- Quarterly Report (10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

/x/	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2009

/ /	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 or Other Jurisdiction of	(IRS Employer Identification
	Incorporation or Organization)	Number)

332 SW Everett Mall Way

P.O. Box 2215

Everett, Washington 98213

(Address of Principal Executive Offices) (Zip Code)

(425) 514-0700

(Registrant’s Telephone Number, Including Area Code)

(Former name, former address and former fiscal year, if changed since last report)

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 [ ]

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or such shorter period that the registrant was required to submit and post such files). Yes [X] No [ ]

Indicate by a check mark whether the registrant is a large accelerated filer, an accelerated filer, a nonaccelerated filer, or a smaller reporting company. See definition of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Act. (Check one):

Large accelerated filer [ ] Accelerated filer [X] Nonaccelerated filer [ ] Smaller reporting company [ ]

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Class	Outstanding at October 30, 2009
Common Stock, no par value	47,131,853

FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES

TABLE OF CONTENTS

REPORT ON FORM 10-Q

FOR THE QUARTER ENDED SEPTEMBER 30, 2009

		Page
PART I.	FINANCIAL INFORMATION

ITEM 1.	Financial Statements		1

	Consolidated Balance Sheets
	September 30, 2009 (Unaudited) and December 31, 2008		1

	Consolidated Statements of Operations (Unaudited)
	Three and Nine Months Ended September 30, 2009 and 2008		2

	Consolidated Statements of Cash Flows (Unaudited)
	Nine Months Ended September 30, 2009 and 2008		3

	Notes to the Consolidated Financial Statements (Unaudited)		5

ITEM 2.	Management's Discussion and Analysis of Financial
	Condition and Results of Operations		24

ITEM 3.	Quantitative and Qualitative Disclosures about Market Risk		50

ITEM 4.	Disclosure Controls and Procedures		50

PART II.	OTHER INFORMATION		51

ITEM 1.	Legal Proceedings		51

ITEM 1A.	Risk Factors		51

ITEM 2.	Unregistered Sales of Equity Securities and Use of Proceeds		55

ITEM 3.	Defaults Upon Senior Securities		55

ITEM 4.	Submission of Matters to a Vote of Security Holders		55

ITEM 5.	Other Information		55

ITEM 6.	Exhibits		56

	Signatures		57

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(In thousands, except for number of shares)

	(Unaudited)
	September 30, 2009			December 31, 2008
ASSETS
Cash and due from banks	$	36,921		$	52,022
Federal funds sold		363,081			117,740
Securities
Available for sale, at fair value		73,834			90,606
Held to maturity, at amortized cost		3,079			3,085
Total securities		76,913			93,691

Loans held for resale		3,464			6,678
Loans		3,147,540			3,772,055
Allowance for loan losses		(142,229	)		(112,556	)
Net loans		3,008,775			3,666,177

Premises and equipment, net		48,826			51,502
Intangible assets		634			794
Federal Home Loan Bank (FHLB) stock		19,885			19,885
Bank owned life insurance		25,116			24,321
Other real estate owned		101,805			10,803
Other assets		90,153			67,510
Total assets	$	3,772,109		$	4,104,445

LIABILITIES
Deposits
Noninterest bearing	$	403,534		$	395,451
Interest bearing		2,822,087			2,879,714
Total deposits		3,225,621			3,275,165
Federal funds purchased and
securities sold under repurchase agreements		15,584			21,616
Federal Home Loan Bank advances		375,752			429,417
Junior subordinated debentures		5,156			5,156
Other liabilities		20,329			21,048
Total liabilities		3,642,442			3,752,402

SHAREHOLDERS' EQUITY
Preferred stock, no par value; 10,000,000 shares authorized		-			-
Common stock, no par value; 100,000,000 shares authorized; 47,131,853
and 47,095,103 shares issued and outstanding at September 30, 2009
and December 31, 2008		258,425			256,137
Retained earnings (accumulated deficit)		(126,873	)		98,020
Accumulated other comprehensive loss, net of tax		(1,885	)		(2,114	)
Total shareholders' equity		129,667			352,043
Total liabilities and shareholders' equity	$	3,772,109		$	4,104,445

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

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FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except for number of shares and per share amounts)

(Unaudited)

	Three Months Ended						Nine Months Ended
	September 30,			September 30,			September 30,			September 30,
	2009			2008			2009			2008
INTEREST INCOME
Interest and fees on loans	$	40,595		$	67,161		$	134,727		$	214,049
Interest on federal funds sold		195			274			547			377
Interest on investments		700			1,386			2,288			4,237
Total interest income		41,490			68,821			137,562			218,663
INTEREST EXPENSE
Interest on deposits		18,703			24,390			61,486			73,376
Interest on borrowed funds		3,909			3,705			11,995			12,272
Total interest expense		22,612			28,095			73,481			85,648
Net interest income		18,878			40,726			64,081			133,015
PROVISION FOR LOAN LOSSES		140,000			42,100			275,000			75,600
Net interest (loss) income after provision
for loan losses		(121,122	)		(1,374	)		(210,919	)		57,415

NONINTEREST INCOME
Provision for loss on securities		-			(6,431	)		-			(6,431	)
Net gain (loss) on sale of securities		-			(1,026	)		(102	)		1,442
Gain on sale of secondary mortgage loans		232			308			1,446			1,074
Net gain (loss) on other real estate owned		(1,068	)		81			(1,519	)		93
Service charges on deposit accounts		1,611			1,384			4,596			4,130
Other noninterest income		2,103			2,511			6,369			7,020
Total noninterest income (loss)		2,878			(3,173	)		10,790			7,328

NONINTEREST EXPENSE
Salaries and employee benefits		11,290			12,420			35,927			39,005
Occupancy expense		2,694			3,161			8,264			8,742
State business taxes		239			498			744			1,643
FDIC insurance		2,682			1,236			11,162			1,920
Other noninterest expense		7,909			4,742			17,396			13,825
Total noninterest expense		24,814			22,057			73,493			65,135

LOSS BEFORE BENEFIT FOR INCOME TAXES		(143,058	)		(26,604	)		(273,622	)		(392	)
BENEFIT FOR INCOME TAXES		(1,970	)		(8,808	)		(48,729	)		(171	)
NET LOSS	$	(141,088	)	$	(17,796	)	$	(224,893	)	$	(221	)
Weighted average number of
shares outstanding for the period		47,131,853			47,010,944			47,126,801			46,987,948
Basic losses per share	$	(2.99	)	$	(0.38	)	$	(4.77	)	$	(0.00	)
Weighted average number of diluted shares
outstanding for period		47,131,853			47,010,944			47,126,801			46,987,948
Diluted losses per share	$	(2.99	)	$	(0.38	)	$	(4.77	)	$	(0.00	)

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

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FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

	Nine Months Ended September 30,
	2009			2008
Cash flows from operating activities
Net loss	$	(224,893	)	$	(221	)
Adjustments to reconcile net loss to net cash
provided by operating activities
Depreciation		2,890			2,902
Amortization		423			184
Intangible amortization		160			212
Provision for loan losses		275,000			75,600
Provision for loss on securities		-			6,431
(Gain) loss on sale of securities		102			(1,442	)
Gain on sale of other real estate owned		(3,124	)		(93	)
Valuation adjustment on other real estate owned		4,643			-
Gain on sale of secondary mortgage loans		(1,446	)		(1,074	)
Deferred taxes		36,354			(19,703	)
Share-based compensation		2,288			2,170
Excess tax benefits associated with share-based compensation		-			(49	)
Increase in surrender value of bank owned life insurance		(795	)		(322	)
Changes in operating assets and liabilities
Proceeds from sale of mortgage loans		122,862			77,961
Origination of mortgage loans held for sale		(118,202	)		(73,764	)
Income taxes receivable		(65,422	)		-
Income taxes payable		396			(154	)
Interest receivable		6,668			2,137
Interest payable		(6,044	)		2,130
Other operating activities		5,543			(1,207	)
Net cash provided by operating activities		37,403			71,698

Cash flows from investing activities
Net change in federal funds sold		(245,341	)		(130,329	)
Purchase of securities available for sale		(47,276	)		(273,230	)
Proceeds from sale of available for sale securities		1,407			17,338
Principal repayments on mortgage-backed securities		5,373			-
Proceeds from maturities of available for sale securities		57,103			277,165
Net cash flows from loan activities		261,870			(251,914	)
Purchases of premises and equipment		(531	)		(7,432	)
Redemption of Federal Home Loan Bank stock		-			3,116
Proceeds from the sale of other real estate owned		24,515			2,355
Capitalized improvement related to other real estate owned		(383	)		(513	)
Net cash provided by (used in) investing activities	$	56,737		$	(363,444	)

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

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FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)

(In thousands)

(Unaudited)

	Nine Months Ended September 30,
	2009			2008
Cash flows from financing activities
Net change in core deposit accounts	$	(26,892	)	$	(37,892	)
Net change in certificates of deposit		(22,652	)		498,650
Net change in federal funds purchased and securities
sold under repurchase agreements		(6,032	)		(223,444	)
Advances from Federal Home Loan Bank		45,000			185,000
Repayment of Federal Home Loan Bank advances		(98,665	)		(153,803	)
Stock options exercised		-			389
Excess tax benefits associated with share-based compensation		-			49
Cash dividends paid		-			(19,598	)
Net cash provided by (used in) financing activities		(109,241	)		249,351

Decrease in cash and due from banks		(15,101	)		(42,395	)

Cash and due from banks at beginning of period		52,022			99,102

Cash and due from banks at end of period	$	36,921		$	56,707


Supplemental disclosure of cash flow information
Cash paid during the period for interest	$	79,525		$	83,518
Cash paid during the period for income taxes	$	-		$	20,340

Supplemental information about noncash investing and financing activities
Transfer of loans to other real estate owned	$	116,653		$	5,075
Transfer of premises and equipment to other real estate owned	$	317		$	-
Change in portion of reserve identified for undisbursed loans and
reclassified as a liability	$	982			826

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

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FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Note 1: Principles of Consolidation

The consolidated financial statements of Frontier Financial Corporation (“FFC”, the “Corporation”, “us”, “we” or “our”) include the accounts of Frontier Financial Corporation, a bank holding company, and our wholly-owned subsidiary Frontier Bank (the “Bank”). All material intercompany balances and transactions have been eliminated. The consolidated financial statements have been prepared substantially consistent with the accounting principles applied in the 2008 Annual Report incorporated by reference on Form 10-K for the year ended December 31, 2008. In the opinion of management, the consolidated financial statements reflect all adjustments necessary for a fair presentation of the financial condition and results of operation for the interim periods presented. Operating results for the three and nine months ended September 30, 2009, are not necessarily indicative of the results that may be expected for the year ending December 31, 2009. Subsequent events were evaluated through November 2, 2009, the date these consolidated financial statements were issued.

Certain amounts in the prior years’ financial statements have been reclassified to conform to the 2009 presentation. These reclassifications have no effect on the previously reported financial condition or results of operations of the Corporation.

Note 2: Recently Issued Accounting Pronouncements

In June 2009, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 168, The FASB Accounting Standards Codification TM and the Hierarchy of Generally Accepted Accounting Principles – a replacement of FASB Statement No. 162 (“SFAS 168”). SFAS 168 establishes the FASB Accounting Standards Codification TM (“ASC”) as the source of authoritative generally accepted accounting principles (“GAAP”) for nongovernmental entities. FASB ASC does not change GAAP. Instead, it takes the thousands of individual pronouncements that currently comprise GAAP and reorganizes them into approximately 90 accounting Topics, and displays all Topics using a consistent structure. Contents in each Topic are further organized first by Subtopic, then Section and finally Paragraph.

In conjunction with the issuance of SFAS 168, the FASB also issued its first Accounting Standards Update No. 2009-1, Topic 105 –Generally Accepted Accounting Principles (“ASU 2009-1”) which includes SFAS 168 in its entirety as a transition to the ASC. ASU 2009-1 is effective for interim and annual periods ending after September 15, 2009, and will not have an impact on the Corporation’s financial position or results of operations but will change the referencing system for accounting standards. Certain of the following pronouncements were issued prior to the issuance of the ASC and adoption of the ASUs. For such pronouncements, citations to the applicable Codification by Topic, Subtopic and Section are provided where applicable in addition to the original standard type and number.

SFAS 167 (not yet reflected in FASB ASC), Amendments to FASB Interpretation No. 46(R), (“SFAS 167”) was issued in June 2009. The standard amends FIN 46(R) to require a company to analyze whether its interest in a variable interest entity (“VIE”) gives it a controlling financial interest. A company must assess whether it has an implicit financial responsibility to ensure that the VIE operates as designed when determining whether it has the power to direct the activities of the VIE that significantly impact its economic performance. Ongoing reassessment of whether a company is the primary beneficiary is also required by the standard. SFAS 167 amends the criteria to qualify as a primary beneficiary as well as how to determine the existence of a VIE. The standard also eliminates certain exceptions that were available under FIN 46(R). SFAS 167 is effective as of the beginning of each reporting entity’s first annual reporting period that begins after November 15, 2009, for interim periods within that first annual reporting period, and for interim and annual reporting periods thereafter. Earlier application is prohibited. Comparative disclosures will be required for periods after the effective date. We do not expect the standard to have any impact on our consolidated financial statements.

The FASB issued ASU 2009–05, Fair Value Measurements and Disclosures (Topic 820) – Measuring Liabilities at Fair Value, in August 2009 to provide guidance when estimating the fair value of a liability. When a quoted price in an active market for the identical liability is not available, fair value should be measured using (a) the quoted price of an identical liability when traded as an asset; (b) quoted prices for similar liabilities or similar liabilities when traded as assets; or (c) another valuation technique consistent with the principles of Topic 820 such as an income approach or a market approach. If a restriction exists that prevents the transfer of the liability, a separate adjustment related to the restriction is not required when estimating fair value. The ASU was effective October 1, 2009, and will have no impact on our consolidated financial statements.

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FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

Note 2: Recently Issued Accounting Pronouncements (continued)

ASU 2009-12, Fair Value Measurements and Disclosures (Topic 820) - Investments in Certain Entities That Calculate Net Asset Value per Share (or Its Equivalent), issued in September 2009, allows a company to measure the fair value of an investment that has no readily determinable fair market value on the basis of the investee’s net asset value per share as provided by the investee. This allowance assumes that the investee has calculated net asset value in accordance with the GAAP measurement principles of Topic 946 as of the reporting entity’s measurement date. Examples of such investments include investments in hedge funds, private equity funds, real estate funds and venture capital funds. The update also provides guidance on how the investment should be classified within the fair value hierarchy based on the value for which the investment can be redeemed. The amendment is effective for interim and annual periods ending after December 15, 2009, with early adoption permitted. We do not have investments in such entities and, therefore, there will be no impact to our consolidated financial statements.

ASU 2009-13, Revenue Recognition (Topic 605): Multiple-Deliverable Revenue Arrangements – a consensus of the FASB Emerging Issues Task Force, was issued in October 2009 and provides guidance on accounting for products or services (deliverables) separately rather than as a combined unit utilizing a selling price hierarchy to determine the selling price of a deliverable. The selling price is based on vendor-specific evidence, third-party evidence or estimated selling price. The amendments in the update are effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010, with early adoption permitted. We do not expect the standard to have any impact on our consolidated financial statements.

Issued October, 2009, ASU 2009-15, Accounting for Own-Share Lending Arrangements in Contemplation of Convertible Debt Issuance or Other Financing , amends ASC Topic 470 and provides guidance for accounting and reporting for own-share lending arrangements issued in contemplation of a convertible debt issuance. At the date of issuance, a share-lending arrangement entered into on an entity’s own shares should be measured at fair value in accordance with Topic 820 and recognized as an issuance cost, with an offset to additional paid-in capital. Loaned shares are excluded from basic and diluted earnings per share unless default of the share-lending arrangement occurs. The amendments also require several disclosures including a description and the terms of the arrangement and the reason for entering into the arrangement. The effective dates of the amendments are dependent upon the date the share-lending arrangement was entered into and include retrospective application for arrangements outstanding as of the beginning of fiscal years beginning on or after December 15, 2009. We currently have no plans to issue convertible debt and, therefore, do not expect the update to have an impact on our consolidated financial statements.

Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies are not expected to have a material impact on our consolidated financial statements.

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FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

Note 3: Regulatory Actions, Strategic Plan and Continuing Operations

Regulatory Actions

FDIC Order

On March 20, 2009, Frontier Bank entered into a Stipulation and Consent to the Issuance of an Order to Cease and Desist (the “FDIC Order”) with the Federal Deposit Insurance Corporation (the “FDIC”) and the Washington Department of Financial Institutions (the “Washington DFI”). The regulators alleged that Frontier Bank had engaged in unsafe or unsound banking practices by operating with inadequate management and board supervision; engaging in unsatisfactory lending and collection practices; operating with inadequate capital in relation to the kind and quality of assets held at Frontier Bank; operating with an inadequate loan valuation reserve; operating with a large volume of poor quality loans; operating in such a manner as to produce low earnings and operating with inadequate provisions for liquidity. By consenting to the FDIC Order, Frontier Bank neither admitted nor denied the alleged charges.

Under the terms of the FDIC Order, Frontier Bank cannot declare dividends or pay any management, consulting or other fees or funds to the Corporation, without the prior written approval of the FDIC and the Washington DFI. Other material provisions of the FDIC Order require Frontier Bank to: (1) review the qualifications of Frontier Bank’s management, (2) provide the FDIC with 30 days written notice prior to adding any individual to the Board of Directors of Frontier Bank (the “Frontier Bank Board”) or employing any individual as a senior executive officer, (3) increase director participation and supervision of Frontier Bank affairs, (4) improve Frontier Bank’s lending and collection policies and procedures, particularly with respect to the origination and monitoring of real estate construction and land development loans, (5) develop a capital plan and increase Tier 1 leverage capital to 10% of Frontier Bank’s total assets by July 29, 2009, and maintain that capital level, in addition to maintaining a fully funded allowance for loan losses satisfactory to the regulators, (6) implement a comprehensive policy for determining the adequacy of the allowance for loan losses and limiting concentrations in commercial real estate and acquisition, development and construction loans, (7) formulate a written plan to reduce Frontier Bank’s risk exposure to adversely classified loans and nonperforming assets, (8) refrain from extending additional credit with respect to loans charged-off or classified as “loss” and uncollected, (9) refrain from extending additional credit with respect to other adversely classified loans without collecting all past due interest, without the prior approval of a majority of the directors on the Frontier Bank Board or its loan committee, (10) develop a plan to control overhead and other expenses to restore profitability, (11) implement a liquidity and funds management policy to reduce Frontier Bank’s reliance on brokered deposits and other non-core funding sources, and (12) prepare and submit progress reports to the FDIC and the Washington DFI. The FDIC Order will remain in effect until modified or terminated by the FDIC and the Washington DFI.

The FDIC Order does not restrict Frontier Bank from transacting its normal banking business. Frontier Bank will continue to serve its customers in all areas including making loans, establishing lines of credit, accepting deposits and processing banking transactions. Customer deposits remain fully insured to the highest limits set by FDIC. The FDIC and Washington DFI did not impose any monetary penalties in connection with the FDIC Order.

FRB Agreement

In addition, on July 2, 2009, the Corporation entered into a Written Agreement (the “FRB Written Agreement”) with the Federal Reserve Bank of San Francisco (the “FRB”). Under the terms of the FRB Written Agreement, the Corporation has agreed to: (1) refrain from declaring or paying any dividends without prior written consent of the FRB; (2) refrain from taking dividends or any other form of payment that represents a reduction in capital from Frontier Bank without prior written consent of the FRB; (3) refrain from making any distributions of interest or principal on subordinated debentures or trust preferred securities without prior written consent of the FRB; (4) refrain from incurring, increasing or guaranteeing any debt without prior written consent of the FRB; (5) refrain from purchasing or redeeming any shares of its stock without prior written consent of the FRB; (6) implement a capital plan and maintain sufficient capital; (7) comply with notice and approval requirements established by the FRB relating to the appointment of directors and senior executive officers as well as any change in the responsibility of any current senior executive officer; (8) not pay or agree to pay any indemnification and severance payments except under certain circumstances, and with the prior approval of the FRB; and (9) provide quarterly progress reports to the FRB.

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FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

Note 3: Regulatory Actions, Strategic Plan and Continuing Operations (continued)

Compliance Memorandum of Understanding

Frontier Bank and the Frontier Bank Board also entered into a Memorandum of Understanding with the FDIC dated August 20, 2008, relating to the correction of certain violations of applicable consumer protection and fair lending laws and regulations, principally including the failure to provide certain notices to consumers pursuant to the Flood Disaster Protection Act of 1973, and certain violations of the Truth in Lending Act and Regulation Z.

The Memorandum of Understanding requires Frontier Bank and the Frontier Bank Board to (1) correct all violations found and implement procedures to prevent their recurrence; (2) increase oversight of the Frontier Bank Board’s compliance function, including monthly reports from Frontier Bank’s compliance officer to the Frontier Bank Board detailing actions taken to comply with the Memorandum of Understanding; (3) review its compliance policies and procedures and develop and implement detailed operating procedures and controls, where necessary, to ensure compliance with all consumer protection laws and regulations; (4) establish monitoring procedures to ensure compliance with all consumer protection laws and regulations (including flood insurance), including the documentation and reporting of all exceptions to the Frontier Bank Board and its audit committee; (5) review, expand and improve the quality of such compliance with the frequency of compliance audits to be reviewed and approved annually by the Frontier Bank Board or audit committee, with a goal of auditing compliance at least annually; (6) ensure that Frontier Bank’s compliance management function has adequate staff, resources, training and authority for the size and structure of Frontier Bank; (7) establish flood insurance monitoring procedures to ensure loans are not closed without flood insurance and prior notices to customers required by law, that lapses of flood insurance do not occur, and to develop methods to ensure that adequate amounts of flood insurance are provided, with Frontier Bank agreeing to force place flood insurance when necessary; (8) provide additional training for all Frontier Bank personnel, including the Frontier Bank Board and audit and compliance staff for applicable laws and regulations and (9) furnish quarterly progress reports to the Regional Director of the FDIC detailing the actions taken to secure compliance with the Memorandum of Understanding until the Regional Director has released the institution, in writing, from submitting further reports. Frontier Bank was assessed civil monetary penalties of $48,895 for flood insurance violations and required to pay $10,974 in restitution to customers for certain violations of the Truth in Lending Act and Regulation Z.

We have been actively engaged in responding to the concerns raised in the FDIC Order, the FRB Agreement and the Memorandum of Understanding and believes we have addressed all the regulators’ requirements and that we are in compliance with all the terms of these regulatory actions, with the exception of increasing Tier 1 leverage capital to 10% of the Bank’s total assets. See “Strategic Plan – Capital Preservation” below.

These regulatory actions may adversely affect our ability to obtain regulatory approval for future initiatives requiring regulatory action, such as acquisitions. The regulatory actions will remain in effect until modified or terminated by the regulators.

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FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

Note 3: Regulatory Actions, Strategic Plan and Continuing Operations (continued)

Compliance Efforts in Response to Regulatory Actions

We are actively engaged in responding to the concerns raised by the regulators and have acted promptly on directions received by taking the following actions:


	•	Engaged Patrick M. Fahey as chairman of the board and chief executive officer of Frontier, and Michael J. Clementz as president, on December 4, 2008;

	•	Retained an independent consultant to review and evaluate the loan portfolio in the Fall of 2008, and again in July, 2009;

	•	Organized a special assets group staffed by 37 managers and employees, to accelerate the collection and resolution of delinquent and adversely classified loans;

	•	Developed capital management, liquidity and funds management plans;

	•	Increased board and senior management oversight of Frontier Bank, its lending and operations, including special weekly board meetings;

	•	Established a communications procedure for reporting progress in all areas to the FDIC, Washington DFI and FRB.

Strategic Plan

The results for the first nine months of 2009 reflect continued pressure from an uncertain economy and the negative impact of the local housing market. Despite these challenging times, the Board of Directors and management continue to take important steps to strengthen the Corporation.

Diversifying the Loan Portfolio

Management has been diligently working to reduce the concentration in real estate construction and land development loans, and has successfully reduced these portfolios by $537.4 million, or 35.1%, from December 31, 2008 to September 30, 2009. In addition, undisbursed loan commitments related to these portfolios decreased $158.1 million, or 88.2%, for the same period.

Asset Quality

Management continues to proactively manage credit quality and loan collections and address work out strategies. For the nine months ended September 30, 2009, net charge-offs totaled $246.3 million.

Capital Preservation

As of September 30, 2009, Frontier Bank’s total risk-based capital ratio was less than 6.0%, and therefore, Frontier Bank is considered “significantly undercapitalized” under federal regulatory guidelines, as a result of significant additional provisions for loan losses and charge-offs in the third quarter of 2009. In addition, Frontier Bank’s Tier 1 leverage capital ratio remains less than the 10% required by the terms of the FDIC Order. See “Regulatory Actions” above.

We continue to take steps to strengthen our capital position. Efforts to raise additional capital began in the third quarter of 2008, when the Board of Directors retained an investment banking firm to assist in raising capital and deleveraging our balance sheet. Our ability to raise additional capital has been adversely affected by unfavorable conditions in the capital markets and our financial performance, and we have not been able to raise additional capital to date. If we cannot raise additional capital, continue to shrink our balance sheet and/or enter into a strategic merger or sale, we may not be able to sustain further deterioration in our financial condition and further regulatory actions or restrictions may be taken against us.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

Note 3: Regulatory Actions, Strategic Plan and Continuing Operations (continued)

Liquidity

We continue to closely monitor and manage our liquidity position, understanding that this is of critical importance in the current adverse economic environment. Attracting and retaining customer deposits remains our primary source of liquidity. Noninterest bearing deposits increased $8.1 million, or 2.0%, from December 31, 2008 to September 30, 2009.

During the third quarter 2009, we announced our continued participation in the Federal Deposit Insurance Corporation's ("FDIC") voluntary Transaction Account Guarantee ("TAG") portion of the Temporary Liquidity Guarantee Program through June 30, 2010. Under this program, noninterest bearing transaction accounts and qualified NOW checking accounts are fully guaranteed by the FDIC for an unlimited amount of coverage. The coverage under the TAG program is in addition to, and separate from, the coverage available under the FDIC's general deposit insurance protection.

In an effort to increase on-balance sheet liquidity, we have been focused on restructuring our balance sheet, and in particular, reducing the loan portfolio. For the nine months ended September 30, 2009, total loans decreased $627.7 million, or 16.6%, compared to December 31, 2008. Additionally, we have increased our federal funds sold balances to $363.1 million at September 30, 2009, an increase of $245.3 million from December 31, 2008.

Expense Reduction Measures

We continue to seek out feasible expense reduction measures. Previously announced expense reduction measures include: a six percent reduction in workforce, the suspension of the Corporation’s matching of employee 401(K) Plan contributions, effective May 1, 2009, and reductions to executive compensation, salary freezes and the elimination of performance bonuses and discretionary profit sharing contributions to the 401(K) Plan. Additionally, full time equivalents (“FTE”) employees are down 158, or 18.5%, from the peek in May 2008 to September 30, 2009.

Continuing Operations

Our consolidated financial statements have been prepared assuming that we will continue as a going concern.

In connection with continuing turmoil in the economy, and more specifically, within the local real estate market, we recorded net losses of $141.1 million and $224.9 million for the three and nine months ended September 30, 2009, respectively. These losses were primarily the result of increases in our provision for loan losses during these periods, and declining net interest margins caused by increased amounts of nonperforming loans. These losses, the FDIC Order, and the high level of risk associated with our real estate loan portfolio have resulted in Frontier Bank being regarded by our regulators as “significantly undercapitalized.” See Note 6 - Shareholders’ Equity and Regulatory Matters. The net losses for the periods have had a negative impact on our operations, liquidity and capital adequacy and could result in further actions by our regulators to restrict our operations as discussed below.

On July 31, 2009, we announced the signing of an agreement and plan of merger with SP Acquisition Holdings (“SPAH”). The merger was expected to close in the fourth quarter of 2009. SPAH was a special purpose acquisition company with nearly $429 million in liquid assets. On October 5, 2009, we mutually agreed to terminate the agreement and plan of merger with SPAH due to the fact that certain closing conditions contained in the merger agreement could not be met.

In order to achieve compliance with the risk-based capital requirement of the FDIC Order and return to being at least “adequately capitalized” for federal regulatory purposes, we will need to either raise capital, sell assets to deleverage, or both. Our ability to accomplish these goals is significantly constricted by the current adverse economic environment, in which access to capital markets has been limited, and we can give no assurances that we will be able to access any such capital or sell more assets. See “Capital Preservation” above.

Our ability to decrease our levels of nonperforming assets is also vulnerable to market conditions as many of our borrowers rely on an active real estate market as a source of repayment, particularly our real estate construction and real estate development loan borrowers. If the real estate market does not improve or declines further, our level of nonperforming assets may not decline.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

Note 3: Regulatory Actions, Strategic Plan and Continuing Operations (continued)

As a result of the asset quality and capital concerns affecting us, we have been aggressively addressing our liquidity needs to maintain an adequate cash flow position to sustain operations. At September 30, 2009, we maintained approximately $363.1 million of federal funds sold to increase on-balance sheet liquidity.

We have ceased originating new real estate construction development loans and completed lot loans, although we continue to selectively fund on commitments previously issued. Finally, our special assets group has been aggressively marketing foreclosed real estate in an effort to sell noninterest earning assets at sales prices that do not further deteriorate our capital position.

We have determined that significant additional sources of capital will be required for us to continue operations through 2009 and beyond. We have engaged financial advisors to assist us in our efforts to raise additional capital and explore other strategic alternatives to address our current and expected capital deficiencies. Based on their assessment of our ability to continue to operate in compliance with the FDIC Order, our regulators may take other and further actions, including the assessment of civil money penalties against the Bank or the Corporation and their respective officers, directors and other interested parties or they may seek to enforce the order or agreement in federal court. If the Bank or the Corporation were to engage in other unsafe and unsound banking practices, the regulators have various enforcement tools available to them including the issuance of capital directives, orders to cease engaging in certain business activities and the issuance of modified or additional orders or agreements.

There can be no assurances that our actions referred to above will be successful. These events raise doubt about our ability to continue as a going concern. The consolidated financial statements do not include any adjustments that might result from the outcome of these uncertainties.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

Note 4: Securities

Our investment portfolio is classified into two groups - securities available for sale (“AFS”) and securities held to maturity (“HTM”). Securities that are classified as AFS are carried at fair value. Unrealized gains and losses for AFS securities are excluded from earnings and reported as a separate component of equity, net of tax. AFS securities may be sold at any time. Securities that are classified as HTM are carried at cost, adjusted for amortization of premiums and accretion of discounts which are recognized as adjustments to income. Gains and losses on both AFS and HTM securities that are disposed of prior to maturity are based on the net proceeds and the adjusted carrying amount of the specific security sold.

The following table presents the amortized cost, unrealized gains, unrealized losses and fair value of available for sale and held to maturity securities at September 30, 2009 (in thousands). At September 30, 2009, there were no securities classified as trading.

	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses (less than 12 months)			Gross Unrealized Losses (12 months or more)			Aggregate Fair Value
AFS Securities
Equities	$	6,106	$	183	$	-		$	(3,811	)	$	2,478
U.S. Treasuries		251		64		-			-			315
U.S. Agencies		29,902		75		(12	)		-			29,965
Corporate securities		2,516		-		(327	)		-			2,189
Mortgage-backed securities		35,613		631		(117	)		-			36,127
Municipal securities		2,665		96		-			(1	)		2,760
		77,053		1,049		(456	)		(3,812	)		73,834

HTM Securities
Corporate securities		1,524		-		(38	)		-			1,486
Municipal securities		1,555		21		-			-			1,576
		3,079		21		(38	)		-			3,062
Total	$	80,132	$	1,070	$	(494	)	$	(3,812	)	$	76,896

Certain securities shown above currently have fair values less than amortized cost, and therefore, contain unrealized losses. In the opinion of management, these securities are considered only temporarily impaired due to changes in market interest rates, the widening of market spreads subsequent to the initial purchase of the securities or to disruptions to credit markets and not due to concerns regarding the underlying credit of the issuers or the underlying collateral. There were 12 securities with unrealized losses at September 30, 2009.

Management evaluates securities and FHLB stock for other-than-temporary impairment at least on an annual basis, and more frequently when economic or market concerns warrant such evaluation. Consideration is given to: (1) the length of time and extent to which the fair value has been less than cost, (2) the financial condition and near term prospects of the issuer, (3) our intent and ability to retain a security for a period of time sufficient to allow for any anticipated recovery in fair value and (4) whether we expect to recover the amortized cost basis of the security. We did not recognize any other-than-temporary impairment losses for the three or nine months ended September 30, 2009. For the three and nine months ended September 30, 2008, we recognized a $6.4 million pre-tax loss related to other than temporarily impaired investments in Fannie Mae, Freddie Mac and Lehman Brothers.

Investments in equity securities consist of investments in the common stock of three financial institutions. We have evaluated the near term prospects of the issuer and have considered their cash position, earnings and revenue outlook, liquidity and capital levels, among other factors. Based on this evaluation and our ability and intent to hold these securities for a reasonable period of time sufficient for a forecasted recovery of fair value, we do not consider these securities to be other-than-temporarily impaired.

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(Unaudited)

Note 4: Securities (continued)

The unrealized losses on investments in U.S. Agencies securities were caused by changes in market interest rates. The contractual terms of these investments do not permit the issuer to settle the securities at a price less than par. Because we do not intend to sell the securities and it is not more likely than not that we will be required to sell the securities before recovery of their amortized cost bases, which may be maturity, the unrealized losses on these securities are not considered other-than-temporarily impaired.

The unrealized losses on corporate securities, which consist of trust preferred securities, were primarily attributable to temporary disruptions of credit markets and the related impact on the securities within those classes, not deteriorating credit quality of specific securities. Because the decline in fair value is attributable to disruptions of credit markets and not credit quality, and because we do not intend to sell the security and it is not more likely than not that we will be required to sell the security before recovery of their amortized cost bases, which may be maturity, the unrealized losses on these investments are not considered other-than-temporarily impaired.

The unrealized losses on mortgage-backed securities were caused by changes in market interest rates. The contractual cash flows of these securities are guaranteed by an agency of the U.S. government, and accordingly, we do not expect these securities to be settled at a price less than the amortized cost of the investment. Because the decline in fair value is attributable to changes in interest rates and not credit quality, and because we do not intend to sell the security and it is not more likely than not that we will be required to sell the security before recovery of their amortized cost bases, which may be maturity, the unrealized losses on these securities are not considered other-than-temporarily impaired.

The unrealized losses on obligations of municipalities were caused by changes in market interest rates or the widening of market spreads subsequent to the initial purchase of the securities. Management monitors published credit ratings of these securities and no adverse ratings changes have occurred since the date of purchase on obligations of municipalities in an unrealized loss position as of September 30, 2009. Because the decline in fair value is attributable to changes in interest rates or widening market spreads and not credit quality, and because we do not intend to sell the security and it is not more likely than not that we will be required to sell the security before recovery of their amortized cost bases, which may be maturity, the unrealized losses on these investments are not considered other-than-temporarily impaired.

Contractual maturities of securities at September 30, 2009, are shown below (in thousands). Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without prepayment penalties.

	Available for Sale				Held to Maturity
Maturity	Amortized Cost		Fair Value		Amortized Cost		Fair Value
0 - 1 years	$	7,011	$	7,051	$	571	$	573
1 - 5 years		23,225		23,253		984		1,003
5 - 10 years		1,609		1,710		-		-
Over 10 years		45,208		41,820		1,524		1,486
	$	77,053	$	73,834	$	3,079	$	3,062

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(Unaudited)

Note 5: Loans and Allowance for Loan Losses

The major classifications of loans, excluding loans held for resale, are as follows (in thousands):

	September 30, 2009			December 31, 2008
Commercial and industrial	$	406,170		$	458,263
Real Estate:
Commercial		991,572			1,048,431
Construction		588,632			952,619
Land development		405,706			581,683
Completed lots		257,602			250,405
Residential 1-4 family		434,607			425,874
Installment and other loans		70,803			65,490
		3,155,092			3,782,765
Unearned fee income		(7,552	)		(10,710	)
Total loans	$	3,147,540		$	3,772,055

The following table presents the activity related to the allowance for loan losses (in thousands):

	Nine Months Ended			Twelve Months Ended
	September 30, 2009			December 31, 2008
Beginning balance	$	114,638		$	57,658
Provision for loan losses		275,000			120,000
Charge-offs		(249,284	)		(63,526	)
Recoveries		2,975			506
Balance before portion identified for undisbursed loans		143,329			114,638
Portion of reserve identified for undisbursed
loans and reclassified as a liability		(1,100	)		(2,082	)
Balance at end of period	$	142,229		$	112,556

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

Note 5: Loans and Allowance for Loan Losses (continued)

Nonperforming Assets

Nonaccruing loans, restructured loans and other real estate owned (“OREO”) are summarized as follows (in thousands):

	September 30, 2009			December 31, 2008
Commercial and industrial	$	29,147		$	12,908
Real estate:
Commercial		81,870			10,937
Construction		277,146			181,905
Land development		274,959			177,139
Completed lots		85,341			34,005
Residential 1-4 family		60,669			17,686
Installment and other		1,388			645
Total nonaccruing loans		810,520			435,225

Other real estate owned		101,805			10,803
Total nonperforming assets	$	912,325		$	446,028

Restructured loans	$	-		$	-

Total loans at end of period (1)	$	3,151,004		$	3,778,733
Total assets at end of period	$	3,772,109		$	4,104,445

Total nonaccruing loans to total loans		25.72	%		11.52	%
Total nonperforming assets to total assets		24.19	%		10.87	%

(1) Includes loans held for resale.

At September 30, 2009 and December 31, 2008, nonaccruing loans totaling $396.7 million and $96.2 million had related specific reserves in the allowance for loan losses of $66.8 million and $12.9 million, respectively. Nonaccruing loans without related specific reserves in the allowance for loan losses at September 30, 2009 and December 31, 2008, totaled $413.8 million and $339.0 million, respectively.

Other Real Estate Owned

The following table presents the activity related to other real estate owned (“OREO”) (in thousands):

	Nine Months Ended						Twelve Months Ended
	September 30, 2009						December 31, 2008
	Amount			Number			Amount			Number
Beginning balance	$	10,803			64		$	367			1
Additions to OREO		116,653			357			12,992			76
Capitalized improvements		383						623
Valuation adjustments		(4,643	)					(68	)
Disposition of OREO		(21,391	)		(99	)		(3,111	)		(13	)
Ending balance	$	101,805			322		$	10,803			64

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(Unaudited)

Note 6: Shareholders’ Equity and Regulatory Matters

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. We are subject to regulatory actions, including an FDIC Order requiring Frontier Bank to raise its Tier 1 leverage capital ratio to the higher than normal level of 10% of its total assets. See “Note 3: — Regulatory Actions, Strategic Plan and Continuing Operations.”

The minimum ratios and the actual capital ratios at September 30, 2009, are set forth in the table below (in thousands):

	Frontier Financial Corporation			Frontier Bank			Well Capitalized Minimum			Adequately Capitalized Minimum
Total capital to risk-weighted assets		5.62	%		5.35	%		10.00	%		8.00	%
Tier 1 capital to risk-weighted assets		4.33	%		4.06	%		6.00	%		4.00	%
Tier 1 leverage capital to average assets		3.40	%		3.19	%		5.00	%		4.00	%

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 are “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized,” and “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.

Frontier Bank’s total capital to risk-weighted assets ratio dropped below 6.0% as of September 30, 2009, as a result of the additional provisions for loan losses and charge-offs in the third quarter of 2009, and therefore, the Corporation and the Bank were “significantly undercapitalized” as of September 30, 2009.

Note 7: Share-Based Compensation Plans

Stock Incentive Plan

In 2006, our shareholders approved a Stock Incentive Plan (the “Plan”) to promote the best interest of the Corporation, our subsidiaries and our shareholders, by providing an incentive to those key employees who contribute to our success. 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. At September 30, 2009, 4,400,204 common shares were available for grant. Shares issued and outstanding are adjusted to reflect common stock dividends, splits, recapitalization or reorganization. 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 but not paid on incentive stock options. Certain options provide for accelerated vesting if there is a change in control.

The following table presents the activity related to options for the nine months ended September 30, 2009:

	Options Outstanding			Weighted Average Exercise Price		Weighted Average Contractual Terms (in years)		Aggregate Intrinsic Value (in thousands)
Outstanding, January 1, 2009		1,374,734		$	16.69
Granted		-			-
Exercised		-			-
Forfeited/expired		(172,404	)	$	16.59
Balance, September 30, 2009		1,202,330		$	16.70		5.6	$	-

Exercisable, September 30, 2009		895,388		$	16.90		4.6	$	-

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

Note 7: Share-Based Compensation Plans (continued)

The following table presents the activity related to nonvested stock awards under the Plan for the nine months ended September 30, 2009:

	Shares			Weighted Average Grant Date Fair Value
Nonvested at January 1, 2009		269,762		$	11.74
Awarded		36,000		$	3.02
Vested		(36,750	)	$	3.21
Forfeited		(24,904	)	$	11.40
Nonvested at September 30, 2009		244,108		$	11.78

At September 30, 2009, there was $2.1 million of total unrecognized compensation expense related to the nonvested share-based compensation arrangements granted under the Plan. The cost is expected to be recognized over a weighted-average period of 1.5 years. No stock options were granted during the three or nine months ended September 30, 2009 or 2008.

The total fair value of shares and options vested and recognized as compensation expense under this Plan for the three and nine months ended September 30, 2009, was $731 thousand and $2.3 million, compared to $693 thousand and $2.1 million for the three and nine months ended September 30, 2008, respectively.

There were no stock option exercises for the nine months ended September 30, 2009. The total intrinsic value, amount by which the fair value of the underlying stock exceeded the exercise price of an option on exercise date, of options exercised for the nine months ended September 30, 2008, was $159 thousand. Cash received and the actual tax benefit realized for the tax deductions from options exercised was $389 thousand and $49 thousand, respectively, for the nine months ended September 30, 2008.

1999 Employee Stock Award Plan

We adopted a 1999 Employee Stock Award Plan to recognize, motivate and reward eligible employees for longstanding performance. Employees eligible to receive stock awards under this Plan must have been employees 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. The stock awards vest immediately when granted. The Plan expires in 2009 and there are currently no plans to renew the Plan. Any future grants will be made out of the 2006 Stock Incentive Plan, as noted above.

There were no shares issued from this Plan during the nine months ended September 30, 2009. For the nine months ended September 30, 2008, 1,470 shares were issued from this Plan with a total fair value of $25 thousand recognized as compensation expense.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

Note 8: Losses per Share

The following table reconciles basic to diluted weighted average shares outstanding used to calculate losses per share data and provides a summary of the calculation of both basic and diluted losses per share (in thousands, except per share amounts):

	Three Months Ended						Nine Months Ended
	September 30,			September 30,			September 30,			September 30,
	2009			2008			2009			2008

Net loss	$	(141,088	)	$	(17,796	)	$	(224,893	)	$	(221	)

Average basic shares outstanding		47,132			47,011			47,127			46,988

Dilutive shares		-			-			-			-

Average diluted shares outstanding		47,132			47,011			47,127			46,988

Basic losses per share	$	(2.99	)	$	(0.38	)	$	(4.77	)	$	(0.00	)

Diluted losses per share	$	(2.99	)	$	(0.38	)	$	(4.77	)	$	(0.00	)

Note 9: Fair Values

FASB ASC 820, Fair Value Measurements and Disclosure , and FASB ASC 825, Financial Instruments, (formerly FSP No. FAS 107-1 and APB 28-1, Disclosures about Fair Value of Financial Instruments) , requires disclosure of fair value information about financial instruments, whether or not recognized in the consolidated financial statements. The following table presents estimated fair values of our financial instruments at September 30, 2009 and December 31, 2008 (in thousands):

	September 30, 2009				December 31, 2008
	Carrying		Fair		Carrying		Fair
	Value		Value		Value		Value
Assets
Cash and due from banks	$	36,921	$	36,921	$	52,022	$	52,022
Federal funds sold		363,081		363,081		117,740		117,740
Securities
Available for sale		73,834		73,834		90,606		90,606
Held to maturity		3,079		3,062		3,085		3,340
Loans held for resale		3,464		3,464		6,678		6,678
Loans, net		3,008,725		2,836,454		3,666,177		3,714,492
Bank owned life insurance		25,116		25,166		24,321		24,321

Liabilities
Noninterest bearing deposits		403,534		403,534		395,451		395,451
Interest bearing deposits		2,822,087		2,852,126		2,879,714		2,909,730
Federal funds purchased and securities
sold under agreements to repurchase		15,584		15,584		21,616		21,616
FHLB advances		375,752		392,854		429,417		444,441
Junior subordinated debentures		5,156		2,191		5,156		1,676

We determined the estimated fair value amounts 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.

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(Unaudited)

Note 9: Fair Values (continued)

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 fair value.

Cash Equivalents and Federal Funds Sold - For these short-term instruments, the carrying amount is a reasonable estimate of fair value.

Securities - 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.

Loans Held for Resale – For loans held for resale, carrying value approximates fair value.

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. The fair value calculation, however, does not take into consideration the ultimate collectibility of the loan. 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.

Bank Owned Life Insurance – The fair value of Bank owned life insurance policies are based on cash surrender value of the insurance contract, less any applicable surrender charges.

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.

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.

Junior Subordinated Debentures – The fair value of junior subordinated debentures is estimated using a discounted cash flow model.

FASB ASC 820, Fair Value Measurements and Disclosure ( formerly SFAS 157, Fair Value Measurements ), defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. FASB ASC 820 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:

Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

Level 2: Significant other observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active and other inputs that are observable or can be corroborated by observable market data.

Level 3: Significant unobservable inputs that reflect a company’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

The following is a description of the valuation methodologies used to measure and disclose the fair value of assets and liabilities on a recurring or nonrecurring basis:

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(Unaudited)

Note 9: Fair Values (continued)

Securities

Securities available for sale are recorded at fair value on a recurring basis. Fair value is determined by obtaining quoted prices on nationally recognized securities exchanges (Level 1), through the use of alternative approaches, such as matrix or model pricing, when market quotes are not readily available (Level 2) or through the use of valuation techniques, such as discounted cash flow models (Level 3).

We use an outside vendor to price our securities, Interactive Data Corporation (“IDC”). IDC provides independent evaluations and is recognized industry-wide as one of the most reliable valuation services. IDC’s evaluations are based on market data. IDC utilizes evaluated pricing models that vary based on asset class and include available trade, bid and other market information. Methodology includes broker quotes, proprietary modes, vast descriptive terms and conditions databases, as well as extensive quality control programs. IDC uses a pricing model only on our municipal securities totaling $3.8 million which are subject to IDC’s quality control program.

All pricing information and quotes we obtain from IDC on our securities are reviewed for reasonableness and used directly for the preparation of our financial statement. We have not had to adjust prices provided by IDC, since the majority of our security prices are based on market data.

Impaired Loans

From time to time, and on a nonrecurring basis, fair value adjustments to collateral dependent loans are recorded to reflect partial write-downs based on the current appraised value of the collateral or internally developed models which contain management’s assumptions (Level 3).

Other Real Estate Owned

Other real estate owned (“OREO”) consists principally of properties acquired through foreclosure. At the time of foreclosure, OREO is recorded at the lower of the carrying amount of the loan or fair value less costs to sell, which becomes the new basis. Subsequent to the transfer of loans to OREO, and on a nonrecurring basis, fair value adjustments are recorded to reflect partial write-downs based on the current appraised value or internally developed models which contain management’s assumptions (Level 3).

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FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

Note 9: Fair Values (continued)

The following table presents the balances of assets measured at fair value on a recurring basis at September 30, 2009 and December 31, 2008 (in thousands):

	Fair Value at September 30, 2009
	Level 1		Level 2		Level 3		Total
Available for sale securities
Equities	$	1,868	$	610	$	-	$	2,478
U.S. Treasuries		-		315		-		315
U.S. Agencies		-		29,965		-		29,965
Corporate securities		-		990		1,199		2,189
Mortgage-backed securities		-		36,127		-		36,127
Municipal securities		-		2,760		-		2,760
Total	$	1,868	$	70,767	$	1,199	$	73,834

	Fair Value at December 31, 2008
	Level 1		Level 2		Level 3		Total
Available for sale securities
Equities	$	1,327	$	603	$	-	$	1,930
U.S. Treasuries		-		6,457		-		6,457
U.S. Agencies		-		52,055		-		52,055
Corporate securities		-		2,939		1,500		4,439
Mortgage-backed securities		-		22,791		-		22,791
Municipal securities		-		2,934		-		2,934
Total	$	1,327	$	87,779	$	1,500	$	90,606

The following table presents the fair value adjustments of assets measured on a recurring basis, using significant unobservable inputs (Level 3), for the nine months ended September 30, 2009 (in thousands). There were no financial assets or liabilities measured at fair value using Level 3 inputs on a recurring basis during the nine months ended September 30, 2008.

	Fair Value Measurements Using Significant Unobservable Inputs (Level 3)
Balance at January 1, 2009	$	1,500
Total unrealized gains or losses		(301	)
Purchases		-
Transfers in and/or out of Level 3		-
Balance at September 30, 2009	$	1,199

At September 30, 2009, we valued an investment in a single issuer trust preferred security using a discounted cash flow model. As a result of unprecedented disruptions of certain financial markets, we determined that the level and volume of activity for this type of security had significantly decreased, and therefore, there were insufficient transactions to accurately determine the fair value. Using a discounted cash flow method, the fair value of this security was determined to be $1.2 million at September 30, 2009. In our model, we used a discount factor of 14%, which we estimated based on risk and the current market for this type of security. This determination is considered a Level 3 input. For the nine months ended September 30, 2009, there were no realized losses with respect to this security.

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FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

Note 9: Fair Values (continued)

The following table presents the balance of assets measured at fair value on a nonrecurring basis at September 30, 2009 and December 31, 2008 (in thousands):

	Fair Value at September 30, 2009
	Level 1		Level 2		Level 3		Total
Impaired loans (1)	$	-	$	-	$	582,447	$	582,447
OREO (2)		-		-		94,900		94,900
	$	-	$	-	$	677,347	$	677,347

	Fair Value at December 31, 2008
	Level 1		Level 2		Level 3		Total
Impaired loans (1)	$	-	$	-	$	268,193	$	268,193
OREO (2)		-		-		10,803		10,803
	$	-	$	-	$	278,996	$	278,996

The following table presents the losses resulting from nonrecurring fair value adjustments for the nine months ended September 30, 2009 and 2008 (in thousands):

	Nine Months Ended
	September 30,
	2009		2008
Impaired loans (1)	$	167,455	$	27,661
OREO (2)		53,537		947
Total loss from nonrecurring measurements	$	220,992	$	28,608

(1)

The balance of impaired loans measured at fair value at September 30, 2009 and December 31, 2008, represents nonaccruing loans that have had charge-offs and/or have a specific reserve in the allowance for loan losses. The loss on impaired loans for the nine months ended September 30, 2009 and 2008, represents charge-offs or impairments on collateral dependent loans for fair value adjustments based on the fair value of collateral recognized through the allowance for loan losses.

(2)

The balance of OREO measured at fair value at September 30, 2009 and December 31, 2008, represents real estate that was recorded at fair value less costs to sell at the time of foreclosure and/or has had a valuation adjustment subsequent to becoming OREO. The loss on OREO for the nine months ended September 30, 2009, represents charge-offs of $48.9 million at the time of foreclosure and subsequent valuation adjustments of $4.6 million. The loss on OREO for the nine months ended September 30, 2008, presents charge-offs at the time of foreclosure.

There were no material liabilities carried at fair value, measured on a recurring or nonrecurring basis, at September 30, 2009 or 2008.

Note 10: Income Taxes

We adopted the provisions of FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes , on January 1, 2007 (“FIN 48”). This Interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This Interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. We had no unrecognized tax benefits which would require an adjustment to the January 1, 2007, beginning balance of retained earnings. We had no unrecognized tax benefits at January 1, 2007, September 30, 2008, or September 30, 2009.

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FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

Note 10: Income Taxes (continued)

During the nine months ended September 30, 2009, we reclassified our deferred tax asset to income taxes receivable, resulting from the preparation of our 2008 income tax return. Both the deferred tax asset and receivable for income taxes are included in other assets, and therefore, this reclassification had no effect on our consolidated balance sheet at September 30, 2009. Management has evaluated the tax positions taken on our 2008 income tax return and believes it is more likely than not that we will be entitled to a tax refund of approximately $73.5 million, included in other assets, resulting from the carry back of losses in 2008 and 2009.

We recognize interest accrued and penalties related to unrecognized tax benefits in tax expense. For the three and nine months ended September 30, 2009 and 2008, we recognized no interest or penalties.

We file federal and various state and local income tax returns. With few exceptions, we are no longer subject to U.S. federal or state/local income tax examinations by tax authorities for years before 2006.

Note 11: Subsequent Event

As previously announced, on October 5, 2009, the Corporation and SP Acquisition Holdings, Inc. (“SPAH”) mutually agreed to terminate the Agreement and Plan of Merger, dated as of July 30, 2009, by and between SPAH and Frontier, as amended by Amendment No. 1 to Agreement and Plan of Merger, dated as of August 10, 2009, effective immediately, due to the fact that certain closing conditions contained in the merger agreement could not be met. We continue to seek out private equity investors and other capital sources, and to facilitate this process, we have engaged an investment banking firm.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Forward-Looking Statements

This quarterly report on Form 10-Q includes forward-looking statements, within the meaning of Section 27A of the Securities Act of 1933, 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, that are subject to risks and uncertainties that could cause actual results to differ materially from those projected. These statements may be identified by the use of forward-looking terminology such as “anticipate,” “believe,” “continue,” “could,” “estimate,” “expect,” “intend,” “may,” “might,” “plan,” “potential,” “predict,” “should” or “will” or the negative thereof or other variations thereon or comparable terminology. We have based these forward-looking statements on our current expectations, assumptions, estimates and projections. While we believe these expectations, assumptions, estimates and projections are reasonable, such forward-looking statements are only predictions and involve known and unknown risks and uncertainties, many of which are beyond our control. These and other important factors, including those discussed in our December 31, 2008 Form 10-K, filed with the Securities and Exchange Commission, under the headings “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Business,” and those discussed in this Form 10-Q under Part II, Item 1A "Risk Factors" below, may cause our actual results, performance or achievements to differ materially from any future results, performance or achievements expressed or implied by these forward-looking statements. Some of the key factors that could cause actual results to differ from our expectations are:

·	changes in general economic conditions, either nationally or locally in western Washington and Oregon;

·	the extent and duration of continued economic, credit, housing and financial market disruptions and governmental actions to address these disruptions;

·	inflation, interest rate, market and monetary fluctuations;

·	legislative or regulatory changes or changes in accounting principles, policies or guidelines;

·	the adequacy of our credit risk management and the allowance for loan losses, asset quality and our ability to collect on delinquent loans, including residential construction and land development loans;

·	the availability of and costs associated with sources of liquidity;

·	changes in real estate values generally, within the markets in which we generate loans, which could adversely affect the demand for loans and may adversely affect collateral held on outstanding loans;

·	the possibility that we will be unable to raise capital and comply with the conditions imposed upon us in the FDIC Order or the FRB Agreement, which could result in the imposition of further restrictions on our operations, penalties or other regulatory actions;

·	our ability to successfully defend against claims asserted against us in lawsuits arising out of, or related to, our lending operations or any regulatory action taken against us, as well as any unanticipated litigation or other regulatory proceedings;

·	the possibility that we may be required to pay significantly higher FDIC insurance premiums in the future;

·	our success at managing the risks involved in the foregoing; and

·	other risks which may be described in our future filings with the SEC under the Securities Exchange Act of 1934.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

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. In addition, we may make certain statements in future Securities and Exchange Commission (“SEC”) filings, in press releases and in oral and written statements that are not statements of historical fact and may constitute forward-looking statements.

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 bank holding company owning all of the equity of its wholly owned subsidiary, Frontier Bank (the "Bank").

Financial Overview

The results for the first nine months of 2009 reflect continued pressure from an uncertain economy and the negative impact of the economy on the local housing market in Washington and Oregon. For the three months ended September 30, 2009, we reported a net loss of $141.1 million, or ($2.99) per diluted share, compared to a net loss of $17.8 million, or ($0.38) per diluted share, for the three months ended September 30, 2008. For the nine months ended September 30, 2009, net losses totaled $224.9 million, or ($4.77) per diluted share, compared to a net loss of $221 thousand, or ($0.00) per diluted share for the same period in 2008. Contributing to the net losses for the three and nine months ended September 30, 2009, were provisions for loan losses of $140.0 million and $275.0 million, respectively.

The following table presents the basic and diluted losses per share, cash dividends declared per common share, the dividend payout ratio, the returns on average assets and average shareholders’ equity for the three and nine months ended September 30, 2009 and 2008 (in thousands):

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2009			2008			2009			2008
Net loss	$	(141,088	)	$	(17,796	)	$	(224,893	)	$	(221	)
Basic losses per share	$	(2.99	)	$	(0.38	)	$	(4.77	)	$	(0.00	)
Diluted losses per share	$	(2.99	)	$	(0.38	)	$	(4.77	)	$	(0.00	)
Cash dividends declared
per common share	$	-		$	0.06		$	-		$	0.30
Dividend payout ratio		-			-15.79	%		-		NM
Return on Average
Assets		-14.39	%		-1.69	%		-7.38	%		-0.01	%
Equity		-234.71	%		-15.32	%		-100.06	%		-0.06	%
Average equity/average assets		6.13	%		11.00	%		7.37	%		11.45	%

NM - Not meaningful.

Despite these challenging times, the Board of Directors and management continue to take important steps to strengthen the Corporation. Management has been diligently working to reduce the concentration in real estate construction and land development loans, improve asset quality, capital and on-balance sheet liquidity and reduce expenses.

We continue to proactively manage credit quality and loan collections and address work out strategies. In addition, we continue to charge-off confirmed losses against specific reserves in the allowance for loan losses. For the nine months ended September 30, 2009, net charge-offs totaled $246.3 million.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

We continue to closely monitor and manage our liquidity position, understanding that this is of critical importance in the current economic environment. Attracting and retaining customer deposits remains our primary source of liquidity. Noninterest bearing deposits increased $8.1 million, or 2.0%, from December 31, 2008 to September 30, 2009.

Expense Reduction Measures

Regulatory Actions

FDIC Order

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

FRB Agreement

Compliance Memorandum of Understanding

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

Compliance Efforts in Response to Regulatory Actions

We are actively engaged in responding to the concerns raised by the regulators and have acted promptly on directions received from by taking the following actions:


	•	Engaged Patrick M. Fahey as chairman of the board and chief executive officer of Frontier, and Michael J. Clementz as president, on December 4, 2008;

	•	Retained an independent consultant to review and evaluate the loan portfolio in the Fall of 2008, and again in July, 2009;

	•	Organized a special assets group staffed by 37 managers and employees, to accelerate the collection and resolution of delinquent and adversely classified loans;

	•	Developed capital management, liquidity and funds management plans;

	•	Increased board and senior management oversight of Frontier Bank, its lending and operations, including special weekly board meetings;

	•	Established a communications procedure for reporting progress in all areas to the FDIC, Washington DFI and FRB.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

Continuing Operations

In connection with continuing turmoil in the economy, and more specifically, within the local real estate market, we recorded net losses of $141.1 million and $224.9 million for the three and nine months ended September 30, 2009, respectively. These losses were primarily the result of necessary increases in our provision for loan losses during these periods, and declining net interest margins caused by increased amounts of nonperforming loans. These losses, the FDIC Order, and the high level of risk associated with our real estate loan portfolio have resulted in Frontier Bank being regarded by our regulators as “significantly undercapitalized” at September 30, 2009. The net losses for the periods have had a negative impact on our operations, liquidity and capital adequacy and could result in further actions by our regulators to restrict our operations as discussed below.

On July 31, 2009, we announced the signing of an agreement and plan of merger with SP Acquisition Holdings (“SPAH”). The merger was expected to close in the fourth quarter of 2009. SPAH was a special purpose acquisition company with nearly $429 million in assets. On October 5, 2009, we mutually agreed to terminate the agreement and plan of merger with SPAH due to the fact that certain closing conditions contained in the merger agreement could not be met.

In order to achieve compliance with the risk-based capital requirement of the FDIC Order, we will need to either raise capital, sell assets to deleverage, or both. Our ability to accomplish these goals is significantly constricted by the current economic environment, in which access to capital markets has been limited, and we can give no assurances that we will be able to access any such capital or sell more assets.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

Review of Financial Condition – September 30, 2009 and December 31, 2008

Federal Funds Sold

At September 30, 2009, federal funds sold totaled $363.1 million, compared to $117.7 million at December 31, 2008, an increase of $245.3 million, or 208.4%. Federal funds sold fluctuate on a daily basis depending on our net cash position for the day. In addition, increased federal fund sold balances improves on-balance sheet liquidity, which is an ongoing focus of management.

Securities

The following table represents the available for sale and held to maturity securities portfolios by type at September 30, 2009 and December 31, 2008 (in thousands):

	Securities Available for Sale
	September 30, 2009					December 31, 2008
	Fair Value		% of total			Fair Value		% of total
Equities	$	2,478		3.4	%	$	1,930		2.1	%
U.S. Treasuries		315		0.4	%		6,457		7.1	%
U.S. Agencies		29,965		40.6	%		52,055		57.5	%
Corporate securities		2,189		3.0	%		4,439		4.9	%
Mortgage-backed securities		36,127		48.9	%		22,791		25.2	%
Municipal securities		2,760		3.7	%		2,934		3.2	%
Total	$	73,834		100.0	%	$	90,606		100.0	%

	Securities Held to Maturity
	September 30, 2009					December 31, 2008
	Amortized Cost		% of total			Amortized Cost		% of total
Corporate securities	$	1,524		49.5	%	$	1,524		49.4	%
Municipal securities		1,555		50.5	%		1,561		50.6	%
Total	$	3,079		100.0	%	$	3,085		100.0	%

Available for sale securities totaled $73.8 million at September 30, 2009, compared to $90.6 million at December 31, 2008, a decrease of $16.8 million, or 18.5%. This decrease is primarily attributable to calls and maturities totaling $57.1 million, principal pay-downs on mortgage-backed securities of $5.4 million and sales of corporate securities totaling $1.4 million; partially offset by the purchase of $47.3 million of securities, principally U.S. Agencies and mortgage-backed securities.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

Loans

The following table represents the loan portfolio by type, excluding loans held for resale and net of unearned income, at September 30, 2009 and December 31, 2008 (in thousands):

	September 30, 2009					December 31, 2008
	Amount		% of total			Amount		% of total
Commercial and industrial	$	405,405		12.9	%	$	457,215		12.1	%
Real estate loans:
Commercial		988,004		31.4	%		1,044,833		27.7	%
Construction		587,594		18.7	%		949,909		25.2	%
Land development		405,400		12.9	%		580,453		15.4	%
Completed lots		257,057		8.2	%		249,685		6.6	%
Residential 1-4 family		433,280		13.8	%		424,492		11.3	%
Installment and other		70,800		2.2	%		65,468		1.7	%
Total	$	3,147,540		100.0	%	$	3,772,055		100.0	%

Total loans, excluding loans held for resale, decreased $624.5 million, or 16.6%, to a balance of $3.15 billion at September 30, 2009, from $3.77 billion at December 31, 2008. Management has been diligently working to reduce the concentration in real estate construction and land development loans, as defined by the FDIC, and has successfully reduced these portfolios by $731.8 million, or 35.8%, from December 31, 2008 to September 30, 2009, including undisbursed loan commitments.

Despite the increase in outstanding balance, there were no new completed lot loans originated from December 31, 2008 to September 30, 2009. In certain circumstances, where real estate construction projects will not be completed, they are reclassified as real estate completed lot loans. We reclassified $17.3 million of residential construction loans to residential completed lot loans as of September 30, 2009. Reclassification of a residential construction loan to a residential lot loan eliminates any remaining unadvanced funds originally intended for construction. The background loan loss reserve is adjusted on subject loans to the new loan type and grade, and if placed into nonperforming status, a specific reserve is assigned. There were no changes in the related loan agreements resulting in credits that would be considered troubled debt restructurings. At September 30, 2009, $11.0 million of residential construction loans converted to residential lot loans were nonperforming.

At September 30, 2009, real estate residential 1-4 family loans totaled $433.3 million, an increase of $8.8 million, or 2.1%, compared to December 31, 2008. The increase in real estate residential 1-4 family loans for the period is primarily attributable to the conversion of certain real estate construction properties into rentals. Due to the weakened economy and the adverse effect on home sales, some builders have converted speculative homes that they have been unable to sell into investment properties. For the nine months ended September 30, 2009, $35.3 million of real estate construction loans were converted to residential 1-4 family loans. The conversion of these real estate construction loans changed the payment structure to principal and interest and extended maturity dates. There were no changes in the related loan agreements resulting in credits that would be considered troubled debt restructurings. Additionally, no conversions resulted in loans moving from a nonperforming status to a performing status, and therefore, had no impact on the loan loss reserve as nonperforming loans are assigned a specific reserve. At September 30, 2009, $8.2 million residential construction loans converted to residential 1-4 family loans were nonperforming.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

Allowance for Loan Losses

The allowance for loan losses is the amount which, in the opinion of management, is necessary to absorb probable 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 our ongoing internal credit review staff. Management also reviews the growth and terms of loans so that the allowance can be adjusted for probable losses. 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.

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 grades 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 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.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

The allowance for loan losses, loan charge-offs and loan recoveries are summarized as follows (in thousands):

	Nine Months Ended			Twelve Months Ended
	September 30, 2009			December 31, 2008

Beginning balance	$	114,638		$	57,658

Provision for loan losses		275,000			120,000

Charge-offs:
Commercial and industrial		(26,494	)		(3,101	)
Real estate:
Commercial		(9,212	)		(1,264	)
Construction		(90,431	)		(31,968	)
Land development		(74,231	)		(12,165	)
Completed lots		(35,525	)		(13,839	)
Residential 1-4 family		(11,596	)		(846	)
Installment and other		(1,795	)		(343	)
Total charge-offs		(249,284	)		(63,526	)

Recoveries:
Commercial and industrial		616			308
Real estate:
Commercial		-			-
Construction		2,048			161
Land development		57			-
Completed lots		148			9
Residential 1-4 family		59			-
Installment and other		47			28
Total recoveries		2,975			506

Net charge-offs		(246,309	)		(63,020	)
Balance before portion identified for
undisbursed loans		143,329			114,638
Portion of reserve identified for
undisbursed loans and
reclassified as a liability		(1,100	)		(2,082	)
Balance at end of period	$	142,229		$	112,556

Total loans, including loans held
for resale	$	3,151,004		$	3,778,733

Average loans for the period	$	3,553,982		$	3,774,501

Ratio of net charge-offs to average
loans outstanding during the period		6.93	%		1.67	%

Allowance for loan losses as a percentage
of total loans, including loans held
for resale		4.51	%		2.98	%

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

The allocation of the allowance for loan losses at September 30, 2009 and December 31, 2008 are as follows (in thousands):

	September 30, 2009		December 31, 2008
Commercial and industrial	$	17,849	$	15,127
Real Estate:
Commercial		16,083		11,388
Construction		34,565		27,636
Land development		38,297		22,701
Completed lots		13,684		9,054
Residential 1-4 family		14,611		14,056
Installment and other		1,949		1,071
Unallocated		5,191		11,523
Total	$	142,229	$	112,556

The allowance for loan losses totaled $142.2 million, or 4.51%, of total loans outstanding at September 30, 2009, compared to $112.6 million, or 2.98%, of total loans outstanding at December 31, 2008. Including the allocation for undisbursed loans of $1.1 million, would result in a total allowance of $143.3 million, or 4.55%, of total loans outstanding at September 30, 2009. This compares to the undisbursed allocation of $2.1 million, for a total allowance of $114.6 million, or 3.03%, of total loans outstanding at December 31, 2008.

Our allowance for loan losses, as a percentage of total loans, is impacted by nonperforming loans as a significant portion of our nonperforming loans are collateral dependent. Nonperforming loans result in the assignment of a specific reserve that adjusts the net book value of the loan’s principal balance to reflect the estimated fair value of supporting collateral or result in no assignment of a specific reserve if the loans collateral value is in excess of its book value. Our customary practice is to charge-off the amount of impairment representing the excess of the loan’s net book value over the estimated fair value within the quarter a loan is identified as nonperforming and a confirmed loss (“partial charge-off”). For nonperforming loans not immediately charged-off as a result of the determination of a confirmed loss, a specific reserve representing the amount of estimated impairment is applied. Impaired loans are assessed for valuation on a recurring basis. Once a partial charge-off is taken no additional reserve is required, unless as a result of our recurring impairment analysis, new information becomes available that would necessitate further adjustment to the allowance for loan losses and subsequent write downs. As a result, many of the nonperforming loans are collateral-based loans measured at fair value and the balance in excess of collateral value is charged-off during the same quarter, thus resulting in a lower coverage ratio (total allowance for loan losses divided by total nonperforming loans).

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

The following table includes information pertaining to the allowance for loan losses and nonperforming loans (in thousands):

	September 30, 2009			December 31, 2008
Total loans	$	3,151,004		$	3,778,733

General reserves	$	75,454		$	99,671
Specific reserves		66,775			12,885
Total allowance for loan losses	$	142,229		$	112,556

Nonperforming loans with specific reserves
included in the allowance for loan losses		396,674		$	96,238
Nonperforming loans without specific reserves
included in the allowance for loan losses		413,846			338,987
Total nonperforming loans	$	810,520		$	435,225

Total charge-offs related to nonperforming loans	$	167,455		$	48,168

Nonperforming loans recorded at carrying
value to total loans		13.13	%		8.97	%
Nonperforming loans recorded at carrying value
to total nonperforming loans		51.06	%		77.89	%

Coverage ratio (total allowance for loan losses divided
by total nonperforming loans)		17.55	%		25.86	%
Coverage ratio after considering effects of charge-offs		31.67	%		33.25	%
Coverage ratio net of nonperforming loans carried at
carrying value		35.86	%		116.96	%
Total loans less nonperforming loans at carrying value	$	2,737,158		$	3,439,746

Total allowance for loan losses/total loans		4.51	%		2.98	%
Total allowance for loan losses/total loans less nonperforming
loans at carrying value		5.20	%		3.27	%
Specific reserves/balance of nonperforming loans with
specific reserves		16.83	%		13.39	%

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

Nonperforming Assets

Nonaccruing loans, other real estate owned (“OREO”) and restructured loans and are as follows (in thousands):

	September 30, 2009			December 31, 2008
Commercial and industrial	$	29,147		$	12,908
Real estate:
Commercial		81,870			10,937
Construction		277,146			181,905
Land development		274,959			177,139
Completed lots		85,341			34,005
Residential 1-4 family		60,669			17,686
Installment and other		1,388			645
Total nonaccruing loans		810,520			435,225

Other real estate owned		101,805			10,803
Total nonperforming assets	$	912,325		$	446,028

Restructured loans	$	-		$	-

Total loans at end of period (1)	$	3,151,004		$	3,778,733
Total assets at end of period	$	3,772,109		$	4,104,445

Total nonaccruing loans to total loans		25.72	%		11.52	%
Total nonperforming assets to total assets		24.19	%		10.87	%

(1) Includes loans held for resale.

Impaired Loans

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 nonaccrual loans, restructured loans 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 Bank. If the current value of the impaired loan is less than the recorded investment in the loan impairment is recognized by creating or adjusting an existing allocation of the allowance for loan losses.

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.

At September 30, 2009, nonaccruing loans totaled $810.5 million, compared to $435.2 million at December 31, 2008. The increase in nonaccruing loans for the period is primarily attributable to the continued downturn in the local housing market and economy, which significantly impacted our real estate construction, land development and completed lot portfolios. Of the total nonaccrual loans at September 30, 2009, 78.6% relate to our real estate construction, land development and completed lot portfolios.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

Restructured Loans

In cases where a borrower experiences financial difficulties and we make 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.

Interest income on restructured loans is recognized pursuant to the terms of the new loan agreement. Interest income on 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. There were no restructured loans at September 30, 2009 or December 31, 2008.

Other Real Estate Owned

Other real estate owned (“OREO”) is carried at the lesser of book value or market value, less selling costs. 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 other expense.

The following table presents the activity related to OREO (in thousands):

	Nine Months Ended						Twelve Months Ended
	September 30, 2009						December 31, 2008
	Amount			Number			Amount			Number
Beginning balance	$	10,803			64		$	367			1
Additions to OREO		116,653			357			12,992			76
Capitalized improvements		383						623
Valuation adjustments		(4,643	)					(68	)
Disposition of OREO		(21,391	)		(99	)		(3,111	)		(13	)
Ending balance	$	101,805			322		$	10,803			64

Certain other loans, currently in nonaccrual, are in the process of foreclosure and potentially could become OREO. Efforts, however, are constantly underway to reduce and minimize such nonperforming assets. During 2008, we expanded our special assets group to focus on reducing nonperforming assets.

The decision to begin a foreclosure action generally occurs after all other reasonable collection efforts have been found ineffective. We comply with all applicable state statues regarding foreclosure proceedings. Loans in foreclosure are always categorized as nonperforming assets, and as such, have been assigned a specific loan loss reserve based on the most current property valuations available, discounted to reflect foreclosure expense, holding time and sales costs. Assuming no other legal actions, the statutory processing period for a so-called nonjudicial foreclosure in the state of Washington is a minimum of 120 days or 190 days after the date of default. The first step is a notice of default that is mailed to the borrower and posted at the property or the notice is delivered to the borrower in person. The borrower is given 30 days to respond to the notice of default. If the borrower does not stop the foreclosure within 30 days after receiving the notice of default, we record a notice of sale with the appropriate county recorder. The notice of sale is recorded at least 90 days before the sale date and is mailed to the borrower and any other lien holders. The notice of sale is also published twice in a local newspaper. A notice of foreclosure is also required to be sent to the borrower and/or guarantors if we want to retain the right to a deficiency. We are required to publish the notice of sale once between the 32nd and 28th days prior to the sale, and once between the 11th and 7th days before the sale. Foreclosure sales are by public auction with the property going to the highest bidder.

We will bid up to the amount of our loan balance. If we do not have a buyer for the collateral by the sale date, and there is no other or higher bidder, then we acquire ownership of the property for the amount of our credit bid, and the property becomes an OREO property of the Bank. The obligations of the guarantors (but not the borrower) of a commercial loan for any deficiency (the amount by which the loan balance exceeds the foreclosure sale price), generally survives the sale and we may bring a lawsuit against the guarantors to collect the deficiency if we determine a judgment against the guarantors may be collectible and cost-effective.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

A judicial foreclosure action may also be brought to collect a real estate loan in the state of Washington, and is used by Frontier Bank in certain cases; however, nonjudicial foreclosure is usually the preferred remedy because it is normally faster and less expensive than litigation, which can take from 6 months for summary judgment, to 2 years for trial.

Foreclosure proceedings in the state of Oregon are similar to Washington’s in most material respects.

In addition, where appropriate, instead of foreclosure, we may negotiate a settlement agreement with the borrower, with a deed in lieu of foreclosure conveying the property to the Bank, to enable the Bank to acquire possession of the property faster than pursuing the normal foreclosure process.

The transition of loans from performing to nonperforming status will generally result in the assignment of a specific reserve that adjusts the net book value of the loan’s principal balance to reflect the estimated fair value of supporting collateral or result in no assignment of a specific reserve if the loans collateral value is in excess of its book value. Subsequent write-downs, requiring additional loan loss provisioning, could occur as a loan moves through the foreclosure process into OREO based on recurring impairment analysis up to and until a property becomes an OREO.

Other Assets

Other assets totaled $90.2 million at September 30, 2009, compared to $67.5 million at December 31, 2008. The increase of $22.7 million, or 33.5%, is primarily attributable to the increase in income tax receivable related to the 2009 net operating loss carry back, partially offset by the decrease in the deferred tax asset.

Deposits

The following table represents the major classifications of interest bearing deposits at September 30, 2009 and December 31, 2008 (in thousands):

	September 30, 2009					December 31, 2008
	Amount		% of total			Amount		% of total
Money market, sweep and NOW accounts	$	428,704		15.2	%	$	325,554		11.3	%
Savings		276,989		9.8	%		365,114		12.7	%
Time deposits		2,116,394		75.0	%		2,189,046		76.0	%
Total	$	2,822,087		100.0	%	$	2,879,714		100.0	%

The following table represents maturities of time deposits of $100,000 and over at September 30, 2009 (in thousands):

	September 30, 2009
3 months or less	$	325,925
Over 3 months through 6 months		213,892
Over 6 months through 12 months		472,623
Over 12 months		304,483
Total	$	1,316,923

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

Review of Financial Condition – September 30, 2009 and September 30, 2008

Below are abbreviated balance sheets at September 30, 2009 and 2008, which indicate changes that have occurred over the past year (in thousands):

	September 30,		September 30,
	2009		2008		$ Change			% Change
ASSETS
Federal funds sold	$	363,081	$	130,334	$	232,747			178.6	%
Securities		76,913		101,832		(24,919	)		-24.5	%
Loans (net of unearned fee income):
Commercial and industrial		405,405		452,286		(46,881	)		-10.4	%
Real Estate:
Commercial		988,004		1,049,939		(61,935	)		-5.9	%
Construction		587,594		1,030,591		(442,997	)		-43.0	%
Land development		405,400		607,501		(202,101	)		-33.3	%
Completed lots		257,057		242,234		14,823			6.1	%
Residential 1-4 family		436,744		379,485		57,259			15.1	%
Installment and other loans		70,800		70,016		784			1.1	%
Total loans		3,151,004		3,832,052		(681,048	)		-17.8	%
FHLB stock		19,885		15,622		4,263			27.3	%
Total earning assets	$	3,610,883	$	4,079,840	$	(468,957	)		-11.5	%
Total assets	$	3,772,109	$	4,244,963	$	(472,854	)		-11.1	%

LIABILITIES
Noninterest bearing deposits	$	403,534	$	377,279	$	26,255			7.0	%
Interest bearing deposits:
Money market, sweep and NOW		428,704		557,323		(128,619	)		-23.1	%
Savings accounts		276,989		418,535		(141,546	)		-33.8	%
Time certificates		2,116,394		2,050,857		65,537			3.2	%
Total interest bearing deposits		2,822,087		3,026,715		(204,628	)		-6.8	%
Total deposits		3,225,621		3,403,994		(178,373	)		-5.2	%
Federal funds purchased and securities
sold under repurchase agreements		15,584		34,701		(19,117	)		-55.1	%
FHLB advances		375,752		329,833		45,919			13.9	%
Junior subordinated debt		5,156		5,156		-			0.0	%
Total interest bearing liabilities		3,218,579		3,396,405		(177,826	)		-5.2	%
Shareholders' equity	$	129,667	$	443,731	$	(314,064	)		-70.8	%

Federal Funds Sold

At September 30, 2009, federal funds sold totaled $363.1 million, compared to $130.3 million at September 30, 2008. Federal funds sold fluctuate on a daily basis depending on our net cash position for the day. In addition, increased federal fund sold balances improves on-balance sheet liquidity, which is an ongoing focus of management.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

Securities

The following table represents the available for sale and held to maturity securities portfolios by type at September 30, 2009 and 2008 (in thousands):

	Securities Available for Sale
	September 30, 2009					September 30, 2008
	Fair Value		% of total			Fair Value		% of total
Equities	$	2,478		3.4	%	$	10,352		10.6	%
U.S. Treasuries		315		0.4	%		6,386		6.5	%
U.S. Agencies		29,965		40.6	%		75,022		76.5	%
Corporate securities		2,189		3.0	%		3,396		3.5	%
Mortgage-backed securities		36,127		48.9	%		-		0.0	%
Municipal securities		2,760		3.7	%		2,939		3.0	%
Total	$	73,834		100.0	%	$	98,095		100.0	%

	Securities Held to Maturity
	September 30, 2009					September 30, 2008
	Amortized Cost		% of total			Amortized Cost		% of total
Corporate securities	$	1,524		49.5	%	$	1,525		40.8	%
Municipal securities		1,555		50.5	%		2,212		59.2	%
Total	$	3,079		100.0	%	$	3,737		100.0	%

Available for sale securities totaled $73.8 million at September 30, 2009, compared to $98.1 million at September 30, 2008, a decrease of $24.3 million, or 24.7%. This decrease is primarily attributable to calls, maturities and sales totaling $97.7 million and principal repayments on mortgage-backed securities of $5.4 million, partially offset by the purchase of $80.2 million of primarily U.S. Agency and mortgage-backed securities.

Loans

At September 30, 2009, total loans, including loans held for resale, were down $681.0 million, or 17.8%, from a year ago. The largest decline came from our real estate construction portfolio, which decreased $443.0 million, or 43.0%, for the period. Management has been diligently working to reduce the concentration in real estate construction and land development loans, as defined by the FDIC, and has successfully reduced these portfolios by $1.00 billion, or 43.4%, from September 30, 2008 to September 30, 2009, including undisbursed loan commitments.

In an effort to reduce our concentrations and diversify our loan portfolio, we are, for the most part, not currently originating new real estate construction loans. For the nine months ended September 30, 2009, total new loan originations were $100.1 million, compared to $759.3 million for the nine months ended September 30, 2008, a decrease of $659.2 million, or 86.8%.

At September 30, 2009, the year-over-year increase in real estate completed lot loans is primarily attributable to disbursement on existing projects. At September 30, 2009, total undisbursed commitments to lend totaled $234.3 million, down from $650.8 million a year ago, a decrease of $416.5 million, or 64.0%. In addition, in certain circumstances in which real estate construction loans are no longer performing and will not be completed, they are reclassified as real estate completed lot loans. From September 30, 2008 to September 30, 2009, $20.1 million of real estate construction loans were converted to real estate completed lot loans. Of these converted loans, $13.2 million were nonperforming at September 30, 2009.

The $57.3 million, or 15.1%, increase in real estate residential 1-4 family loans for the period is primarily attributable to the conversion of certain real estate construction properties into rentals. Due to the weakened economy and the adverse effect on home sales, some builders have converted speculative homes that they have been unable to sell into investment properties.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

From September 30, 2008 to September 30, 2009, $73.0 million of real estate construction loans were converted to residential 1-4 family loans. The conversion of these real estate construction loans changed the payment structure to principal and interest and extended maturity dates. There were no changes in the related loan agreements resulting in credits that would be considered troubled debt restructurings. Additionally, the conversion had no impact on the loan loss reserve as nonperforming loans are assigned a specific reserve. No conversions resulted in loans moving from nonperforming to a performing status. At September 30, 2009, $18.5 million residential construction loans converted to residential 1-4 family loans were nonperforming.

Deposits

At September 30, 2009, noninterest bearing deposits totaled $403.5 million, compared to $377.3 million at September 30, 2008, an increase of $26.3 million, or 7.0%. The increase in noninterest bearing deposits can be attributed, in part, to the unlimited FDIC insurance on these accounts through June 30, 2010, due to our participation in the FDIC’s Transaction Account Guarantee Program. In addition, we have been promoting deposit growth to increase on-balance sheet liquidity.

Total interest bearing deposits decreased $204.6 million, or 6.8%, to $2.82 billion at September 30, 2009, compared to $3.03 billion a year ago. At September 30, 2009, money market, sweep and NOW accounts made up 15.2% of total interest bearing deposits, compared to 18.4% at September 30, 2008, and time deposits made up 75.0%, compared to 67.8% a year ago. The shift in deposit mix over the last year, in part, can be attributed to our participation in the CDARS program, which commenced in the second quarter of 2008. In addition, our money market, sweep and NOW accounts are typically more sensitive to changes in the Federal Funds rate than time deposits. At September 30, 2009, the Federal Funds rate was 0.25%, down 175 basis points from 2.00% at September 30, 2008.

FHLB advances

FHLB advances totaled $375.8 million at September 30, 2009, compared to $329.8 million at September 30, 2008, an increase of $45.9 million, or 13.9%. For the period, FHLB advances totaled approximately $145.0 million and were partially offset by repayments of $98.7 million. At September 30, 2009, our unused line of credit at the FHLB totaled $28.6 million.

Results of Operations

Net Interest Income

Net interest income is the difference between total interest income and total interest expense and is the largest source of our operating income. Several factors contribute to changes in net interest income, including: the effects of changes in average balances, changes in rates on earning assets and rates paid for interest bearing liabilities and the levels of noninterest bearing deposits, shareholders’ equity and nonaccrual loans.

Net interest income for the three months ended September 30, 2009, totaled $18.9 million, down $21.8 million, or 53.6%, from the same period a year ago. Net interest income for the three months ended September 30, 2009, was negatively impacted by the $3.5 million reversal of interest income on loans during the quarter and the increase in nonperforming loans. At September 30, 2009, nonperforming loans totaled $810.5 million, compared to $205.2 million a year ago.

Net interest income for the nine months ended September 30, 2009, was $64.1 million, compared to $133.0 million for the nine months ended September 30, 2008, a decrease of $68.9 million, or 51.8%. Net interest income for the nine months ended September 30, 2009, was negatively impacted by the $15.3 million reversal of interest income on loans and the $605.3 million increase in nonperforming loans for the period.

The earnings from certain assets are exempt from federal income tax, and it is customary in the financial services industry to analyze changes in net interest income on a “tax equivalent” (“TE”) or fully taxable basis. TE is a non-GAAP performance measurement used by management in operating and analyzing the business, which management believes provides financial statement users with a more accurate picture of the net interest margin for comparative purposes. Under this method, nontaxable income from loans and investments is adjusted to an amount which would have been earned if such income were subject to federal income tax. The discussion below presents an analysis based on TE amounts using a 35% tax rate. (However, there are no tax equivalent additions to the interest expense or noninterest income and expense amounts.)

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

The annualized tax equivalent net interest margin was 2.04% for the three months ended September 30, 2009, down 201 basis points from the same period in 2008. This decrease primarily resulted from the decrease in the average yield on earning assets of 233 basis points, resulting from the increase in nonperforming loans; partially offset by the decrease in the average rate on interest bearing liabilities of 57 basis points. The $3.5 million reversal of interest income on nonaccrual loans in the quarter contributed to a 38 basis point decline in the annualized tax equivalent net interest margin during the quarter.

The annualized tax equivalent net interest margin was 2.21% for the nine months ended September 30, 2009, compared to 4.55% for the nine months ended September 30, 2008, a decrease of 234 basis points. The decrease in the annualized tax equivalent net interest margin primarily resulted from the decrease in the average yield on earning assets of 277 basis points, resulting from the increase in nonperforming loans; partially offset by the decrease in the average rate on interest bearing liabilities of 61 basis points. For the nine months ended September 30, 2009, the reversal of $15.3 million of interest income on nonaccrual loans lowered the tax equivalent net interest margin by approximately 52 basis points.

The following tables represent condensed average balance sheet information, together with interest income and yields on average earning assets, interest expense and rates paid on average interest bearing liabilities and the changes in tax equivalent net interest income due to changes in average balances (volume) and changes in average rates (rate) for the three and nine months ended September 30, 2009 and 2008 (in thousands):

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

	Three Months Ended September 30,
	2009								2008
				TE		Average						TE		Average
				Interest		Rates						Interest		Rates
	Average			Income/		Earned/			Average			Income/		Earned/
	Balance			Expense		Paid (3)			Balance			Expense		Paid (3)
Interest Earning Assets
Taxable investments	$	98,161		$	700		2.66	%	$	153,814		$	1,386		3.48	%
Nontaxable investments (1)		4,225			22		6.01	%		5,077			40		6.27	%
Total		102,386			722		2.80	%		158,891			1,426		3.57	%
Federal funds sold		306,772			195					58,168			274		1.87	%
Loans (1) (2)
Installment		70,868			1,252		7.01	%		69,163			1,425		8.20	%
Commercial		423,953			6,622		6.20	%		458,330			8,200		7.12	%
Real estate
Commercial		1,003,786			17,512		6.92	%		1,055,207			20,169		7.60	%
Construction		661,786			5,008		3.00	%		1,051,884			16,658		6.30	%
Land development		455,623			1,481		1.29	%		602,436			10,364		6.84	%
Completed lots		271,602			2,629		3.84	%		241,036			4,017		6.63	%
Residential 1-4 family		430,649			6,400		5.90	%		365,365			6,658		7.25	%
Total loans		3,318,267			40,904		4.89	%		3,843,421			67,491		6.99	%
Total earning assets/total
interest income		3,727,425			41,821		4.45	%		4,060,480			69,191		6.78	%
Reserve for loan losses		(108,254	)							(87,365	)
Cash and due from banks		43,317								53,789
Other assets		259,527								194,826
TOTAL ASSETS	$	3,922,015							$	4,221,730
Interest Bearing Liabilities
Money Market, Sweep &
NOW accounts	$	416,738		$	801		0.76	%	$	586,319		$	2,086		1.42	%
Savings accounts		282,065			669		0.94	%		392,552			2,161		2.19	%
Other time deposits		2,137,770			17,233		3.20	%		2,008,838			20,143		3.99	%
Total interest bearing
deposits		2,836,573			18,703		2.62	%		2,987,709			24,390		3.25	%
Short-term borrowings		15,806			3		0.08	%		33,631			126		1.49	%
FHLB borrowings		397,578			3,850		3.84	%		329,985			3,510		4.23	%
Subordinated debt		5,156			56		4.30	%		5,156			69		5.30	%
Total interest bearing
liabilities/total
interest expense		3,255,113			22,612		2.76	%		3,356,481			28,095		3.33	%
Noninterest bearing
deposits		404,988								386,896
Other liabilities		21,466								13,853
Shareholders' equity		240,448								464,500
TOTAL LIABILITIES
AND CAPITAL	$	3,922,015							$	4,221,730
TE NET INTEREST INCOME				$	19,209							$	41,096
TE NET INTEREST MARGIN							2.04	%							4.05	%

(1) Includes amounts to convert nontaxable amounts to a fully taxable equivalent basis at a 35% tax rate. The amounts
totaled $331 thousand and $370 thousand for the three months ended September 30, 2009 and 2008, respectively.
(2) Includes nonaccruing loans.
(3) Annualized.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

	Nine Months Ended September 30,
	2009								2008
				TE		Average						TE		Average
				Interest		Rates						Interest		Rates
	Average			Income/		Earned/			Average			Income/		Earned/
	Balance			Expense		Paid (3)			Balance			Expense		Paid (3)
Interest Earning Assets
Taxable investments	$	100,066		$	2,288		2.88	%	$	148,442		$	4,237		3.71	%
Nontaxable investments (1)		4,348			68		6.15	%		5,074			124		6.13	%
Total		104,414			2,356		3.02	%		153,516			4,361		3.79	%
Federal funds sold		286,241			547		0.26	%		24,145			377		2.09	%
Loans (1) (2)
Installment		69,632			3,749		7.20	%		68,195			4,411		8.64	%
Commercial		438,227			20,458		6.24	%		431,062			24,375		7.55	%
Real estate
Commercial		1,017,262			53,946		7.09	%		1,031,928			60,106		7.78	%
Construction		808,002			20,506		3.39	%		1,066,762			59,361		7.43	%
Land development		505,012			9,295		2.46	%		579,007			33,981		7.84	%
Completed lots		278,892			7,772		3.73	%		242,741			13,694		7.54	%
Residential 1-4 family		436,955			19,932		6.10	%		332,734			19,119		7.68	%
Total loans		3,553,982			135,658		5.10	%		3,752,429			215,047		7.66	%
Total earning assets/total
interest income		3,944,637			138,561		4.70	%		3,930,090			219,785		7.47	%
Reserve for loan losses		(115,060	)							(69,091	)
Cash and due from banks		45,047								51,125
Other assets		201,852								189,910
TOTAL ASSETS	$	4,076,476							$	4,102,034
Interest Bearing Liabilities
Money Market, Sweep &
NOW accounts	$	378,870		$	1,958		0.69	%	$	647,108		$	7,964		1.64	%
Savings accounts		313,436			2,728		1.16	%		334,703			5,517		2.20	%
Other time deposits		2,221,187			56,800		3.42	%		1,836,898			59,895		4.36	%
Total interest bearing
deposits		2,913,493			61,486		2.82	%		2,818,709			73,376		3.48	%
Short-term borrowings		17,824			12		0.09	%		77,480			1,462		2.52	%
FHLB borrowings		417,614			11,806		3.78	%		331,207			10,590		4.27	%
Subordinated debt		5,156			177		4.59	%		5,156			220		5.69	%
Total interest bearing
liabilities/total
interest expense		3,354,087			73,481		2.93	%		3,232,552			85,648		3.54	%
Noninterest bearing
deposits		398,604								376,623
Other liabilities		23,287								23,132
Shareholders' equity		300,498								469,727
TOTAL LIABILITIES
AND CAPITAL	$	4,076,476							$	4,102,034
TE NET INTEREST INCOME				$	65,080							$	134,137
TE NET INTEREST MARGIN							2.21	%							4.55	%

(1) Includes amounts to convert nontaxable amounts to a fully taxable equivalent basis at a 35% tax rate. The amounts
totaled $999 thousand and $1.1 million for the nine months ended September 30, 2009 and 2008, respectively.
(2) Includes nonaccruing loans.
(3) Annualized.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

	Three Months Ended September 30,									Nine Months Ended September 30,
	2009 versus 2008									2009 versus 2008
	Increase (Decrease) Due									Increase (Decrease) Due
	to Change in									to Change in
							Total									Total
	Average			Average			Increase			Average			Average			Increase
	Volume			Rate			(Decrease)			Volume			Rate			(Decrease)
INTEREST INCOME
Taxable investments	$	(487	)	$	(201	)	$	(688	)	$	(1,345	)	$	(627	)	$	(1,972	)
Nontaxable investments		(13	)		(3	)		(16	)		(33	)		-			(33	)
Total		(500	)		(204	)		(704	)		(1,378	)		(627	)		(2,005	)

Federal funds sold		1,171			(1,250	)		(79	)		4,092			(3,922	)		170

Loans
Installment		35			(208	)		(173	)		93			(755	)		(662	)
Commercial		(615	)		(963	)		(1,578	)		405			(4,322	)		(3,917	)
Real estate								-									-
Commercial		(983	)		(1,674	)		(2,657	)		(854	)		(5,306	)		(6,160	)
Construction		(6,178	)		(5,472	)		(11,650	)		(14,399	)		(24,456	)		(38,855	)
Land development		(2,526	)		(6,357	)		(8,883	)		(4,343	)		(20,343	)		(24,686	)
Completed lots		509			(1,897	)		(1,388	)		2,039			(7,961	)		(5,922	)
Residential 1-4 family		1,190			(1,448	)		(258	)		5,989			(5,176	)		813
Total loans		(8,568	)		(18,019	)		(26,587	)		(11,070	)		(68,319	)		(79,389	)

TOTAL INTEREST INCOME		(7,897	)		(19,473	)		(27,370	)		(8,356	)		(72,868	)		(81,224	)

INTEREST EXPENSE
Money Market, Sweep &
NOW accounts		(603	)		(682	)		(1,285	)		(3,301	)		(2,705	)		(6,006	)
Savings accounts		(608	)		(884	)		(1,492	)		(351	)		(2,438	)		(2,789	)
Other time deposits		1,293			(4,203	)		(2,910	)		12,530			(15,625	)		(3,095	)
Total interest bearing deposits		82			(5,769	)		(5,687	)		8,878			(20,768	)		(11,890	)

Short-term borrowings		(67	)		(56	)		(123	)		(1,126	)		(324	)		(1,450	)
FHLB borrowing		719			(379	)		340			2,763			(1,547	)		1,216
Subordinated debt		-			(13	)		(13	)		-			(43	)		(43	)

TOTAL INTEREST EXPENSE		734			(6,217	)		(5,483	)		10,515			(22,682	)		(12,167	)

CHANGE IN NET INTEREST INCOME	$	(8,631	)	$	(13,256	)	$	(21,887	)	$	(18,871	)	$	(50,186	)	$	(69,057	)

Provision for Loan Losses

The provision for loan losses totaled $275.0 million for the nine months ended September 30, 2009, compared to $75.6 million for the nine months ended September 30, 2008.

The increase in the provision for loan losses in first nine months of 2009, as compared to the first nine months of 2008, is primarily attributable to the overall decline in the economy, the downturn in the local housing market and its impact on our real estate construction, land development and completed lot loan portfolios and an increase in nonperforming loans. At September 30, 2009, nonperforming loans totaled $810.5 million, compared to $205.2 million at September 30, 2008.

The provision for loan losses is based on management’s evaluation of inherent risks in the loan portfolio and a corresponding analysis of the allowance for loan losses. Additional discussion on the allowance for loan losses is provided under the heading Allowance for Loan Losses above.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

Noninterest Income

The following table represents the key components of noninterest income for the three and nine months ended September 30, 2009 and 2008 (in thousands):

	Three Months Ended September 30,
	2009			2008			$ Change			% Change
Provision for loss on securities	$	-		$	(6,431	)		6,431			-100.0	%
Net gain (loss) on sale of securities		-			(1,026	)		1,026			-100.0	%
Gain on sale of secondary mortgage loans		232			308			(76	)		-24.7	%
Net gain (loss) on other real estate owned		(1,068	)		81			(1,149	)		-1418.5	%
Service charges on deposit accounts		1,611			1,384			227			16.4	%
Other noninterest income		2,103			2,511			(408	)		-16.2	%
Total noninterest income (loss)	$	2,878		$	(3,173	)	$	6,051			-190.7	%

	Nine Months Ended September 30,
		2009			2008		$ Change			% Change
Provision for loss on securities	$	-		$	(6,431	)	$	6,431			-100.0	%
Net gain (loss) on sale of securities		(102	)		1,442			(1,544	)		-107.1	%
Gain on sale of secondary mortgage loans		1,446			1,074			372			34.6	%
Net gain (loss) on other real estate owned		(1,519	)		93			(1,612	)		-1733.3	%
Service charges on deposit accounts		4,596			4,130			466			11.3	%
Other noninterest income		6,369			7,020			(651	)		-9.3	%
Total noninterest income	$	10,790		$	7,328		$	3,462			47.2	%

Total noninterest income increased $6.1 million and $3.5 million, respectively, for the three and nine months ended September 30, 2009, compared to the same periods in 2008.

During the third quarter 2008, we recognized a $6.4 million pre-tax loss related to other than temporarily impaired investments in Fannie Mae, Freddie Mac and Lehman Brothers. There were no such impairment charges during the three and nine months ended September 30, 2009.

For the three months ended September 30, 2008, we recognized a net $1.0 million loss on the sale of a security. There were no security sales for the three months ended September 30, 2009. For the nine months ended September 30, 2009, we recognized a net loss on sale of securities of $102 thousand, compared to a $1.4 million net gain a year ago when we sold our stock in Skagit State Bank.

Net losses on other real estate owned totaled $1.1 million and $1.5 million for the three and nine months ended September 30, 2009, respectively. The losses for the periods were primarily due to valuation adjustments resulting from declines in the market value of these properties subsequent to foreclosure. Net gain on other real estate owned totaled $81 thousand and $93 thousand for the three and nine months ended September 30, 2008, respectively.

The increase in service charges on deposit accounts in 2009, over the same periods in 2008, is primarily attributable to increases in overdraft fees.

The decrease in other noninterest income for the three and nine months ended September 30, 2009, compared to the same periods in 2008, is primarily attributable to decreases in insurance and financial service fees and annuity commissions generated by our Trust department.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

Noninterest Expense

The following table represents the key components of noninterest expense for the three and nine months ended September 30, 2009 and 2008 (in thousands):

	Three Months Ended September 30,
	2009		2008		$ Change			% Change
Salaries and employee benefits	$	11,290	$	12,420	$	(1,130	)		-9.1	%
Occupancy expense		2,694		3,161		(467	)		-14.8	%
State business taxes		239		498		(259	)		-52.0	%
FDIC insurance		2,682		1,236		1,446			117.0	%
Other noninterest expense		7,909		4,742		3,167			66.8	%
Total noninterest expense	$	24,814	$	22,057	$	2,757			12.5	%

	Nine Months Ended September 30,
		2009		2008	$ Change			% Change
Salaries and employee benefits	$	35,927	$	39,005	$	(3,078	)		-7.9	%
Occupancy expense		8,264		8,742		(478	)		-5.5	%
State business taxes		744		1,643		(899	)		-54.7	%
FDIC insurance		11,162		1,920		9,242			481.4	%
Other noninterest expense		17,396		13,825		3,571			25.8	%
Total noninterest expense	$	73,493	$	65,135	$	8,358			12.8	%

For the three months ended September 30, 2009, total noninterest expense totaled $24.8 million, compared to $22.1 million for the same period in 2008, an increase of $2.8 million, or 12.5%. For the nine months ended September 30, 2009, total noninterest expense totaled $73.5 million, an increase of $8.4 million, or 12.8%, compared to the nine months ended September 30, 2008.

The decrease in salaries and employee benefits in 2009, over the same periods in 2008, was primarily attributable to the elimination of bonus and incentive pay, a reduction in executive compensation, a moratorium on hiring and a reduction in force. At September 30, 2009, full time equivalents (“FTE”) employees totaled 698, down from 827 at September 30, 2008. In addition, the Board of Directors voted to suspend the Corporation’s matching of employee 401(K) Plan contributions, effective May 1, 2009.

The increase in FDIC insurance for the three and nine months ended September 30, 2009, compared to the same periods a year ago, were primarily attributable increases in premiums. Additionally, we recognized a special assessment of $1.9 million during the second quarter 2009, which was paid in the third quarter 2009.

The $3.2 million, or 66.8%, increase in other noninterest expense for the three months ended September 30, 2009, compared to the same in 2008, was primarily attributable to the $2.0 million increase in collection and foreclosure expenses, the $1.0 million increase in consulting fees, which related to the proposed merger with SPAH, and the $948 thousand increase in legal expenses. The increase to collection and foreclosure expense for the period was primarily attributable to the increase in nonperforming assets. The increase in legal expense was attributable to both an increase in nonperforming assets and the proposed merger. For the period, total merger related expenses were approximately $2.0 million. The increases in other noninterest expense, however, were partially offset by decreases in other miscellaneous other noninterest expense accounts as part of our continuing efforts to cut costs.

For the nine months ended September 30, 2009, compared to the same period a year ago, other noninterest expense increased $3.6 million, or 25.8%. This increase was primarily attributable to the $4.1 million increase in collection and foreclosure expenses, resulting from an increase in nonperforming assets.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

Liquidity Resources

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. We monitor the sources and uses of funds on a daily basis to maintain an acceptable liquidity position. 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. At September 30, 2009, Frontier Bank’s liquidity ratio, as defined by the FDIC, was 13.1%.

We continue to closely monitor and manage our liquidity position, understanding that this continues to be of critical importance in the current economic environment. To further increase our on-balance sheet liquidity, we have been focused on reducing our balance sheet, and in particular, the real estate loan portfolio. For the nine months ended September 30, 2009, total loans decreased $627.7 million, or 16.6% compared to December 31, 2008. Additionally, we have increased our federal funds sold balances to $363.1 million at September 30, 2009, an increase of $245.3 million from December 31, 2008.

As shown in the Consolidated Statements of Cash Flows, net cash provided by operating activities was $37.4 million for the nine months ended September 30, 2009. The primary source of cash provided by operating activities was net income, after excluding non-cash charges such as the provision for loan losses of $275.0 million. Net cash of $56.7 million provided by investing activities consisted primarily of $261.9 million from the net reduction of loan, $57.1 million from the maturity of available for sale securities and $24.5 million from proceeds on the sale of other real estate owned, partially offset by the $245.3 million increase in net federal funds sold and the $47.3 million purchase of available for sale securities. The $109.2 million of cash used in financing activities primarily consisted of the $53.7 million net decrease in FHLB advances and the $49.5 million net decrease deposits.

Capital Requirements

The minimum ratios and the actual capital ratios at September 30, 2009, are set forth in the table below (in thousands):

	Frontier Financial Corporation			Frontier Bank			Well Capitalized Minimum			Adequately Capitalized Minimum
Total capital to risk-weighted assets		5.62	%		5.35	%		10.00	%		8.00	%
Tier 1 capital to risk-weighted assets		4.33	%		4.06	%		6.00	%		4.00	%
Tier 1 leverage capital to average assets		3.40	%		3.19	%		5.00	%		4.00	%

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

Interest Rate Risk

Interest rate risk refers to the exposure of earnings and capital arising from changes in interest rates. Management’s objectives are to control interest rate risk and to ensure predictable and consistent growth of earnings and capital. Interest rate risk management focuses on fluctuations in net interest income identified through computer simulations to evaluate volatility under varying interest rate, spread and volume assumptions. The risk is quantified and compared against tolerance levels.

We use a simulation model to estimate the impact of changing interest rates on earnings and capital. The model calculates the change in net interest income and net income under various rate shocks. As of September 30, 2009, the model predicted that net interest income and net income, over a one-year horizon, would decrease by approximately $6.9 million and $4.5 million, respectively, if rates increased 2%. The model also predicted that if rates decreased 0.25%, over a one-year horizon, net interest income would increase $1.1 million and net income would decrease $699 thousand. The decrease in both net interest income and net income if rates were to increase, over a one-year horizon, is attributable to our balance sheet becoming more liability sensitive during the first nine months of 2009.

The actual change in earnings will be dependent upon the dynamic changes that occur when rates change. Many of these changes are predictable, but the exact amount is difficult to predict and actual events may vary substantially from the simulation model results.

Recent Accounting Pronouncements

See Note 2 of the Consolidated Financial Statements for a discussion of recently issued accounting pronouncements.

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

There has been no material change in information regarding quantitative and qualitative disclosures about market risk at September 30, 2009, from the information presented in Item 7A. Quantitative and Qualitative Disclosures about Market Risk on Form 10-K for the fiscal year ended December 31, 2008.

ITEM 4. DISCLOSURE CONTROLS AND PROCEDURES

Our principal executive and financial officers evaluated our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities and Exchange Act of 1934, or Exchange Act) as of September 30, 2009. Based upon that evaluation, they concluded as of September 30, 2009, that our disclosure controls and procedures were effective to ensure that information we are required to disclosure in the reports that we file under the Exchange Act is recorded, processed, summarized and reported within time periods specified in Securities and Exchange Commission rules and forms. In addition, our principal executive and financial officers concluded as of September 30, 2009, that our disclosure controls and procedures are also effective to ensure that information required to be disclosed in reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure.

During the three and nine months ended September 30, 2009, there were no changes in our internal control over financial reporting that materially affected, or are reasonable likely to materially affect, our internal control over financial reporting.

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PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

On August 20, 2009, a putative shareholders’ class action lawsuit was filed in the Superior Court of Washington, for King County, Civil Action No. 09 2 07813 9, against Frontier, its directors and SPAH alleging that (i) the merger consideration and process are unfair to Frontier’s shareholders, (ii) there are material omissions and misrepresentations in the registration statement and (iii) certain provisions of the merger agreement improperly discourage competing offers for Frontier, and claiming self-dealing on the part of the Frontier directors. The lawsuit seeks to enjoin the consummation of the merger, damages against the defendants if the transaction is consummated and other relief. Frontier and its directors believe the plaintiffs’ allegations are without merit and intend to vigorously defend this action. The lawsuit has been stayed temporarily as a result of the termination of the merger agreement with SPAH.

In addition, Frontier is periodically a party to or otherwise involved in legal proceedings arising in the normal and ordinary course of business, such as claims to enforce liens, foreclose on loan defaults, and other issues incident to its business. As of September 30, 2009, Frontier Bank had commenced collection proceedings on approximately 664 real estate loans, and there may be additional lawsuits or claims arising out of or related to the impaired loans.

Frontier is unable to predict the outcome of these matters. Frontier’s cash expenditures, including legal fees, associated with the pending litigation described above, and the regulatory proceedings described in “— Management’s Discussion & Analysis of Financial Condition and Results of Operations — Regulatory Actions”, cannot be reasonably predicted at this time. Litigation and any potential regulatory actions or proceedings can be time-consuming and expensive and could divert management time and attention from Frontier’s business, which could have a material adverse effect on Frontier’s business, results of operations and financial condition.

ITEM 1A. RISK FACTORS

The continued downturn in our real estate market areas and weakness in the economy could adversely affect our financial condition and profitability.

The Washington and Oregon economies and real estate markets experienced a significant, dramatic downturn in the past year, resulting in significant declines in real estate values. Average home sale prices declined by 7.9% year over year in Washington as of September 30, 2009, and 13.4% year over year as of December 31, 2008, and average home sale prices had declined by 10.7% year over year in Oregon as of September 30, 2008, according to data published by the National Association of Realtors. Unemployment increased by 3.8% to 9.3% in Washington over the twelve months ended September 30, 2009, and by 4.7% to 11.5% in Oregon over the same period, according to the National Bureau of Labor Statistics, while according to RealtyTrac foreclosures rose by 33% and 77% in Washington and Oregon, respectively.

We are currently operating in a challenging and uncertain economic environment, both nationally and locally. Like many other financial institutions, we are being affected by sharp declines in the real estate market, constrained financial markets and a weak economy. Continued declines in residential and commercial real estate values and home sales and financial stress on borrowers as a result of the uncertain economic environment, including job losses, could have an adverse effect on our borrowers or their customers and demand for our products and services, which could adversely affect our financial condition and earnings, increase loan delinquencies, defaults and foreclosures, and significantly impair the value of our collateral and our ability to sell the collateral upon foreclosure.

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We are experiencing deterioration in our loan portfolio, centered in our residential construction and land development loans.

As of September 30, 2009, approximately 85.0% of our loan portfolio was comprised of loans secured by real estate. Of this 85.0% of real estate loans, 31.4% are commercial real estate loans, 18.7% are residential and commercial construction loans, 12.9% are land development loans, 13.8% are term 1-4 family residential loans and 8.2% are lot loans. We have been experiencing deterioration in our loan portfolio, centered in our residential construction and land development loans. Many of these loans are maturing and classified as nonperforming assets while we work with the borrowers to maximize our recovery. If loan payments from borrowers are over 90 days past due, or sooner if normal repayment cannot resume, the loans are placed on nonaccrual status, thereby reducing and/or reversing previously accrued interest income. From third quarter 2008 to September 30, 2009, our nonperforming and nonaccrual loans increased significantly, from $205.2 million to $810.5 million, $552.1 million of which were construction and land development loans, which represent 53.8% of our construction and land development loans. The contraction or expansion of our nonaccrual loan portfolio and other real estate owned (“OREO”) properties in future periods will depend upon our ongoing collection efforts and changes in market conditions. We have a dedicated a team of 38 employees focused on the management of problem loans, but there is no guarantee that this team will be able to effectively manage the amount of problem loans we may encounter in the future. Additional information regarding credit risk is included in “Management’s Discussion and Analysis of Financial Condition and Results of Operations —Loans.”

Due to unforeseen circumstances and/or changes in estimates, our allowance for loan losses may not be adequate to cover actual losses.

An essential element of our business is to make loans. We maintain an allowance for loan losses that we believe is a reasonable estimate of known and inherent losses within the loan portfolio. Our loan portfolio and allowance for loan losses are assessed each quarter by management, and were subject to recent examinations by our federal and state regulators. As of September 30, 2009, our allowance for loan losses increased to $142.2 million or 4.51% of our total loans of $3.1 billion, as a result of significant additional provisions for loan losses and charge-offs in the third quarter of 2009. See “Management’s Discussion & Analysis of Financial Condition and Results of Operations — Allowance for Loan Losses.” The determination of the appropriate level of loan loss allowance as well as the appropriate amount of loan charge-offs (net of loan recoveries) is an inherently difficult process and is based on numerous assumptions and there may be a range of potential estimates. The amount of future losses is susceptible to changes in economic, operating and other conditions, including changes in our real estate markets and interest rates that are beyond our control. Our underwriting policies, credit monitoring processes and risk management systems and controls may not prevent unexpected losses. In addition, bank regulators periodically review our allowance for loan losses and may require us to increase our provision for loan losses or recognize further loan charge-offs. Any such additional loan losses, should they occur, would adversely affect our financial condition and profitability.

Defaults and related losses in our residential construction and land development loan portfolio could result in a significant increase in OREO balances and the number of properties to be disposed of, which would adversely affect our financial results.

As part of our collection process for all nonperforming real estate loans, we may foreclose on and take title to the property serving as collateral for the loan. Real estate owned by us and not used in the ordinary course of our operations is referred to as other real estate owned (OREO) property. We expect to take additional properties into OREO. Increased OREO balances lead to greater expenses as we incurs costs to manage and dispose of the properties and, in certain cases, complete construction of improvements prior to sale. Any decrease in sale prices on properties may lead to OREO write-downs with a corresponding expense in our statement of operations. Our management expects that earnings over the next several quarters could be negatively affected by various expenses associated with OREO, including personnel costs, insurance and taxes, completion and repair costs, and other costs associated with property ownership, as well as by the funding costs associated with assets that are tied up in real estate during the period they are held in OREO. The management and oversight of OREO is time consuming and can be complex and can require significant resources of our management and employees. We will also be at risk of further declines in real estate prices in the market areas in which we conduct our lending business.

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Restrictions imposed by regulatory actions could have an adverse effect on us and failure to comply with any of its provisions could result in further regulatory action or restrictions.

The businesses and operations of the Corporation and our subsidiary, Frontier Bank, are currently subject to regulatory actions, including the FDIC Order and the FRB Written Agreement, which , for example, generally prohibit us from paying dividends, repurchasing stock, retaining new directors or senior managers or changing the duties of senior management, paying management or consulting fees or other funds to the Corporation, and extending additional credit with respect to nonperforming and adversely classified loans which management believes, complicates the workout of troubled loans. The FDIC Order also requires Frontier Bank to raise its Tier 1 leverage capital ratio to a higher than normal level of 10% of its assets and to maintain that capital level, in addition to maintaining a fully funded allowance for loan losses satisfactory to the FDIC and the Washington DFI. These and other regulatory actions are described in more detail in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Regulatory Actions.” The FDIC identified deficiencies in the management and supervision of Frontier Bank that primarily relate to loan underwriting, procedures and monitoring, excessive concentrations in construction and land development loans, and related concerns about Frontier Bank’s capital and liquidity. Management believes it has addressed the concerns and that it is in compliance with all the requirements of the FDIC Order and the FRB Written Agreement, other than the Tier 1 capital requirement for Frontier Bank. These regulatory actions and any future actions could continue to adversely affect its earnings, business and operations. In addition, failure to comply with these regulatory actions or any future actions could result in further regulatory actions or restrictions, including monetary penalties and the potential closure of Frontier Bank.

Our future earnings may be adversely affected by the legal and regulatory actions taken against us, as well as those legal actions that Frontier has and may pursue.

Frontier and the Frontier Board have been sued in the putative securities class action lawsuit described in “Item 1: Legal Proceedings,” which, if adversely determined, could have a material adverse effect on its consolidated financial position, results of operations or cash flows and our ability to raise capital. Further, Frontier and Frontier Bank are also involved in the regulatory, collection and potential foreclosure actions and proceedings described therein. Because we are unable to predict the impact or resolution of these outstanding litigation and regulatory matters or to reasonably estimate the potential loss, if any, no reserves have yet been established therefore. We may determine in the future that it is necessary to establish such reserves and, if so established, such reserves could have a material adverse impact on its financial condition.

Our profitability and the value of stockholder’s investments may suffer because of rapid and unpredictable changes in the highly regulated environment in which we operate.

We are subject to extensive supervision by several governmental regulatory agencies at the federal and state levels in the financial services area. Recently enacted, proposed and future legislation and regulations have had, and will continue to have, or may have a significant impact on the financial services industry. These regulations, which are generally intended to protect depositors and not stockholders, and the interpretation and application of them by federal and state regulators, are beyond our control, may change rapidly and unpredictably and can be expected to influence earnings and growth. For example, the FDIC and the Federal Reserve 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 Frontier Bank, based on our current loan portfolio, and our management expects that our business and operations will be subject to enhanced regulatory review for the foreseeable future. Regulatory authorities have extensive discretion in their supervisory and enforcement activities, including the imposition of restrictions on operations, the classification of assets and determination of the level of allowance for loan losses. Our success depends on our continued ability to maintain compliance with these regulations. Such additional regulation and supervision may increase our costs and limit our ability to pursue business opportunities.

Market and other constraints on our construction loan origination volume are expected to lead to decreases in our interest and fee income that are not expected to be fully offset by reductions in our noninterest expenses.

Due to existing conditions in housing markets in the areas where we operate, the recession and other factors, we project construction loan originations to be materially constrained in 2009 and beyond. Additionally, management’s revised business plan will de-emphasize the origination of construction loans. This will lower interest income and fees generated from this part of our business. Unless this revenue decline is offset by other areas of operations, our total revenues may decline relative to our total noninterest expense. We expect that it will be difficult to find new revenue sources in the near term to completely offset expected declines in our interest income. In that regard, the adverse economic conditions that began in 2007 and that have continued in 2009 have significantly reduced our origination of all new loans, and management cannot assure you that our total loans or assets will increase or not decline in 2009.

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Concern of customers over the safety of their deposits may cause a decrease in deposits.

With recent increased concerns about bank failures, customers increasingly are concerned about the safety of their deposits and the extent to which their deposits are insured by the FDIC. Customers may not believe Frontier Bank is a safe place to keep their deposit accounts and they may remove their deposit accounts. Additionally, customers may withdraw deposits from Frontier Bank in an effort to ensure that the amount they have on deposit at Frontier Bank is fully insured. Decreases in deposits may adversely affect our funding costs, liquidity and net income.

We depend on key personnel for success.

Our operating results and ability to adequately manage our growth and minimize loan and lease losses are highly dependent on the services, managerial abilities and performance of our current executive officers and other key personnel. We have an experienced management team that the Board of Directors believes is capable of managing and growing our operations. However, losses of or changes in our current executive officers or other key personnel and their responsibilities may disrupt our business and could adversely affect financial condition, results of operations and liquidity. We may not be successful in retaining our current executive officers or other key personnel.

We are required by the terms of the FDIC Order to raise additional capital, but that capital has not been available to date and without additional capital other courses, such as selling assets and looking for merger partners, will need to be pursued.

Under the terms of the FDIC Order, Frontier Bank was required to increase its Tier 1 leverage capital ratio to 10% of the Bank’s total assets by July 20, 2009. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Regulatory Actions.” Our ability to raise additional capital has been contingent on the current capital markets and on our financial performance. Available capital markets are not currently favorable and we have not been able to raise the required capital to date and cannot be certain of our ability to raise additional capital on any terms. If we cannot raise additional capital, and/or continue to shrink our balance sheet, or engage a strategic merger or sale, we may not be able to sustain further deterioration in our financial condition and other regulatory actions may be taken.

Frontier’s total capital to risk-weighted assets ratio dropped below 6.0% as of September 30, 2009, as a result of the additional provisions for loan losses and charge-offs in the third quarter of 2009, and therefore, Frontier and the Bank were “significantly undercapitalized” as of September 30, 2009.

See also the discussion of our risk factors on Form 10-K for the fiscal year ended December 31, 2008, as filed with the SEC on March 11, 2009.

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ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

We did not repurchase any shares during the three or nine months ended September 30, 2009.

We have not paid, and currently have no plans to pay, cash dividends to our shareholders, and the FDIC Order prohibits us from doing so. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Regulatory Actions.”

Additionally, our junior subordinated debt agreement prohibits us from paying dividends if we have deferred payment of interest on outstanding trust preferred securities. We began deferring interest on our trust preferred securities beginning in the first quarter of 2009.

FFC is a legal entity separate and distinct from Frontier Bank. Because FFC is bank holding company with no significant assets other than Frontier Bank, FFC is dependent upon dividends from Frontier Bank for cash with which to pay dividends. For a discussion of the regulatory limitations on Frontier Bank’s ability to pay dividends, see “Regulation and Supervision – Federal and State Regulation of the Bank – Dividends” on Form 10-K for the fiscal year ended December 31, 2008, and “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Regulatory Actions” on this Form 10-Q.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

Not applicable.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

There were no matters submitted to a vote of security holders during the quarter ended September 30, 2009.

ITEM 5. OTHER INFORMATION

Not applicable.

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ITEM 6. EXHIBITS

	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 3.1 to
			Form 8-K, filed on July 23, 2007 (File No. 000-15540).

*	10	(a)	Amended and Restated Frontier Financial Corporation Incentive Stock Option Plan incorporated
			herein by reference to Exhibit 33.1 to Registration Statement on Form S-8, filed March 2, 1999.
			(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 February 28, 2007 (File No. 000-15540).

*	10	(i)	Change of Control Agreement with other Executive Officers is incorporated by reference to
			Exhibit 10(h) to Annual Report on Form 10-K filed February 28, 2007 (File No. 000-15540).

	31.1		Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

	31.2		Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

	32.1		Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

	32.2		Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

	*		Compensatory plan or arrangement

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SIGNATURES

Pursuant to the requirements 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

	/s/ Patrick M. Fahey
	Patrick M. Fahey
	Chairman and Chief Executive Officer
	November 3, 2009

	/s/ Carol E. Wheeler
	Carol E. Wheeler
	Chief Financial Officer
	November 3, 2009

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