UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)
x	Quarterly Report Pursuant to Section 13 or 15(d) of The Securities Exchange Act of 1934
	For the quarterly period ended………………March 31, 2007

	OR

o	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 005-57091

FIRST MUTUAL BANCSHARES, INC.

(Exact name of registrant as specified in its charter)

WASHINGTON (State or other jurisdiction of incorporation or organization)	91-2005970 (I.R.S. Employer Identification Number)

400 108th Avenue N.E., Bellevue, WA (Address of principal executive offices)	98004 (Zip code)

Registrant’s telephone number, including area code: (425) 453-5301

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 x No o

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

Large accelerated filer o

Accelerated filer x

Non-accelerated filer o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date. May 7, 2007 6,690,776

FIRST MUTUAL BANCSHARES, INC.

QUARTERLY REPORT ON FORM 10-Q

March 31, 2007

TABLE OF CONTENTS

	Page

PART I: FINANCIAL INFORMATION	1
Forward-Looking Statements Disclaimer	1
ITEM 1. Financial Statements	1
ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	21
General	21
Overview	21
Results of Operations	22
Net Income	22
Net Interest Income	22
Noninterest Income	25
Noninterest Expense	28
Financial Condition	31
Adoption of SFAS No. 157 and 159	34
Asset Quality	36
Portfolio Information	37
Deposit Information	42
Business Segments	43
Retail Banking	45
Sales Finance	46
Residential Lending	46
Business Banking Lending	47
Income Property Lending	48
Investments and Treasury	49
Liquidity	50
Capital	52
Subsequent Events	53
ITEM 3. Quantitative and Qualitative Disclosures About Market Risk	54
ITEM 4. Controls and Procedures	60
PART II: OTHER INFORMATION	60
ITEM 1. Legal Proceedings	60
ITEM 1A. Risk Factors	60
ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds	60
ITEM 3. Defaults Upon Senior Securities	60
ITEM 4. Submission of Matters to a Vote of Security Holders	60
ITEM 5. Other Information	61
ITEM 6. Exhibits	62
SIGNATURES	63
CERTIFICATIONS

PART I:

FINANCIAL INFORMATION

FORWARD-LOOKING STATEMENTS DISCLAIMER

Our Form 10-Q for the quarter ended March 31, 2007, contains statements concerning forecasts of our financial results and condition, expectations of our operations and business and our assumptions for those forecasts and expectations that are forward-looking statements for the purposes of the safe harbor provisions under the Private Securities Litigation Reform Act of 1995. Such forward-looking statements include statements regarding our forecasts and expectations with respect to our target net income and return on equity; as well as references to potential changes in interest rate margins, anticipated growth in sales of loans and securities and in servicing assets, our intentions regarding our Business Banking segment and other segments, observations regarding our loan collections and provision for loan losses, information regarding our intentions to move away from offering rates competitive with higher rates in our area and the effects of such a move, our intent to refinance our trust preferred debenture, information regarding the possible effects of hedging our trading portfolio and information based on our market risk models and analysis. Although we believe that the expectations expressed in these forward-looking statements are based on reasonable assumptions within the bounds of our knowledge of our business, operations, and prospects, these forward-looking statements are subject to numerous uncertainties and risks, and actual events, results, and developments will ultimately differ from the expectations and may differ materially from those expressed or implied in such forward-looking statements. Factors which could affect actual results include economic conditions in our market area and the nation as a whole, interest rate fluctuations, the impact of competitive products, services, and pricing, our credit risk management, our ability to control our costs and expenses, and the legislative and regulatory changes affecting the banking industry. There are other risks and uncertainties that could affect us which are discussed from time to time in our filings with the Securities and Exchange Commission. These risks and uncertainties should be considered in evaluating the forward-looking statements, and undue reliance should not be placed on such statements. We are not responsible for updating any such forward-looking statements.

ITEM 1.

Financial Statements

In the opinion of management, the accompanying consolidated statements of financial condition and related interim consolidated statements of income, comprehensive income, stockholders’ equity and cash flows reflect all adjustments (which include reclassifications and normal recurring adjustments) that are necessary for a fair presentation in conformity with accounting principles generally accepted in the United States of America (“GAAP”). The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect amounts reported in the financial statements. Changes in these estimates and assumptions are considered reasonably possible and may have a material impact on the financial statements.

Certain reclassifications have been made to the 2006 financial statements to conform to the 2007 presentation. There is no effect on net income, earnings per share, or equity. All significant intercompany transactions and balances have been eliminated.

The information included in this Form 10-Q should be read in conjunction with the First Mutual Bancshares, Inc. Year 2006 Annual Report on Form 10-K to the Securities and Exchange Commission. Interim results are not necessarily indicative of results for a full year.

Consolidated Financial Statements of the Company begin on page 2.

Item 1. Financial Statements

FIRST MUTUAL BANCSHARES, INC.

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

(Dollars in thousands)

	March 31,			December 31,
	2007			2006
Assets	(Unaudited)

Cash and Cash Equivalents:
Interest-earning deposits	$	3,557		$	6,990
Noninterest-earning demand deposits and cash on hand		13,385			18,372

Total cash and cash equivalents		16,942			25,362

Mortgage-backed and other securities available-for-sale (at fair value)		4,589			89,728
Mortgage-backed and other securities held for trading (at fair value)		86,733			—
Mortgage-backed and other securities held-to-maturity
fair value of $5,176 and $5,585		5,208			5,620
Loans held for sale		20,915			13,733
Loans receivable		870,707			893,431
Reserve for loan and lease losses		(9,773	)		(9,728	)
Loans receivable, net		860,934			883,703

Accrued interest receivable		5,585			5,534
Land, buildings and equipment, net		35,696			35,566
Federal Home Loan Bank (FHLB) stock, at cost		13,122			13,122
Servicing assets		4,608			4,011
Other assets		2,515			2,884

Total Assets	$	1,056,847		$	1,079,263

See Notes to the Financial Statements

FIRST MUTUAL BANCSHARES, INC.

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

(Dollars in thousands)

(Continued)

	March 31,			December 31,
	2007			2006
	(Unaudited)
Liabilities
Deposits:
Non-interest-bearing	$	56,022		$	56,566
Interest-bearing transactions and savings accounts		275,997			263,830
Interest-bearing time deposits		439,640			485,399

Total deposits		771,659			805,795

Drafts payable		911			1,314
Accounts payable and other liabilities		9,600			7,018
Advance payments by borrowers for taxes and insurance		2,601			1,583
FHLB advances		178,067			171,932
Other advances		4,600			4,600
Junior subordinated long-term debentures (at fair value)		9,044			9,000
Junior subordinated long-term debentures		8,000			8,000

Total liabilities		984,482			1,009,242

Stockholders’ Equity
Common stock, $1 par value, 30,000,000 shares authorized,
6,687,975 and 6,673,528 shares issued and outstanding	$	6,688		$	6,674
Additional paid-in capital		45,538			45,119
Retained earnings		20,148			19,589
Accumulated other comprehensive income(loss):
Unrealized (loss) on securities available-for-sale,
net of federal income tax		(9	)		(1,361	)

Total stockholders’ equity		72,365			70,021

Total Liabilities and Stockholders’ Equity	$	1,056,847		$	1,079,263

See Notes to the Financial Statements

FIRST MUTUAL BANCSHARES, INC.

CONSOLIDATED STATEMENTS OF INCOME

(Dollars in thousands)

	Quarter ended March 31,
	2007			2006

	(Unaudited)
Interest Income
Loans receivable	$	18,500		$	17,547
Interest on available-for-sale securities-taxable		54			1,193
Interest on held-to-maturity securities-taxable		61			74
Interest on held-to-maturity securities-non taxable		16			16
Interest on held-for-trading securities-taxable		833			—
Interest on held-for-trading securities-non taxable		112			—
Interest other		206			118

Total interest income		19,782			18,948

Interest Expense
Deposits		7,710			5,916
FHLB and other advances		2,721			2,801

Total interest expense		10,431			8,717

Net interest income		9,351			10,231

Provision for loan and lease losses		(152	)		(71	)

Net interest income, after provision
for loan and lease losses		9,199			10,160

Noninterest Income
Gain on sales of loans		973			756
Gain from mark to market (SFAS No. 159)		447			—
Servicing fees, net of amortization		437			335
Fees on deposits		188			182
Other		618			442

Total noninterest income		2,663			1,715

See Notes to the Financial Statements

FIRST MUTUAL BANCSHARES, INC.

CONSOLIDATED STATEMENTS OF INCOME

(Dollars in thousands except per share amounts)

(Continued)

	Quarter ended March 31,
	2007		2006
	(Unaudited)



Noninterest Expense
Salaries and employee benefits	$	4,509	$	4,446
Occupancy		982		1,010
Credit insurance premiums		426		463
Other		1,819		1,769

Total noninterest expense		7,736		7,688

Income before provision for federal income tax		4,126		4,187

Provision for federal income tax		1,411		1,473


Net Income	$	2,715	$	2,714

Per Share Data(1):

Basic earnings per common share	$	0.41	$	0.41

Diluted earnings per common share	$	0.39	$	0.40


Weighted Average Number of Shares Outstanding		6,682,000		6,627,298

Weighted Average Number of Shares Outstanding
Including Dilutive Stock Options		6,933,269		6,758,785

(1)	Shares and EPS have been adjusted to reflect the five-for-four stock split paid on October 4, 2006.

See Notes to the Financial Statements

First Mutual Bancshares, Inc. and Subsidiaries

Consolidated Statements of Stockholders’ Equity and Comprehensive Income

(Dollars in thousands except per share amounts)

													Accumulated
							Additional						Comprehensive
	Common Stock (1)						Paid-in			Retained			Income
	Shares			Amount			Capital (1)			Earnings			(Loss)			Total



BALANCE, December 31, 2004		6,611		$	6,611		$	44,273		$	9,220		$	(657	)	$	59,447


Comprehensive income:
Net income											10,319						10,319
Other comprehensive income (loss), net of tax:
Unrealized (loss) on securities available-for-sale														(945	)		(945	)
Unrealized gain on interest rate swap														166			166
Total comprehensive income																	9,540
Options exercised, including tax benefit of $479		185			185			1,727									1,912
Retirement of shares repurchased		(180	)		(180	)		(2,130	)		(1,344	)					(3,654	)
Issuance of stock through employees’ stock plans		5			5			95									100
Cash dividend declared ($1.11 per share)											(7,318	)					(7,318	)
																	—
BALANCE, December 31, 2005		6,621		$	6,621		$	43,965		$	10,877		$	(1,436	)	$	60,027

Comprehensive income:
Net income											10,980						10,980
Other comprehensive income (loss), net of tax:
Unrealized gain on securities available-for-sale														75			75
Total comprehensive income																	11,055
Compensation related to stock options								633									633
Options exercised, including tax benefit of $110		48			48			427									475
Issuance of stock through employees’ stock plans		5			5			95									100
Cash in lieu of shares issued for 5 for 4 stock split					—												—
Cash dividend declared ($0.32 per share)											(2,268	)					(2,268	)
																	—
BALANCE, December 31, 2006		6,674		$	6,674		$	45,120		$	19,589		$	(1,361	)	$	70,022

Cummulative-effect adjustment for the initial adoption of SFAS No. 159											(1,554	)					(1,554	)

Comprehensive income:
Net income											2,715						2,715
Other comprehensive income, net of tax:
Unrealized gain on securities available-for-sale														1,352			1,352
Total comprehensive income																	4,067
Compensation related to stock options								184									184
Options exercised, including tax benefit of $37		9			9			120									129
Issuance of stock through employees’ stock plans		5			5			114									119
Cash dividend declared ($0.09 per share)											(602	)					(602	)
																	—
BALANCE, March 31, 2007		6,688		$	6,688		$	45,538		$	20,148		$	(9	)	$	72,365

(1)	The number and amount of common shares issued and outstanding have been adjusted to reflect the five-for-four stock split paid on October 4, 2006.

FIRST MUTUAL BANCSHARES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in thousands)

	Three months ended March 31,
	2007			2006
	(Unaudited)
Cash Flows from Operating Activities
Net income	$	2,715		$	2,714
Adjustments to reconcile net income to net cash from operating activities:
Provision for loan and lease losses		152			71
Depreciation and amortization		461			448
Deferred loan origination fees, net of accretion		(275	)		247
Amortization of servicing assets		495			251
Gain on sales of loans		(973	)		(756	)
Stock-based compensation		184			135
Excess tax benefit from stock-based compensation		(37	)		(5	)
Changes in operating assets and liabilities:
Loans held-for-sale		(7,182	)		764
Accrued interest receivable		(51	)		(11	)
Other assets		186			(108	)
Drafts payable		(403	)		438
Accounts payable and other liabilities		2,629			(2,901	)
Advance payments by borrowers for taxes and insurance		1,018			1,206

Net cash provided/(used) by operating activities		(1,081	)		2,493

Cash Flows from Investing Activities
Loan originations		(61,691	)		(98,760	)
Loan principal repayments		100,470			99,693
Decrease in undisbursed loan proceeds		(16,561	)		(4,734	)
Principal repayments and redemptions on mortgage-backed and other securities		4,343			11,398
Purchase of securities available-for-sale		(4,955	)		(7,170	)
Purchases of premises and equipment		(591	)		(1,329	)
Proceeds from sale of impaired loan		—			340

Net cash provided/(used) by investing activities		21,015			(562	)

See Notes to the Financial Statements

FIRST MUTUAL BANCSHARES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in thousands)

(Continued)

	Three months ended March 31,
	2007			2006
	(Unaudited)
Cash Flows from Financing Activities
Net increase/(decrease) in deposit accounts	$	(41,330	)	$	17,497
Interest credited to deposit accounts		7,194			5,397
Issuance of stock through employees’ stock plans		119			100
Proceeds from advances		135,032			143,556
Repayment of advances		(128,897	)		(162,292	)
Dividends paid		(601	)		(5,824	)
Proceeds from exercise of stock options and excess tax benefit of $37 and $5 from stock-based compensation		129			126

Net cash (used) by financing activities		(28,354	)		(1,440	)

Increase/(decrease) in cash and cash equivalents	$	(8,420	)	$	491
Cash and cash equivalents, beginning of the year		25,362			25,781
Cash and cash equivalents, end of quarter	$	16,942		$	26,272

Supplemental Disclosures of Cash Flow Information
Loans originated for sale in the secondary market	$	33,710		$	22,657
Loans originated for investment activities		61,691			98,760
Proceeds from sale of loans held-for-sale		26,527			23,421
Additions to servicing assets		1,092			860
Cash paid during the year for:
Interest		10,581			8,272


Supplemental Disclosures of Noncash Investing Activities

Loans transferred to real estate, held-for-sale, net	$	—		$	28

See Notes to the Financial Statements

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Note 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

The results of operations for the interim periods shown in this report are not necessarily indicative of results to be expected for the fiscal year. In the opinion of management, the information contained herein reflects all adjustments necessary to make the results of operations for the interim periods a fair statement of such operations.

Note 2. ADOPTION OF NEW ACCOUNTING STANDARDS

Financial Accounting Standards Board Interpretation No. 48, Accounting for Uncertainty in Income Taxes (FIN No. 48)

In June 2006, the Financial Accounting Standards Board (FASB) issued FIN No. 48 - an interpretation of FASB Statement No. 109, Accounting for Income Taxes. FIN No. 48 establishes a single model to address accounting for uncertain tax positions. FIN No. 48 clarifies the accounting for income taxes by prescribing a minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. FIN No. 48 also provides guidance on derecognition, measurement classification, interest and penalties, accounting in interim periods, disclosure and transition. We adopted FIN No. 48 on January 1, 2007, no adjustments have been made to our financial statements as a result of this adoption. We do not believe that we have any uncertain tax positions that would rise to the level of having a material impact on our financial statements.

Our continuing practice is to recognize interest and/or penalties related to income tax matters in income tax expense.

Statement of Financial Accounting Standards No. 156 (SFAS 156), Accounting for Servicing of Financial Assets

In March of 2006, the FASB published SFAS No. 156, which amends SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, with respect to the accounting for servicing of financial assets. SFAS No. 156 requires that all seperately recognized servicing rights be initially measured at fair value, if practicable. For each class of seperately recognized servicing assets and liabilities, SFAS No. 156 permits an entity to choose either of the following subsequent measurement methods: (1) the amortization of servicing assets or liabilities in proportion to and over the period of estimated net servicing income or net servicing loss or (2) the reporting of servicing assets or liabilities at fair value at each reporting date and reporting changes in fair value in earnings in the period in which the changes occur. SFAS No. 156 also requires additional disclosures for all seperately recognized servicing rights. We adopted SFAS No. 156 on January 1, 2007 and have elected to continue to amortize our servicing assets or liabilities in proportion to and over the period of estimated net servicing income or net servicing loss.

Originated servicing assets are recorded when loans are originated and subsequently sold or securitized (and held as available-for-sale securities) with the servicing rights retained. Servicing assets are initially recognized at fair value on the balance sheet. Fair value is based on market prices for comparable servicing contracts, when available, or alternatively, is based on a valuation model that calculates the present value of the estimated future cash flows. Assumptions used in the valuation model include market discount rates and anticipated prepayment speeds. The prepayment speeds of the servicing portfolio are based on our prepayment experience for those stratas for which market data is not readily available. These servicing assets include sales finance loans, construction loan participations, lot loans, and other commercial loans for which there is no readily available online quotation data. In addition, estimates of the cost of servicing per loan, an inflation rate, ancillary income per loan, and default rates are used. The cost relating to the servicing rights is capitalized and amortized into noninterest income in proportion to, and over the period of, estimated future net servicing income. Amounts capitalized are recorded at cost, net of accumulated amortization and valuation allowance.

We assess impairment of the capitalized servicing assets based on recalculations of the present value of the remaining future cash flows using updated market discount rates and prepayment speeds. Subsequent loan prepayments and changes in prepayment assumptions in excess of those forecasted can adversely impact the carrying value of the servicing assets. Impairment is assessed on a stratum-by-stratum basis with any impairment recognized through a valuation allowance for each impaired stratum. The servicing assets are stratified based on the types of loans and the underlying collateral. We have three strata or classes of servicing assets: consumer (sales finance), commercial, and residential.

The effect of changes in market interest rates on estimated rates of loan prepayments is the predominant risk characteristic for mortgage servicing rights. For those loans that do not have quoted prepayment rates we utilize our own prepayment experience over the previous three months to reflect the actual prepayment environment in our underlying assumptions of the estimated fair value of the servicing rights upon recognition. The significant assumption used in the valuation model is the discount rate. This is generally the weighted average note rate of the underlying loans.

Changes in the servicing asset balances, the fair values, discount and prepayment assumptions by strata are as follows:

	First Quarter 2007
	Consumer			Commercial			Residential			Total
	(Dollars in thousands)
Balance, beginning of year	$	3,724		$	224		$	63		$	4,011
Additions		1,092			—			—			1,092
Amortization		(430	)		(49	)		(6	)		(485	)
Impairment		—			(10	)		—			(10	)
Balance at March 31, 2007	$	4,386		$	165		$	57		$	4,608

Fair Values at
January 1, 2007	$	4,071		$	334		$	83

Fair Values at
March 31, 2007	$	4,544		$	165		$	97

Discount rate		11.4	%		9.9	%		8.0	%

Prepayment speed		35.6	%		45.6	%		18.8	%


	First Quarter 2006
	Consumer			Commercial			Residential			Total
	(Dollars in thousands)
Balance, beginning of year	$	1,460		$	292		$	114		$	1,866
Additions		839			21			—			860
Amortization		(192	)		(38	)		(22	)		(252	)
Impairment		—			—			—			—
Balance at March 31, 2006	$	2,107		$	275		$	92		$	2,474

Fair Values at
January 1, 2006	$	1,973		$	516		$	150

Fair Values at
March 31, 2006	$	2,314		$	488		$	160

Discount rate		10.7	%		10.2	%		8.7	%

Prepayment speed		38.5	%		31.4	%		37.1	%

Servicing fee income, net of amortization, consisted of the following for the quarters ended March 31, 2007, 2006 and 2005:

	First Quarter 2007
	Consumer			Commercial			Residential			Total
	(Dollars in thousands)
Servicing fees	$	892		$	33		$	7		$	932
Amortization		(430	)		(59	)		(6	)		(495	)
Loan servicing fees, net	$	462		$	(26	)	$	1		$	437


	First Quarter 2006
	Consumer			Commercial			Residential			Total
	(Dollars in thousands)
Servicing fees	$	523		$	47		$	16		$	586
Amortization		(191	)		(38	)		(22	)		(251	)
Loan servicing fees, net	$	332		$	9		$	(6	)	$	335

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Note 2. ADOPTION OF NEW ACCOUNTING STANDARDS (Continued)

Statement of Financial Accounting Standards No. 157, Fair Value Measurements and No 159, The Fair Value Option for Financial Assets and Financial Liabilities, (SFAS No. 157 and SFAS No. 159)

We elected early adoption of SFAS No. 157 and SFAS No. 159 effective January 1, 2007.

In September 2006, the FASB issued SFAS No. 157 which defines fair value, establishes a consistent framework for measuring fair value in Generally Accepted Accounting Principles, and expands disclosure requirements about fair value measurements. SFAS No. 157 among other things requires us to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.

Valuation techniques are based upon observable and unobservable inputs. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect our market assumptions. These two types of inputs create the following fair value hierarchy:

Level 1 - Quoted prices for identical instruments in active markets.

Level 2 - Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations whose inputs are observable.

Level 3 - Instruments whose significant value drivers are observable.

In February 2007, the FASB issued SFAS No. 159. SFAS 159 allows entities to voluntarily choose, at specified election dates, to measure many financial assets and financial liabilities at fair value. The election is made on an instrument-by-instrument basis and is irrevocable. If the fair value option is elected for an instrument, all subsequent changes in fair value for that instrument shall be reported in earnings.

The following is a breakdown of the cumulative effect adjustment that was made to retained earnings upon adoption of SFAS 159:

Description	Balance Sheet at January 1, 2007 prior to Adoption			Net Gain/(Loss) upon Adoption			Balance Sheet at January 1, 2007 after Adoption of the Fair Value Option
	(Dollars in thousands)

Mortgage-backed and agency securities - gross	$	87,148		$	(2,149	)	$	84,999
(excluding premiums and discounts)

Premiums and discounts related to securities		(97	)		97			—

Long-term debentures payable (trust preferred securities)		9,000			(89	)		8,911

Issuance costs related to long-term debentures		249			(249	)		—

Pretax cumulative effect of adoption of
the fair value option					(2,390	)

Increase in deferred tax asset					836

Cumulative effect of adoption of the fair value
option (charge to retained earnings)				$	(1,554	)

Mortgage-Backed and Agency Securities

The mortgage-backed and agency securities selected for treatment under SFAS No. 159 consisted of $87.1 million or 89% of the securities portfolio. Securities with a remaining balance less than one

million dollars and instruments held for Community Reinvestment Act (CRA) investments were not included in the adoption of SFAS No. 159. Securites with small balances are much less attractive to potential purchasers and the CRA investments were purchased to facilitate compliance with the Community Reinvestment Act. The initial fair value of the securities selected for SFAS No. 159 adoption resulted in a $1,334,000 cummulative-effect adjustment, net of tax, recorded as a reduction in retained earnings as of January 1, 2007. Under SFAS No. 159, this one-time charge will not be recognized in earnings. As a result of the fair value measurement election for these securities, we recorded gains in the first quarter 2007 earnings of $402,000. The early adoption of the standard will enable us to manage interest rate risk more effectively.

The securities selected to be accounted for under SFAS No. 159 are presented seperately from the securities that are accounted for at cost and titled “Held for Trading (at fair value)”.

Junior Subordinated Long-Term Debentures Payable (Trust Preferred Securities)

The junior subordinated long-term debentures selected for treatment under SFAS No. 159 totaled $9 million. The initial fair value measurement resulted in a $220,000, net of tax, charge to retained earnings for unamortized issuance costs and excess interest. In the first quarter of 2007, we recorded $45,000 in pre-tax mark-to-market gains. We elected to account for our first $9 million junior subordinated long-term debenture issuance and not the other two issuances of $4 million each under SFAS No. 159 because this particular security is hedged with an interest-rate swap that is carried at fair value, with changes in value reflected in our earnings (the other two debentures are not hedged). The election to fair value the debentures matches the change in value of the interest-rate swap with the change in value of the debentures - effectively reducing the volitility in earnings. This security is eligible for prepayment on September 30, 2007. We have entered into a committment to replace this instrument with another long-term debenture.

The long-term debentures payable selected to be accounted for under SFAS No. 159 are presented seperately from the long-term debentures payable that are accounted for at cost and titled “long-term debentures payable (at fair value)”.

Interest-Rate Swaps

The interest-rate swaps and related commercial loans were included in the early adoption of SFAS 159 for administrative reasons. We have two fair value swaps that are hedged with commercial loans and are evaluated quarterly in accordance with SFAS 133, the hedge accounting statement. The inclusion of these two swaps and loans in the adoption of SFAS 159 did not impact retained earnings or net income, however, the administrative burden associated with accounting for these instruments will be greatly reduced under the new accounting statement. These two swaps were the only swaps that were accounted for in accordance with the long-haul accounting method, under SFAS No. 133, as amended.

The fair value of the swaps are included in “Accounts Payable and Other” and the fair value of the commercial loans that are being hedged are included in “Loans Receivable” on the balance sheet. On January 1, 2007 the fair value of the two swaps was $23,517 and the fair value of the loans totaled $22,742. On March 31, 2007 the fair value of the swaps included in “Accounts Payable and Other” totaled $23,689 and the fair value of the loans amounted to $23,698.

			Fair Value Measurements at March 31, 2007					Changes in Fair Values for the 3- Month Period Ended March 31, 2007, for Items Measured at Fair Value Pursuant to Election of the Fair Value Option
Description	Fair Value Measurements 3/31/07		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)	Interest Expense - FHLB and Other Advances		Interest Income on Loans	Total Changes in Fair Values Included in Current- Period Earnings
	(Dollars in thousands)
Trading securities		86,733		86,733								—
Long-term debentures payable		9,044				9,044			209			209
Loans Receivable		24					24			27		27

The contractual long-term debenture payable totaled $9.0 million and the unpaid principal balance on the two loans that were selected to be carried at fair value totaled $1.4 million at March 31, 2007.

Note 3.

Mortgage-Backed and Other Securities Available-for-Sale

The amortized cost and estimated fair value of securities available-for-sale at March 31, 2007 and December 31, 2006 are summarized as follows:

					Gross		Gross
			Gross		Unrealized		Unrealized		Estimated
	Amortized		Unrealized		Losses		Losses		Fair
	Cost		Gains		<1 Year		>1 Year		Value
March 31, 2007	(Dollars in thousands)
Freddie Mac securities	$	548	$	6	—		$	—	$	554
Fannie Mae securities		1,188		6	—			18		1,176
Ginnie Mae securities		2,868		2	—			11		2,859
	$	4,604	$	14	$	—	$	29	$	4,589

December 31, 2006
Freddie Mac securities	$	14,657	$	9		—	$	565	$	14,101
Fannie Mae securities		32,222		8		—		1,090		31,140
Ginnie Mae securities		34,053		2		—		397		33,658
US agency securities		10,990		—		—		161		10,829
	$	91,922	$	19	$	—	$	2,213	$	89,728

Certain investment securities shown above currently have fair values less than amortized cost and therefore contain unrealized losses. The Bank has evaluated these securities and has determined that the decline in value is temporary and is related to the change in market interest rates since purchase. The decline in value is not related to any company or industry specific event. At March 31, 2007 and December 31, 2006 there were 5 and 32 investment securities with unrealized losses, respectively. The Bank 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.

Note 4.

Mortgage-Backed and Other Securities Held-to-Maturity

The amortized cost and estimated fair value of securities held-to-maturity at March 31, 2007 and December 31, 2006 are summarized as follows:

					Gross		Gross
			Gross		Unrealized		Unrealized		Estimated
	Amortized		Unrealized		Losses		Losses		Fair
	Cost		Gains		<1 Year		>1 Year		Value
March 31, 2007	(Dollars in thousands)
Fannie Mae securities	$	3,863	$	30		—	$	63	$	3,830
Freddie Mac securities		205		4		—		—		209
Municipal bonds		1,140		1		—		4		1,137
	$	5,208	$	35	$	—	$	67	$	5,176
December 31, 2006
Fannie Mae securities	$	4,176	$	35		—	$	74	$	4,137
Freddie Mac securities		300		7		—		—		307
Municipal bonds		1,144		1		—		4		1,141
	$	5,620	$	43	$	—	$	78	$	5,585

Certain investment securities shown above currently have fair values less than amortized cost and therefore contain unrealized losses. The Bank has evaluated these securities and has determined that the decline in value is temporary and is related to the change in market interest rates since purchase. The decline in value is not related to any company or industry specific event. At March 31, 2007 and December 31, 2006 there were 4 investment securities with unrealized losses. The Bank 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.

Note 5.

Nonperforming Assets

Nonperforming loans are summarized as follows:

	March 31, 2007			December 31, 2006
	(Dollars in thousands)
Impaired loans with a valuation allowance	$	870		$	1,283
Valuation allowance related to impaired loans		(198	)		(236	)
Net impaired loans		672			1,047
Non accrual loans		1,309			2,415
Total nonperforming or non-accrual loans		1,981			3,462
Real estate owned		—			—
Nonperforming Assets	$	1,981		$	3,462

Total loans past due 90-days or more and still accruing interest	$	—		$	—
Average balance of impaired loans	$	860		$	592
Interest income recognized on impaired loans	$	—		$	1

Note 6.

Earnings Per Share

Basic Earnings Per Share is computed by dividing net income by the weighted-average number of shares outstanding during the year. Diluted EPS reflects the potential dilutive effect of stock options and is computed by dividing net income by the weighted-average number of shares outstanding during the year, plus the dilutive common shares that would have been outstanding had the stock options been exercised.

The following is a reconciliation of the numerators and denominators of the basic and diluted earnings per share computations for quarters ending March 31, 2007 and March 31, 2006:

	Income		Shares		Per share
	(numerator)		(denominator)		amount
	(Dollars and shares in thousands except per share amounts)
Quarter ended March 31, 2007
Basic EPS:
Income available to common shareholders	$	2,715		6,682	$	0.41

Effect of dilutive stock options		—		251
Diluted EPS:
Income available to common shareholders
plus assumed stock options exercised	$	2,715		6,933	$	0.39


Quarter ended March 31, 2006 (2)
Basic EPS:
Income available to common shareholders	$	2,714		6,627	$	0.41

Effect of dilutive stock options		—		132
Diluted EPS:
Income available to common shareholders
plus assumed stock options exercised	$	2,714		6,759	$	0.40

(2) Shares and EPS have been adjusted to reflect the five-for-four stock split paid on October 4, 2006.

Note 7.

Rate Volume Analysis

	FIRST QUARTER 2007
	VS
	FIRST QUARTER 2006
	INCREASE (DECREASE) DUE TO
							TOTAL
	VOLUME			RATE			CHANGE
INTEREST INCOME	(Dollars in thousands)
Investments:
Available-for-sale securities	$	(692	)	$	(447	)	$	(1,139	)
Held-for-trading securities		945		$	—			945
Held-to-maturity securities		(17	)		4			(13	)
Other equity investments		5			83			88
Total investments		241			(360	)		(119	)

Loans:
Residential	$	701		$	522		$	1,223
Residential construction		(447	)		112			(335	)
Multifamily		(563	)		327			(236	)
Multifamily construction		85			9			94
Commercial real estate and business		305			67			372
Commercial real estate construction		186			55			241
Consumer and other		(346	)		(60	)		(406	)
Total loans		(79	)		1,032			953


Total interest income	$	162		$	672		$	834

INTEREST EXPENSE
Deposits:
Money market deposit and checking	$	204		$	515		$	719
Savings		(3	)		—			(3	)
Time deposits		(111	)		1,189			1,078
Total deposits		90			1,704			1,794

FHLB advances and other		(684	)		604			(80	)
Total interest expense		(594	)		2,308			1,714


Net interest income	$	756		$	(1,636	)	$	(880	)

Note 8.

Business Segments

Beginning January 1, 2007, we changed the presentation of our Business Segments to more accurately reflect the way these segments are managed within the Bank. Prior to 2007, we recognized four business segments: 1) Consumer Lending, 2) Residential Lending, 3) Business Banking Lending, and 4) Income Property Lending. All other departments, including our Banking Centers and investment portfolio were assumed to support these business lines. Consequently, all income generated and expenses incurred at these support centers were allocated to the four business segments, resulting in no net income or loss at any department except the four lending units.

To better reflect how we manage the Bank we have changed our business segments as follows:

Established a “Retail Banking” segment which includes our Banking Centers and direct consumer lending. The Home Equity Lines of Credit (HELOC’s) and other consumer lending originated through the Banking Centers, which were previously included in the “Consumer Lending” segment, are included in this segment. The “Retail Banking” segment does not include Sales Finance lending. This segment also includes Community Business Banking (small business lending) which had been previously included in the “Business Banking” segment.

·	Isolated our Investment Securities activities as a separate business segment so that any changes in the investment portfolio’s market value or level of earning assets do not distort the reported operating results of our other business segments.

In moving the banking centers, our primary source of funds generation, from an allocated overhead category to an operating segment, it became necessary to implement a new process for transferring funds from our funds generating operations to the users of such funds. The objective of the funds transfer process is to isolate the true profit contribution of each side of the balance sheet. Prior to 2007, the profitability of the funds-generating operations, such as the banking centers, was defined as break-even with the lending segments collectively compensating the funds-generating operations such that this result was achieved. Under the new methodology, the rates at which funds are transferred between the generators and users of funds are based on market rates of interest. The profitability of the business segments, including retail banking, then varies depending on the actual rates earned on assets and paid on liabilities as well as expenses incurred in the segments’ operations. To assist in tracking and evaluating the profitability of such funds transfers, we now utilize four line items in determining each segment’s net interest income:

·	Interest Income – This represents the actual interest received from the segment’s loans or securities.

Interest Income on Funding Sources – This represents the interest income received from selling funding sources generated by the segment (i.e. deposits or FHLB advances) to a centralized Treasury function. The interest rate paid to the segment is based on the point on the FHLB rate curve for advances of a duration comparable to the segment’s funding source.

Funding Costs – This represents the interest paid to the centralized Treasury function by each business segment for the funding sources necessary to support earning asset balances. Again, the interest rate charged to the segment is based on the point on the FHLB rate curve for advances of a duration comparable to the segment’s earning assets.

·	Interest Expense – This represents the actual interest paid on the segment’s liabilities (i.e. deposits or FHLB advances).

The management reporting process measures the performance of the operating segments based on the management structure of the Bank and is not necessarily comparable with similar information for any other financial institution.

The reportable segments include the following:

Retail Banking – Retail Banking is the segment primarily responsible for the generation of funding sources, specifically our consumer and small business deposit accounts. In addition to our banking centers, the segment includes our direct consumer and Community Business Banking (small business) lending departments.

Sales Finance Lending – Sales Finance indirectly generates unsecured consumer loans in connection with home improvement projects. A large percentage of this segment’s loan volume is sold into the secondary market on a servicing-retained basis, meaning we continue to process payments and service the loan following the sale.

Residential Lending - Residential lending offers loans to borrowers to purchase, refinance, or build homes secured by one-to-four-unit family dwellings. This segment also sells loans into the secondary market. We may choose to retain or sell the right to service the loans sold (i.e., collection of principal and interest payments) depending upon market conditions.

Business Banking Lending – Business Banking offers a full range of banking services to middle-market size businesses including deposit and cash management products, loans for financing receivables, inventory, equipment as well as permanent and interim construction loans for commercial real estate. The underlying real estate collateral or business asset being financed typically secures these loans.

·	Income Property Lending – Income Property Lending offers permanent and interim construction loans for multifamily housing (over four units) and commercial real estate properties. The underlying real estate collateral being financed typically secures these loans.

Investment Securities - The investment securities segment includes the investment securities portfolio, FHLB stock and interest-earning cash balances. Although management does not consider this to be an operating business line, security investments represent a necessary part of liquidity management for the Bank.

These segments are managed separately because each business unit requires different processes and different marketing strategies to reach the customer base that purchases the products and services. The segments derive a majority of their revenue from interest income, and we rely primarily on net interest revenue in managing these segments. No single customer provides more than 10% of the Bank’s revenues.

			Quarter ended March 31
			Retail Banking			Sales Finance		Residential Lending			Business Banking		Income Property		Investment & Treasury			Consolidated Totals
			(Dollars in thousands)
Interest income		2005	$	616		$	1,693	$	4,099		$	1,510	$	6,014	$	1,467		$	15,399
		2006		820			2,047		5,957			2,241		6,481		1,402			18,948
		2007		854			1,616		6,310			2,867		6,897		1,238			19,782

Treasury and interest income		2005		5,272			48		227			294		204		2,760			8,805
	on funding sources	2006		8,531			21		101			556		93		3,738			13,040
		2007		9,139			17		102			880		137		3,242			13,517

Funding costs		2005		286			643		2,501			614		3,175		1,586			8,805
		2006		529			1,066		4,065			1,366		4,263		1,751			13,040
		2007		543			942		4,307			1,955		4,324		1,446			13,517

Interest expense		2005		3,263			—		—			92		16		2,228			5,599
		2006		5,242			—		—			282		14		3,179			8,717
		2007		6,616			—		—			555		53		3,207			10,431

Net interest income		2005		2,339			1,098		1,825			1,098		3,027		413			9,800
		2006		3,580			1,002		1,993			1,149		2,297		210			10,231
		2007		2,834			691		2,105			1,237		2,657		(173	)		9,351

Provision for loan and lease losses		2005		22			120		49			53		156		—			400
		2006		11			18		(132	)		60		114		—			71
		2007		(5	)		161		(34	)		14		16		—			152

Net interest income, after		2005		2,317			978		1,776			1,045		2,871		413			9,400
	provision for loan and	2006		3,569			984		2,125			1,089		2,183		210			10,160
	lease losses	2007		2,839			530		2,139			1,223		2,641		(173	)		9,199

Noninterest income		2005		298			844		134			36		57		1			1,370
		2006		362			1,126		83			46		97		1			1,715
		2007		415			1,453		204			63		97		431			2,663

Noninterest expense		2005		3,126			1,267		931			722		788		29			6,863
		2006		3,327			1,509		1,059			892		874		27			7,688
		2007		3,397			1,473		1,169			832		842		23			7,736

Income/(loss) before provision		2005		(511	)		555		979			359		2,140		385			3,907
	for federal income taxes	2006		604			601		1,149			243		1,406		184			4,187
		2007		(143	)		510		1,174			454		1,896		235			4,126

Provision for federal		2005		(173	)		189		333			122		727		125			1,323
	income taxes	2006		213			211		406			87		497		59			1,473
		2007		(49	)		175

FIRST MUTUAL BANCSHARES INC 10-Q