HFWA-2013.12.31-10K
Table of Contents


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
 
 
 
FORM 10-K
 
 
 
x
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2013
OR
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
Commission File Number 0-29480 
 
HERITAGE FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter) 
 
 
 
Washington
 
91-1857900
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification No.)
 
 
201 Fifth Avenue SW, Olympia, WA
 
98501
(Address of principal executive offices)
 
(Zip Code)
(360) 943-1500
(Registrant’s telephone number, including area code) 
Securities registered pursuant to Section 12(b) of the Act:
Title of each class
  
Name of each exchange on which registered
Common Stock
  
NASDAQ Stock Market LLC
Securities registered pursuant to Section 12(g) of the Act:
None
 Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ¨    No  ý
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  ¨    No  ý
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  ý    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 for such shorter period that the registrant was required to submit and post such files).    Yes  ý    No  ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.    ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer  ¨      Accelerated filer  ý      Non-accelerated filer  ¨      Smaller reporting company  ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  ý
The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant was $208,300,000 and was based upon the last sales price as quoted on the NASDAQ Stock Market for June 30, 2013.
The registrant had 16,216,367 shares of common stock outstanding as of February 25, 2014.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant’s definitive Proxy Statement for the 2014 Annual Meeting of Shareholders will be incorporated by reference into Part III of this Form 10-K.

Table of Contents


HERITAGE FINANCIAL CORPORATION
FORM 10-K
December 31, 2013
TABLE OF CONTENTS
 
 
 
 
 
Page
 
 
ITEM 1.
ITEM 1A.
ITEM 1B.
ITEM 2.
ITEM 3.
ITEM 4.
 
 
 
 
 
 
 
 
ITEM 5.
ITEM 6.
ITEM 7.
ITEM 7A.
ITEM 8.
ITEM 9.
ITEM 9A.
ITEM 9B.
 
 
 
 
 
 
 
 
ITEM 10.
ITEM 11.
ITEM 12.
ITEM 13.
ITEM 14.
 
 
 
 
 
 
 
 
ITEM 15.
 
 
 
 




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PART 1

ITEM 1.     BUSINESS

General
Heritage Financial Corporation (the “Company” or "Heritage") is a bank holding company that was incorporated in the State of Washington in August 1997. We were organized for the purpose of acquiring all of the capital stock of Heritage Savings Bank upon our reorganization from a mutual holding company form of organization to a stock holding company form of organization. Effective September 1, 2004, Heritage Savings Bank switched its charter from a state chartered savings bank to a state chartered commercial bank and changed its legal name from Heritage Savings Bank to Heritage Bank (the "Bank"). Effective September 1, 2005, Central Valley Bank (acquired by the Company in March 1999) changed its charter from a nationally chartered commercial bank to a state chartered commercial bank. In June 2006, the Company completed the acquisition of Western Washington Bancorp and its wholly owned subsidiary, Washington State Bank, N.A., at which time Washington State Bank, N.A. was merged into Heritage Bank.
Effective July 30, 2010, Heritage Bank entered into a definitive agreement with the Federal Deposit Insurance Corporation (the “FDIC”), pursuant to which Heritage Bank acquired certain assets and assumed certain liabilities of Cowlitz Bank, a Washington state-chartered commercial bank headquartered in Longview, Washington (the “Cowlitz Acquisition”). The Cowlitz Acquisition included nine branches of Cowlitz Bank, including its division Bay Bank, which opened as branches of Heritage Bank on August 2, 2010. The acquisition also included the Trust Services Division of Cowlitz Bank. In 2013, the Company consolidated three of these branches into existing Heritage Bank branches. Effective November 5, 2010, Heritage Bank entered into a definitive agreement with the FDIC, pursuant to which Heritage Bank acquired certain assets and assumed certain liabilities of Pierce Commercial Bank, a Washington state-chartered commercial bank headquartered in Tacoma, Washington (the “Pierce Commercial Acquisition”). The Pierce Commercial Acquisition included one branch, which opened as a branch of Heritage Bank on November 8, 2010. On September 14, 2012, the Company announced that it had entered into a definitive agreement along with Heritage Bank, to acquire Northwest Commercial Bank (“NCB”), a full service commercial bank headquartered in Lakewood, Washington that operated two branch locations in Washington State (the “NCB Acquisition”). The acquisition of NCB was completed on January 9, 2013, at which time NCB was merged with and into Heritage Bank. The Lakewood branch was subsequently consolidated with an existing Heritage Bank branch in 2013. On March 11, 2013, the Company entered into a definitive agreement to acquire Valley Community Bancshares, Inc. ("Valley" or "Valley Community Bancshares") and its wholly-owned subsidiary, Valley Bank, both headquartered in Puyallup, Washington (the “Valley Acquisition”) and its eight branches. The Valley Acquisition was completed on July 15, 2013. Subsequently, four of these branches were consolidated into existing branches and closed as of December 31, 2013.
On April 8, 2013, the Company announced the proposed merger of its two wholly-owned bank subsidiaries Central Valley Bank and Heritage Bank, with Central Valley Bank merging into Heritage Bank. The common control merger was completed on June 19, 2013. Central Valley Bank now operates as a division of Heritage Bank.
On October 23, 2013, the Company, along with the Bank, and Washington Banking Company (“Washington Banking”) and its wholly owned subsidiary bank, Whidbey Island Bank ("Whidbey"), jointly announced the signing of a merger agreement pursuant to which Heritage and Washington Banking will enter into a strategic merger with Washington Banking merging into Heritage. Immediately following the merger, Whidbey will merge into the Bank. Washington Banking branches will adopt the Heritage Bank name in all markets, with the exception of six branches in Whidbey Island markets which will continue to operate using the Whidbey Island Bank name. The corporate headquarters of the combined company will be in Olympia, Washington. The merger is anticipated to be completed in the second quarter of 2014. For additional information on this proposed merger, see Note 22 of the Notes to Consolidated Financial Statements included in "Item 8. Financial Statements and Supplementary Data."
We are primarily engaged in the business of planning, directing, and coordinating the business activities of our wholly owned subsidiary Heritage Bank. The deposits of the Bank are insured by the FDIC. Heritage Bank is headquartered in Olympia, Washington and conducts business in its thirty-five branch offices located in Washington and the greater Portland, Oregon area.
Our business consists primarily of lending and deposit relationships with small businesses and their owners in our market areas, and attracting deposits from the general public. We also make real estate construction and land development loans, one-to-four family residential loans, and consumer loans. Historically the Bank would originate for sale purposes first mortgage loans on residential properties but this operation ceased in the second quarter of 2013.
The Company was a participant in the U.S. Department of the Treasury’s (“Treasury”) Troubled Asset Relief Program (“TARP”) Capital Purchase Plan, pursuant to which the Company sold (i) 24,000 shares of the Company’s

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Fixed Rate Cumulative Perpetual Preferred Stock, Series A (“Series A Preferred Stock”) and (ii) a warrant (the “Warrant”) to purchase 276,074 shares of the Company’s common stock at $13.04 per share for an aggregate purchase price of $24.0 million in cash. Effective December 22, 2010, the Company redeemed all of the Series A Preferred Stock held by the Treasury. Effective August 17, 2011, the Company repurchased the Warrant and has no other obligations under TARP. For additional information, see Note 17 of the Notes to Consolidated Financial Statements included in “Item 8. Financial Statements and Supplementary Data.”
Market Areas
We offer financial services to meet the needs of the communities we serve through our community-oriented financial institutions. Headquartered in Olympia, Thurston County, Washington, we conduct business through Heritage Bank and its thirty-five branch offices located along the I-5 corridor throughout Washington and the greater Portland, Oregon area. We additionally have offices located in eastern Washington primarily in the Yakima county.
Lending Activities
General.     Lending activities are conducted through Heritage Bank. Our focus is on commercial business lending. We also originate consumer loans, real estate construction and land development loans and one-to-four family residential loans. Commercial and industrial loans, including owner occupied commercial real estate loans, totaled $494.4 million, or 50.6% of total originated loans, as of December 31, 2013, and $465.7 million, or 53.3% of total originated loans, as of December 31, 2012 and non-owner occupied commercial real estate totaled $354.5 million, or 36.3%, as of December 31, 2013 and $265.8 million, or 30.4% of total originated loans, as of December 31, 2012. One-to-four family residential loans totaled $39.2 million, or 4.0% of total originated loans, at December 31, 2013, and $38.8 million, or 4.4% of total originated loans, at December 31, 2012. Real estate construction and land development loans totaled $63.8 million, or 6.5% of total originated loans, at December 31, 2013, and $77.3 million, or 8.8% of total originated loans, at December 31, 2012.
Our loans are originated under policies that are reviewed and approved annually by our board of directors. In addition, we have established internal lending guidelines that are updated as needed. These policies and guidelines address underwriting standards, structure and rate considerations, and compliance with laws, regulations and internal lending limits. We conduct post-approval reviews on selected loans and routinely perform internal loan reviews of our loan portfolio to check for credit quality, proper documentation and compliance with laws and regulations.

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The following table provides information about our originated loan portfolio by type of loan for the dates indicated. These balances are prior to deduction for the allowance for loan losses.
 
December 31,
 
2013
 
2012
 
2011
 
2010
 
2009
 
Balance
 
% of Total
(4)
 
Balance
 
% of Total
(4)
 
Balance
 
% of Total
(4)
 
Balance
 
% of Total
(4)
 
Balance
 
% of Total
(4)
 
(Dollars in thousands)
Originated loans:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial business:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial and industrial(1)
$
494,362

 
50.6
%
 
$
465,734

 
53.3
%
 
$
440,471

 
52.5
%
 
$
392,301

 
52.8
%
 
$
408,622

 
52.8
%
Non-owner occupied commercial real estate(1)
354,451

 
36.3

 
265,835

 
30.4

 
251,049

 
30.0

 
221,739

 
29.9

 
194,613

 
25.2

Total commercial business
848,813

 
86.9

 
731,569

 
83.7

 
691,520

 
82.5

 
614,040

 
82.7

 
603,235

 
78.0

One-to-four family residential(2)
39,235

 
4.0

 
38,848

 
4.4

 
37,960

 
4.5

 
47,505

 
6.5

 
53,623

 
7.0

Real estate construction and land development:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
One-to-four family residential
18,593

 
1.9

 
25,175

 
2.9

 
22,369

 
2.7

 
29,377

 
4.0

 
46,060

 
6.0

Five or more family residential and commercial properties
45,184

 
4.6

 
52,075

 
5.9

 
54,954

 
6.6

 
28,588

 
3.8

 
49,665

 
6.4

Total real estate construction and land development(3)
63,777

 
6.5

 
77,250

 
8.8

 
77,323

 
9.3

 
57,965

 
7.8

 
95,725

 
12.4

Consumer
28,130

 
2.9

 
28,914

 
3.3

 
32,981

 
3.9

 
23,832

 
3.2

 
21,261

 
2.8

Gross originated loans
979,955

 
100.3

 
876,581

 
100.2

 
839,784

 
100.2

 
743,342

 
100.2

 
773,844

 
100.2

Less: deferred loan fees
(2,670
)
 
(0.3
)
 
(2,096
)
 
(0.2
)
 
(1,860
)
 
(0.2
)
 
(1,323
)
 
(0.2
)
 
(1,597
)
 
(0.2
)
Total originated loans
$
977,285

 
100.0
%
 
$
874,485

 
100.0
%
 
$
837,924

 
100.0
%
 
$
742,019

 
100.0
%
 
$
772,247

 
100.0
%
(1)
Commercial and industrial loans include owner-occupied commercial real estate
(2)
Excludes loans held for sale of $0, $1.7 million, $1.8 million, $764,000 and $825,000 as of December 31, 2013, 2012, 2011, 2010 and 2009, respectively.
(3)
Balances are net of undisbursed loan proceeds
(4)
Percent of total originated loan balance


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The following table provides information about our purchased covered loan portfolio by type of loan for the years ended December 31, 2013, 2012, 2011 and 2010. There were no purchased covered loans for the year ended December 31, 2009. These balances are the recorded investment balance and are prior to deduction for the allowance for loan losses.
 
December 31,
 
2013
 
2012
 
2011
 
2010
 
Balance
 
% of Total
(3)
 
Balance
 
% of Total
(3)
 
Balance
 
% of Total
(3)
 
Balance
 
% of Total
(3)
 
(Dollars in thousands)
Purchased covered loans:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial business:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial and industrial(1)
$
39,056

 
61.3
%
 
$
60,577

 
68.6
%
 
$
76,674

 
70.1
%
 
$
92,265

 
71.7
%
Non-owner occupied commercial real estate(1)
14,625

 
22.9

 
13,028

 
14.7

 
15,753

 
14.4

 
17,576

 
13.6

Total commercial business
53,681

 
84.2

 
73,605

 
83.3

 
92,427

 
84.5

 
109,841

 
85.3

One-to-four family residential
4,777

 
7.5

 
5,027

 
5.7

 
5,197

 
4.8

 
6,224

 
4.8

Real estate construction and land development:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
One-to-four family residential
1,556

 
2.4

 
4,433

 
5.0

 
5,786

 
5.3

 
5,876

 
4.6

Total real estate construction and land development(2)
1,556

 
2.4

 
4,433

 
5.0

 
5,786

 
5.3

 
5,876

 
4.6

Consumer
3,740

 
5.9

 
5,265

 
6.0

 
5,947

 
5.4

 
6,774

 
5.3

Gross purchased covered loans
$
63,754

 
100.0
%
 
$
88,330

 
100.0
%
 
$
109,357

 
100.0
%
 
$
128,715

 
100.0
%
(1)Commercial and industrial loans include owner-occupied commercial real estate
(2)Balances are net of undisbursed loan proceeds
(3)Percent of total purchased covered loans


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The following table provides information about our purchased non-covered loan portfolio by type of loan for the years ended December 31, 2013, 2012, 2011 and 2010. There were no purchased non-covered loans for the year ended December 31, 2009. These balances are the recorded investment balance and are prior to deduction for the allowance for loan losses.
 
 
December 31,
 
 
2013
 
2012
 
2011
 
2010
 
 
Balance
 
% of Total
(3)
 
Balance
 
% of Total
(3)
 
Balance
 
% of Total
(3)
 
Balance
 
% of Total
(3)
 
 
(Dollars in thousands)
Purchased non-covered loans:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial business:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial and industrial(1)
 
$
123,487

 
64.7
%
 
$
37,974

 
59.2
%
 
$
52,659

 
59.8
%
 
$
77,815

 
59.4
%
Non-owner occupied commercial real estate(1)
 
45,528

 
23.9

 
11,019

 
17.2

 
12,833

 
14.5

 
18,435

 
14.0

Total commercial business
 
169,015

 
88.6

 
48,993

 
76.4

 
65,492

 
74.3

 
96,250

 
73.4

One-to-four family residential
 
3,847

 
2.0

 
3,040

 
4.7

 
2,743

 
3.1

 
4,986

 
3.8

Real estate construction and land development:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
One-to-four family residential
 
1,131

 
0.6

 
513

 
0.8

 
1,381

 
1.6

 
3,816

 
2.9

Five or more family residential and commercial properties
 
3,471

 
1.8

 
864

 
1.4

 
1,078

 
1.2

 
1,244

 
1.0

Total real estate construction and land development(2)
 
4,602

 
2.4

 
1,377

 
2.2

 
2,459

 
2.8

 
5,060

 
3.9

Consumer
 
13,417

 
7.0

 
10,713

 
16.7

 
17,420

 
19.8

 
24,753

 
18.9

Gross purchased non-covered loans
 
$
190,881

 
100.0
%
 
$
64,123

 
100.0
%
 
$
88,114

 
100.0
%
 
$
131,049

 
100.0
%
(1)Commercial and industrial loans include owner-occupied commercial real estate
(2)Balances are net of undisbursed loan proceeds
(3)Percent of total purchased non-covered loans


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The following table presents at December 31, 2013 (i) the aggregate contractual maturities of loans in the named categories of our originated loan portfolio and (ii) the aggregate amounts of fixed rate and variable or adjustable rate loans in the named categories that mature after one year.
 
 
Maturing
 
 
Within
1 year
 
Over 1-5
years
 
After
5 years
 
Total
 
 
(In thousands)
Commercial business
 
$
141,527

 
$
206,660

 
$
500,626

 
$
848,813

Real estate construction and land development
 
53,661

 
5,468

 
4,648

 
63,777

Total
 
$
195,188

 
$
212,128

 
$
505,274

 
$
912,590

Fixed rate loans, due after 1 year
 
 
 
$
123,266

 
$
160,110

 
$
283,376

Variable or adjustable rate loans, due after 1 year
 
 
 
88,862

 
345,164

 
434,026

Total
 
 
 
$
212,128

 
$
505,274

 
$
717,402

Commercial Business Lending
We offer different types of commercial business loans, including lines of credit, term equipment financing and term owner-occupied commercial real estate loans. We also originate loans that are guaranteed by the Small Business Administration (“SBA”), for which Heritage Bank is a “preferred lender.” Before extending credit to a business we analyze the borrower’s management ability, financial history, including cash flow of the borrower and all guarantors, and the liquidation value of the collateral. Emphasis is placed on having a comprehensive understanding of the borrower’s global cash flow and performing necessary financial due diligence.
At December 31, 2013 we had $848.8 million, or 86.9%, of our total originated loans receivable in commercial business loans with an average loan size of approximately $303,000, excluding zero outstanding balance loans.
We originate commercial real estate loans within our primary market areas with a preference for loans secured by owner-occupied properties. Our underwriting standards require that commercial real estate loans not exceed 75% of the lower of appraised value at origination or cost of the underlying collateral. Cash flow coverage to debt servicing requirements is generally a minimum of 1.15 times for five or more family residential loans and 1.25 times for commercial real estate loans. Cash flow coverage is calculated using an “underwriting” interest rate that is higher than the note rate.
Commercial real estate loans typically involve a greater degree of risk than one-to-four family residential loans. Payments on loans secured by commercial real estate properties are dependent on successful operation and management of the properties and repayment of these loans may be affected by adverse conditions in the real estate market or the economy. We seek to minimize these risks by determining the financial condition of the borrower, the quality and value of the collateral, and the management of the property securing the loan. We also generally obtain personal guarantees from the owners of the collateral after a thorough review of personal financial statements. In addition, we review our commercial real estate loan portfolio annually for performance of individual loans, and stress-test loans for potential changes in interest rates, occupancy, and collateral values.
See “Item 1A. Risk Factors—Our loan portfolio is concentrated in loans with a higher risk of loss—Repayment of our commercial business loans consisting of commercial and industrial loans as well as owner-occupied and non-owner occupied commercial real estate loans, is often dependent on the cash flows of the borrower, which may be unpredictable, and the collateral securing these loans may fluctuate in value.” See also “Item 1A. Risk Factors—Our loan portfolio is concentrated in loans with a higher risk of loss—Our non-owner commercial real estate loans, which includes five or more family residential real estate loans, involve higher principal amounts than other loans and repayment of these loans may be dependent on factors outside our control or the control of our borrowers.”
One-to-Four Family Residential Loans
The majority of our one-to-four family residential loans are secured by single-family residences located in our primary market areas. Our underwriting standards require that one-to-four family residential loans generally are owner-occupied and do not exceed 80% of the lower of appraised value at origination or cost of the underlying collateral. Terms typically range from 15 to 30 years. Until the second quarter of 2013, we sold a significant portion of our one-to-four family residential loans in the secondary market.
See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations—Asset/Liability Management.”

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Real Estate Construction and Land Development
We originate one-to-four family residential construction loans for the construction of custom homes (where the home buyer is the borrower). We also provide financing to builders for the construction of pre-sold homes and, in selected cases, to builders for the construction of speculative residential property. Because of the higher risks present in the residential construction industry, our lending to builders is limited to those who have demonstrated a favorable record of performance and who are building in markets that management understands.
We further endeavor to limit our construction lending risk through adherence to strict underwriting guidelines and procedures. Speculative construction loans are short term in nature and priced with a variable rate of interest. We require builders to have tangible equity in each construction project and have prompt and thorough documentation of all draw requests, and we inspect the project prior to paying any draw requests.
See “Item 1A. Risk Factors—Our loan portfolio is concentrated in loans with a higher risk of loss—Our real estate construction and land development loans are based upon estimates of costs and value associated with the completed project. These estimates may be inaccurate.”
Origination and Sales of One-to-Four Family Residential Loans
Historically, as part of the asset/liability management strategy, we sold a significant portion of our one-to-four family residential loans into the secondary market. We discontinued this strategy in the second quarter of 2013, which also set forth a reduction in mortgage department staffing. Currently, all mortgage loan originations are retained in the Bank's portfolio.
When we sold mortgage loans, we typically sold the servicing of the loans (i.e., collection of principal and interest payments). However, we serviced a minimal $49,000 and $84,000 in mortgage loans for others as of December 31, 2012 and 2011, respectively. We did not service any mortgage loans for others as of December 31, 2013.
The following table presents summary information concerning our origination and sale of our one-to-four family residential loans and the gains from the sale of loans.
 
 
Years Ended December 31,
 
 
2013
 
2012
 
2011
 
2010
 
2009
 
 
(In thousands)
One-to-four family residential loans:
 
 
 
 
 
 
 
 
 
 
Originated(1)
 
$
18,867

 
$
35,730

 
$
23,865

 
$
18,605

 
$
34,183

Sold
 
8,460

 
21,187

 
15,888

 
16,187

 
25,338

Gains on sales of loans, net(2)
 
142

 
295

 
285

 
226

 
288

(1)
Includes loans originated for our loan portfolio or for sale in the secondary market.
(2)
Excludes gains on sales of SBA loans.

Commitments and Contingent Liabilities
In the ordinary course of business, we enter into various types of transactions that include commitments to extend credit that are not included in our Consolidated Financial Statements. We apply the same credit standards to these commitments as we use in all our lending activities and have included these commitments in our lending risk evaluations. Our exposure to credit loss under commitments to extend credit is represented by the amount of these commitments.

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The following table presents outstanding commitments to extend credit, including letters of credit, at the dates indicated:
 
 
December 31, 2013
 
December 31, 2012
 
 
(In thousands)
Commercial business:
 
 
 
 
Commercial and industrial
 
$
169,079

 
$
126,162

Owner-occupied commercial real estate
 
2,812

 
2,151

Non-owner occupied commercial real estate
 
2,405

 
7,006

Total commercial business
 
174,296

 
135,319

One-to-four family residential
 
45

 
—

Real estate construction and land development:
 

 

One-to-four family residential
 
12,236

 
4,662

Five or more family residential and commercial properties
 
20,720

 
26,301

Total real estate construction and land development
 
32,956

 
30,963

Consumer
 
27,480

 
34,525

Total outstanding commitments
 
$
234,777

 
$
200,807

Delinquencies and Nonperforming Assets
Delinquency Procedures.    We send a borrower a delinquency notice 15 days after the due date when the borrower fails to make a required payment on a loan. If the delinquency is not brought current, additional delinquency notices are mailed at 30 and 45 days for commercial loans. Additional written and oral contacts are made with the borrower between 60 and 90 days after the due date.
If a real estate loan payment is past due for 45 days or more, the collection manager may perform a review of the condition of the property. We may negotiate and accept a repayment program with the borrower, accept a voluntary deed in lieu of foreclosure or, when considered necessary, begin foreclosure proceedings. If foreclosed on, real property is sold at a public sale and we bid on the property to protect our interest. A decision as to whether and when to begin foreclosure proceedings is based on such factors as the amount of the outstanding loan relative to the value of the property securing the original indebtedness, the extent of the delinquency, and the borrower’s ability and willingness to cooperate in resolving the delinquency.
Real estate acquired by us is classified as other real estate owned until it is sold. When property is acquired, it is recorded at the estimated fair value (less costs to sell) at the date of acquisition, not to exceed net realizable value, and any resulting write-down is charged to the allowance for loan losses. Upon acquisition, all costs incurred in maintaining the property are expensed. Costs relating to the development and improvement of the property, however, are capitalized to the extent of the property’s net realizable value. If the estimated realizable value of the other real estate owned property declines after the acquisition date, the adjustment to the value is charged to other real estate owned expense, net.
Delinquencies in the commercial business loan portfolio are handled by the assigned loan officer. Generally, notices are sent and personal contact is made with the borrower when the loan is 15 days past due. Loan officers are responsible for collecting loans they originate or which are assigned to them. Depending on the nature of the loan and the type of collateral securing the loan, we may negotiate and accept a modified payment program or take other actions as circumstances warrant.
Classification of Loans.    Federal regulations require that the Bank periodically evaluates the risks inherent in its loan portfolio. In addition, the Division of Banks of the Washington State Department of Financial Institutions (“Division”) and the FDIC have the authority to identify problem loans and, if appropriate, require them to be reclassified. There are three classifications for problem loans: Substandard, Doubtful, and Loss. Substandard loans have one or more defined weaknesses and are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected. Doubtful loans have the weaknesses of Substandard loans, with additional characteristics that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions, and values questionable. There is a high probability of some loss in loans classified as Doubtful. A loan classified as Loss is considered uncollectible and of such little value that continuance as a loan of the institution is not warranted. If a loan or a portion of the loan is classified as Loss, the institution must charge-off this amount. We also have loans we classify as Watch and Other Assets Especially Mentioned (“OAEM”). Loans classified as Watch are

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performing assets but have elements of risk that require more monitoring than other performing loans. Loans classified as OAEM are assets that continue to perform but have shown deterioration in credit quality and require closer monitoring.
The Bank routinely tests its problem loans for potential impairment. A loan is considered impaired when, based on current information and events, it is probable that the Bank will be unable to collect all amounts due according to the original contractual terms of the loan agreement. Problem loans that may be impaired are identified using the Bank's normal loan review procedures, which include post-approval reviews, monthly reviews by credit administration of criticized loan reports, scheduled internal reviews, underwriting during extensions and renewals and the analysis of information routinely received on a borrower’s financial performance.
Impairment is measured using the present value of expected future cash flows, discounted at the loan’s effective interest rate, unless the loan is collateral dependent, in which case impairment is measured using the fair value of the collateral after deducting appropriate collateral disposition costs. Furthermore, when it is practically expedient, impairment is measured by the fair market price of the loan.
Subsequent to an initial measure of impairment, if there is a significant change in the amount or timing of a loan’s expected future cash flows or a change in the value of collateral or market price of a loan, based on new information received, the impairment is recalculated. However, the net carrying value of a loan never exceeds the recorded investment in the loan.
Nonperforming Assets.    Nonperforming assets consist of nonaccrual loans and other real estate owned. The following table provides information about our originated nonaccrual loans, restructured loans, and other real estate owned for the indicated dates.
 

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December 31,
 
 
2013
 
2012
 
2011
 
2010
 
2009
 
 
(Dollars in thousands)
Nonaccrual originated loans:
 
 
 
 
 
 
 
 
 
 
Commercial business
 
$
5,524

 
$
5,492

 
$
8,266

 
$
10,667

 
$
9,728

One-to-four family residential
 
340

 
389

 
—

 
—

 
—

Real estate construction and land development
 
1,045

 
6,420

 
14,947

 
15,816

 
25,108

Consumer
 
38

 
157

 
125

 
—

 
—

Total nonaccrual originated loans(1)(2)
 
6,947

 
12,458

 
23,338

 
26,483

 
34,836

Noncovered other real estate owned
 
4,377

 
5,406

 
3,710

 
3,030

 
704

Total nonperforming originated assets
 
$
11,324

 
$
17,864

 
$
27,048

 
$
29,513

 
$
35,540

Restructured originated performing loans:
 
 
 
 
 
 
 
 
 
 
Commercial business
 
$
14,043

 
$
14,237

 
$
12,606

 
$
394

 
$
425

One-to-four family residential
 
252

 
422

 
835

 
—

 
—

Real estate construction and land development
 
6,043

 
361

 
364

 
—

 
—

Consumer
 
101

 
19

 
—

 
—

 
—

Total restructured originated performing loans(3)
 
$
20,439

 
$
15,039

 
$
13,805

 
$
394

 
$
425

Accruing originated loans past due 90 days or more(4)
 
$
6

 
$
214

 
$
1,328

 
$
1,313

 
$
277

Potential problem originated loans(5)
 
$
34,504

 
$
28,270

 
$
29,742

 
$
56,088

 
$
53,086

Allowance for loan losses on originated loans
 
$
17,153

 
$
19,125

 
$
22,317

 
$
22,062

 
$
26,164

Nonperforming originated loans to total originated loans(6)
 
0.53
%
 
1.28
%
 
2.57
%
 
3.14
%
 
4.21
%
Allowance for loan losses on originated loans to total originated loans
 
1.76
%
 
2.19
%
 
2.66
%
 
2.97
%
 
3.38
%
Allowance for loan losses on originated loans to nonperforming originated loans(6)
 
329.40
%
 
170.44
%
 
103.52
%
 
94.73
%
 
79.34
%
Nonperforming originated assets to total originated assets(6)
 
0.68
%
 
1.39
%
 
2.14
%
 
2.38
%
 
3.32
%
(1)
$2.5 million, $8.6 million, $11.7 million, $8.7 million and $17.0 million of originated nonaccrual loans were considered troubled debt restructures at December 31, 2013, 2012, 2011, 2010 and 2009, respectively.
(2)
$1.7 million, $1.2 million, $1.8 million, $3.2 million and $2.3 million of originated nonaccrual loans were guaranteed by government agencies at December 31, 2013, 2012, 2011, 2010 and 2009, respectively.
(3)
$1.2 million, $679,000 and $592,000 of originated performing restructured loans were guaranteed by government agencies at December 31, 2013, 2012 and 2011. There were no originated performing restructured loans guaranteed by government agencies at December 31, 2010 and 2009.
(4)
There were no accruing originated loans past due 90 days or more that were guaranteed by government agencies at December 31, 2013, 2012, and 2009. There were accruing originated loans past due 90 days or more of $6,000 and $92,000 guaranteed by government agencies at December 31, 2011 and 2010, respectively.
(5)
$1.8 million, $3.2 million, $2.8 million, $5.4 million and $7.2 million of originated potential problem loans were guaranteed by government agencies at December 31, 2013, 2012, 2011, 2010 and 2009, respectively.
(6)
Excludes portions guaranteed by government agencies.


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Nonaccrual Loans.    Our Consolidated Financial Statements are prepared on the accrual basis of accounting, including the recognition of interest income on our loan portfolio, unless a loan is placed on nonaccrual status. Loans are considered to be impaired and are placed on nonaccrual status when there are serious doubts about the collectability of principal or interest. Our policy is to place a loan on nonaccrual status when the loan becomes past due for 90 days or more, is less than fully collateralized, and is not in the process of collection. Payments received on nonaccrual loans generally are applied first to principal and then to interest only after all principal has been collected.
Nonaccrual originated loans decreased to $6.9 million, or 0.53% of total originated loans, at December 31, 2013 from $12.5 million, or 1.28% of total originated loans, at December 31, 2012 due to the loan resolution efforts of our credit department. During the year ended December 31, 2013, approximately $3.9 million in principal payments were received on the nonaccrual loans and $2.4 million were transferred back to accrual. We also recorded $1.3 million in net charge-offs of originated nonaccrual loans of which $654,000 related to commercial business and $482,000 related to real estate construction loans. In addition, $663,000 of originated nonaccrual loans were transferred to other real estate owned during the year ended December 31, 2013. This decrease in total nonaccrual originated loans was partially offset by $2.7 million in additions to nonperforming originated loans which were outstanding as of December 31, 2013.
Nonperforming originated assets decreased to $11.3 million, or 0.68% of total originated assets, at December 31, 2013 from $17.9 million, or 1.39% of total originated assets, at December 31, 2012 due to a decrease in nonperforming originated loans discussed above as well as an overall decrease in the other real estate owned, noncovered. The other real estate owned balance decreased due to dispositions of $6.3 million offset partially by additions of $5.3 million ($2.3 million of which were acquired with the NCB Acquisition) during the year ended December 31, 2013.
Originated restructured performing loans as of December 31, 2013 and December 31, 2012 were $20.4 million and $15.0 million, respectively. The $5.4 million increase in originated restructured performing loans was primarily due to the addition of one borrowing relationship totaling $2.5 million at December 31, 2013 which was classified as performing troubled debt restructured during the second quarter of 2013. This relationship includes one-to-four family residential real estate construction and land development loans and the related specific valuation allowance on this relationship was $211,000 at December 31, 2013. The increase in the originated restructured performing loans as of December 31, 2013 was also due to a $2.4 million loan which was on nonaccrual at December 31, 2012 that was upgraded to accrual status during the year ended December 31, 2013 as the borrower continued to show sustainable financial improvement and further loss is not anticipated.
Troubled Debt Restructured Loans.    A troubled debt restructured loan (“TDR”) is a restructuring in which the Bank, for economic or legal reasons related to a borrower’s financial difficulties, grants a concession to a borrower that it would not otherwise consider. The majority of the Bank's TDRs are a result of granting extensions to troubled credits which have already been adversely classified. We grant such extensions to reassess the borrower’s financial status and develop a plan for repayment. Certain modifications with extensions also include interest rate reductions, which is the second most prevalent concession. The interest rate reductions can be for a period of time or over the remainder of the life of the loan. We may also bifurcate troubled credits into a “good” loan and a “bad” loan, whereas the good loan continues to accrue under the modified terms. We perform bifurcations to limit potential losses. The remainder of the Bank's TDRs are the result of converting revolving lines of credits to amortizing loans, changing amortizing loans to interest-only loans with balloon payments, or re-amortizing the loan over a longer period of time. These modifications would all be considered a concession for a borrower that could not obtain financing outside of the Bank. We do not forgive principal for a majority of our TDRs, but in those situations where principal is forgiven, the entire amount of such principal forgiveness is immediately charged off to the extent not done so prior to the modification. We sometimes delay the timing on the repayment of a portion of principal (principal forbearance) and charge-off the amount of forbearance if that amount is not considered fully collectible. We also consider insignificant delays in payments when determining if a loan should be classified as a TDR.
TDRs are considered impaired and are separately measured for impairment under Financial Accounting Standards Board ("FASB") Accounting Standards Codification (“ASC”) 310-10-35, whether on accrual or nonaccrual status. At December 31, 2013 and December 31, 2012, the balance of accruing TDRs was $20.4 million and $15.0 million, respectively. The related allowance for loan losses on the accruing TDRs was $2.2 million as of December 31, 2013 and $2.1 million as of December 31, 2012. At December 31, 2013, non-accruing TDRs were $2.5 million and had a related allowance for loan losses of $133,000. At December 31, 2012, non-accruing TDRs of $9.3 million had a related allowance for loan losses of $2.0 million.
A loan may have the TDR classification removed if (a) the restructured interest rate was greater than or equal to the interest rate of a new loan with comparable risk at the time of the restructure, and (b) the loan is no longer impaired based on the terms of the restructured agreement. The Bank's policy is that the borrower must demonstrate

13
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six consecutive monthly payments in accordance with the modified loan before it can be reviewed for removal of TDR classification under the second criteria. However, the loan must be reported as a TDR in at least one of the Company’s Annual Report on Form 10-K. Once a loan has been classified as a TDR, it will continue to be disclosed as an impaired loan until paid off or charged-off, even if the loan subsequently is no longer disclosed as a TDR.
Potential Problem Loans.    Potential problem loans are those loans that are currently accruing interest and are not considered impaired, but which we are monitoring because the financial information of the borrower causes us concerns as to their ability to comply with their loan repayment terms. Loans that are past due 90 days or more and still accruing interest are both well secured and in the process of collection. Originated potential problem loans increased $6.2 million to $34.5 million at December 31, 2013 from $28.3 million at December 31, 2012.
Analysis of Allowance for Loan Losses
Management maintains an allowance for loan losses (“ALL”) to provide for estimated probable credit losses inherent in the loan portfolio. The adequacy of the ALL is monitored through our ongoing quarterly loan quality assessments.
We assess the estimated credit losses inherent in our loan portfolio by considering a number of elements including:
•
Historical loss experience in a number of homogeneous segments of the loan portfolio;
•
The impact of environmental factors, including:
•
Levels of and trends in delinquencies and impaired loans;
•
Levels and trends in charge-offs and recoveries;
•
Effects of changes in risk selection and underwriting standards, and other changes in lending policies, procedures and practices;
•
Experience, ability, and depth of lending management and other relevant staff;
•
National and local economic trends and conditions;
•
External factors such as competition, legal, and regulatory requirements; and
•
Effects of changes in credit concentrations.
We calculate an appropriate ALL for the non-classified and classified performing loans in our loan portfolio by applying historical loss factors for homogeneous classes of the portfolio, adjusted for changes to the above-noted environmental factors. We may record specific provisions for impaired loans, including loans on nonaccrual status and TDRs, after a careful analysis of each loan’s credit and collateral factors. Our analysis of an appropriate ALL combines the provisions made for our non-classified loans, classified loans, and the specific provisions made for each impaired loan.
While we believe we use the best information available to determine the allowance for loan losses, results of operations could be significantly affected if circumstances differ substantially from the assumptions used in determining the allowance. A further decline in local and national economic conditions, or other factors, could result in a material increase in the allowance for loan losses and may adversely affect the Company’s financial condition and results of operations. In addition, the determination of the amount of the allowance for loan losses is subject to review by bank regulators, as part of their routine examination process, which may result in the establishment of additional allowance allocations based upon their judgment of information available to them at the time of their examination.

14
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The following table provides information regarding changes in our allowance for originated loan losses at and for the indicated periods:
 
 
Years Ended December 31,
 
 
2013
 
2012
 
2011
 
2010
 
2009
 
 
(Dollars in thousands)
Allowance for loan losses on originated loans at beginning of the year
 
$
19,125

 
$
22,317

 
$
22,062

 
$
26,164

 
$
15,423

Provision for loan losses on originated loans
 
890

 
695

 
5,180

 
11,990

 
19,390

Charge-offs:
 
 
 
 
 
 
 
 
 
 
Commercial business
 
(2,985
)
 
(3,702
)
 
(2,690
)
 
(8,106
)
 
(2,668
)
One-to-four family residential
 
—

 
(349
)
 
(15
)
 
(169
)
 
(189
)
Real estate construction and land development
 
(565
)
 
(1,280
)
 
(2,948
)
 
(8,344
)
 
(5,774
)
Consumer
 
(241
)
 
(293
)
 
(316
)
 
(73
)
 
(192
)
Total charge-offs
 
(3,791
)
 
(5,624
)
 
(5,969
)
 
(16,692
)
 
(8,823
)
Recoveries:
 
 
 
 
 
 
 
 
 
 
Commercial business
 
808

 
1,579

 
821

 
243

 
1

One-to-four family residential
 
—

 
—

 
—

 
15

 
1

Real estate construction and land development
 
32

 
125

 
201

 
285

 
50

Consumer
 
89

 
33

 
22

 
57

 
122

Total recoveries
 
929

 
1,737

 
1,044

 
600

 
174

Net charge-offs
 
(2,862
)
 
(3,887
)
 
(4,925
)
 
(16,092
)
 
(8,649
)
Allowance for originated loan losses at end of the year
 
$
17,153

 
$
19,125

 
$
22,317

 
$
22,062

 
$
26,164

Originated loans outstanding at end of the year(1)
 
$
977,285

 
$
874,485

 
$
837,924

 
$
742,019

 
$
772,247

Average originated loans receivable during the year(1)
 
948,511

 
855,923

 
833,441

 
717,159

 
787,527

Ratio of net charge-offs during the year to average originated loans receivable
 
(0.30
)%
 
(0.45
)%
 
(0.59
)%
 
(2.24
)%
 
(1.10
)%
(1)Excludes loans held for sale.


15
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The following table shows the allocation of the allowance for loan losses for originated loans at the indicated periods. The allocation is based upon an evaluation of defined loan problems, historical loan loss ratios, and industry wide and other factors that affect loan losses in the categories shown below:
 
December 31,
 
2013
 
2012
 
2011
 
2010
 
2009
 
Allowance
for Loan
Losses
 
% of
Total
(1)
 
Allowance
for Loan
Losses
 
% of
Total
(1)
 
Allowance
for Loan
Losses
 
% of
Total
(1)
 
Allowance
for Loan
Losses
 
% of
Total
(1)
 
Allowance
for Loan
Losses
 
% of
Total
(1)
 
(Dollars in thousands)
Commercial business
$
13,962

 
86.6
%
 
$
12,554

 
83.5
%
 
$
12,888

 
82.3
%
 
$
14,350

 
82.5
%
 
$
12,137

 
77.8
%
One-to-four family residential
564

 
4.0

 
637

 
4.4

 
416

 
4.5

 
500

 
6.5

 
550

 
7.0

Real estate construction
1,495

 
6.5

 
4,316

 
8.8

 
7,556

 
9.3

 
5,435

 
7.8

 
12,892

 
12.4

Consumer
531

 
2.9

 
748

 
3.3

 
547

 
3.9

 
846

 
3.2

 
361

 
2.8

Unallocated
601

 
—

 
870

 
—

 
910

 
—

 
931

 
—

 
224

 
—

Total allowance for originated loan losses (1)
$
17,153

 
100.0
%
 
$
19,125

 
100.0
%
 
$
22,317

 
100.0
%
 
$
22,062

 
100.0
%
 
$
26,164

 
100.0
%
(1)
Represents total originated loans outstanding in each category as a percent of gross originated loans.

Investment Activities
At December 31, 2013, our investment securities portfolio totaled $199.3 million, which consisted of $163.1 million of securities available for sale and $36.2 million of securities held to maturity. This compares with a total portfolio of $154.4 million at December 31, 2012, which was comprised of $144.3 million of securities available for sale and $10.1 million of securities held to maturity. The composition of the two investment portfolios by type of security, at each respective date, is presented in Note 4 to the Notes to Consolidated Financial Statements included in "Item 8. Financial Statements and Supplementary Data."
Our investment policy is established by the Board of Directors and monitored by the Audit and Finance Committee of the Board of Directors. It is designed primarily to provide and maintain liquidity, generate a favorable return on investments without incurring undue interest rate and credit risk, and complements the Bank's lending activities. The policy dictates the criteria for classifying securities as either available for sale or held to maturity. The policy permits investment in various types of liquid assets permissible under applicable regulations, which include U.S. Treasury obligations, U.S. Government agency obligations, some certificates of deposit of insured banks, mortgage backed and mortgage related securities, corporate notes, municipal bonds, and federal funds. Investment in non-investment grade bonds and stripped mortgage backed securities are not permitted under the policy.

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The following table provides information regarding our investment securities available for sale at the dates indicated.
 
December 31, 2013
 
December 31, 2012
 
December 31, 2011
 
Fair Value
 
% of
Total
Investments
 
Fair Value
 
% of
Total
Investments
 
Fair Value
 
% of
Total
Investments
 
(Dollars in thousands)
U.S. Treasury and U.S. Government-sponsored agencies
$
6,039

 
3.7
%
 
$
11,035

 
7.7
%
 
$
31,307

 
21.7
%
Municipal securities
49,060

 
30.1

 
47,360

 
32.8

 
33,423

 
23.1

Corporate securities
—

 
—

 
—

 
—

 
8,097

 
5.6

Mortgage backed securities and collateralized mortgage obligations-residential:
 
 
 
 
 
 
 
 
 
 
 
U.S. Government-sponsored agencies
108,035

 
66.2

 
85,898

 
59.5

 
71,775

 
49.6

Total
$
163,134

 
100.0
%
 
$
144,293

 
100.0
%
 
$
144,602

 
100.0
%

The following table provides information regarding our investment securities available for sale, by contractual maturity, at December 31, 2013.
 
Less Than One 
Year
 
Over One to Five 
Years
 
Over Five to Ten 
Years
 
Over Ten Years
 
Fair 
Value
 
Weighted
Average
Yield(1)
 
Fair 
Value
 
Weighted
Average
Yield(1)
 
Fair 
Value
 
Weighted
Average
Yield(1)
 
Fair 
Value
 
Weighted
Average
Yield(1)
 
(Dollars in thousands)
U.S. Treasury and U.S. Government-sponsored agencies
$
2,025

 
0.19
%
 
$
2,960

 
1.04
%
 
$
565

 
1.92
%
 
$
489

 
1.25
%
Municipal securities
139

 
5.57

 
7,950

 
3.51

 
19,094

 
3.77

 
21,877

 
3.21

Mortgage backed securities and collateralized mortgage obligations-residential:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
U.S. Government-sponsored agencies
—

 
—

 
1,978

 
1.73

 
27,854

 
2.19

 
78,203

 
2.31

Total
$
2,164

 
0.53
%
 
$
12,888

 
2.63
%
 
$
47,513

 
2.83
%
 
$
100,569

 
2.50
%
(1)Taxable equivalent weighted average yield.


17
Table of Contents


The following table provides information regarding our investment securities held to maturity at the dates indicated.
 
 
December 31, 2013
 
December 31, 2012
 
December 31, 2011
 
 
Amortized
Cost
 
% of
Total
Investments
 
Amortized
Cost
 
% of
Total
Investments
 
Amortized
Cost
 
% of
Total
Investments
 
 
(Dollars in thousands)
U.S. Treasury and U.S. Government-sponsored agencies
 
$
1,687

 
4.7
%
 
$
1,740

 
17.2
%
 
$
1,799

 
14.9
%
Municipal securities
 
24,290

 
67.2

 
2,946

 
29.2

 
3,566

 
29.5

Mortgage backed securities and collateralized mortgage obligations-residential:
 
 
 
 
 
 
 
 
 
 
 
 
U.S. Government-sponsored agencies
 
9,129

 
25.2

 
4,245

 
42.0

 
5,412

 
44.7

Private residential collateralized mortgage obligations
 
1,048

 
2.9

 
1,168

 
11.6

 
1,316

 
10.9

Total
 
$
36,154

 
100.0
%
 
$
10,099

 
100.0
%
 
$
12,093

 
100.0
%

The following table provides information regarding our investment securities held to maturity, by contractual maturity, at December 31, 2013.
 
Less Than One 
Year
 
Over One to Five 
Years
 
Over Five to Ten 
Years
 
Over Ten Years
 
Fair 
Value
 
Weighted
Average
Yield(1)
 
Fair 
Value
 
Weighted
Average
Yield(1)
 
Fair 
Value
 
Weighted
Average
Yield(1)
 
Fair 
Value
 
Weighted
Average
Yield(1)
 
(Dollars in thousands)
U.S. Treasury and U.S. Government-sponsored agencies
$
73

 
4.98
%
 
$
—

 
—
%
 
$
1,767

 
3.74
%
 
$
—

 
—
%
Municipal securities
1,714

 
1.53

 
10,707

 
2.10

 
9,883

 
3.53

 
2,002

 
3.95

Mortgage backed securities and collateralized mortgage obligations-residential:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
U.S. Government-sponsored agencies
—

 
—

 
47

 
6.49

 
3,446

 
2.99

 
5,496

 
2.99

Private residential collateralized mortgage obligations
—

 
—

 
—

 
—

 
—

 
—

 
1,205

 
3.42

Total
$
1,787

 
1.67
%
 
$
10,754

 
2.20
%
 
$
15,096

 
3.43
%
 
$
8,703

 
3.27
%
(1)Taxable equivalent weighted average yield.

The Bank is required to maintain an investment in the stock of the Federal Home Loan Bank (“FHLB”) of Seattle in an amount equal to the greater of $500,000 or 0.50% of residential mortgage loans and pass-through securities or

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an advance requirement to be confirmed on the date of the advance and 5.0% of the outstanding balance of mortgage loans sold to the FHLB of Seattle. At December 31, 2013 the Bank was required to maintain an investment in the stock of FHLB of Seattle of at least $1.3 million and had an investment in FHLB stock carried at a cost basis (par value) of $5.7 million.
Consistent with its accounting policy, the Company evaluated its investment in FHLB of Seattle stock for other-than-temporary impairment. The Company took into consideration that in September 2012, the FHLB of Seattle announced that it had been reclassified as adequately capitalized by its regulator, the Federal Housing Finance Agency(“Finance Agency”). Further, during the year ended December 31, 2012, the Finance Agency granted the FHLB of Seattle authority to repurchase up to $25 million of excess capital stock per quarter at par ($100 per share), provided they receive a non-objection for each quarter’s repurchase from the Finance Agency. The FHLB of Seattle has been repurchasing stock throughout 2013.
Based on the Company’s evaluation of the underlying investment, including the long-term nature of the investment, the liquidity position of the FHLB of Seattle, the actions being taken by the FHLB of Seattle to address its regulatory situation and the Company’s intent and ability to hold the investment for a period of time sufficient to recover the par value, the Company did not recognize an other-than-temporary impairment loss on its FHLB of Seattle stock during the years ended December 31, 2013, 2012 and 2011. Despite improvements in the FHLB of Seattle’s regulatory situation, any deterioration in the FHLB of Seattle’s financial position may result in future impairment losses.
Deposit Activities and Other Sources of Funds
General.    Our primary sources of funds are deposits, loan repayments and borrowings. Scheduled loan repayments are a relatively stable source of funds, while deposits and unscheduled loan prepayments, which are influenced significantly by general interest rate levels, interest rates available on other investments, competition, economic conditions, and other factors are not. Customer deposits remain an important source of funding, but these balances have been influenced in the past by adverse market conditions in the industry and may be affected by future developments such as interest rate fluctuations and new competitive pressures. In addition to customer deposits management may utilize brokered deposits on an as-needed basis.
Borrowings may also be used on a short-term basis to compensate for reductions in other sources of funds (such as deposit inflows at less than projected levels). Borrowings may also be used on a longer-term basis to support expanded lending activities and match the maturity of repricing intervals of assets. In addition, the Company utilizes repurchase agreements as a supplement to other funding sources.
During the year ended December 31 2013, non-maturity deposits (total deposits less certificate of deposit accounts) increased by $260.7 million, or 31.4%, to $1.09 billion. The increase was primarily a result of the non-maturity deposits acquired in the Northwest and Valley Acquisitions. The percentage of non-maturity deposits to total deposits increased to 77.9% at December 31, 2013 compared to 74.2% at December 3, 2012. As a result of this increase, the certificate of deposit accounts to total deposits decreased to 22.1% at December 31, 2013 from 25.8% at December 31, 2012.
Deposit Activities.    We offer a variety of deposit accounts designed to attract both short-term and long-term deposits. These accounts include noninterest demand accounts, negotiable order of withdrawal (“NOW”) accounts, money market accounts, savings accounts and certificates of deposit (“CDs”). These accounts, with the exception of noninterest demand accounts, generally earn interest at rates established by management based on competitive market factors and management’s desire to increase or decrease certain types or maturities of deposits. The major categories of deposit accounts are described below.
Noninterest Demand Deposits.    Noninterest demand deposits are noninterest bearing and may be charged service fees based on activity and balances.
NOW Accounts.    NOW accounts are interest bearing and may be charged service fees based on activity and balances. NOW accounts pay interest, but require a higher minimum balance to avoid service charges.
Money Market Accounts.    Money market accounts pay a variable interest rate that is tiered depending on the balance maintained in the account. Minimum opening balances vary.
Savings Accounts.    We offer savings accounts that allow for unlimited deposits and withdrawals, provided that a $100 minimum balance is maintained.
CDs.    We offer several types of CDs with maturities ranging from three months to five years, which require a minimum deposit of $2,500. Negotiable CDs are offered in amounts of $100,000 or more for terms of 30 days to five years.


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The following table provides the balances outstanding for each major category of deposits at the dates indicated:
 
 
December 31, 2013
 
December 31, 2012
 
December 31, 2011
 
 
Amount
 
Percent
 
Amount
 
Percent
 
Amount
 
Percent
 
 
(Dollars in thousands)
Noninterest demand deposits
 
$
349,902

 
25.0
%
 
$
247,048

 
22.1
%
 
$
230,993

 
20.4
%
NOW accounts
 
352,051

 
25.2

 
303,487

 
27.2

 
304,818

 
26.8

Money market accounts
 
232,016

 
16.6

 
157,728

 
14.1

 
166,913

 
14.7

Savings accounts
 
155,790

 
11.1

 
120,781

 
10.8

 
103,716

 
9.1

Total non-maturity deposits
 
1,089,759

 
77.9

 
829,044

 
74.2

 
806,440

 
71.0

CDs
 
309,430

 
22.1

 
288,927

 
25.8

 
329,604

 
29.0

Total deposits
 
$
1,399,189

 
100.0
%
 
$
1,117,971

 
100.0
%
 
$
1,136,044

 
100.0
%

The following table provides the average balances outstanding and the weighted average interest rates for each major category of deposits for the years indicated:
 
 
Years Ended December 31,
 
 
2013
 
2012
 
2011
 
 
Average
Balance
 
Average
Yield/Rate
 
Average
Balance
 
Average
Yield/Rate
 
Average
Balance
 
Average
Yield/Rate
 
 
(Dollars in thousands)
NOW accounts and money market accounts
 
$
541,793

 
0.19
%
 
$
466,268

 
0.27
%
 
$
453,509

 
0.41
%
Savings accounts
 
143,412

 
0.11

 
113,119

 
0.18

 
103,170

 
0.35

CDs
 
307,464

 
0.81

 
306,772

 
0.98

 
355,167

 
1.20

Total interest bearing deposits
 
992,669

 
0.37

 
886,159

 
0.50

 
911,846

 
0.71

Noninterest demand deposits
 
308,582

 
—

 
237,888

 
—

 
205,862

 
—

Total deposits
 
$
1,301,251

 
0.28
%
 
$
1,124,047

 
0.40
%
 
$
1,117,708

 
0.58
%

The following table shows the amount and maturity of certificates of deposit of $100,000 or more:
 
December 31, 2013
 
(In thousands)
Remaining maturity:
 
Three months or less
$
44,895

Over three months through twelve months
78,144

Over twelve months through three years
37,040

Over three years
11,237

Total
$
171,316

Borrowings.    Deposits are the primary source of funds for our lending and investment activities and our general business purposes. We rely upon advances from the FHLB to supplement our supply of lendable funds and meet deposit withdrawal requirements. The FHLB of Seattle serves as one of our secondary sources of liquidity. Advances from the FHLB of Seattle are typically secured by our first lien single family mortgage loans, commercial real estate loans and stock issued by the FHLB, which is owned by us. At December 31, 2013, the Bank maintained an uncommitted credit facility with the FHLB of Seattle of $283.6 million and an uncommitted credit facility with the Federal Reserve Bank of San Francisco of $56.7 million, of which there were no advances or borrowings outstanding. The Bank also maintains advance lines with Zions Bank, Wells Fargo Bank, US Bank and Pacific Coast Bankers’ Bank to purchase federal funds of up to $50.0 million as of December 31, 2013. At December 31, 2013 we had securities sold under agreement to repurchase of $29.4 million which were secured by available for sale investment securities.

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The FHLB functions provide credit for member financial institutions. As a member, we are required to own capital stock in the FHLB and are authorized to apply for advances on the security of such stock and certain of our mortgage loans and other assets (principally securities which are obligations of, or guaranteed by, the United States) provided certain standards related to creditworthiness have been met. Advances are made pursuant to several different programs. Each credit program has its own interest rate and range of maturities. Depending on the program, limitations on the amount of advances are based either on a fixed percentage of an institution’s net worth or on the FHLB’s assessment of the institution’s creditworthiness. Under its current credit policies, the FHLB of Seattle limits advances to 20% of the Bank's assets.
There were no FHLB advances or federal funds purchased for the years ended December 31, 2013, 2012 or 2011.
Supervision and Regulation
We are subject to extensive Federal and Washington State legislation, regulation, and supervision. These laws and regulations are primarily intended to protect depositors, the FDIC and shareholders. The laws and regulations affecting banks and bank holding companies have changed significantly particularly in connection with the enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”). See “—Other Regulatory Developments—The Dodd-Frank Act” herein for a discussion of this legislation. Any change in applicable laws, regulations, or regulatory policies may have a material effect on our business, operations, and prospects. We cannot predict the nature or the extent of the effects on our business and earnings that any fiscal or monetary policies or new Federal or State legislation may have in the future.
The following is a brief discussion of certain laws and regulations applicable to Heritage Financial and Heritage Bank which is qualified in its entirety by reference to the actual laws and regulations.
Heritage Financial.    As a bank holding company registered with the Board of Governors of the Federal Reserve System ("Federal Reserve"), we are subject to regulation and supervision under the Bank Holding Company Act of 1956, as amended. This regulation and supervision is generally intended to ensure that we limit our activities to those allowed by law and that we operate in a safe and sound manner without endangering the financial health of Heritage Bank. As a bank holding company supervised by the Federal Reserve, we are required to file annual and periodic reports with the Federal Reserve and provide additional information as the Federal Reserve may require. The Federal Reserve may examine us, and any of our subsidiaries, and assess us for the cost of such examination.
The Federal Reserve has extensive enforcement authority over bank holding companies, including the ability to assess civil money penalties and to issue cease and desist or removal orders. The Federal Reserve may also order termination of non-banking activities by non-banking subsidiaries of bank holding companies, or divestiture of ownership and control of a non-banking subsidiary by a bank holding company. Some violations may also result in criminal penalties. The FDIC is authorized to exercise comparable authority under the Federal Deposit Insurance Act and other statutes for state nonmember banks such as Heritage Bank.
The Federal Reserve has a policy that a bank holding company is required to serve as a source of financial and managerial strength to its subsidiary banks and may not conduct its operations in an unsafe or unsound manner. The Dodd-Frank Act and earlier Federal Reserve policy provide that a bank holding company should serve as a source of strength to its subsidiary banks by having the ability to provide financial assistance to its subsidiary banks during periods of financial distress. A bank holding company’s failure to meet its obligation to serve as a source of strength to its subsidiary banks is generally considered by the Federal Reserve to be an unsafe and unsound banking practice or a violation of the Federal Reserve’s regulations or both. The Dodd-Frank Act codified the source of strength policy and requires the issuance of implementing regulations. Under the prompt corrective action provisions of the Federal Deposit Insurance Act, a bank holding company parent of an undercapitalized subsidiary bank must guarantee, within limitations, the capital restoration plan that is required to be implemented of an undercapitalized subsidiary bank. If an undercapitalized subsidiary bank fails to file an acceptable capital restoration plan or fails to implement an accepted plan the Federal Reserve may prohibit the bank holding company parent or the undercapitalized subsidiary bank from paying any dividend or making any other form of capital distribution without the prior approval of the Federal Reserve. In addition, the Federal Reserve policy is that a bank holding company should pay cash dividends only to the extent that the company’s net income for the past year is consistent with the company’s capital needs, asset quality and overall condition.
We, and any subsidiaries which we may control, are considered “affiliates” within the meaning of the Federal Reserve Act, and transactions between our bank subsidiary and affiliates are subject to numerous restrictions. With some exceptions, we and our subsidiaries are prohibited from tying the provision of various products or services, such as extensions of credit, to other products or services offered by us, or our affiliates.

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Bank regulations require bank holding companies and banks to maintain a minimum “leverage” ratio of core capital to adjusted quarterly average total assets of at least 4%. In addition, banking regulators have adopted risk-based capital guidelines under which risk percentages are assigned to various categories of assets and off-balance sheet items to calculate a risk-adjusted capital ratio. Tier 1 capital generally consists of common stockholders’ equity (which does not include unrealized gains and losses on securities available for sale), less goodwill and certain identifiable intangible assets. Tier 2 capital includes Tier 1 capital plus the allowance for loan losses and subordinated debt, both subject to some limitations. Regulatory risk-based capital guidelines require Tier 1 capital of 4% of risk-adjusted assets and minimum total capital ratio (combined Tier 1 and Tier 2) of 8% of risk-adjusted assets. In July 2013, the Federal Reserve and the FDIC approved a new rule that will substantially amend the regulatory risk-based capital rules to implement the Basel III regulatory capital reforms and changes required by the Dodd-Frank Act.
For additional information, see “—Capital Adequacy” below.
Subsidiary Bank.    Heritage Bank is a Washington-chartered commercial bank, the deposits of which are insured by the FDIC. Heritage Bank is subject to regulation by the FDIC and the Division.
Applicable Federal and State statutes and regulations which govern a bank’s operations relate to minimum capital requirements, required reserves against deposits, investments, loans, legal lending limits, mergers and consolidation, borrowings, issuance of securities, payment of dividends, establishment of branches, and other aspects of its operations, among other things. The Division and the FDIC also have authority to prohibit banks under their supervision from engaging in what they consider to be unsafe and unsound practices.
The Bank is required to file periodic reports with the FDIC and the Division, and is subject to periodic examinations and evaluations by those regulatory authorities. Based upon these evaluations, the regulators may revalue the assets of an institution and require that it establish specific reserves to compensate for the differences between the determined value and the book value of such assets. These examinations must be conducted every 12 months, except that well-capitalized banks may be examined every 18 months. The FDIC and the Division may each accept the results of an examination by the other in lieu of conducting an independent examination.
Dividends paid by the Bank provide substantially all of our cash flow. Applicable Federal and Washington State regulations restrict capital distributions by our Bank, including dividends. Such restrictions are tied to the institution’s capital levels after giving effect to such distributions. For an additional discussion of restrictions on the payment of dividends, see Part II of “Item 5. Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities” herein.
Capital Adequacy.    The Federal Reserve and FDIC have issued substantially similar risk-based and leverage capital guidelines applicable to bank holding companies and banks. In addition, these regulatory agencies may from time to time require that a bank holding company or bank maintain capital above the minimum levels, based on its financial condition or actual or anticipated growth.
The Federal Reserve’s risk-based guidelines for bank holding companies establish a two-tier capital framework. Tier 1 capital generally consists of common stockholders’ equity (which does not include unrealized gains and losses on securities available for sale), less goodwill and certain identifiable intangible assets. Tier 2 capital includes Tier 1 capital plus the allowance for loan losses and subordinated debt, both subject to some limitations. The sum of Tier 1 and Tier 2 capital represents qualifying total capital, at least 50% of which must consist of Tier 1 capital.
Risk-based capital ratios are calculated by dividing Tier 1 and total capital by risk-weighted assets. Assets and off-balance sheet exposures are assigned to one of four categories of risk-weights, based primarily on relative credit risk. The minimum Tier 1 risk- based capital ratios under these guidelines at December 31, 2013 were 4% and 8%, respectively. At December 31, 2013, we had consolidated Tier 1 risk-based capital and total risk-based capital of 15.5% and 16.8%, respectively.
The Federal Reserve’s leverage capital guidelines establish a minimum leverage ratio determined by dividing Tier 1 capital by adjusted average total assets. The minimum leverage ratio is 3% for bank holding companies that meet certain specified criteria, including having the highest regulatory rating. All other bank holding companies generally are required to maintain a leverage ratio of at least 4%. At December 31, 2013, we had a consolidated leverage ratio of 11.3%.
In July 2013, the Federal banking regulators approved a final rule to implement the revised capital adequacy standards of the Basel Committee on Banking Supervision, commonly called Basel III, and to address relevant provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act). The final rule strengthens the definition of regulatory capital, increases risk-based capital requirements, makes selected changes to the calculation of risk-weighted assets, and adjusts the prompt corrective action thresholds. Community

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banking organizations, such as the Company and the Bank, become subject to the new rule on January 1, 2015 and certain provisions of the new rule will be phased in over the period of 2015 through 2019. The final rule:
•
Permits banking organizations that had less than $15 billion in total consolidated assets as of December 31, 2009, or were mutual holding companies as of May 19, 2010, to include in Tier 1 capital trust preferred securities and cumulative perpetual preferred stock that were issued and included in Tier 1 capital prior to May 19, 2010, subject to a limit of 25% of Tier 1 capital elements, excluding any non-qualifying capital instruments and after all regulatory capital deductions and adjustments have been applied to Tier 1 capital.
•
Establishes new qualifying criteria for regulatory capital, including new limitations on the inclusion of deferred tax assets and mortgage servicing rights.
•
Requires a minimum ratio of common equity Tier 1 capital to risk-weighted assets of 4.5%.
•
Increases the minimum Tier 1 capital to risk-weighted assets ratio requirement from 4% to 6%.
•
Retains the minimum total capital to risk-weighted assets ratio requirement of 8%.
•
Establishes a minimum leverage ratio requirement of 4%.
•
Retains the existing regulatory capital framework for 1-4 family residential mortgage exposures.
•
Permits banking organizations that are not subject to the advanced approaches rule, such as the Company and the Bank, to retain, through a one-time election, the existing treatment for most accumulated other comprehensive income, such that unrealized gains and losses on securities available for sale will not affect regulatory capital amounts and ratios.
•
Implements a new capital conservation buffer requirement for a banking organization to maintain a common equity capital ratio more than 2.5% above the minimum common equity Tier 1 capital, Tier 1 capital and total risk-based capital ratios in order to avoid limitations on capital distributions, including dividend payments, and certain discretionary bonus payments. The capital conservation buffer requirement will be phased in beginning on January 1, 2016 at 0.625% and will be fully phased in at 2.50% by January 1, 2019. A banking organization with a buffer of less than the required amount would be subject to increasingly stringent limitations on such distributions and payments as the buffer approaches zero. The new rule also generally prohibits a banking organization from making such distributions or payments during any quarter if its eligible retained income is negative and its capital conservation buffer ratio was 2.5% or less at the end of the previous quarter. The eligible retained income of a banking organization is defined as its net income for the four calendar quarters preceding the current calendar quarter, based on the organization’s quarterly regulatory reports, net of any distributions and associated tax effects not already reflected in net income.
•
Increases capital requirements for past-due loans, high volatility commercial real estate exposures, and certain short-term commitments and securitization exposures.
•
Expands the recognition of collateral and guarantors in determining risk-weighted assets.
•
Removes references to credit ratings consistent with the Dodd-Frank Act and establishes due diligence requirements for securitization exposures.
The FDIC may impose additional restrictions on institutions that are undercapitalized and generally is authorized to reclassify an institution into a lower capital category and impose the restrictions applicable to such category if the institution is engaged in unsafe or unsound practices or is in an unsafe or unsound condition. An institution is deemed “well capitalized” if it has at least a 5.0% Tier 1 capital ratio, a 6.0% Tier 1 risk-based capital ratio and 10.0% total risk-based capital ratio. At December 31, 2013, the Bank was considered a “well capitalized” institution. For a complete description of the Company’s and the Bank's required and actual capital levels as of December 31, 2013, see Note 19 of the Notes to Consolidated Financial Statements included in “Item 8. Financial Statements and Supplementary Data.”
Prompt Corrective Action.    Federal statutes establish a supervisory framework based on five capital categories: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. An institution’s category depends upon where its capital levels are in relation to relevant capital measures, which include a risk-based capital measure, a leverage ratio capital measure and certain other factors. The federal banking agencies have adopted regulations that implement this statutory framework. Under these regulations, an institution is treated as well capitalized if its ratio of total capital to risk-weighted assets is 10% or more, its ratio of core capital to risk-weighted assets is 6% or more, its ratio of core capital to adjusted total assets (leverage ratio) is 5% or more, and it is not subject to any federal supervisory order or directive to meet a specific capital level. In order to be adequately capitalized, an institution must have a total risk-based capital ratio of not less than 8%, a core capital to risk-weighted assets ratio of not less than 4%, and a leverage ratio of not less than 4%. An institution that is not well

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capitalized is subject to certain restrictions on brokered deposits, including restrictions on the rates it can offer on its deposits generally. Any institution which is neither well capitalized nor adequately capitalized is considered undercapitalized.
Undercapitalized institutions are subject to certain prompt corrective action requirements, regulatory controls and restrictions which become more extensive as an institution becomes more severely undercapitalized. Failure by Heritage Bank to comply with applicable capital requirements would, if unremedied, result in progressively more severe restrictions on its activities and lead to enforcement actions, including, but not limited to, the issuance of a capital directive to ensure the maintenance of required capital levels and, ultimately, the appointment of the FDIC as receiver or conservator. Banking regulators will take prompt corrective action with respect to depository institutions that do not meet minimum capital requirements. Additionally, approval of any regulatory application filed for their review may be dependent on compliance with capital requirements.
As of December 31, 2013, the Bank met the requirements to be classified as “well-capitalized.”
Federal law generally bars institutions which are not well capitalized from soliciting or accepting brokered deposits bearing interest rates significantly higher than prevailing market rates.
The recently adopted final rule to strengthen regulatory capital standards will adjust the prompt corrective action categories accordingly.
Deposit Insurance and Other FDIC Programs.    The deposits of the Bank are insured up to applicable limits by the Deposit Insurance Fund (“DIF”), which is administered by the FDIC. The FDIC is an independent federal agency that insures the deposits, up to applicable limits, of depository institutions. As insurer of the Bank's deposits, the FDIC has supervisory and enforcement authority over Heritage Bank and this insurance is backed by the full faith and credit of the United States government. As insurer, the FDIC imposes deposit insurance premiums and is authorized to conduct examinations of and to require reporting by institutions insured by the FDIC. It also may prohibit any institution insured by the FDIC from engaging in any activity determined by regulation or order to pose a serious risk to the institution and the DIF. The FDIC also has the authority to initiate enforcement actions and may terminate the deposit insurance if it determines that an institution has engaged in unsafe or unsound practices or is in an unsafe or unsound condition.
The Dodd-Frank Act requires the FDIC’s deposit insurance assessments to be based on assets instead of deposits. The FDIC issued rules under which the assessment base for a bank is equal to its total average consolidated assets less average tangible capital. The FDIC assessment rates range from approximately five basis points to 35 basis points, depending on applicable adjustments for unsecured debt issued by an institution and brokered deposits (and to further adjustment for institutions that hold unsecured debt of other FDIC-insured institutions), until such time as the FDIC’s reserve ratio equals 1.15%. Once the FDIC’s reserve ratio reaches 1.15% and the reserve ratio for the immediately prior assessment period is less than 2.0%, the applicable assessment rates may range from three basis points to 30 basis points (subject to adjustments as described above). If the reserve ratio for the prior assessment period is equal to, or greater than 2.0% and less than 2.5%, the assessment rates may range from two basis points to 28 basis points and if the prior assessment period is greater than 2.5%, the assessment rates may range from one basis point to 25 basis points (in each case subject to adjustments as described above. No institution may pay a dividend if it is in default on its federal deposit insurance assessment.
As insurer, the FDIC is authorized to conduct examinations of and to require reporting by FDIC-insured institutions. It also may prohibit any FDIC-insured institution from engaging in any activity the FDIC determines by regulation or order to pose a serious threat to the DIF. The FDIC also has the authority to take enforcement actions against banks and savings associations.
Other Regulatory Developments.    Significant federal banking legislation has been enacted in recent years. The following summarizes some of the recent significant federal banking legislation.
The Dodd-Frank Act:    The Dodd-Frank-Act imposes new restrictions and an expanded framework of regulatory oversight for financial institutions, including depository institutions and implements new capital regulations that we will become subject to and that are discussed above under “- Capital Adequacy.”
In addition, among other changes, the Dodd-Frank Act requires public companies, like us, to (i) provide their shareholders with a non-binding vote (a) at least once every three years on the compensation paid to executive officers and (b) at least once every six years on whether they should have a “say on pay” vote every one, two or three years; (ii) have a separate, non-binding shareholder vote regarding golden parachutes for named executive officers when a shareholder vote takes place on mergers, acquisitions, dispositions or other transactions that would trigger the parachute payments; (iii) provide disclosure in annual proxy materials concerning the relationship between the executive compensation paid and the financial performance of the issuer; and (iv) amend Item 402 of Regulation S-K to require

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companies to disclose the ratio of the Chief Executive Officer's annual total compensation to the median annual total compensation of all other employees. For certain of these changes, the implementing regulations have not been promulgated, so the full impact of the Dodd-Frank Act on public companies cannot be determined at this time.
Sarbanes-Oxley Act.    On July 30, 2002, the Sarbanes-Oxley Act of 2002 was signed into law in response to public concerns regarding corporate accountability in connection with various accounting scandals. The stated goals of the Sarbanes-Oxley Act are to increase corporate responsibility, to provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies and to protect investors by improving the accuracy and reliability of corporate disclosures pursuant to the securities laws. The Sarbanes-Oxley Act generally applies to all companies that file or are required to file periodic reports with the Securities and Exchange Commission (“SEC”), under the Securities Exchange Act of 1934.
The Sarbanes-Oxley Act includes very specific additional disclosure requirements and corporate governance rules, requires the SEC and securities exchanges to adopt extensive additional disclosure, corporate governance and other related rules. The Sarbanes-Oxley Act represents significant federal involvement in matters traditionally left to state regulatory systems, such as the regulation of the accounting profession, and to state corporate law, such as the relationship between a board of directors and management and between a board of directors and its committees. Our policies and procedures have been updated to comply with the requirements of the Sarbanes-Oxley Act.
Financial Services Reform Legislation.    On November 12, 1999, the Gramm-Leach-Bliley Act (“GLBA”) was enacted into law. The GLBA removes various barriers imposed by the Glass-Steagall Act of 1933, specifically those prohibiting banks and bank holding companies from engaging in the securities and insurance business. The GLBA also expands the bank holding company act framework to permit bank holding companies with subsidiary banks meeting certain capital and management requirements to elect to become a “financial holding company”.
Financial holding companies may engage in a full range of financial activities, including not only banking, insurance, and securities activities, but also merchant banking and additional activities determined to be “financial in nature” or “complementary” to an activity that is financial in nature. The GLBA also provides that the list of permissible financial activities will be expanded as necessary for a financial holding company to keep abreast of competitive and technological changes.
In addition, the GLBA expands the activities in which insured state banks may engage. Under the GLBA, insured state banks are given the ability to engage in financial activities through a subsidiary, as long as the bank and its affiliates meet and comply with certain requirements. First, each bank must be “well capitalized”. Second, the bank must comply with certain capital deduction and financial statement requirements provided under the GLBA. Third, the bank must comply with certain financial and operational safeguards provided under the GLBA. Fourth, the bank must comply with the limits imposed by the GLBA on transactions with affiliates.
Website Access to Company Reports
We post publicly available reports required to be filed with the SEC on our website, www.HF-WA.com, as soon as reasonably practicable after filing such reports with the SEC. The required reports are available free of charge through our website.
Code of Ethics
We have adopted Code of Ethics that applies to our principal executive officer, principal financial officer and controller. We have posted the text of our code of ethics at www.HF-WA.com in the section titled Investor Information: Corporate Governance. Any waivers of the code of the ethics will be publicly disclosed to shareholders.
Competition
We compete for loans and deposits with other commercial banks, credit unions, mortgage bankers, and other institutions in the scope and type of services offered, interest rates paid on deposits, pricing of loans, and number and locations of branches, among other things. Many of our competitors have substantially greater resources than we do. Particularly in times of high or rising interest rates, we also face significant competition for investors’ funds from short-term money market securities and other corporate and government securities.
We compete for loans principally through the range and quality of the services we provide, interest rates and loan fees, and the locations of our Bank's branches. We actively solicit deposit-related clients and compete for deposits by offering depositors a variety of savings accounts, checking accounts, cash management and other services.

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Employees
We had 373 full-time equivalent employees at December 31, 2013. We believe that employees play a vital role in the success of a service company. Employees are provided with a variety of benefits such as medical, vision, dental and life insurance, a retirement plan, and paid vacations and sick leave. None of our employees are covered by a collective bargaining agreement.
Executive Officers
The following table sets forth certain information with respect to the executive officers of the Company at December 31, 2013.
Name
 
Age as of
December 31,
2013
 
Position
 
Has Served the 
Company or Heritage Bank Since
Brian L. Vance
 
59

 
President and Chief Executive Officer of Heritage; Chief Executive Officer of Heritage Bank
 
1996
Jeffrey J. Deuel
 
55

 
Executive Vice President, Heritage; President and Chief Operating Officer of Heritage Bank
 
2010
Donald J. Hinson
 
52

 
Executive Vice President and Chief Financial Officer of Heritage and Heritage Bank
 
2005
D. Michael Broadhead
 
68

 
President of Central Valley Bank, a division of Heritage Bank
 
1986
David A. Spurling
 
60

 
Senior Vice President and Chief Credit Officer of Heritage Bank
 
1999
The business experience of each executive officer is set forth below.
Brian L. Vance is the President and Chief Executive Officer of Heritage and Chief Executive Officer of Heritage Bank as well as a director of Heritage.  Mr. Vance was appointed President and Chief Executive Officer of Heritage and Heritage Bank in 2006.  In 2003, Mr. Vance was appointed President and Chief Executive Officer of Heritage Bank and in 1998, Mr. Vance was named President and Chief Operating Officer of Heritage Bank. Mr. Vance joined Heritage Bank in 1996 as its Executive Vice President and Chief Credit Officer. Prior to joining Heritage Bank, Mr. Vance was employed for 24 years with West One Bank, a bank with offices in Idaho, Utah, Oregon and Washington. Prior to leaving West One, he was Senior Vice President and Regional Manager of Banking Operations for the south Puget Sound region.
Jeffrey J. Deuel was promoted to President and Chief Operating Officer of Heritage Bank and Executive Vice President of Heritage in September 2012.  In November 2010, Mr. Deuel was named Executive Vice President and Chief Operating Officer of Heritage Bank and Executive Vice President of the Company. Mr. Deuel joined Heritage Bank in February 2010 as Executive Vice President. Mr. Deuel came to the Company with 28 years of banking experience and most recently held the position of Executive Vice President Commercial Operations with JPMorgan Chase, formerly Washington Mutual. Prior to joining Washington Mutual Mr. Deuel was based in Philadelphia where he worked for Bank United, First Union Bank, CoreStates Bank, and First Pennsylvania Bank. During his career Mr. Deuel held a variety of leadership positions in commercial banking including lending, retail and support services, corporate strategies, credit administration, and portfolio management. He earned his Bachelor’s degree at Gettysburg College.
Donald J. Hinson became Executive Vice President and Chief Financial Officer of Heritage Bank in September 2012. In 2007 Mr. Hinson was appointed the Senior Vice President and Chief Financial Officer of Heritage and Heritage Bank. Mr. Hinson joined Heritage Bank in 2005 as Vice President and Controller. Prior to that, he served in the banking audit practice of local and national accounting firms of Knight, Vale and Gregory and RSM McGladrey from 1994 to 2005. Mr. Hinson holds a Bachelors of Science degree in Accounting from Central Washington University and is a licensed Certified Public Accountant.
D. Michael Broadhead has served as the President of Central Valley Bank since 1990 and in June 2013, Central Valley Bank merged into Heritage Bank but continues to operate as a division of Heritage Bank. The Company acquired Central Valley Bank in March 1999, and Mr. Broadhead had been with the bank since 1986.  Previously, Mr. Broadhead held positions with Farmers Home Administration and First Bank and Trust of Idaho where he held the position of Chief Executive Officer.

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David A. Spurling became Executive Vice President and Chief Credit Officer of Heritage Bank in January 2014. Prior to that, he was the Senior Vice President and Chief Credit Officer of Heritage Bank beginning in 2007.  Mr. Spurling joined Heritage Bank in 2001 as a commercial lender, followed by a role as a commercial team leader. He began his banking career as a middle market lender at Seafirst Bank, followed by positions as a commercial lender at Bank of America in Small Business Banking and as a regional manager for Bank of America’s government-guaranteed lending division. Mr. Spurling holds a Master’s Degree in Business Administration from the University of Washington and is Credit Risk Certified by the Risk Management Association.

ITEM 1A.     RISK FACTORS

We assume and manage a certain degree of risk in order to conduct our business strategy. The following provides a discussion of certain risks that management believes are specific to our business. This discussion should not be viewed as an all inclusive list or in any particular order.
Our strategy of pursuing acquisitions and de novo branching exposes us to financial, execution and operational risks that could adversely affect us.
We are pursuing a strategy of supplementing organic growth by acquiring other financial institutions or their businesses that we believe will help us fulfill our strategic objectives and enhance our earnings. There are risks associated with this strategy, however, including the following:
•
we may be exposed to potential asset quality issues or unknown or contingent liabilities of the banks, businesses, assets and liabilities we acquire. If these issues or liabilities exceed our estimates, our results of operations and financial condition may be materially negatively affected;
•
prices at which acquisitions can be made fluctuate with market conditions. We have experienced times during which acquisitions could not be made in specific markets at prices we considered acceptable and expect that we may continue to experience this condition in the future;
•
the acquisition of other entities generally requires integration of systems, procedures and personnel of the acquired entity into our company to make the transaction economically successful. This integration process is complicated and time consuming and can also be disruptive to the customers of the acquired business. If the integration process is not conducted successfully and with minimal effect on the acquired business and its customers, we may not realize the anticipated economic benefits of an acquisition within the expected time frame, and we may lose customers or employees of the acquired business. We may also experience greater than anticipated customer losses even if the integration process is successful. These risks are present in our completed FDIC-assisted transactions involving our assumption of deposits and the acquisition of assets of Cowlitz Bank (the "Cowlitz Acquisition") and Pierce Commercial Bank (the "Pierce Commercial Acquisition"), and together with the Cowlitz Acquisition, the "Cowlitz and Pierce Commercial Acquisitions" in 2010 and in the recently completed open-bank acquisitions of Northwest Commercial Bank and Valley Community Bancshares on January 9, 2013 and July 15, 2013, respectively. This risk is also present in the pending merger with Washington Banking Company;
•
to finance an acquisition, we may borrow funds, thereby increasing our leverage and diminishing our liquidity, or raise additional capital, which could dilute the interests of our existing shareholders.
•
we completed two acquisitions during 2010 and two acquisitions during 2013 that enhanced our rate of growth. We also announced the merger of Washington Banking Company and its subsidiary, Whidbey Island Bank, in October 2013, which is currently expected to be completed in the second quarter of 2014. We may not be able to continue to sustain our past rate of growth or to grow at all in the future;
•
we expect our net income will increase following our acquisitions, however, we also expect our general and administrative expenses and consequently our efficiency ratios will also increase. Ultimately, we would expect our efficiency ratio to improve; however, if we are not successful in our integration process, this may not occur, and our acquisitions or branching activities may not be accretive to earnings in the short or long-term; and
•
the purchase and assumption agreement and the shared-loss agreements we entered into with the FDIC in connection with the Cowlitz and Pierce Commercial Acquisitions, have specific, detailed and cumbersome compliance, servicing, notification and reporting requirements. Our failure to comply with the terms of the agreements or to properly service the loans and real estate owned under the

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requirements of the shared-loss agreements may cause individual loans or large pools of loans to lose eligibility for loss share payments from the FDIC. This could result in material losses that are currently not anticipated.
Our business strategy includes significant growth plans, and our financial condition and results of operations could be negatively affected if we fail to grow or fail to manage our growth effectively.
We intend to pursue a significant growth strategy for our business. We regularly evaluate potential acquisitions and expansion opportunities. If appropriate opportunities present themselves, we expect to engage in selected acquisitions of financial institutions in the future, including FDIC-assisted transactions, branch acquisitions, or other business growth initiatives or undertakings. There can be no assurance that we will successfully identify appropriate opportunities, that we will be able to negotiate or finance such activities or that such activities, if undertaken, will be successful.
Our growth initiatives may require us to recruit experienced personnel to assist in such initiatives, which will increase our compensation costs. In addition, the failure to identify and retain such personnel would place significant limitations on our ability to successfully execute our growth strategy. To the extent we expand our lending beyond our current market areas, we also could incur additional risk related to those new market areas. We may not be able to expand our market presence in our existing market areas or successfully enter new markets.
If we do not successfully execute our acquisition growth plan, it could adversely affect our business, financial condition, results of operations, reputation and growth prospects. In addition, if we were to conclude that the value of an acquired business had decreased and that the related goodwill had been impaired, that conclusion would result in an impairment of goodwill charge to us, which would adversely affect our results of operations. While we believe we have the executive management resources and internal systems in place to successfully manage our future growth, there can be no assurance that suitable growth opportunities will be available or that we will successfully manage our growth. See “-If the goodwill we have recorded in connection with acquisitions becomes impaired, our earnings and capital could be reduced” and “-Our strategy of pursuing acquisitions and de novo branching exposes us to financial, execution and operational risks that could adversely affect us” for additional risks related to our acquisition strategy.
Failure to comply with the terms of the shared-loss agreements with the FDIC may result in significant losses.
In connection with the Cowlitz Bank Acquisition, Heritage Bank entered into shared-loss agreements with the FDIC that significantly reduce the Bank’s credit loss exposure. The purchase and assumption agreement and the shared-loss agreements for the Cowlitz Bank Acquisition have specific, detailed and cumbersome compliance, servicing, notification and reporting requirements. Our failure to comply with the terms of the agreements or to properly service the loans and other real estate owned under the requirements of the shared-loss agreement may cause individual loans or large pools of loans to lose eligibility for loss share payments from the FDIC. This could result in material losses that are currently not anticipated.
We may engage in additional FDIC-assisted transactions, which could present additional risks to our business.
We may have additional opportunities to acquire the assets and liabilities of failed banks in FDIC-assisted transactions. Although these FDIC-assisted transactions typically provide for FDIC assistance to an acquirer to mitigate certain risks, such as sharing exposure to loan losses and providing indemnification against certain liabilities of the failed institution, we are (and would be in future transactions) subject to many of the same risks we would experience in acquiring another bank in a negotiated transaction, including risks associated with maintaining customer relationships and failure to realize the anticipated acquisition benefits in the amounts and within the timeframes we expect. In addition, because these acquisitions are structured in a manner that would not allow us the time and access to information normally associated with preparing for and evaluating a negotiated acquisition, we may face additional risks in FDIC-assisted transactions, including additional pressure on management resources, management of problem loans, problems related to integration of personnel and operating systems, and the resulting impact to our capital resources that may require us to raise additional capital. We may not be successful in overcoming these risks or any other problems encountered in connection with FDIC-assisted transactions. Our inability to overcome these risks could have a material adverse effect on our business, financial condition and results of operations.

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We operate in a highly regulated environment and may be adversely affected by changes in federal and state laws and regulations.
We are subject to extensive examination, supervision and comprehensive regulation by the Federal Reserve and Heritage Bank is subject to examination, supervision and comprehensive regulation by the FDIC and the Division. The Federal Reserve, FDIC and Division govern the activities in which we may engage, primarily for the protection of depositors and the Deposit Insurance Fund. These regulatory authorities have extensive discretion in connection with their supervisory and enforcement activities, including the requirement for additional capital, the imposition of restrictions on an institution’s operations, the reclassification of assets and the adequacy of an institution’s allowance for loan losses, the determination of the level of deposit insurance premiums assessed and the approval of merger transactions.
The potential exists for additional Federal or state laws and regulations regarding capital requirements, lending and funding practices and liquidity standards, and bank regulatory agencies are expected to remain active in responding to concerns and trends identified in examinations, including the potential issuance of formal enforcement orders. Actions taken to date, as well as potential actions, may not have the beneficial effects that are intended. In addition, new laws, regulations, and other regulatory changes could increase our costs of regulatory compliance and of doing business, and otherwise affect our operations. New laws, regulations, and other regulatory changes, along with negative developments in the financial industry and the domestic and international credit markets, may significantly affect the markets in which we do business, the markets for and value of our loans and investments, and our on-going operations, costs and profitability.
The Dodd-Frank Act, among other things, created a new CFPB, tightened capital standards and will continue to result in new laws and regulations that are expected to increase our costs of operations.
The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”) has significantly changed the bank regulatory structure and has affected the lending, deposit, investment, trading and operating activities of financial institutions and their holding companies. The Dodd-Frank Act requires various federal agencies to adopt a broad range of new rules and regulations, and to prepare numerous studies and reports for Congress. The federal agencies are given significant discretion in drafting the implementing rules and regulations, and consequently, many of the details and much of the impact of the Dodd-Frank Act may not be known for many months or years. However, it is expected that the legislation and implementing regulations may materially increase our operating and compliance costs.
The Dodd-Frank Act created a new Consumer Financial Protection Bureau (“CFPB”) with broad powers to supervise and enforce consumer protection laws. The CFPB has broad rule-making authority for a wide range of consumer protection laws that apply to all banks and savings institutions, including the authority to prohibit “unfair, deceptive or abusive” acts and practices. The CFPB has examination and enforcement authority over all banks and savings institutions with more than $10 billion in assets. Financial institutions such as Heritage Bank with $10 billion or less in assets will continue to be examined for compliance with the consumer laws by their primary bank regulators.
Effective July 21, 2011, the Dodd-Frank Act eliminated the federal prohibitions on paying interest on demand deposits, thus allowing businesses to have interest bearing checking accounts, which could result in an increase in our interest expense.
The Dodd-Frank Act also broadens the base for FDIC insurance assessments. Assessments are now based on the average consolidated total assets less tangible equity capital of a financial institution. The Dodd-Frank Act also permanently increased the maximum amount of deposit insurance for banks, savings institutions and credit unions to $250,000 per depositor retroactive to January 1, 2009, and non-interest bearing transaction accounts had unlimited deposit insurance through December 31, 2012. The legislation also increases the required minimum reserve ratio for the Deposit Insurance Fund from 1.15% to 1.35% of insured deposits, and directs the FDIC to offset the effects of increased assessments on depository institutions with less than $10 billion in assets.
The Dodd-Frank Act requires publicly traded companies to give stockholders a non-binding vote on executive compensation and so-called “golden parachute” payments and authorizes the SEC to promulgate rules that would allow stockholders to nominate their own candidate using a company’s proxy materials. It also provides that the listing standards of the national securities exchanges shall require listed companies to implement and disclose “clawback” policies mandating the recovery of incentive compensation paid to executive officers in connection with accounting restatements. The legislation also directs the Federal Reserve to promulgate rules prohibiting excessive compensation paid to bank holding company executives, regardless of whether the company is publicly traded.
Effective December 10, 2013, pursuant to the Dodd-Frank Act, federal banking and securities regulators issued final rules to implement Section 619 of the Dodd-Frank Act (the “Volcker Rule”). Generally, subject to a transition period and certain exceptions, the Volcker Rule restricts insured depository institutions and their affiliated companies from engaging in short-term proprietary trading of certain securities, investing in funds with collateral comprised of less than

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100% loans that are not registered with the SEC and from engaging in hedging activities that do not hedge a specific identified risk. After the transition period, the Volcker Rule prohibitions and restrictions will apply to banking entities, including the Company, unless an exception applies. We are analyzing the impact of the Volcker Rule on our investment portfolio and we anticipate changes to our investment strategies, which could negatively affect our earnings.
The full impact of the Dodd-Frank Act on our business and operations may not be known for years until final regulations implementing the statute are adopted. The Dodd-Frank Act may have a material impact on our operations, particularly through increased regulatory burden and compliance costs. Any future legislative changes could have a material impact on our profitability, the value of assets held for investment or the value of collateral for loans. Future legislative changes could also require changes to business practices or force us to discontinue businesses and potentially expose us to additional costs, liabilities, enforcement action and reputational risk.
The short-term and long-term impact of the changing regulatory capital requirements and new capital rules is uncertain.
In July 2013, the FDIC and the Federal Reserve Board approved a new rule that will substantially amend the regulatory risk-based capital rules applicable to the Company and the Bank. The final rule implements the “Basel III” regulatory capital reforms and changes required by the Dodd-Frank Act.
The final rule includes new capital requirements under regulations adopted by the federal banking regulators to implement the Basel III regulatory capital reform and changes required by the Dodd-Frank Act. These new requirements are effective for the Company and the Bank on January 1, 2015 and establish the following minimum capital ratios: (1) a common equity Tier 1 (“CET1”) capital ratio of 4.5% of risk-weighted assets; (2) a Tier 1 capital ratio of 6.0% of risk-weighted assets; (3) a total capital ratio of 8.0% of risk-weighted assets; and (4) a leverage ratio of 4.0%. In addition, there is a new requirement to maintain a capital conservation buffer, comprised of CET1 capital, in an amount greater than 2.5% of risk-weighted assets over the minimum capital required by each of the minimum risk-based capital ratios in order to avoid limitations on the organization’s ability to pay dividends, repurchase shares or pay discretionary bonuses. The capital conservation buffer requirement will be phased in, beginning January 1, 2016, requiring during 2016 a buffer amount greater than 0.625% in order to avoid these limitations, and increasing the amount each year until beginning January 1, 2019, the buffer amount must be greater than 2.5% in order to avoid the limitation.
The new regulations also change what qualifies as capital for purposes of meeting these various capital requirements, as well as the risk-weights of certain assets for purposes of the risk-based capital ratios. Under the new regulations, in order to be considered well-capitalized for prompt corrective action purposes, Heritage Bank will be required to maintain the following ratios: (1) a CET1 ratio of at least 6.5% of risk-weighted assets; (2) a Tier 1 capital ratio of at least 8.0% of risk-weighted assets; (3) a total capital ratio of at least 10.0% of risk-weighted assets; and (4) a leverage ratio of at least 5.0%.
The application of more stringent capital requirements for us and Heritage Bank could, among other things, result in lower returns on invested capital, require the raising of additional capital, and result in regulatory actions if we were to be unable to comply with such requirements. Furthermore, the imposition of liquidity requirements in connection with the implementation of Basel III could result in our having to lengthen the term of our funding, restructure our business models, and/or increase our holdings of liquid assets. Implementation of changes to asset risk weightings for risk based capital calculations, items included or deducted in calculating regulatory capital and/or additional capital conservation buffers could result in management modifying its business strategy and could limit our ability to make distributions, including paying out dividends or buying back shares.
New regulations could restrict our ability to originate and sell mortgage loans.
The CFPB has issued a rule designed to clarify for lenders how they can avoid monetary damages under the Dodd-Frank Act, which would hold lenders accountable for ensuring a borrower’s ability to repay a mortgage. Loans that meet this “qualified mortgage” definition will be presumed to have complied with the new ability-to-repay standard. Under the CFPB’s rule, a “qualified mortgage” loan must not contain certain specified features, including:

•
excessive upfront points and fees (those exceeding 3% of the total loan amount, less “bona fide discount points” for prime loans);
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interest-only payments;
•
Negative-amortization; and
•
terms longer than 30 years.
Also, to qualify as a “qualified mortgage,” a borrower’s total debt-to-income ratio may not exceed 43%. Lenders must also verify and document the income and financial resources relied upon to qualify the borrower for the loan and underwrite the loan based on a fully amortizing payment schedule and maximum interest rate during the first five years,

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taking into account all applicable taxes, insurance and assessments. The CFPB’s rule on qualified mortgages could limit our ability or desire to make certain types of loans or loans to certain borrowers, or could make it more expensive/and or time consuming to make these loans, which could limit our growth or profitability.
Our loan portfolio is concentrated in loans with a higher risk of loss.
Repayment of our commercial business loans, consisting of commercial and industrial loans as well as owner-occupied and non-owner occupied commercial real estate loans, is often dependent on the cash flows of the borrower, which may be unpredictable, and the collateral securing these loans may fluctuate in value.    We offer different types of commercial loans to a variety of businesses with a focus on real estate related industries and businesses in agricultural, healthcare, legal, and other professions. The types of commercial loans offered are business lines of credit, term equipment financing and term real estate loans. We also originate loans that are guaranteed by the Small Business Administration, or SBA, and are a “preferred lender” of the SBA. Commercial business lending involves risks that are different from those associated with real estate lending. Real estate lending is generally considered to be collateral based lending with loan amounts established on predetermined loan to collateral values and liquidation of the underlying real estate collateral being viewed as the primary source of repayment in the event of borrower default. Our commercial business loans are primarily made based on our assessment of the cash flow of the borrower and secondarily on the underlying collateral provided by the borrower. The borrowers’ cash flow may be unpredictable, and collateral securing these loans may fluctuate in value. Although commercial business loans are often collateralized by equipment, inventory, accounts receivable, or other business assets, the liquidation of collateral in the event of default is often an insufficient source of repayment because accounts receivable may be uncollectible and inventories may be obsolete or of limited use, among other things. Accordingly, the repayment of commercial business loans depends primarily on the cash flow and creditworthiness of the borrower and secondarily on the underlying collateral provided by the borrower. In addition, as part of our commercial business lending activities, we originate agricultural loans. Payments on agricultural loans are typically dependent on the profitable operation or management of the related farm property. The success of the farm may be affected by many factors outside the control of the borrower, including adverse weather conditions that prevent the planting of a crop or limit crop yields, declines in market prices for agricultural products and the impact of government regulations. In addition, many farms are dependent on a limited number of key individuals whose injury or death may significantly affect the successful operation of the farm. If the cash flow from a farming operation is diminished, the borrower’s ability to repay the loan may be impaired.
At December 31, 2013, our originated commercial business loans (consisting of commercial and industrial loans, owner-occupied commercial real estate loans and non-owner occupied commercial real estate loans) totaled $848.8 million, or approximately 86.9% of our total originated loan portfolio. Approximately $5.5 million, or 0.7%, of our total originated commercial business loans were nonperforming at December 31, 2013. The majority of the nonperforming commercial business loans were commercial and industrial loans.
Our non-owner occupied commercial real estate loans, which includes five or more family residential real estate loans, involve higher principal amounts than other loans and repayment of these loans may be dependent on factors outside our control or the control of our borrowers.    We originate commercial and five or more family residential real estate loans for individuals and businesses for various purposes, which are secured by commercial properties. These loans typically involve higher principal amounts than other types of loans, and repayment is dependent upon income generated, or expected to be generated, by the property securing the loan in amounts sufficient to cover operating expenses and debt service, which may be adversely affected by changes in the economy or local market conditions. For example, if the cash flow from the borrower’s project is reduced as a result of leases not being obtained or renewed, the borrower’s ability to repay the loan may be impaired.
Commercial and five or more family residential real estate loans also expose us to greater credit risk than loans secured by residential real estate because the collateral securing these loans typically cannot be sold as easily as residential real estate. In addition, many of our commercial and five or more family residential real estate loans are not fully amortizing and contain large balloon payments upon maturity. Such balloon payments may require the borrower to either sell or refinance the underlying property in order to make the payment, which may increase the risk of default or non-payment. If we foreclose on a commercial and five or more family residential real estate loan, our holding period for the collateral typically is longer than for one-to-four family residential mortgage loans because there are fewer potential purchasers of the collateral. Additionally, commercial and five or more family residential real estate loans generally have relatively large balances to single borrowers or related groups of borrowers. Accordingly, if we make any errors in judgment in the collectability of our commercial and five or more family residential real estate loans, any resulting charge-offs may be larger on a per loan basis than those incurred with our residential or consumer loan portfolios.
As of December 31, 2013, our non-owner occupied commercial real estate loans totaled $354.5 million, or 36.3% of our total originated loan portfolio.

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Our real estate construction and land development loans are based upon estimates of costs and value associated with the completed project. These estimates may be inaccurate.    Construction lending can involve a higher level of risk than other types of lending because funds are advanced partially based upon the value of the project, which is uncertain prior to the project’s completion. Because of the uncertainties inherent in estimating construction costs as well as the market value of a completed project and the effects of governmental regulation of real property, our estimates with regards to the total funds required to complete a project and the related loan-to-value ratio may vary from actual results. As a result, construction loans often involve the disbursement of substantial funds with repayment dependent, in part, on the success of the ultimate project and the ability of the borrower to sell or lease the property or refinance the indebtedness. If our estimate of the value of a project at completion proves to be overstated, it may have inadequate security for repayment of the loan and may incur a loss.
As of December 31, 2013, our originated real estate construction and land development loans totaled $63.8 million, or 6.5% of our total originated loan portfolio. Of these loans, $18.6 million, or 1.9% of our total originated loan portfolio, were one-to-four family residential construction related and $45.2 million, or 4.6% of our total originated loan portfolio, were five-or-more family residential and commercial construction related. Approximately $1.0 million, or 1.6%, of our total originated construction loans were nonperforming at December 31, 2013.
Our allowance for loan losses may prove to be insufficient to absorb losses in our loan portfolio.
Lending money is a substantial part of our business. Every loan carries a certain risk that it will not be repaid in accordance with its terms or that any underlying collateral will not be sufficient to assure repayment. This risk is affected by, among other things:
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cash flow of the borrower and/or the project being financed;
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the changes and uncertainties as to the future value of the collateral, in the case of a collateralized loan;
•
the character and creditworthiness of a particular borrower;
•
changes in economic and industry conditions; and
•
the duration of the loan.
We maintain an allowance for loan losses on our loans, which is a reserve established through a provision for loan losses charged against income, which we believe is appropriate to provide for probable losses in our loan portfolio. The amount of this allowance is determined by our management through a periodic review and consideration of several factors, including, but not limited to:
•
our general reserve, based on our historical default and loss experience;
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our specific reserve, based on our evaluation of nonperforming loans and their underlying collateral or discounted cash flows; and
•
current macroeconomic factors and management’s expectation of future events.
The determination of the appropriate level of the allowance for loan losses inherently involves a high degree of subjectivity and requires us to make significant estimates of current credit risks and future trends, all of which may undergo material changes. Continuing deterioration in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of our control, may require an increase in the allowance for loan losses. If current weak conditions in the housing and real estate markets continue, we expect we will continue to experience further delinquencies and credit losses. In addition, bank regulatory agencies periodically review our allowance for loan losses and may require an increase in the provision for possible loan losses or the recognition of further loan charge-offs, based on judgments different than those of management. In addition, if charge-offs in future periods exceed the allowance for loan losses we will need additional provisions to increase the allowance for loan losses. Any increases in the allowance for loan losses will result in a decrease in net income and possibly capital, and may have a material adverse effect on our financial condition and results of operations.
If our allowance for loan losses is not adequate, we may be required to make further increases in our provision for loan losses and to charge-off additional loans, which could adversely affect our results of operations and our capital.
For the year ended December 31, 2013 we recorded a total provision for loan losses of $3.7 million compared to $2.0 million for the year ended December 31, 2012. The provision related to the originated portfolio was $890,000 and $695,000 for the years ended December 31, 2013 and 2012, respectively. Our provision for loan losses on purchased loans was $2.8 million and $1.3 million for the years ended December 31, 2013 and 2012, respectively. We recorded net loan charge-offs of $3.4 million for the year ended December 31, 2013 compared to $4.3 million for the year ended December 31, 2012. The net charge-offs related to the originated portfolio was $2.9 million and $3.9 million for the years ended December 31, 2013 and 2012, respectively. Recently, we have been experiencing decreasing loan delinquencies and decreasing loan charge-offs. Generally, our nonperforming loans and assets reflect operating

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difficulties of individual borrowers resulting from weakness in the local economy. The deterioration in the general economy has been a significant contributing factor to our current level of delinquencies and nonperforming loans. The economy has significantly impacted our commercial and industrial loan portfolio, which represented 64.7% of our nonaccrual originated loans at December 31, 2013. Slower sales and excess inventory in the housing market has been the primary cause of the increase in foreclosures for one-to-four family residential construction loans, which represented 15.0% of our nonperforming originated loans at December 31, 2013. At December 31, 2013 our total nonperforming originated loans were $6.9 million, or 0.53% of total originated loans, compared to $12.5 million or 1.28% of total originated loans at December 31, 2012. If economic conditions deteriorate, we expect that we could experience significantly higher delinquencies and loan charge-offs. As a result, we may be required to make further increases in our provision for loan losses in the future, which could adversely affect our financial condition and results of operations, perhaps materially.
The current economic condition in the market areas we serve may continue to adversely impact our earnings and could increase the credit risk associated with our loan portfolio.
Substantially all of our loans are to businesses and individuals in the states of Washington and Oregon, and a continuing decline in the economies of our primary market areas of the Pacific Northwest could have a material adverse effect on our business, financial condition, results of operations and prospects. In particular, in the current downturn, the Puget Sound and Portland, Oregon areas have experienced substantial home price declines, increased foreclosures and above-average unemployment rates. Many large Pacific Northwest businesses have implemented substantial employee layoffs and scaled back plans for future growth. The Yakima Valley also has similarly experienced an increased unemployment rate and a continued decline in housing prices.
Continued weakness or a further deterioration in economic conditions in the market areas we serve could result in the following consequences, any of which could have a materially adverse impact on our business, financial condition and results of operations:
•
loan delinquencies, problem assets and foreclosures may increase;
•
we may increase our provision for loan losses;
•
demand for our products and services may decline possibly resulting in a decrease in our total loans;
•
collateral for loans made may decline further in value, exposing us to increased risk of loss on existing loans;
•
the net worth and liquidity of loan guarantors may decline, impairing their ability to honor commitments to us; and
•
the amount of our deposits may decrease and the composition of our deposits may be adversely affected.
If the goodwill we have recorded in connection with acquisitions becomes impaired, our earnings and capital could be reduced.
Accounting standards require that we account for acquisitions using the purchase method of accounting. Under purchase accounting, if the purchase price of an acquired company exceeds the fair value of its net assets, the excess is carried on the acquirer’s balance sheet as goodwill. In accordance with generally accepted accounting principles, our goodwill is evaluated for impairment on an annual basis or more frequently if events or circumstances indicate that a potential impairment exists. Such evaluation is based on a variety of factors, including the quoted price of our common stock, market prices of common stock of other banking organizations, common stock trading multiples, discounted cash flows, and data from comparable acquisitions. At December 31, 2013, we had goodwill with a carrying amount of $29.4 million.
Declines in our stock price or a prolonged weakness in the operating environment of the financial services industry may result in a future impairment charge. Any such impairment charge could have a material adverse affect on our operating results and capital.
Fluctuating interest rates can adversely affect our profitability.
Our profitability is dependent to a large extent upon net interest income, which is the difference (or “spread”) between the interest earned on loans, securities and other interest-earning assets and the interest paid on deposits, borrowings, and other interest-bearing liabilities. Because of the differences in maturities and repricing characteristics of our interest-earning assets and interest-bearing liabilities, changes in interest rates do not produce equivalent changes in interest income earned on interest-earning assets and interest paid on interest-bearing liabilities. Accordingly, fluctuations in interest rates could adversely affect our interest rate spread, and, in turn, our profitability.
Although management believes it has implemented effective asset and liability management strategies to reduce the potential effects of changes in interest rates on our results of operations, any substantial, unexpected or prolonged change in market interest rates could have a material adverse effect on our financial condition and results

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of operations. Also, our interest rate risk modeling techniques and assumptions likely may not fully predict or capture the impact of actual interest rate changes on our balance sheet.
Historically low interest rates may adversely affect our net interest income and profitability.
During the past four years it has been the policy of the Federal Reserve Board to maintain interest rates at historically low levels through its targeted federal funds rate and the purchase of mortgage-backed securities. As a result, market rates on the loans we have originated and the yields on securities we have purchased have been at lower levels than available prior to 2008. As a general matter, our interest-bearing liabilities reprice or mature more quickly than our interest-earning assets, which has been one factor contributing to the increase in our interest rate spread as interest rates decreased. However, our ability to lower our interest expense will be limited at these interest rate levels while the average yield on our interest-earning assets may continue to decrease. The Federal Reserve Board has recently indicated its intention to maintain low interest rates through at least late 2014. Accordingly, our net interest income may be adversely affected and may decrease, which may have an adverse effect on our profitability.
The tightening of available liquidity could limit our ability to replace deposits and fund loan demand, which could adversely affect our earnings and capital levels.
A tightening of the credit markets and the inability to obtain adequate funding to replace deposits and fund continued loan growth may negatively affect asset growth and, consequently, our earnings capability and capital levels. In addition to any deposit growth, maturity of investment securities and loan payments, we rely from time to time on advances from the Federal Home Loan Bank of Seattle, or FHLB, and certain other wholesale funding sources to fund loans and replace deposits. In the event of a further downturn in the economy, these additional funding sources could be negatively affected which could limit the funds available to us. Our liquidity position could be significantly constrained if we were unable to access funds from the FHLB or other wholesale funding sources.
Our growth or future losses may require us to raise additional capital in the future, but that capital may not be available when it is needed or the cost of that capital may be very high; further, the resulting dilution of our equity may adversely affect the market price of our common stock.
We are required by federal and state regulatory authorities to maintain adequate levels of capital to support our operations. At some point we may need to raise additional capital to support continued internal growth and growth through acquisitions. Our ability to raise additional capital, however, will depend on conditions in the capital markets at that time, which are outside our control, and on our financial condition and performance. If we are able to raise capital it may not be on terms that are acceptable to us. If we cannot raise additional capital when needed, our ability to further expand our operations through internal growth and acquisitions could be materially impaired and our financial condition and liquidity could be materially and adversely affected. Accordingly, we cannot make assurances that we will be able to raise additional capital when needed.
We are not restricted from issuing additional common stock or preferred stock, including any securities that are convertible into or exchangeable for, or that represent the right to receive, common stock or preferred stock or any substantially similar securities. The market price of our common stock could decline as a result of sales of a large number of shares of common stock or preferred stock or similar securities in the market or from the perception that such sales could occur.
Our board of directors is authorized generally to cause us to issue additional common stock, as well as series of preferred stock, without any action on the part of our shareholders except as may be required under the listing requirements of the NASDAQ Stock Market. In addition, the board has the power, without shareholder approval, to set the terms of any such series of preferred stock that may be issued, including voting rights, dividend rights and preferences over the common stock with respect to dividends or upon the liquidation, dissolution or winding-up of our business and other terms.
In addition, if we issue preferred stock in the future that has a preference over the common stock with respect to the payment of dividends or upon liquidation, dissolution or winding-up, or if we issue preferred stock with voting rights that dilute the voting power of the common stock, the rights of holders of the common stock or the market price of the common stock could be adversely affected.
Deterioration in the financial position of the Federal Home Loan Bank of Seattle may result in future impairment losses of our investment in Federal Home Loan Bank stock.
At December 31, 2013, we owned $5.7 million of stock of the FHLB of Seattle. As a condition of membership at the FHLB, we are required to purchase and hold a certain amount of FHLB stock. Our stock purchase requirement is based, in part, upon the outstanding principal balance of advances from the FHLB and is calculated in accordance with the Capital Plan of the FHLB. Our FHLB stock has a par value of $100, is carried at cost, and is subject to impairment testing pursuant to applicable accounting standards. In December 2008, the FHLB announced that it had

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a risk-based capital deficiency under the regulations of the Federal Housing Finance Agency, or the FHFA, its primary regulator, and that it would suspend future dividends and the repurchase and redemption of outstanding common stock. As a result, on October 25, 2010, the FHLB received a consent order from the FHFA, which it has been operating under since that time. In September 2012, the FHLB of Seattle announced that its financial condition had improved and that the FHFA had authorized the FHLB Seattle to repurchase up to $25 million of excess capital stock per quarter at par ($100 per share) as long as its financial condition does not deteriorate. After receiving FHFA approval, the FHLB of Seattle repurchased $24.1 million in excess capital stock in late September 2012. In July 2013 the FHLB announced that, based on its second quarter 2013 financial results, their Board of Directors had declared a $0.025 per share cash dividend. This represented the first dividend in a number of years and represents a significant milestone in FHLB's return to normal operations. Subsequently, the FHLB declared an additional dividend of $0.025 per share based on its third quarter 2013 financial results. In addition, the FHLB of Seattle repurchased $74.0 million in excess capital stock from January 1, 2013 to September 30, 2013. As a result of the FHLB of Seattle's improved financial condition, we have not recorded an impairment on our investment in FHLB stock. Further deterioration in the FHLB's financial position may, however, result in future impairment in the value of those securities. We will continue to monitor the financial condition of the FHLB as it relates to, among other things, the recoverability of our investment.
New or changing tax, accounting, and regulatory rules and interpretations could significantly impact strategic initiatives, results of operations, cash flows, and financial condition.
The financial services industry is extensively regulated. Federal and state banking regulations are designed primarily to protect the deposit insurance funds and consumers, not to benefit a company’s stockholders. Regulatory authorities have extensive discretion in connection with their supervisory and enforcement activities, including the imposition of restrictions on the operation of an institution, the classification of assets by the institution and the adequacy of an institution’s allowance for loan losses. Additionally, actions by regulatory agencies or significant litigation against us could require us to devote significant time and resources to defending our business and may lead to penalties that materially affect us. These regulations, along with the currently existing tax, accounting, securities, insurance, and monetary laws, regulations, rules, standards, policies, and interpretations control the methods by which financial institutions conduct business, implement strategic initiatives and tax compliance, and govern financial reporting and disclosures. These laws, regulations, rules, standards, policies, and interpretations are constantly evolving and may change significantly over time. For information regarding the significant federal and state banking regulations that affect us, see “Item 1. Business—Supervision and Regulation.”
We rely heavily on the proper functioning of our technology.
We rely heavily on communications and information systems to conduct our business. Any failure, interruption or breach in security of these systems could result in failures or disruptions in our customer relationship management, general ledger, deposit, loan and other systems. While we have policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of our information systems, there can be no assurance that any such failures, interruptions or security breaches will not occur or, if they do occur, that they will be adequately addressed. The occurrence of any failures, interruptions or security breaches of our information systems could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our financial condition and results of operations.
We rely on third-party service providers for much of our communications, information, operating and financial control systems technology. If any of our third-party service providers experience financial, operational or technological difficulties, or if there is any other disruption in our relationships with them, we may be required to locate alternative sources of such services, and we cannot assure that we could negotiate terms that are as favorable to us, or could obtain services with similar functionality, as found in our existing systems, without the need to expend substantial resources, if at all. Any of these circumstances could have an adverse effect on our business.
Changes in accounting standards may affect how we record and report our performance.
Our accounting policies and methods are fundamental to how we record and report our financial condition and results of operations. From time to time there are changes in the financial accounting and reporting standards that govern the preparation of our financial statements. These changes can be difficult to predict and can materially impact how we report and record our financial condition and results of operations. In some cases, we could be required to apply a new or revised standard retroactively, resulting in a retrospective adjustment to prior financial statements.
We are dependent on key personnel and the loss of one or more of those key personnel may materially and adversely affect our prospects.
Competition for qualified employees and personnel in the banking industry is intense and there are a limited number of qualified persons with knowledge of, and experience in, the community banking industry where we conduct

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our business. The process of recruiting personnel with the combination of skills and attributes required to carry out our strategies is often lengthy. Our success depends to a significant degree upon our ability to attract and retain qualified management, loan origination, finance, administrative, marketing and technical personnel and upon the continued contributions of our management and personnel. In particular, our success has been and continues to be highly dependent upon the abilities of key executives, including our President and Chief Executive Officer, Mr. Brian L. Vance, and certain other employees. The loss of key personnel could adversely affect our ability to successfully conduct our business.

ITEM 1B.     UNRESOLVED STAFF COMMENTS

The Company has no unresolved staff comments from the Securities and Exchange Commission ("SEC") as it relates to the Company's financial information as reported on Form 10-K.
    
ITEM 2.     PROPERTIES

Our executive offices and the main office of Heritage Bank are located in approximately 22,000 square feet of the headquarters building and adjacent office space and main branch office which are owned by Heritage Bank and located in downtown Olympia. The Company's branch network at December 31, 2013 is comprised of 35 branches located throughout Washington and Oregon counties. The number of branches per county, as well as occupancy type, is detailed in the following table.
 
 
 
 
Occupancy Type
County
 
Number of Branches
 
Owned
 
Leased
Pierce
 
13

 
8

 
5

King
 
6

 
2

 
4

Thurston
 
5

 
5

 
—

Yakima
 
5

 
5

 
—

Cowlitz
 
2

 
2

 
—

Clark
 
1

 
—

 
1

Multnomah
 
1

 
—

 
1

Mason
 
1

 
1

 
—

Kittitas
 
1

 
1

 
—

Total
 
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