million for 2005 and 2004, respectively.
 
Average interest bearing liabilities rose $434.7 million during the year, following increases of $193.4 million and $92.5 million in 2005 and 2004, respectively. The growth over the past year has been from interest bearing deposits, which increased $393.9 million. The increase in interest bearing liabilities contributed $13.5 million to interest expense in 2006. The effect of changing interest rates increased interest expense $21.7 million in 2006. In 2005, increased balances of interest bearing liabilities increased interest expense by $6.1 million, while increasing rates increased interest expense by $10.7 million. In 2004, increased volume of interest bearing liabilities increased interest expense by $2.9 million and declining rates decreased interest expense by $5.8 million.
 
The tax equivalent net interest margin increased in 2006 to 5.73% from 5.48% the previous year, and 5.14% in 2004. The increase in the net interest margin in 2006 is attributable to the four rate increases in our base rate during the first six months of the year and liabilities not repricing as quickly. During 2005 there were eight rate increases in our base rate which had the same effect as in 2006. The decrease in the net interest margin in 2004 is attributable to the interest income ratio decreasing faster than interest expense ratio. The interest expense ratio (interest expense/average deposits and borrowings) increased from 2.83% in 2005 to 3.84% in 2006, an increase of 101 basis points over the prior year end. During the same period the interest income ratio (interest income/average earning assets) increased 106 basis points. Several factors contributed to the movement in the ratios, including the effect of interest rates and the repricing characteristics of loans and deposits.

During 2006 the Federal Reserve Bank (FRB) increased short-term rates four times, 50 basis points in the first quarter and 50 basis points in the second quarter. The FRB increased short-term interest rates eight times in 2005, 25 basis points each time, for a total of two 25 basis point rate increases in each quarter of 2005. These increases increased our net interest margin to 5.73%, up 25 basis points from 2005. Although rates were increased in 2004, the 25 basis point increases were not substantial enough to bring many loans off of their floors, and not until the fourth quarter did we see a meaningful movement of the net interest margin, which was 5.32%.

Interest bearing liabilities are mainly comprised of deposits, which make up 87.5% of all interest-bearing liabilities at December 31, 2006. In contrast to adjustable-rate loans, deposit rates are not directly governed by indexes. We set our deposit rates as often as weekly depending on the general rates in effect for competing financial institutions. When interest rates drop quickly, there is a tendency for deposit rates to decline more slowly than loan rates, because of local competitive factors.

- 32 -

Following is a table showing the tax equivalent net interest margin at each quarter end:

       
Tax Equivalent
 
Tax Equivalent
 
   
Net Interest
  
Effect on
 
Net Interest
 
Quarter Ended
 
Margin
  
Margin
 
Margin
 
December 31, 2005
    
5.75
%
  
0.05
%
  
5.80
%
March 31, 2006
    
5.57
%
  
0.04
%
  
5.61
%
June 30, 2006
    
5.62
%
  
0.04
%
  
5.66
%
September 30, 2006
    
5.79
%
  
0.03
%
  
5.82
%
December 31, 2006
    
5.78
%
  
0.03
%
  
5.81
%
 
 
A review of the past 12 months shows that the tax equivalent net interest margin began year 2006 at 5.80% (quarter ended December 31, 2005). The margin then declined to 5.61% for the first quarter and then increased to 5.66% in the second quarter. The increase continued in the third quarter to 5.82% and decreased slightly to 5.81% in the fourth quarter. The Corporation increased its key lending index 25 basis points in January, March, May, and June. The movement in the net interest margin was attributed to these rate increases. During 2005, the Corporation increased its index eight times. In 2004, the Corporation increased its key lending index 25 basis points in August, September, November and December.
 
We attempt to measure the effect of changing interest rates with our interest rate simulation model. The simulation model suggests that rising rates would continue to be to our advantage. At December 31, 2006, if rates were to raise 200 basis points ratably over the next 3 months and then maintain that level for the next nine months, our net interest income would improve by 8.2%, or $14.2 million. If rates were to fall 100 basis points, our net interest income would decrease 3.5%, or $6.0 million. The model indicates that we are currently positively gapped, meaning that more assets will reprice within a one-year period than liabilities. See a further discussion of this subject, under the headings “Market Risk Sensitivity Instruments” and “Asset/Liability Management”, on pages 36 and 37.
 
OTHER OPERATING INCOME
 
Service Charges
 
Deposit fee income has decreased $151 thousand to $4.2 million, or 3.5% less than the prior year-end. In 2005, deposit fee income decreased $561 thousand to $4.4 million and increased from $4.9 million in 2004. Virtually all of this income is attributable to checking accounts. While our growth in checking account balances has moderated this year, with an increase from $395.9 million last year to $406.6 million this year, or 2.7%, the continued increase in the use of debit cards results in reduced service fees.
 
Other Income
 
Other income is comprised of a variety of sources, and increased in 2006 by $2.3 million, or 29.6%, to $9.9 million. The 2006 increase was primarily due to the sale of a property which had been held for several years for branch expansion, but was no longer needed. As a result of this sale we recognized a nonrecurring pre-tax gain on the sale of $2.1 million. Other income in 2005 of $7.7 million was comparable to that reported for the year 2004, which was $8.0 million. The $8.0 million of other income in 2004 included a gain on the sale of other real estate owned for $610 thousand, an increase in insurance and financial service fees of $648 thousand, and an increase in trust department fees of $273 thousand over the prior year.
 
- 33 -
 
Gain (Loss) On the Sale of Investments
 
In 2006, we had a small loss of $25 thousand on the sale of a security. In 2005, the $211 thousand loss on sale of securities was due to a write down of an equity investment in a financial services company. For 2004, we had a small loss on the sale of a security of $44 thousand due to credit concerns.
 
OTHER OPERATING EXPENSES
 
Salaries and Employee Benefits

Salaries and benefits expense rose $5.4 million or 14.9% for 2006 to $42.0 million. These costs similarly rose $4.6 million or 14.5% in 2005 and $3.1 million or 10.8% in 2004. Salaries and employee benefits costs in these years were affected by increases in staff, merit raises and a rise in commissions and bonuses.
 
The staffing level, referred to as full-time equivalent (FTE), totaled 721 at year-end 2006, an increase of 8.7%, over the prior year. That figure compares to 663 at December 2005, and 643 at December 31, 2004.
 
One of the issues that complicates the reporting of compensation expense is the deferral of loan origination costs. In accordance with the current accounting standards, loan origination costs are deferred and amortized over the life of the loan. The loan costs, which are determined for each loan type, are then deducted from personnel expense, with the net figures reported in the financial statements. Compensation is thus comprised of the expected items such as salaries, benefits and commissions, but also the effect of deferred loan origination costs, which can vary substantially from year-to-year.

Occupancy Expense

Occupancy expense increased $1.5 million or 19.0% to $9.1 million for 2006 primarily as a result of increases of $147 thousand in depreciation expense, $428 thousand in office rentals, $265 thousand in software expense, and $432 thousand in maintenance agreements. Occupancy expense of $7.7 million in 2005 was up 8.8% from $7.0 million in 2004 mainly due to increased depreciation expense of $203 thousand related to new or relocated offices and infrastructure improvements of $416 thousand.

Other Expenses

Other expense increased $1.5 million in 2006, or 13.4% due to increased marketing expense of $413 thousand, director fees of $317 thousand, communication networks of $256 thousand, amortization expense of intangible assets related to the NorthStar merger of $232 thousand, and equity compensation expense of $73 thousand. Other expense increased $2.1 million in 2005, or 20.8% and increased $678 thousand, or 7.7% in 2004. For 2005, the largest increase in this category was consulting fees, which increased $518 thousand over the previous year as a part of our information technology upgrade. Some of the other areas of increases were legal fees of $120 thousand, data security expenses of $130 thousand, audits and examinations of $310 thousand, deposit account fees paid of $150 thousand and Nasdaq fees of $49 thousand. Other expense increased $678 thousand in 2004, or 7.7%.

Allowance for Loan Losses

Management’s determination of the level of the provision for loan losses is based on various judgments and assumptions, including general economic conditions, loan portfolio composition, prior loan loss experience, the evaluation of credit risk related to specific credits and market segments, and monitoring results from the Corporation’s ongoing internal credit review staff. Management believes our methodology for assessing credit risk is adequate and reflected in the resulting allowance calculation. The allowance methodology takes into account that the loan loss reserve will change at different points in time based on economic conditions, credit performance, loan mix and collateral values.

The allowance for loan losses increased to $40.6 million as of December 31, 2006. At year-end 2005, the allowance balance was $33.8 million, which was an increase of $3.4 million over year-end 2004 balance of $30.4 million. The allowance for loan loss reserve was 1.40% of totals loans as of year-end December 31, 2006. For year-end December 31, 2005 our reserve ratio was 1.41% and was 1.54% for year-end 2004.

- 34 -

The Bank considers the allowance for loan losses adequate to cover losses inherent in the portfolio at December 31, 2006.
 
REVIEW OF FINANCIAL CONDITION
 
Investment Securities
 
Investment securities increased $4.1 million, or 3.7% to $114.7 million as of December 31, 2006. Approximately 20% of the securities matured or were called during the year; however short-term securities were purchased for collateral purposes thereby showing a slight increase in the investment portfolio. During 2005 and 2004, investment securities decreased $42.8 million or 27.9% and $34.5 million or 18.3%, respectively. Almost all of this run off was due to maturities and calls prior to maturity. During 2005 and 2004, management used these cash flows for funding growth in the loan portfolio.
 
Loans
 
Loans increased 21.7% in 2006, from $2.39 billion at December 31, 2005, to $2.91 billion at year-end 2006. Approximately $165.0 million of this increase was from the merger with NorthStar. Loans grew 20.8% in 2005 or $411.2 million. In 2004, loans grew to $1.98 billion from $1.77 billion in 2003, an increase of 11.9%. Please see pages 44 and 45 of this report and Form 10-K for the year-ended December 31, 2006 for a further discussion of loans.
 
Deposits
 
Deposits increased $392.3 million, or 19.0%, in 2006, and $265.5 million, or 14.8% in 2004 and $128.8 million, or 7.7% in 2004. The movement between types of deposit accounts was characterized by a changing interest rate environment.
 
Interest bearing deposits at December 31,

In Thousands
              
   
2006
  
2005
  
2004
  
NOW and money market accounts
  
$
683,948
  
$
322,283
  
$
270,894
  
Savings accounts
    
305,669
   
495,108
   
642,434
 
Time deposits
    
1,057,394
   
848,137
   
569,239
 
Total
  
$
2,047,011
  
$
1,665,528
  
$
1,482,567
  
 
As reflected on the above chart, the shift from decreasing savings balances into short-term NOW, money market accounts and time deposits continued in 2006. The trend prior to 2004, had been declining time deposits and increasing savings balances, due to the aversion of customers to lock into low rate CD’s. However, with interest rates on the rise in late 2004, 2005 and 2006, that trend has reversed. Total interest bearing deposits increased $381.5 million, or 22.9% in 2006, $183.0 million, or 12.3% in 2005 and $87.0 million, or 6.2% in 2004. NOW and money market accounts increased all three years. Starting in the second half of 2004, CD’s became more attractive to investors and continued throughout 2005 and 2006. Balances increased to $1.1 billion in 2006, $209.3 million over 2005 of $848.1 million and $278.9 million over 2004. Prior to 2004, the type of savings accounts having the largest increase over the last 3 years was our premium savings account, which increased from $415.4 million in 2002 to $577.8 million in 2004. This account was created as an alternative to certificates of deposit and pays a higher annual percentage yield than other core deposits. However, these accounts ran off substantially in 2005 to a portfolio balance of $450.2 million and in 2006 to a balance of $258.5 million. As an alternative to this account, investors moved money into our premier treasury account, which is a tiered account, tied to the discount rate for 13-week U.S. Treasury Bill and offering a higher short-term yielding account. The balance of premier treasury accounts at December 31, 2006 and 2005 was $369.5 million and $40.4 million, respectively.

- 35 -

MARKET RISK SENSITIVE INSTRUMENTS
 
Market risk is the risk of loss from adverse changes in market prices and rates. A significant market risk arises from interest rate risk inherent in our lending, deposit, borrowing, and mortgage-banking activities. To that end, we actively monitor and manage interest rate risk exposure.
 
A number of measures are utilized to monitor and manage interest rate risk, including income simulation and "gap" analysis (further discussed under the subheading "Asset and Liability Management" on page 37). An income simulation model is primarily used to assess the impact on earnings changes that interest rates may produce. Key assumptions in the model include, cash flows and maturities of financial instruments, changes in market conditions, loan volumes and pricing, deposit sensitivity, consumer preferences, and management's capital leverage plans. These assumptions are inherently uncertain; therefore, the model cannot precisely estimate net interest income or precisely predict the impact of higher or lower interest rates on net interest income. Actual results may significantly differ from simulated results due to timing, magnitude and frequency of interest rate changes, and changes in market conditions and specific strategies, among other factors. The model also uses a multiplier effect which is discussed later.
 
We use a simulation model to estimate the impact of changing interest rates on the Corporation’s earnings and capital. The model calculates the change in net interest income under various rate shocks. As of December 31, 2006, the model predicted that net income would increase about $9.0 million if rates increased 2%, and decrease about $3.8 million if rates fell 1%.
 
Based on the results of simulations at the end of the last three years, the estimated impact of a steady change in interest rates over the next 12 months is shown in the table below (assumes a 34% tax rate):
 
In Thousands
                      
   
2007 Estimated Change
  
2006 Estimated Change
  
2005 Estimated Change
  
Rate shock
    
-1.0
%
  
2.0%
 
  
-1.0
%
  
2.0%
 
  
-1.0
%
  
2.0%
 
Net interest income
    
($6,034
)
$
14,162
    
($5,213
)
$
19,922
    
($309
)
$
8,969
  
Net income
    
(3,817
)
  
9,004
   
(3,409
)
  
12,768
   
(71
)
  
5,597
 

During 2006, we had a 100 basis point upward movement in rates. At year-end 2005, the model predicted that our net interest income would increase $9.2 million and our net income would increase $5.9 million, if rates increased by 1%. Actually, our net interest income increased $36.1 million and our net income increased $17.3 million, approximately 4 and 3 times the model estimate. Net loan growth was approximately 4 times the growth anticipated at the time of the projections and gross loan production for the year was approximately $3.8 billion, considerably more than estimated.

The interest rate scenarios reflected above represent the results of possible near-term interest rate movements. Approximately 57% of the loan portfolio is tied to rate indexes that are one year or less in duration. These indexes include our Base rate, Federal Home Loan Bank of Seattle (FHLB) Advance Rate, Wall Street Journal prime, London Interbank Offering Rate (LIBOR), and Constant Maturity Treasury (CMT).
 
The percentages shown represent changes over a 12-month period in net interest income and net income under two rate scenarios. The cash flows have been adjusted to account for prepayments and other factors.
 
Our primary objective in managing interest rate risk is to minimize the adverse impact of changes in interest rates on our net interest income and capital, while structuring the asset and liability components to obtain the maximum net interest margin. We rely primarily on our asset and liability structure to control interest rate risk.

- 36 -
 
ASSET AND LIABILITY MANAGEMENT
 
Asset and liability management is the responsibility of the Asset/Liability Committee, which acts within policy directives established by the Board of Directors. This Committee meets regularly to monitor the composition of the balance sheet, to assess projected earnings trends, and to formulate strategies consistent with the objectives for liquidity, interest rate risk, and capital adequacy. The objective of asset/liability management is to maximize long-term shareholder returns by optimizing net interest income within the constraints of credit quality, interest rate risk policies, levels of capital leverage, and adequate liquidity.
 
Assets and liabilities are managed by matching maturities and repricing in a systematic manner. In addition to a simulation model, an interest rate "gap" analysis is used to measure the effect interest rate changes have on net interest income. The gap is the difference between the amount of interest-earning assets maturing or repricing within a specific time period and the amount of interest bearing liabilities maturing or repricing in that same time period. A gap is considered positive when the amount of interest-rate-sensitive assets exceeds the amount of interest-rate-sensitive liabilities. A gap is considered negative in the reverse situation. However, the exact impact of the gap on future income is uncertain both in timing and amount because interest rates for our assets and liabilities can change rapidly as a result of market conditions and customer behavior patterns.
 
In the following table the expected maturities for financial liabilities with no stated maturity, reflect assumptions using the run-off rates for noninterest bearing deposits of 6% per year; for NOW, sweep and money market accounts 8% per year; and for savings accounts 10% per year. The weighted average interest rates for financial instruments presented are for year-end 2006. Please refer to page 26 of this report for details regarding estimated fair value.

- 37 -
 
 
In Thousands, at December 31, 2006
                                  
   
Expected Maturity Date
          
Fair
  
   
2007
  
2008
  
2009
  
2010
  
2011
  
Thereafter
  
Total
  
Value
  
Financial Assets
                                  
Cash and due from banks
                                  
Noninterest bearing
  
$
104,222
    
-
    
-
    
-
    
-
    
-
  
$
104,222
  
$
104,222
  
Fed Funds Sold
                                                  
Variable Rate
    
18,673
    
-
    
-
    
-
    
-
    
-
    
18,673
    
18,673
  
Weighted average interest rate
    
5.39
%
                                
5.39
%
      
Securities available for sale
                                                
Fixed Rate
    
44,823
   
32,878
    
18,615
    
2,163
    
335
    
2,798
    
101,612
    
111,112
  
Weighted average interest rate (1)
    
3.45
%
  
3.59
%
  
3.90
%
  
3.12
%
  
5.68
%
  
10.20
%
  
3.76
%
      
Securities held to maturity
                                              
Fixed Rate
    
715
    
680
    
200
    
244
    
234
    
1,526
    
3,599
    
3,623
  
Weighted average interest rate (1)
    
8.02
%
  
8.17
%
  
7.95
%
  
8.25
%
  
8.90
%
  
9.66
%
  
8.81
%
      
Loans Receivable, net
                                                
Fixed Rate
    
179,901
    
222,536
    
153,250
    
126,730
    
134,308
    
59,584
    
876,309
    
877,250
  
Weighted average interest rate (2)
    
7.23
%
  
6.65
%
  
6.92
%
  
7.15
%
  
7.83
%
  
6.69
%
  
7.07
%
    
Variable Rate
    
1,471,124
    
88,874
    
35,357
    
14,034
    
23,087
    
391,995
    
2,024,471
    
2,046,917
  
Weighted average interest rate (2)
    
9.51
%
  
8.97
%
  
9.10
%
  
8.42
%
  
8.10
%
  
7.01
%
  
8.98
%
      
                                                 
Financial Liabilities
                                                
Noninterest bearing deposits
    
24,397
    
22,933
    
21,557
    
20,264
    
19,048
    
298,422
    
406,621
    
406,621
  
NOW, Sweep and Money Market accounts
    
54,716
    
50,339
    
46,311
    
42,607
    
39,198
    
450,777
    
683,948
    
683,948
  
Weighted average interest rate
    
3.52
%
  
3.52
%
  
3.52
%
  
3.52
%
  
3.52
%
  
3.52
%
  
3.52
%
    
Savings accounts
    
30,567
    
27,510
    
24,759
    
22,283
    
20,055
    
180,495
    
305,669
    
305,669
  
Weighted average interest rate
    
2.38
%
  
2.38
%
  
2.38
%
  
2.38
%
  
2.38
%
  
2.38
%
  
2.38
%
      
Time Certificates
                                              
Fixed Rate
    
906,406
    
67,835
    
37,088
    
27,272
    
17,489
    
1,304
    
1,057,394
    
1,058,131
  
Weighted average interest rate
    
4.91
%
  
4.35
%
  
4.15
%
  
4.32
%
  
5.00
%
  
5.02
%
  
4.83
%
      
Federal funds purchased & securities
                                              
sold under agreements to repurchase
                                                 
Variable rate
    
81,673
    
-
    
-
    
-
    
-
    
-
    
81,673
    
81,673
  
Weighted average interest rate
    
5.24
%
                                
5.24
%
      
Subordinate debt
    
-
   
-
    
-
    
5,156
   
-
    
-
    
5,156
   
5,123
  
Weighted average interest rate
                      
6.42
%
              
6.42
%
      
FHLB advances
                                                
Fixed Rate
    
41,368
    
42,906
    
39,885
    
72,087
    
20,000
    
65,771
    
282,017
    
277,450
  
Weighted average interest rate
    
4.50
%
  
4.39
%
  
4.14
%
  
5.66
%
  
4.89
%
  
4.24
%
  
4.70
%
      

(1) Represents tax equivalent yield
(2) Represents weighted note rates exclusive of loan fees

Please note that in the above chart, financial assets and liabilities are listed at their expected maturity date. Our variable rate financial assets will reprice much sooner than their expected maturity date and liabilities may or may not run off at the expected rate as indicated above. We like to analyze our assets and liabilities as shown in the chart below, which indicates when the assets and liabilities can be repriced.

- 38 -
 
REPRICING OPPORTUNITIES FOR ASSETS AND LIABILITIES

In Thousands, at December 31, 2006
                          
   
2007
  
2008
  
2009
  
2010
  
2011
  
Thereafter
  
Total
  
ASSETS
                              
Loans (1) (2)
  
$
1,908,940
  
$
360,447
  
$
237,018
  
$
185,627
  
$
162,474
  
$
46,274
  
$
2,900,780
  
Yield
    
9.14
%
  
6.62
%
  
6.96
%
  
7.12
%
  
7.73
%
  
6.67
%
  
8.39
%
Investments (2) (3)
    
45,538
   
33,558
   
18,815
   
2,407
   
569
   
4,324
   
105,211
 
Yield
    
3.52
%
  
3.68
%
  
3.94
%
  
3.64
%
  
7.00
%
  
10.01
%
  
3.93
%
Fed funds sold
    
18,673
   
-
   
-
   
-
   
-
   
-
   
18,673
 
Yield
    
5.39
%
                                
5.39
%
Total earning assets
    
1,973,151
   
394,005
   
255,833
   
188,034
   
163,043
   
50,598
   
3,024,664
 
Yield
    
9.06
%
  
6.95
%
  
7.01
%
  
7.21
%
  
7.87
%
  
6.99
%
  
8.22
%
                                             
LIABILITIES
                                        
NOW, money market, and sweep accounts
    
526,845
   
62,261
   
50,376
   
38,621
   
5,845
   
-
   
683,948
 
Cost
    
3.52
%
  
3.52
%
  
3.52
%
  
3.52
%
  
3.52
%
        
3.52
%
Savings
    
56,064
   
42,847
   
25,848
   
25,848
   
25,848
   
129,214
   
305,669
 
Cost
    
2.38
%
  
2.38
%
  
2.38
%
  
2.38
%
  
2.38
%
  
2.38
%
  
2.38
%
Time deposits
    
906,406
   
67,835
   
37,088
   
27,272
   
17,489
   
1,304
   
1,057,394
 
Cost
    
4.91
%
  
4.35
%
  
4.15
%
  
4.32
%
  
5.00
%
  
5.02
%
  
4.83
%
Fed funds purchased nd repurchase agreements
    
81,673
   
-
   
-
   
-
   
-
   
-
   
81,673
 
Cost
    
5.24
%
                                
5.24
%
Subordinated debt
    
-
   
-
   
-
   
5,156
   
-
   
-
   
5,156
 
Cost
                      
6.42
%
              
6.42
%
FHLB borrowings
    
41,368
   
42,906
   
39,885
   
72,087
   
20,000
   
65,771
   
282,017
 
Cost
    
4.50
%
  
4.39
%
  
4.14
%
  
5.66
%
  
4.89
%
  
4.24
%
  
4.70
%
Total interest bearing liabilities
    
1,612,356
   
215,849
   
153,197
   
168,984
   
69,182
   
196,289
   
2,415,857
 
Cost
    
4.38
%
  
3.73
%
  
3.64
%
  
4.14
%
  
3.86
%
  
3.02
%
  
4.15
%
GAP
  
$
360,795
  
$
178,156
  
$
102,636
  
$
19,050
  
$
93,861
    
($145,691
)
$
608,807
  
 
(1) Loan fees and costs are included in balance but not in the yield
(2) Taxable equivalent
(3) Amortized cost
 
It is generally assumed that during a period of rising interest rates, the net earnings of an institution with a negative gap may be adversely affected due to its interest bearing liabilities repricing to a greater extent than its interest-earning assets. Conversely, during a period of falling interest rates, net earnings may increase. That assumption, however, is based on the premise that assets/liabilities within a one-year time frame will generally move in the same direction at approximately the same rate. However, historical data reflects that the relationship between one-year asset/liabilities may not be as strongly correlated as assumed. Loans with one-year repricing characteristics are tied to a number of indexes to include our base rate, the Wall Street Journal prime, the one-year constant maturity treasury, LIBOR, and FHLB rates. Those indexes are subject to the movement of the one-year market rates. On the other hand, NOW and CD’S, which constitute the bulk of the one-year repricing liabilities, are subject to the local financial institutions' market. Pricing for NOW and CD’s is dependent on customer preferences and the subjective pricing influence of local banks, credit unions, etc. Thus, while a good portion of our loans are tied to national and international money markets, deposits are subject to the conditions of the Puget Sound area. Additionally, when interest rates change, different rates change by different amounts. The use of “multipliers” is used that represent the change of each asset/liability rate compared to the change in the federal funds rate. For example, the prime rate has a factor of 1 indicating it changes the same amount as any federal funds rate change. Core deposit sectors may have a factor of .25, indicating those rates move only 25% as much. Applying the multipliers to the balance sheet, at December 31, 2006, the Bank had a positive gap of $360.8 million, compared to a positive gap of $577.0 million at December 31, 2005.

- 39 -

ASSET QUALITY

The Bank’s nonperforming assets (NPA’s) include the balances of loans placed in nonaccrual status and Other Real Estate Owned. The following chart summarizes the composition of our nonperforming assets, including restructured debt.

In Thousands
  
Years ending December 31,
  
   
2006
  
2005
  
2004
  
Total nonaccruing loans
  
$
8,653
  
$
4,949
  
$
14,107
  
Other real estate owned
    
-
   
-
   
-
 
Total nonperforming assets
  
$
8,653
  
$
4,949
  
$
14,107
  
                     
Restructured loans
    
-
   
-
   
-
 
                     
NPA's to total loans
    
0.30
%
  
0.21
%
  
0.71
%
NPA's to total assets
    
0.27
%
  
0.19
%
  
0.63
%
NPA's to total capital
    
2.19
%
  
1.67
%
  
5.55
%
                     
NPA's & restructured loans to total assets
    
0.27
%
  
0.19
%
  
0.63
%

NONACCRUAL LOANS

It is the Bank's practice to discontinue accruing interest on virtually all loans that are delinquent in excess of 90 days regardless of risk of loss, collateral, etc. Some problem loans, which are less than 90 days delinquent, are also placed into nonaccrual status if the success of collecting full principal and interest in a timely manner is in doubt. Some loans will remain in nonaccrual even after improved performance until a consistent timely repayment pattern is exhibited and/or timely performance is considered reliable.

The Bank ended the year 2006 with eight nonaccruing loans with a combined balance of $8.7 million. This compares to three nonaccruing loans with a combined year-end balance of $4.9 million in 2005 and six nonaccruing loans with a combined balance of $14.1 million at the end of 2004. One loan, totaling $7.1 million, makes up 82.5% of our 2006 year-end balance.

OTHER REAL ESTATE OWNED
 
Other real estate owned (OREO) is carried at the lesser of book value or market value. The costs related to completion, repair, maintenance, or other costs of such properties, are generally expensed with any gains or inadvertent shortfalls from the ultimate sale of OREO being shown as other income or other expense.
 
The Bank had no OREO totals to report at year-end December 31, 2006, 2005 and 2004.
 
Certain other loans, currently in nonaccrual, are in the process of foreclosure and there is a likelihood these foreclosures will be completed and the loans will then become OREO. This is viewed as an ordinary part of the collection process and efforts are constantly underway to reduce and minimize such nonperforming assets.

- 40 -

LIQUIDITY
 
Liquidity refers to the ability to generate sufficient cash to meet the funding needs of current loan demand, deposit withdrawals, principal and interest payments with respect to outstanding borrowings, and payment of operating expenses. The need for liquidity is affected by loan demand, net changes in deposit levels, and the scheduled maturities of borrowings. Liquidity is derived from assets by receipt of interest and principal payments and prepayments, by the ability to sell assets at market prices, earnings, and by utilizing unpledged assets as collateral for borrowings. Liquidity is also derived from a variety of funding sources, including advances from the FHLB, and other short and long term borrowings.
 
The principal use of funds is to invest in loans and securities. Security purchases amounted to $17.3 million in 2006, down 71% from $58.9 million in purchases in 2005. Security purchases totaled $47.1 million in 2004. The reduction in security purchases was to allow lower yielding securities to run off. Net cash flows funding loan activities totaled $517.3 million, $409.3 million, and $204.8 million during 2006, 2005, and 2004, respectively. Our continued use of cash to fund loan activities reflects the continuing growth of our business.
 
The increased use of cash for the origination of mortgage loans held for sale totaled $111.7 million, $93.2 million, and $67.7 million during 2006, 2005, and 2004, respectively. This corresponds to the increase in cash provided by the proceeds from the sales of mortgage loans with amounted to $111.7 million in 2006, $91.3 million in 2005, and $65.8 million in 2004, reflecting the increased volume of business in this area.
 
In 2006, almost all of the funding for our $598.2 increase in assets came from three sources; $183.0 million came from increased core deposits, $209.3 million came from increased certificates of deposits (cd’s) and $42.0 million came from net FHLB advances. In 2005, the major funding activities were cd’s which provided $278.9 million, net FHLB advances which provided $64.9 million and maturities or calls of securities which provided $90.3 million in cash flows. In 2004, the major funding activities were core deposit increases of $78.0 million, increased cd’s of $50.8 million and maturities or calls of securities in the amount of $84.1 million.
 
Our line of credit with the FHLB has been established at 19% of qualifying loans, which at December 31, 2006 equaled $597.8 million. Net advances totaled $42.0 million, $64.9 million and $5.0 million for 2006, 2005 and 2004, respectively. Borrowings totaled $282.0 million, $240.0 million, $175.1 million, at December 31, 2006, 2005, and 2004, respectively. These borrowings represented 8.7% of year-end assets in 2006, 9.1% in 2005, and 7.8% in 2004.
 
Unused lines of credit available to us include $247.8 million available at FHLB and $85.0 million available from correspondent banks. We also have the option of funding asset growth or funding withdrawals with brokered deposits. At year-end 2006, broker deposits were $44.9 million, representing 1/8% of total deposits.
 
The table on the next page is a probable indication of when we might expect assets to mature, but we cannot be certain that we will receive or pay out these cash flows as loans may be renewed and depositors may not want to roll over their deposits at the current rate we are willing to pay.

- 41 -

MATURITY SCHEDULE FOR EARNING ASSETS

In Thousands
                          
December 31, 2006
  
0-1
Year
  
1-5
Years
  
After
5 Years
  
Total
  
Total Fair
Value
  
Percent
of Total
Fair
Value
  
                           
Investments (1)
  
$
45,538
  
$
55,349
  
$
4,324
  
$
105,211
  
$
114,735
    
3.8
%
                                       
Loans
    
1,651,025
   
798,176
   
451,579
   
2,900,780
   
2,883,518
   
95.6
%
                                       
Federal funds sold
    
18,673
   
-
   
-
   
18,673
   
18,673
   
0.6
%
                                       
Total
  
$
1,715,236
  
$
853,525
  
$
455,903
  
$
3,024,664
  
$
3,016,926
    
100.0
%

In Thousands
                          
December 31, 2005
  
0-1
Year
  
1-5
Years
  
After 5
Years
  
Total
Carrying
Cost
  
Total
Fair
Value
  
Percent of
Total
Fair
Value
  
Investments (1)
 
$
35,599
  
$
63,635
  
$
4,576
  
$
103,810
  
$
110,823
    
4.5
%
                                       
Loans
    
1,101,193
   
925,635
   
362,396
   
2,389,224
   
2,355,206
   
95.5
%
Federal funds sold
    
733
   
-
   
-
   
733
   
733
   
0.0
%
Total
  
$
1,137,525
  
$
989,270
  
$
366,972
  
$
2,493,767
  
$
2,466,762
    
100.0
%
(1) Amortized cost
 
For additional information regarding liquidity, see the Statement of Cash Flows in the Consolidated Financial Statements.
 
CAPITAL
 
We are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a material effect on our financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, we must meet specific capital guidelines that involve quantitative measures of assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. The minimum ratios and the actual capital ratios are set forth in the table below.
 
CAPITAL RATIOS
  
Frontier
Financial
Corporation
 
Frontier
Bank
 
Well
Capitalized
Minimum
 
Total capital to risk-weighted assets
    
12.85
%
  
11.92
%
  
10.00
%
Tier 1 capital to risk-weighted assets
    
11.59
%
  
10.66
%
  
6.00
%
Tier 1 leverage capital to average assets
    
11.32
%
  
10.47
%
  
5.00
%

The holding company is registered with the Federal Reserve Bank as a financial holding company. The Federal Reserve Bank requires financial holding companies to meet the well-capitalized status of the regulatory capital requirements.

- 42 -

The capital of the Corporation at year-end 2006 was $395.3 million, up from $296.1 million a year ago, or an increase of 33.5%. Frontier began paying cash dividends to shareowners in 1999 and approved a stock repurchase plan in 2000. During 2006, cash dividends of $22.4 million were paid to shareowners. The Corporation did not repurchase any common stock in the open market in 2006. Subsequent to year end, the Corporation repurchased 218,940 shares at an average cost per share of $26.85 through February 21, 2007.
 
CONTRACTUAL OBLIGATIONS AND COMMITMENTS
 
The following table sets forth the Corporation’s long-term contractual obligations at December 31, 2006:
 
In Thousands
  
Payments due per period
      
   
Less Than
One Year
  
1-3 Years
  
3-5 Years
  
Thereafter
  
Total
  
                       
Time deposits
  
$
906,406
  
$
104,923
  
$
44,761
  
$
1,304
  
$
1,057,394
  
FHLB borrowings
    
41,369
    
82,791
    
92,087
    
65,770
    
282,017
  
Junior subordinated debt     -     -     -     5,156     5,156  
Operating leases
    
1,824
    
3,244
    
1,944
    
2,421
    
9,433
  
Total
  
$
949,599
  
$
190,958
  
$
138,792
  
$
74,651
  
$
1,354,000
  
 
See additional discussion under Notes 6, 8 and 16 of the Consolidated Financial Statements.
 
OFF-BALANCE SHEET ARRANGEMENTS
 
See Note 16 of the Consolidated Financial Statements for discussion.
 
MARKET FOR FRONTIER FINANCIAL CORPORATION’S COMMON STOCK AND RELATED SHAREOWNERS’ MATTERS
 
Frontier Financial Corporation’s common stock began trading on the National Association of Securities Dealers’ Automated Quotation System (Nasdaq) on April 16, 1998. Nasdaq reported the 2006 daily average trade volume was 118,275 shares and a total trade volume of 29,686,942. During 2006, the market price of our common stock ranged from $20.38 to $31.33. The average price for the year was $24.607.
 
At December 31, 2006, the total number of shareowners of record of Frontier Financial Corporation’s common stock was 3,556 and there were 45,350,316 shares outstanding, which included 24,866,577 shares registered in street name.
 
Prior to 1999 the Corporation had always paid stock dividends, which ranged from 7% to 10% and the Corporation has had eight stock splits since the Bank opened in 1978. In 1999, the Board of Directors declared the first annual cash dividend of $.25 per share on post two-for-one split shares. On January 19, 2000, the Board declared the first quarterly cash dividend. Please see the table below for the detail of the year 2006 dividends declared.

Dividend Payable
  
Record Date
  
Payable Date
$.113
  
January 9, 2006
  
January 24, 2006
$.117
  
April 11, 2006
  
April 24, 2006
$.12
  
July 10, 2006
  
July 24, 2006
$.15
  
October 10, 2006
  
October 24, 2006

The Board will continue to review the dividend policy on a quarterly basis.

- 43 -
 
STOCK REPURCHASE PROGRAM
 
There was no stock repurchase activity in 2006. On August 16, 2006, the Corporation authorized a new plan to repurchase 5% of its outstanding stock. There are currently 2,263,323 authorized under this plan. Subsequent to year-end, the Corporation repurchased 218,940 shares at an average cost per share of $26.85 through February 21, 2007.
 
LOAN PORTFOLIO

The Bank classifies its lending activities in the following principal areas: installment, commercial and agriculture, real estate commercial, real estate construction and land development, and residential. As of December 31, 2006, these categories accounted for approximately 2.2%, 13.4%, 32.9%, 43.2% and 8.3% respectively of the Bank’s loan portfolio.

The chart below summarizes the composition of the loan portfolio for the past three years by average balance:
 
In Thousands
  
2006
  
2005
  
2004
  
   
Amount
 
Percentage
  
Amount
 
Percentage
  
Amount
 
Percentage
  
Installment
  
$
60,871
    
2.2
%
$
47,930
    
2.2
%
$
44,111
    
2.3
%
Commercial and agriculture
    
366,601
   
13.4
%
  
320,923
   
14.6
%
  
287,180
   
15.2
%
Real estate commercial
    
897,258
   
32.9
%
  
866,647
   
39.4
%
  
831,823
   
44.1
%
Real estate construction and land development
    
1,180,486
   
43.2
%
  
779,364
   
35.4
%
  
564,726
   
29.9
%
Real estate residential
    
226,041
   
8.3
%
  
185,480
   
8.4
%
  
159,688
   
8.5
%
Total
  
$
2,731,257
    
100.0
%
$
2,200,344
    
100.0
%
$
1,887,528
    
100.0
%

Total average loan balances increased $530.9 million, or 24.1% over the average balance for 2005. Loan balances in 2005 increased $312.8 million, or 16.6% over 2004. 2004 average loans increased $196.5 million, or 11.6% over 2003. These increases were mostly driven by the increases in real estate commercial and real estate construction and land development loans that, combined, have historically comprised the largest portion of the Corporation’s loan portfolio and represented 76% of the loan portfolio in 2006.

The average balances of real estate construction and land development loans, which represented 43.2% of the Corporation’s loan mix in 2006, increased by $401.1 million, or 51%, as continued demand for housing and favorable interest rates continue to fuel this growth. Real estate construction loans are generally composed of commitments to customers within our market area for construction purposes. Loans within this category are used for construction projects that range from residential and commercial land development to residential and commercial building projects. They are generally secured by first trust deeds with well-defined repayment sources following project completion. Maturities are set to match the time required for project completion, which typically run from 12 to 18 months depending on complexity.

Our commercial real estate portfolio consists of a wide cross-section of retail, small office, warehouse, and industrial type properties. These loans are secured by first trust deeds with maturities from three to ten years and original loan-to-value ratios generally from 65% to 75%. Ten-year maturities generally reprice every five years. A substantial number of these properties are owner-occupied. While the Corporation has significant balances within this lending category, management believes that its lending policies and underwriting standards are sufficient to minimize risk even during uncertain economic times. Management closely monitors the effects of current and expected market conditions and other factors that may influence the repayment of these loans.

Average commercial and agriculture loans balances increased $45.7 million, or 14.2% in 2006. Expanding our branch network and the recruitment of seasoned local lenders provided strong support for favorable growth in commercial loan totals.

- 44 -

At 2.2% of total average loans, our installment lending continues to be the smallest portion of our overall loan portfolio, while these loans increased 27% in 2006, the percentage of these loans remained relatively unchanged for the year. This area of consumer lending continues a shift toward credit card, factory-lending programs for automobiles and home equity lines of credit. While the Corporation does offer credit cards and home equity lines, emphasis has not been placed on these product offerings.

Real estate residential loans averaged $226.0 million in 2006. Loans within this category are used to finance individual owner and nonowner occupied residences. These loans will generally be repaid at maturity as they move into lower interest rate term mortgage loans available through secondary market programs.

The yield on the loan portfolio average balance increased to 8.98% in 2006 from 7.92% in 2005 and 7.08% in 2004. There were four rate increases in 2006 and eight rate increases in 2005. Although FRB increased rates five times in the second half of 2004, many variable rate loans in our portfolio had floors, which slowed down the increase in interest income.

For 2006, the tax equivalent interest and fees totaled $245.3 million, increasing $70.9 million or 40.7% from the prior year-end. In 2005 we saw an increase in tax equivalent loan interest and fees, which totaled $174.3 million and increased $40.6 million, or 30.4% from 2004. Tax equivalent interest and fee income from loans increased $6.8 million in 2004, or 5.3%. The increase of $530.9 million in the average balances of loans in 2006 increased interest income $46.5 million and the increase in rates increased interest income by $24.4 million, for a total increase of $70.9 million. The increase of $312.8 million in the average balance of loans in 2005 increased interest income $23.1 million and the increase in rates increased interest income by $17.5 million, for a net increase of $40.6 million. The increase of $196.5 million in the average balance of loans in 2004 increased interest income by $15.0 million and the decline in rates reduced interest income by $8.2 million, for a net increase of $6.8 million.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect amounts reported in the consolidated financial statements and the accompanying notes. Changes in these estimates and assumptions are considered reasonably possible and may have a material impact on the consolidated financial statements and thus actual results could differ from the amounts reported and disclosed herein. The Company considers the allowance for loan loss a critical accounting policy subject to estimate.

For additional information regarding the allowance for loan losses, see “Analysis of the Allowance for Loan Losses” in this Management’s Discussion and Analysis and “Allowance for Loan Losses” in Note 1 in Notes to the Consolidated Financial Statements.
 
The Company’s financial statements are based on the selection and application of significant accounting policies which require management to make significant estimates and assumptions (see Note 1 to the consolidated financial statements). The Company believes that the allowance for loan losses is one of the more critical judgment areas in the application of its accounting policies that affect financial condition and results of operations. This is more fully described in the Liquidity section.

Material estimates that are particularly susceptible to significant change, relate to the determination of the allowance for loan losses, deferred income taxes, and the valuation of stock options, and valuation of real estate acquired in connection with foreclosures or in satisfaction of loans. In connection with the determination of the allowance for loan losses and the valuation of foreclosed assets held for sale, management obtains independent appraisals for significant properties.

- 45 -

FORWARD LOOKING STATEMENTS

Except for historical financial information contained herein, the matter discussed in this annual report of the Corporation may be considered “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1993, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended and subject to the safe harbor created by the Private Securities Litigation Reform Act of 1995. Forward-looking statements are subject to risks and uncertainties that may cause actual future results to differ materially. Sentences containing words such as “may”, “will”, “expect”, “anticipate”, “believe”, “estimate”, “should”, “projected” or similar words may constitute forward-looking statement. The Corporation may have used the statements to describe expectations and estimates in various areas, including, but not limited to: changes in the economy of the markets in which it operates: interest rate movements; future acquisitions and growth strategies; system conversions and integration activities; the impact of competitive products, services and pricing; and legislative, regulatory and accounting changes affecting the banking and financial service industry. Actual results could vary materially from the future results covered in forward-looking statements. Factors such as interest rate trends and loan delinquency rates, as well as the general state of the economy in Washington state and the United States as a whole, could also cause actual results to vary materially from the future results anticipated in such forward-looking statements. These factors should be considered in evaluating the forward-looking statements and undue reliance should not be placed on such statements.

- 46 -

AVERAGE BALANCES AND TAX-EQUIVALENT NET INTEREST MARGIN - Table 1

   
Year Ended December 31,
  
   
2006
  
2005
  
2004
  
In Thousands
  
Average
Balance
  
Interest
Income/
Expense
  
Average Rates Earned/
Paid
  
Average
Balance
  
Interest
Income/
Expense
  
Average Rates
Earned/
Paid
  
Average
Balance
  
Interest
Income/
Expense
  
Average
Rates Earned/
Paid
  
Interest Earning Assets
                                      
Taxable investments
  
$
102,488
  
$
4,097
    
4.00
%
$
117,268
  
$
4,586
    
3.91
%
$
154,381
  
$
6,411
    
4.15
%
Nontaxable investments (1)
    
4,872
   
306
   
6.28
%
  
5,810
   
423
   
7.28
%
  
9,438
   
731
   
7.75
%
Total
    
107,360
   
4,403
   
4.10
%
  
123,078
   
5,009
   
4.07
%
  
163,819
   
7,142
   
4.36
%
Federal funds sold
    
28,534
   
1,448
   
5.07
%
  
11,445
   
361
   
3.15
%
  
13,779
   
170
   
1.23
%
Loans (1) (2)
                                                        
Installment
    
60,871
   
5,764
   
9.47
%
  
47,930
   
4,244
   
8.85
%
  
44,111
   
3,626
   
8.22
%
Commercial(1)
    
366,601
   
31,013
   
8.46
%
  
320,923
   
23,364
   
7.28
%
  
287,180
   
18,383
   
6.40
%
Real estate
                
               
               
 
Commercial (1)
    
897,258
   
68,350
   
7.62
%
  
866,647
   
60,468
   
6.98
%
  
831,823
   
56,868
   
6.84
%
Construction
    
1,180,486
   
121,319
   
10.28
%
  
779,364
   
71,155
   
9.13
%
  
564,726
   
43,110
   
7.63
%
Residential
    
226,041
   
18,826
   
8.33
%
  
185,480
   
15,111
   
8.15
%
  
159,688
   
11,718
   
7.34
%
Total
    
2,731,257
   
245,272
   
8.98
%
  
2,200,344
   
174,342
   
7.92
%
  
1,887,528
   
133,705
   
7.08
%
Total earning assets/total interest income
    
2,867,151
   
251,123
   
8.76
%
  
2,334,867
   
179,712
   
7.70
%
  
2,065,126
   
141,017
   
6.83
%
                                                         
Reserve for loan losses
    
(38,766
)
              
(32,031
)
              
(28,908
)
            
Cash and due from banks
    
83,351
               
80,644
               
75,768
             
Other assets
    
129,836
               
85,205
               
69,260
             
                                                         
TOTAL ASSETS
  
$
3,041,572
              
$
2,468,685
              
$
2,181,246
              
                                                         
Interest Bearing Liabilities
                                                        
Money Market, Sweep & NOW accounts
  
$
542,335
    
17,123
   
3.16
%
$
302,497
    
4,195
   
1.39
%
$
249,789
    
1,707
   
0.68
%
Savings accounts
    
374,167
   
8,718
   
2.33
%
  
575,164
   
11,539
   
2.01
%
  
649,678
   
9,246
   
1.42
%
Other time deposits
    
1,063,229
   
47,685
   
4.48
%
  
708,201
   
24,980
   
3.53
%
  
539,784
   
15,465
   
2.87
%
Total interest bearing deposits
    
1,979,731
   
73,526
   
3.71
%
  
1,585,862
   
40,714
   
2.57
%
  
1,439,251
   
26,418
   
1.84
%
                                                         
Short-term borrowings
    
20,089
   
910
   
4.53
%
  
21,614
   
588
   
2.72
%
  
15,400
   
156
   
1.01
%
FHLB borrowings
    
258,991
   
12,195
   
4.71
%
  
221,392
   
10,434
   
4.71
%
  
180,860
   
8,365
   
4.63
%
Subordinated debt
    
4,726
   
311
   
6.58
%
  
-
   
-
   
 
    
-
   
-
   
 
  
                                                         
Total interest bearing
                                                        
liabilities/total
                                                        
interest expense
    
2,263,537
   
86,942
   
3.84
%
  
1,828,868
   
51,736
   
2.83
%
  
1,635,511
   
34,939
   
2.14
%
Noninterest bearing deposits
    
389,945
               
348,737
               
298,711
             
Other liabilities
    
23,722
               
15,979
               
12,481
             
Shareowners' equity
    
364,368
               
275,101
               
234,543
             
TOTAL LIABILITIES AND CAPITAL
  
$
3,041,572
              
$
2,468,685
              
$
2,181,246
              
NET INTEREST INCOME
        
$
164,181
              
$
127,976
              
$
106,078
        
NET YIELD ON INTEREST EARNING ASSETS
                
5.73
%
              
5.48
%
              
5.14
%

(1) Includes amounts to convert nontaxable amounts to a fully taxable equivalent basis at a 35% tax rate.
(2) Includes nonaccruing loans.

- 47 -
 
RATE/VOLUME ANALYSIS OF CHANGES IN NET INTEREST INCOME - Table 2

   
Year ended December 31,
  
   
2006 versus 2005
  
2005 versus 2004
  
2004 versus 2003
  
In Thousands
  
Increase (Decrease) Due
to Change in
  
Increase (Decrease) Due
to Change in
  
Increase (Decrease) Due
to Change in
  
   
Average
Volume
  
Average
Rate
  
Total
Increase
(Decrease)
  
Average
Volume
  
Average
Rate
  
Total
Increase
(Decrease)
  
Average
Volume
  
Average
Rate
  
Total
Increase
](Decrease)
  
INTEREST INCOME
                                      
Taxable investments
    
($578
)
$
89
    
($489
)
  
($1,541
)
  
($284
)
  
($1,825
)
$
659
    
($1,293
)
  
($634
)
Nontaxable investments
    
(68
)
  
(49
)
  
(117
)
  
(281
)
  
(27
)
  
(308
)
  
(837
)
  
(36
)
  
(873
)
                                                         
Total
    
(646
)
  
40
   
(606
)
  
(1,822
)
  
(311
)
  
(2,133
)
  
(178
)
  
(1,329
)
  
(1,507
)
                                                         
Federal funds sold
    
539
   
548
   
1,087
   
(29
)
  
220
   
191
   
(412
)
  
24
   
(388
)
                                                         
Loans
                                                        
Installment
    
1,146
   
374
   
1,520
   
314
   
304
   
618
   
119
   
(225
)
  
(106
)
Commercial
    
3,325
   
4,324
   
7,649
   
2,160
   
2,821
   
4,981
   
796
   
(1,318
)
  
(522
)
Real estate
                                                        
Commercial
    
2,136
   
5,746
   
7,882
   
2,381
   
1,219
   
3,600
   
5,155
   
(4,437
)
  
718
 
Construction
    
36,622
   
13,542
   
50,164
   
16,385
   
11,660
   
28,045
   
7,198
   
(1,390
)
  
5,808
 
Residential
    
3,304
   
411
   
3,715
   
1,893
   
1,500
   
3,393
   
1,760
   
(897
)
  
863
 
                                                         
Total
    
46,533
   
24,397
   
70,930
   
23,133
   
17,504
   
40,637
   
15,028
   
(8,267
)
  
6,761
 
                                                         
TOTAL INTEREST
                                                        
INCOME
    
46,426
   
24,985
   
71,411
   
21,282
   
17,413
   
38,695
   
14,438
   
(9,572
)
  
4,866
 
                                                         
INTEREST EXPENSE
                                                        
Money Market, Sweep &
                                                        
NOW accounts
    
3,326
   
9,602
   
12,928
   
360
   
2,128
   
2,488
   
(188
)
  
(716
)
  
(904
)
Savings accounts
    
(4,032
)
  
1,211
   
(2,821
)
  
(1,060
)
  
3,353
   
2,293
   
1,299
   
(2,643
)
  
(1,344
)
Other time deposits
    
12,523
   
10,182
   
22,705
   
4,825
   
4,690
   
9,515
   
621
   
(1,862
)
  
(1,241
)
                                                         
Total interest bearing deposits
    
11,817
   
20,995
   
32,812
   
4,125
   
10,171
   
14,296
   
1,732
   
(5,221
)
  
(3,489
)
                                                         
Short-term borrowings
    
(41
)
  
363
   
322
   
63
   
369
   
432
   
(22
)
  
19
   
(3
)
FHLB borrowing
    
1,772
   
(11
)
  
1,761
   
1,875
   
194
   
2,069
   
1,208
   
(606
)
  
602
 
Subordinated debt
    
-
   
311
   
311
   
-
   
-
   
-
   
-
   
-
   
-
 
                                                         
TOTAL INTEREST
                                                        
EXPENSE
    
13,548
   
21,658
   
35,206
   
6,063
   
10,734
   
16,797
   
2,918
   
(5,808
)
  
(2,890
)
                                                         
CHANGE IN NET
                                                       
INTEREST INCOME
  
$
32,878
  
$
3,327
  
$
36,205
  
$
15,219
  
$
6,679
  
$
21,898
  
$
11,520
    
($3,764
)
$
7,756
  
 
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 EX-14 5 ex14.htm EXHIBIT 14 Exhibit 14
Exhibit 14
 
7.2 CODE OF ETHICS FOR BUSINESS CONDUCT
 
 
INTRODUCTION
 
Frontier Financial Corporation, and all of its subsidiaries and affiliates, including but not limited to, Frontier Bank, hereinafter referred to as “Frontier” has many important assets, but the most valuable is our established and unquestioned reputation for integrity. As professionals, we are judged by our conduct, and we must act in a manner that merits public trust and confidence. Frontier’s philosophy is to give our customers that “extra something” - be it courtesy, fairness, flexibility, efficiency or professionalism. This special service is reflected in the attitude of all who work for the organization. Because of the nature of the banking business, many people hold us to a higher standard than the general business world. Frontier has adopted this Code of Ethics for Business Conduct to help ensure that it retains its integrity and merits public trust and confidence.

Who Is Responsible? All officers, directors and employees of Frontier, its subsidiaries and its affiliates are responsible for becoming familiar with, following and promoting compliance with this Code. You shall comply with the spirit of these guidelines and not attempt to achieve either directly or indirectly, through the use of agents or other intermediaries, what is forbidden. Frontier’s Corporate Governance Committee of its Board of Directors periodically reviews this Code. This Committee is also charged with administering the Code, enforcing its provisions and ensuring periodic training and acknowledgement of this policy. Also, the Committee will review any new business activities that may require updating of this policy and any other policies as applicable. Frontier Bank’s internal auditors are also involved with the Code of Ethics by monitoring, identifying, protecting, correcting, and ensuring compliance with any and all laws, regulations and internal policies regarding any possible self-serving practices and conflicts of interest that may arise.
 
Guidance for Using This Code. The Code is a general outline of the standard by which all directors, officers and employees of Frontier should conduct themselves. The Code is not intended to cover every applicable law or provide answers to all questions that might arise. It is a part of the policies and procedures governing all of us at Frontier. You should read this Code carefully, and if you have any questions, they should be directed to the Executive Vice President of Human Resources. The Code is not intended to and does not in any way constitute an employment contract or assurance of continued employment, and does not create any rights for any director, officer, employee, client, supplier, competitor, shareowner or any other person or entity.

In most situations, our personal values and integrity will guide us to the right decision. However, we must always keep in mind how our actions affect the credibility of our organization as a whole. For this reason, our business ethics must reflect the values and standards of conduct outlined in this Code. We encourage each employee to ask questions, seek guidance and express any concerns they may have. When in doubt, employees should ask themselves the following questions:

 
·
Is my action legal? If legal, is it also ethical?

 
·
Are my actions honest in every respect?

 
·
Would I be proud to read about my action in the newspaper?

 
·
Can I defend my action with a clear conscience?

 
·
Would it be helpful to ask for guidance before taking any action?
 
   
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7.2 Code of Ethics for Business Conduct
 

7.2 CODE OF ETHICS FOR BUSINESS CONDUCT (CONT.)
 
 
 
·
Is it the right thing to do?

 
·
How would my friends, family, customers, other employees, community, regulators and shareholders react to my actions?

If your answers to these questions are troubling in any respect, it may be that whatever you are considering is the wrong course of action. Call the Executive Vice President of Human Resources with any questions.

This Code replaces any editions previously provided to you and your adherence to this Code is required to the same extent as you previously had agreed.

Message to Managers. While ethical conduct is expected at all levels of Frontier, individuals in executive and management roles should exemplify the highest standards of such conduct. As role models for the entire organization, you are expected to provide leadership to others to appropriately apply our ethical standards to everyday behavior, communications and conduct.
 
STANDARDS OF CONDUCT
 
Employees are expected to uphold the image of Frontier at all times. Professional conduct is imperative to our success. The following behaviors are examples of what is not in accordance with our ethics policy: use of abusive or threatening language, harassment of any kind, consumption of drugs/alcohol during business hours or performing duties under the influence of drugs/alcohol, and threatening or violent behavior. Unprofessional behaviors such as these will be addressed and action taken, which may include termination of employment.
 
CONFLICTS OF INTEREST
 
You have a duty of loyalty to Frontier and must therefore avoid any actual or apparent conflict of interest with Frontier or its customers. A conflict situation can arise if you take action or have an interest that may make it difficult to perform your work objectively and effectively. Conflicts of interest may also arise if you or a family member receives improper personal benefits as a result of your position with Frontier.

Corporate Opportunities. You may not (a) take for yourself personally opportunities that are discovered through the use of Frontier’s property, information or your position; (b) use Frontier’s property, information or position for personal gain; or (c) compete with Frontier. You owe a duty to Frontier to advance the company’s legitimate interests when the opportunity to do so arises. Without prior approval, you are not permitted to participate with customers or suppliers in business ventures, serve or act as a director, agent, broker or representative of any for-profit company or organization. Call the Executive Vice President of Human Resources to inquire about obtaining this approval.

Gifts or Requests. Federal law makes it a criminal offense for you (1) to solicit for yourself or for a third party (other than Frontier) anything of value from anyone in return for any business, service or confidential information about Frontier or (2) to accept anything of value (other than authorized compensation) from anyone in connection with the business of Frontier, either before or after a transaction is discussed or consummated. Any gift or gratuity from present or former customers, suppliers or shareowners should be declined to avoid any appearance of impropriety or undue influence, with the following exceptions:

 
·
Ordinary business meals or entertainment (sporting events, shows, etc.);

 
·
Modest holiday gifts;

 
·
Gifts based upon a family relationship or close personal relationship pre-dating your involvement with Frontier;
 
   
0715/06
7.2 Code of Ethics for Business Conduct
 
 
7.2 CODE OF ETHICS FOR BUSINESS CONDUCT (CONT.)
 
 
 
·
Acceptance of loans from other banks or financial institutions on terms generally available to the public at large; or

 
·
Acceptance of discounts or rebates on merchandise or services on terms generally available to the public at large or on terms generally available to Frontier employees.

These permissible gifts or gratuities should only be accepted when it is clear the donor is not trying to exert any influence over you or receive special treatment from you or Frontier in connection with a transaction involving Frontier. It is also important that the gift or gratuity is unsolicited. Frontier recognizes that the refusal of such gifts or gratuities may potentially damage relationships. In these situations employees should consult with the Executive Vice President of Human Resources regarding the appropriateness of exceptions. Exceptions are occasionally made allowing or encouraging employees to attend events or speaking engagements that exceed the policy if significant customers, investors, investment bankers, charities or vendors sponsor an event or if attendance at an event is important to maintaining Frontier’s relationship with that individual or group. Expenses may also be reimbursed for these activities. Generally, however, gifts or gratuities are to be limited to a nominal value. Cash or checks cannot be accepted regardless of the amount.

If you become aware that you are a beneficiary of a gift or bequest under a will or trust agreement of a customer or former customer, supplier or shareowner (other than someone related by blood or marriage), you should promptly report it to the Manager of Frontier Bank’s Trust Department and take all reasonable steps to have the will or trust instrument amended to remove yourself as a beneficiary. Likewise, you may not accept a bequest or devise from a customer or former customer, supplier or shareholder without prior written approval of the Manager of Frontier Bank’s Trust Department.

Transactions. While performing your duties for Frontier, you are not to handle transactions or any part thereof, where your personal interest might take, or appear to take, precedence over the best interests of Frontier. Employees will not process any transaction for themselves, for members of their family, or handle any part of an account where they might have a personal interest or serve as a signer. Loan Officers will not approve and/or process loan transactions for any family member, or derive any personal benefit from loan proceeds. Any leases between a director, officer or employee and Frontier must be approved by the Board of Directors.

All employee accounts are subject to random review and audit. Check kiting is an illegal practice and will not be tolerated by any Frontier employee. Kiting is a practice in which checks are drawn against uncollected or nonexistent funds and are covered by depositing a check from a like account drawn on a second bank. This occurs before the original check is presented for payment at Frontier.

Kiting, and any other illegal or fraudulent acts, as well as inappropriate handling of the types of transactions listed above, are grounds for immediate termination of employment.

Investments. You should avoid any substantial investment in the business of a customer, supplier or competitor unless the security is publicly traded on a national exchange and there is no possibility for a conflict of interest. You should also avoid any investment in an initial public offering of any company if one of the underwriters or other investment banks involved in the offering is providing, has provided, or may likely provide in the future, products or services to, or for, Frontier. You should make personal investments with prudence and avoid situations which might influence one’s business judgment or advice. In no event should you use confidential or proprietary information or work product developed or acquired during the course of your employment as a means for making any personal gain.

   
0715/06
7.2 Code of Ethics for Business Conduct
 

7.2 CODE OF ETHICS FOR BUSINESS CONDUCT (CONT.)
 
 
Employment. Regulations prohibit any individual from becoming or continuing to serve as a director, officer, or employee of Frontier if they have been removed from office or prohibited from participating in any manner in the conduct of the affairs of a financial institution. Further, no individual may serve in any capacity at Frontier if they have been charged in any information, indictment or complaint for a crime involving dishonesty, breach of trust, or money laundering which is punishable by imprisonment for a term exceeding one year under state or federal law; or has agreed to enter into a pretrial diversion or similar program in connection with a prosecution for such offense.

For our full-time employees, outside employment is strongly discouraged. For all Frontier employees, it is a conflict of interest if you have outside employment that interferes with your Frontier responsibilities or affects your ability to perform your duties properly. Directors, officers and employees are prohibited from serving or working for two different banks at the same time. Any employment activity, which is in competition with Frontier, must be avoided. Frontier reserves the right to prohibit full or part-time employees from engaging in outside employment where it might subject Frontier to criticism or might interfere with your employment at Frontier. You must receive prior approval from your Manager and the Executive Vice President of Human Resources of any outside employment in which you are presently engaged or desire to accept while employed by Frontier on a full or part-time basis. After notification, the Executive Vice President of Human Resources will advise you if there is a potential problem.

Any bank officer or director that serves concurrently as an officer or director of a public utility shall not participate in any deliberations or decision involving the selection of any bank or securities underwriting/marketing firm if Frontier is one of the institutions under consideration.

No director, officer or employee will be granted an employment contract, compensation or benefit agreement, fee arrangement or perquisite, stock option plan, post employment benefit or other compensatory agreement that would provide him or her with excessive compensation fees or benefits. Frontier may prohibit or limit by regulation or order, any golden parachute payment or indemnification payment.

Recommendation of Professionals or Products. When a recommendation is requested from you by customers or business partners of Frontier for their own use or by other employees, officers or directors of Frontier for use by Frontier regarding professional services such as accountants, attorneys, investment bankers, realtors, or insurance agents or regarding products to be leased or purchased, you should not recommend any specific professional, supplier or product unless in every case:

 
·
You provide several professionals or products without indicating any favoritism;

 
·
You are familiar with the work and competence of all of the professionals you name and are satisfied that they are competent and ethical;

 
·
You are familiar and satisfied with the quality of all the products and services you name; and

 
·
You believe your recommendation will reflect positively upon Frontier.

You should avoid recommending a professional, supplier or product if you or a family member receives improper personal benefits as a result of your recommendation. You should disclose any such relationships to the party requesting the recommendation and report any possible personal benefits that you or a family member may receive as a result of your recommendation to the Executive Vice President of Human Resources.

Civic and Charitable Activities. Before you become a director or trustee of an outside not-for-profit organization, you must first notify your supervisor for approval if any of the volunteer work were to occur during normal working hours. Volunteer work and participation in worthwhile and responsible civic and not-for-profit organizations are encouraged, provided it does not unduly interfere with your employment, pose a conflict of interest with your duties and responsibilities to Frontier or its customers, or impair your ability to perform your own work at Frontier.
 
   
0715/06
7.2 Code of Ethics for Business Conduct
 

7.2 CODE OF ETHICS FOR BUSINESS CONDUCT (CONT.)
 
 
Politics. Frontier Financial Corporation or its subsidiaries is prohibited from engaging in politics; however, understands that you may participate in political activities through contributions of time or money in your individual capacity unless you are restricted by applicable securities or other laws, rules or regulations or the requirements of any other regulatory authority. Prior approval, however, must be obtained before you accept appointment or nomination to any public office or before you become a candidate for the same. Call the Executive Vice President of Human Resources to inquire about obtaining this approval.

Other Activities. Without prior approval, you may not act as:

 
·
Agent, deputy or in any signing capacity on any account of another (except for members of your family or a civic or charitable association of which you are a member); or

 
·
A fiduciary under a will or trust agreement of another not related by blood or marriage.

Call the Executive Vice President of Human Resources to inquire about obtaining this approval.
 
BUSINESS CONDUCT
 
You should endeavor to deal honestly, ethically, fairly and in good faith with Frontier’s customers, shareowners, employees, suppliers, regulators, business partners, competitors and others. You may not take unfair advantage of anyone through manipulation, concealment, abuse of privileged or confidential information, misrepresentation, fraudulent behavior or any other unfair dealing practice.

Compliance With Laws, Rules, Regulations. You must conduct yourself at Frontier, and at all of its functions or when acting on its behalf, in a manner which is in full compliance with all applicable laws, rules and regulations, as well as with all of Frontier’s other policies and procedures. Activity or behavior, which would be criminally or civilly actionable, is deemed not to be in compliance. The Executive Vice President of Human Resources should be consulted when appropriate. In no case shall an employee, officer or director use illegal (theft, bribery, misrepresentation, or espionage) or unethical means or methods when acting on behalf of Frontier.

Company Reporting. It is of critical importance that Frontier’s filings with the Securities and Exchange Commission, banking regulators and other regulatory agencies and authorities as well as its other public communications be full, fair, accurate, timely and clear. Frontier has created a Corporate Governance Committee and adopted Corporate Governance Committee Guidelines to govern these filings and disclosures. Depending on your position with Frontier, you may be called upon to provide necessary information to assure that Frontier’s filings and public reports meet these standards. Frontier expects employees, officers and directors to take this responsibility very seriously and to provide prompt, accurate answers to inquiries from the Corporate Governance Committee related to Frontier’s filing and public disclosure requirements.

Auditors, Examiners and Legal Counsel. You may be called upon to respond to our auditors (either in-house or from outside the bank), examiners and/or regulators who come into Frontier, or legal counsel, who you may work with or respond to on a variety of different issues. It is vital that you respond to these people in an open, candid and honest manner. Also, any information and/or documentation requested by these individuals should be responded to in a quick, complete, honest
 
   
0715/06
7.2 Code of Ethics for Business Conduct
 

7.2 CODE OF ETHICS FOR BUSINESS CONDUCT (CONT.)
 
 
and straightforward manner. This applies to everyone associated with Frontier, including directors, officers, employees and contractors. If you have any questions or concerns, contact the Executive Vice President of Human Resources for assistance.

Books and Records. Frontier’s books, records and accounts shall accurately and fairly reflect the transactions of Frontier in reasonable detail and in accordance with Frontier’s accounting practices and policies.

For example:

a.   No false or deliberately inaccurate entries (such as overbilling) shall be made for any reason. Discounts, rebates, credits and allowances do not constitute overbilling when lawfully granted; the reasons for the grant should be documented in writing in Frontier’s records, including the party requesting the treatment.

b.   No payment shall be made with the intention or understanding that all or any part of it is to be used for any purpose other than that described by the documents supporting the payment.

c.   No undisclosed or unrecorded funds or assets shall be established for any purpose unless permitted by applicable laws, rules and regulations and applicable accounting guidelines.

d.   No false or misleading statements, written or oral, shall be made to any internal or external accountant, auditor, attorney or other representative with respect to preparation of Frontier’s financial statement or documents to be filed with the Securities and Exchange Commission, banking regulators or other governmental authorities or regulatory bodies.

Questionable or Improper Payments. The use of any funds or assets of Frontier or subsidiaries for any unlawful or improper gifts, payments to customers, government employees or other third parties is strictly prohibited.

Foreign Corrupt Practices Act (“FCPA”). The FCPA broadly prohibits U.S. firms and persons from offering money or “anything of value” to any foreign government official for the purpose of influencing such official. The consequences of violating the FCPA are extremely severe, including possible civil and criminal penalties for both Frontier and individuals. In the United States, nothing of value (for example, gifts or entertainment) may be provided to government personnel unless clearly permitted by law and any applicable regulation.

Therefore, no payment from Frontier’s funds or assets shall be made to or for the benefit of a representative of any domestic or foreign government (or subdivision thereof), labor union, or any current or prospective customer or supplier for the purpose of improperly obtaining a desired government action, or any sale, purchase, contract or other commercial benefit. This prohibition applies to direct or indirect payments made through third parties and employees as well as is intended to prevent bribes, kickbacks or any other form of payoff.

Under the FCPA, so-called “facilitating payments” made in foreign countries to low-level government employees may be permissible in certain circumstances. All such payments must be pre-authorized by the Chief Executive Officer or President of Frontier Bank.

Competition. Any business activities which involve any of our competitors should be conducted cautiously. Agreements between competitors relating to prices or allocations of territories or customers are unlawful. When banking relationships involve loan participants and the like, discussions should be limited to the specific transaction involved. Competitive marketing and bidding activities should be fair and ethical.

Protection and Proper Use of Company Assets. Company assets, such as information, materials, supplies, time, intellectual property, software, hardware, and facilities, among other property, are valuable resources owned, licensed, or otherwise belonging to Frontier. You are expected to treat the property of Frontier with care and should not remove it from Company premises without a supervisor’s approval. Unauthorized removal of assets or supplies will be considered theft and subject to termination of employment and possible prosecution. Frontier’s property should only be used for legitimate business purposes. Any work product of any employee is the property of Frontier if it is the result of work performed while at work or with company property.
 
   
0715/06
7.2 Code of Ethics for Business Conduct
 

7.2 CODE OF ETHICS FOR BUSINESS CONDUCT (CONT.)
 
 
All written communication, including via e-mail, should reflect the professional and ethical standards of Frontier at all times. Utilization of company stationary by any employee must be for official business. Stationary and postage are not to be used for personal matters. No employee should present himself or herself as a representative of Frontier for any purpose other than company business. Occasional reasonable personal use of the bank’s e-mail and/or internet access by authorized users is permissible.

All assets of Frontier are to be protected from loss. Any assets not receiving full book value must be approved by your supervisor before a writedown of the asset is performed. Any significant compromise of debt or forgiveness of interest must by approved be the CEO or the appointed designate.

Employees and their immediate families, whether acting individually or in a fiduciary capacity, are not permitted to sell assets to, or purchase assets from the company without prior consent by the appropriate officer. Exceptions to this rule are assets being offered at a public sale or public auction, or the purchase or sale has been approved by a court of competent jurisdiction.
 
BACKGROUND CHECKS
 
Frontier Bank may apply various pre-employment background screening tools when considering individuals for employment. The screening tools used will be at the discretion of the bank and may require the authorization of those individuals seeking employment with the bank. Also, contractors may be subject to the background screening process and therefore, may need to submit requested authorizations to the bank in order to continue or be considered for employment at the bank.
 
CONFIDENTIAL AND PROPRIETARY INFORMATION
 
You have an obligation to maintain the confidentiality of information entrusted to you by Frontier, its business partners, suppliers, customers or others related to Frontier’s business and subsidiaries. Confidential or proprietary information may not be disclosed to others except when disclosure is authorized by Frontier or is legally required.
 
What Constitutes Confidential Information? All oral and written communications relating to Frontier, or its customer, suppliers, shareowners and other employees of Frontier, which you acquire during the scope of your employment and which is not otherwise available to the general public constitutes confidential information. This includes not only information you acquire from third parties but also any work product you generate as an officer, director or employee of Frontier including, customer and prospect lists and computer programs. You should assume that any such work product or materials are confidential information subject to the policies and restrictions on use and disclosure outlined in this Code and in our Confidentiality Agreement.

What Constitutes Proprietary Information? Certain types of information may not be confidential but may still be proprietary property of Frontier. You acknowledge that while employed by Frontier all work products that you produce are and shall remain the sole and exclusive property of Frontier. Even though information, such as customer and prospect names, presentation materials, marketing materials, product information, business methods or processes, may otherwise be available to the general public, it remains the property of Frontier and individual employees shall have no personal rights to such information or products either during or after employment with Frontier.
 
   
0715/06
7.2 Code of Ethics for Business Conduct
 
 
7.2 CODE OF ETHICS FOR BUSINESS CONDUCT (CONT.)
 
 
Customer/Supplier Information. You also have an obligation to keep confidential any information acquired with respect to present, past or prospective customers, suppliers, shareholders and other employees of Frontier and subsidiaries. Any such information shall be used solely for banking or corporate purposes and shall under no circumstances be revealed to unauthorized persons, whether within or outside of Frontier. Aside from routine credit and personal inquires, information concerning a customer, employee, shareowner or a business transaction may be revealed only with the consent of the individual or entity involved, or pursuant to proper subpoena, court order or other legal process.

Data Security. It is the policy of Frontier to protect its systems and data by controlling access to such systems and data through our Information and Technical Services Department. This department, which is segregated from users and programming areas, establishes documents and administers data security policies, procedures and controls, and access to Frontier systems and data must be authorized accordingly.

You acknowledge that Frontier’s data processing systems and data are private and confidential, and you may only access or update the systems and data according to the authority given to you. Any unauthorized access, update or use of Frontier’s systems or data is strictly prohibited. Furthermore, you acknowledge your responsibility to protect the integrity of all systems and data for which you are authorized to access or update, and you will only divulge information related to such systems or data to those having an authorized business requirement. You will not compromise access to such systems or data by communicating your user identification and/or password to anyone.

You will report all violations or suspected violations of this policy immediately by either calling Ethics Point at (800) 868-8393 or going to the website www.ethicspoint.com.

Records Retention. You are expected to become familiar with Frontier’s policies regarding records retention and to strictly adhere to those procedures as outlined in the policies.
 
VIOLATION OF THE CODE OF ETHICS FOR BUSINESS CONDUCT
 
Your Duty to Report. You have a duty to adhere to this Code of Ethics for Business Conduct and all other existing company policies and to report to Frontier any suspected violations by yourself or any other employee, officer or director of Frontier. You should report violations of this Code by either calling Ethics Point at (800) 868-8393 or going to the website www.ethicspoint.com. Your report will be dealt with anonymously and confidentially.

Response to Reports. Frontier will investigate any matter so reported and, upon a determination by the Corporate Governance Committee of its Board of Directors (or a panel designated by such committee) or upon a determination by the Audit Committee (for actions by senior financial officers) that a violation has occurred, will take appropriate disciplinary and corrective action, up to and including termination. Frontier forbids retaliation against employees, officers or directors who report violations of this Code of Ethics for Business Conduct in good faith (except for any disciplinary action as determined above for self-reported violations).

Questions? When you have a question about this Code applying to a particular situation, employees are encouraged to contact Ethics Point for further discussion.
 
WAIVERS
 
Any waivers of this Code for executive officers (Chief Executive Officer, President, Chief Financial Officer, Secretary/Treasurer and others) or directors may be made only by the Board of Directors of Frontier Financial Corporation upon the recommendation of its Corporate Governance Committee, and must be promptly filed and/or disclosed to the public as required by all applicable securities or other laws, rules or regulations or the requirements applicable to Nasdaq National Market issuers or such other exchange or system upon which Frontier’s securities (stock symbol FTBK) are listed, quoted or traded. Any waivers of this Code for other personnel may be made by the Executive Vice President of Human Resources.
 
   
0715/06
7.2 Code of Ethics for Business Conduct
 
 
EX-21 6 ex21.htm EXHIBIT 21 Exhibit 21
Exhibit 21

SUBSIDIARIES

The subsidiaries of the Corporation as of December 31, 2006 are as follows: 
 
Name of Subsidiary
  
Jurisdiction of Incorporation
     
Frontier Bank
  
Washington
 
    
FFP, Inc.
  
Washington
 
 
EX-23.1 7 ex23_1.htm EXHIBIT 23.1
Exhibit 23.1
 
 
CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors
Frontier Financial Corporation

We consent to the incorporation by reference in Registration Statement Numbers 333-48805, 333-73217, 333-54362, 333-37242, 333-50882, 333-132487 and 333-136298 on Forms S-8 of Frontier Financial Corporation, of our report dated February 27, 2007, with respect to the consolidated balance sheet of Frontier Financial Corporation as of December 31, 2006 and December 31, 2005, and the related consolidated statements of income, shareowners’ equity and cash flows for the three years ended December 31, 2006, and in our same report, with respect to Frontier Financial Corporation, management’s assessment of the effectiveness of internal control over financial reporting and the effectiveness of internal control over financial reporting, which is included in the annual report on Form 10-K of Frontier Financial Corporation, for the year ended December 31, 2006.


/s/ Moss Adams LLP

Everett, Washington
February 27, 2007
 
 
EX-31.1 8 ex31_1.htm EXHIBIT 31.1 Exhibit 31.1
Exhibit 31.1

CERTIFICATION OF CHIEF EXECUTIVE OFFICER


I, John J. Dickson, certify that:

 
1.
I have reviewed this annual report on Form 10-K of Frontier Financial Corporation;

 
2.
Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

 
3.
Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

 
4.
The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal controls over financial reporting (as defined in Exchange Act rules 13a-15(f) and 15d-15(f)) for the registrant and we have:

 
(a)
designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

 
(b)
designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

 
(c)
evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

 
(d)
disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonable likely to materially affect, the registrant’s internal control over financial reporting; and

 
5.
The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the Audit Committee of registrant’s Board of Directors (or persons performing the equivalent functions):

 
(a)
all significant deficiencies and material weaknesses in the design or operation of internal controls over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

 
(b)
any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls over financial reporting.


Date: February 27, 2007
  
/s/ John J. Dickson
  
   
President and Chief Executive Officer
  
   
(Principal Executive Officer)
  
 
 
 EX-31.2 9 ex31_2.htm EXHIBIT 31.2 Exhibit 31.2
Exhibit 31.2

CERTIFICATION OF CHIEF FINANCIAL OFFICER


I, Carol E. Wheeler, certify that:

 
1.
I have reviewed this annual report on Form 10-K Frontier Financial Corporation;

 
2.
Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

 
3.
Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

 
4.
The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal controls over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and we have:

 
(a)
designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

 
(b)
designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

 
(c)
evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

 
(d)
disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonable likely to materially affect, the registrant’s internal control over financial reporting; and

 
5.
The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the Audit Committee of registrant’s Board of Directors (or persons performing the equivalent functions):

 
(a)
all significant deficiencies and material weaknesses in the design or operation of internal controls over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

 
(b)
any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls over financial reporting.


Date: February 27, 2007
  
/s/ Carol E. Wheeler
  
   
Chief Financial Officer
  
   
(Principal Financial Officer)
  
 
 
EX-32 10 ex32.htm EXHIBIT 32 Exhibit 32
Exhibit 32

CERTIFICATION PURSUANT TO
18 U.S.C. SECTION 1350,
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Annual Report of Frontier Financial Corporation (the “Corporation”) on Form 10-K for the fiscal year ending December 31, 2006 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, John J. Dickson, Chief Executive Officer of the Corporation, and Carol E. Wheeler, Chief Financial Officer of the Corporation, certify, pursuant to 18 U.S.C. § 1350, as adopted pursuant to § 906 of the Sarbanes-Oxley Act of 2002, that to our knowledge:

1)
The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934, 15 U.S. C. § 78m or 78o(d); and

2)
The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Corporation.


/s/ John J. Dickson
  
/s/ Carol E. Wheeler
John J. Dickson
  
Carol E. Wheeler
President Chief Executive Officer
  
Chief Financial Officer

February 27, 2007
 
 
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