Edgar Filing: HERITAGE FINANCIAL CORP /WA/

HFWA-2014.03.31 10Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q



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

For the quarterly period ended March 31, 2014



¨	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)

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 whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.



Large accelerated filer	¨	Accelerated filer	x
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

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

As of April 22, 2014 there were 16,210,833 shares of the registrant's common stock, no par value per share, outstanding.

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HERITAGE FINANCIAL CORPORATION

FORM 10-Q

INDEX

March 31, 2014



		Page
FORWARD LOOKING STATEMENTS

Part I.	FINANCIAL INFORMATION	4
Item 1.	FINANCIAL STATEMENTS	4
	Condensed Consolidated Statements of Financial Condition as of March 31, 2014 and December 31, 2013	4
	Condensed Consolidated Statements of Income for the Three Months Ended March 31, 2014 and 2013	5
	Condensed Consolidated Statements of Comprehensive Income for the Three Months Ended March 31, 2014 and 2013	6
	Condensed Consolidated Statements of Stockholders’ Equity for the Three Months Ended March 31, 2014 and 2013	7
	Condensed Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2014 and 2013	8
	Notes to Condensed Consolidated Financial Statements	10
Item 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	50
Item 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	66
Item 4.	CONTROLS AND PROCEDURES	66

Part II.	OTHER INFORMATION	66
Item 1.	LEGAL PROCEEDINGS	66
Item 1A.	RISK FACTORS	67
Item 2.	UNREGISTERED SALES OF EQUITYSECURITIES AND USE OF PROCEEDS	67
Item 3.	DEFAULTS UPON SENIOR SECURITIES	68
Item 4.	MINE SAFETY DISCLOSURES	68
Item 5.	OTHER INFORMATION	68
Item 6.	EXHIBITS	69
	SIGNATURES	70
	CERTIFICATIONS

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FORWARD LOOKING STATEMENTS:

“Safe Harbor” statement under the Private Securities Litigation Reform Act of 1995: This Quarterly Report on Form 10-Q ("Form 10-Q") contains forward-looking statements that are subject to risks and uncertainties, including, but not limited to: our ability to successfully integrate any assets, liabilities, customers, systems, and management personnel we have acquired, including those from Cowlitz Bank, Pierce Commercial Bank, Northwest Commercial Bank, Valley Community Bancshares and the proposed Washington Banking Company transactions described in this Form 10-Q, or may in the future acquire, into our operations and our ability to realize related revenue synergies and cost savings within expected time frames or at all, and any goodwill charges related thereto and costs or difficulties relating to integration matters, including but not limited to customer and employee retention, which might be greater than expected; the credit risks of lending activities, including changes in the level and trend of loan delinquencies and write-offs and changes in our allowance for loan losses and provision for loan losses that may be impacted by deterioration in the housing and commercial real estate markets, which may lead to increased losses and non-performing assets in our loan portfolio, and may result in our allowance for loan losses no longer being adequate to cover actual losses, and require us to increase our allowance for loan losses; changes in general economic conditions, either nationally or in our market areas; changes in the levels of general interest rates, and the relative differences between short and long term interest rates, deposit interest rates, our net interest margin and funding sources; risks related to acquiring assets in or entering markets in which we have not previously operated and may not be familiar; fluctuations in the demand for loans, the number of unsold homes and other properties and fluctuations in real estate values in our market areas; results of examinations of us by the Board of Governors of the Federal Reserve System ("Federal Reserve") and of our bank subsidiary by the Federal Deposit Insurance Corporation ("FDIC"), the Washington State Department of Financial Institutions, Division of Banks ("Division") or other regulatory authorities, including the possibility that any such regulatory authority may, among other things, require us to increase our allowance for loan losses, write-down assets, or change our regulatory capital position or affect our ability to borrow funds or maintain or increase deposits, which could adversely affect our liquidity and earnings; legislative or regulatory changes that adversely affect our business including changes in regulatory policies and principles, or the interpretation of regulatory capital or other rules including as a result of Basel III; our ability to control operating costs and expenses; the impact of the Wall Street Reform and Consumer Protection Act ("Dodd-Frank Act") and the implementing regulations; further increases in premiums for deposit insurance; the use of estimates in determining fair value of certain of our assets, which estimates may prove to be incorrect and result in significant declines in valuation; difficulties in reducing risk associated with the loans on our Condensed Consolidated Statement of Financial Condition; staffing fluctuations in response to product demand or the implementation of corporate strategies that affect our workforce and potential associated charges; failure or security breach of computer systems on which we depend; our ability to retain key members of our senior management team; costs and effects of litigation, including settlements and judgments; our ability to implement our expansion strategy of pursuing acquisitions and de novo branching; our ability to successfully integrate any assets, liabilities, customers, systems, and management personnel we have acquired or may in the future acquire into our operations and our ability to realize related revenue synergies and cost savings within expected time frames and any goodwill charges related thereto; increased competitive pressures among financial service companies; changes in consumer spending, borrowing and savings habits; the availability of resources to address changes in laws, rules, or regulations or to respond to regulatory actions; adverse changes in the securities markets; inability of key third-party providers to perform their obligations to us; changes in accounting policies and practices, as may be adopted by the financial institution regulatory agencies or the Financial Accounting Standards Board ("FASB"), including additional guidance and interpretation on accounting issues and details of the implementation of new accounting methods; and other economic, competitive, governmental, regulatory, and technological factors affecting our operations, pricing, products and services and other risks detailed from time to time in our filings with the Securities and Exchange Commission "SEC" including our Annual Report on Form 10-K for the year ended December 31, 2013.

The Company cautions readers not to place undue reliance on any forward-looking statements. Moreover, you should treat these statements as speaking only as of the date they are made and based only on information then actually known to the Company. The Company does not undertake and specifically disclaims any obligation to revise any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements. These risks could cause our actual results for future periods to differ materially from those expressed in any forward-looking statements by, or on behalf of, us, and could negatively affect the Company’s operating and stock price performance.

As used throughout this report, the terms “we”, “our”, “us”, or the “Company” refer to Heritage Financial Corporation and its consolidated subsidiary, unless the context otherwise requires.

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PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARY

CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

March 31, 2014 and December 31, 2013

(Dollars in thousands)

(Unaudited)



	March 31, 2014			December 31, 2013
ASSETS
Cash on hand and in banks	$	40,042		$	40,162
Interest earning deposits	114,353			90,238
Cash and cash equivalents	154,395			130,400
Other interest earning deposits	15,150			15,662
Investment securities available for sale, at fair value	138,794			163,134
Investment securities held to maturity (fair value of $39,713 and $36,340, respectively)	39,208			36,154
Originated loans receivable, net	993,911			977,285
Less: Allowance for loan losses	(17,534		)	(17,153		)
Originated loans receivable, net of allowance for loan losses	976,377			960,132
Purchased covered loans receivable, net of allowance for loan losses ($6,567 and $6,167, respectively)	54,907			57,587
Purchased non-covered loans receivable, net of allowance for loan losses ($5,286 and $5,504, respectively)	176,366			185,377
Total loans receivable, net	1,207,650			1,203,096
Federal Deposit Insurance Corporation indemnification asset	3,969			4,382
Other real estate owned ($182 and $182 covered by FDIC shared-loss agreements, respectively)	4,284			4,559
Premises and equipment, net	33,907			34,348
Federal Home Loan Bank stock, at cost	5,666			5,741
Accrued interest receivable	5,180			5,462
Prepaid expenses and other assets	23,446			25,120
Other intangible assets, net	1,459			1,615
Goodwill	29,365			29,365
Total assets	$	1,662,473		$	1,659,038
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits	$	1,404,214		$	1,399,189
Securities sold under agreement to repurchase	28,790			29,420
Accrued expenses and other liabilities	13,052			14,667
Total liabilities	1,446,056			1,443,276
Stockholders’ equity:
Preferred stock, no par value, 2,500,000 shares authorized; no shares issued and outstanding at March 31, 2014 and December 31, 2013	—			—
Common stock, no par value, 50,000,000 shares authorized; 16,211,537 and 16,210,747 shares issued and outstanding at March 31, 2014 and December 31, 2013, respectively	138,874			138,659
Retained earnings	78,214			78,265
Accumulated other comprehensive loss, net	(671		)	(1,162		)
Total stockholders’ equity	216,417			215,762
Total liabilities and stockholders’ equity	$	1,662,473		$	1,659,038

See accompanying Notes to Condensed Consolidated Financial Statements.

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARY

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

For the Three Months Ended March 31, 2014 and 2013

(Dollars in thousands, except per share amounts)

(Unaudited)



	Three Months Ended March 31,
	2014			2013
INTEREST INCOME:
Interest and fees on loans	$	16,451		$	16,756
Taxable interest on investment securities	639			373
Nontaxable interest on investment securities	436			335
Interest and dividends on other interest earning assets	87			57
Total interest income	17,613			17,521
INTEREST EXPENSE:
Deposits	854			937
Other borrowings	18			9
Total interest expense	872			946
Net interest income	16,741			16,575
Provision for loan losses on originated loans	200			495
Provision for loan losses on purchased loans	258			363
Total provision for loan losses	458			858
Net interest income after provision for loan losses	16,283			15,717
NONINTEREST INCOME:
Bargain purchase gain on bank acquisition	—			399
Service charges and other fees	1,398			1,353
Merchant Visa income, net	245			172
Change in FDIC indemnification asset	(37		)	(267		)
Gain on sale of investment securities, net	180			—
Other income	521			588
Total noninterest income	2,307			2,245
NONINTEREST EXPENSE:
Impairment loss on investment securities	8			2
Compensation and employee benefits	8,011			7,589
Occupancy and equipment	2,617			1,920
Data processing	996			1,136
Marketing	505			326
Professional services	830			1,030
State and local taxes	249			279
Federal deposit insurance premium	252			233
Other real estate owned, net	52			(104		)
Amortization of intangible assets	156			115
Other expense	1,103			1,193
Total noninterest expense	14,779			13,719
Income before income taxes	3,811			4,243
Income tax expense	1,268			1,358
Net income	$	2,543		$	2,885
Basic earnings per common share	$	0.16		$	0.19
Diluted earnings per common share	$	0.16		$	0.19
Dividends declared per common share	$	0.16		$	0.08

See accompanying Notes to Condensed Consolidated Financial Statements.

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARY

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

For the Three Months Ended March 31, 2014 and 2013

(Dollars in thousands)

(Unaudited)



	Three Months Ended March 31,
	2014			2013
Net income	$	2,543		$	2,885
Change in fair value of securities available for sale, net of tax of $319 and $(184), respectively	593			(342		)
Reclassification adjustment of net gain from sale of available for sale securities included in income, net of tax of $(63) and $0, respectively	(117		)	—
Accretion of other-than-temporary impairment on securities held to maturity, net of tax of $8 and $7, respectively	15			14
Other comprehensive income (loss)	$	491		$	(328	)
Comprehensive income	$	3,034		$	2,557

See accompanying Notes to Condensed Consolidated Financial Statements.

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARY

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

For the Three Months Ended March 31, 2014 and 2013

(In thousands, except per share amounts)

(Unaudited)



	Number of common shares		Common stock			Retained earnings			Accumulated other comprehensive income (loss), net			Total stock- holders’ equity
Balance at December 31, 2012	15,118		$	121,832		$	75,362		$	1,744		$	198,938
Restricted and unrestricted stock awards issued, net of forfeitures	36		—			—			—			—
Stock option compensation expense	—		22			—			—			22
Exercise of stock options (including excess tax benefits from nonqualified stock options)	2		20			—			—			20
Restricted stock compensation expense	—		251			—			—			251
Excess tax benefits from restricted stock	—		47			—			—			47
Common stock repurchased and retired	(8	)	(118		)	—			—			(118		)
Net income	—		—			2,885			—			2,885
Other comprehensive loss, net of tax	—		—			—			(328		)	(328		)
Cash dividends declared on common stock ($0.08 per share)	—		—			(1,209		)	—			(1,209		)
Balance at March 31, 2013	15,148		$	122,054		$	77,038		$	1,416		$	200,508

Balance at December 31, 2013	16,211		$	138,659		$	78,265		$	(1,162	)	$	215,762
Restricted and unrestricted stock awards issued, net of forfeitures	5		—			—			—			—
Stock option compensation expense	—		15			—			—			15
Exercise of stock options (including excess tax benefits from nonqualified stock options)	4		57			—			—			57
Restricted stock compensation expense	—		276			—			—			276
Excess tax benefits from restricted stock	—		32			—			—			32
Common stock repurchased and retired	(9	)	(165		)	—			—			(165		)
Net income	—		—			2,543			—			2,543
Other comprehensive income, net of tax	—		—			—			491			491
Cash dividends declared on common stock ($0.16 per share)	—		—			(2,594		)	—			(2,594		)
Balance at March 31, 2014	16,211		$	138,874		$	78,214		$	(671	)	$	216,417

See accompanying Notes to Condensed Consolidated Financial Statements.

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARY

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

For the Three Months Ended March 31, 2014 and 2013

(Dollars in thousands)

(Unaudited)



	Three Months Ended March 31,
	2014			2013
Cash flows from operating activities:
Net income	$	2,543		$	2,885
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization	2,666			1,292
Changes in net deferred loan fees, net of amortization	(48		)	148
Provision for loan losses	458			858
Net change in accrued interest receivable, prepaid expenses and other assets, accrued expenses and other liabilities	(776		)	(1,483		)
Restricted and unrestricted stock compensation expense	276			251
Stock option compensation expense	15			22
Excess tax benefits from stock options and restricted and unrestricted stock	(32		)	(47		)
Amortization of intangible assets	156			115
Bargain purchase gain on bank acquisition	—			(399		)
Gain on sale of investment securities, net	(180		)	—
Impairment loss on investment of securities	8			2
Origination of loans held for sale	—			(4,143		)
Gain on sale of loans	—			(81		)
Proceeds from sale of loans	—			5,171
Valuation adjustment on other real estate owned	—			(107		)
Gain on other real estate owned, net	(27		)	(172		)
Write-off of furniture, equipment and leasehold improvements	421			—
Net cash provided by operating activities	5,480			4,312
Cash flows from investing activities:
Loans originated, net of principal payments	(5,180		)	(6,393		)
Maturities of other interest earning deposits	497			—
Maturities of investment securities available for sale	7,343			16,109
Maturities of investment securities held to maturity	241			338
Purchase of investment securities available for sale	(24,443		)	(17,490		)
Purchase of investment securities held to maturity	(3,294		)	(1,157		)
Purchase of premises and equipment	(584		)	(1,527		)
Proceeds from sales of other real estate owned	520			2,711
Proceeds from sales of investment securities available for sale	40,318			—
Proceeds from redemption of FHLB stock	75			50
Net cash received from acquisitions	—			748
Net cash provided by (used in) investing activities	15,493			(6,611		)
Cash flows from financing activities:
Net increase in deposits	5,025			46,699
Common stock cash dividends paid	(1,297		)	(1,209		)
Net decrease in securities sold under agreement to repurchase	(630		)	(3,992		)
Proceeds from exercise of stock options	57			20
Excess tax benefits from stock options and restricted and unrestricted stock	32			47
Repurchase of common stock	(165		)	(118		)
Net cash provided by financing activities	3,022			41,447
Net increase in cash and cash equivalents	23,995			39,148

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	Three Months Ended March 31,
	2014		2013
Cash and cash equivalents at beginning of period	130,400		107,086
Cash and cash equivalents at end of period	$	154,395	$	146,234

Supplemental disclosures of cash flow information:
Cash paid for interest	$	887	$	952
Cash paid for income taxes	7		2,612
Transfers of loans receivable to other real estate owned	218		—
Seller-financed sale of other real estate owned	—		250
Assets acquired (liabilities assumed) in acquisitions:
Investment securities available for sale	—		2,753
Purchased non-covered loans receivable	—		51,509
Other real estate owned	—		2,279
Premises and equipment	—		214
FHLB stock	—		88
Accrued interest receivable	—		232
Prepaid expenses and other assets	—		4,048
Core deposit intangible	—		156
Deposits	—		(60,442		)
Accrued expenses and other liabilities	—		(1,186		)

See accompanying Notes to Condensed Consolidated Financial Statements.

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

For the Three Months Ended March 31, 2014 and 2013

(Unaudited)


(1)	Description of Business, Basis of Presentation and Significant Accounting Policies

(a) Description of Business

Heritage Financial Corporation (the “Company”) is a bank holding company that was incorporated in the State of Washington in August 1997. The Company is primarily engaged in the business of planning, directing and coordinating the business activities of its wholly-owned subsidiary Heritage Bank (the “Bank”). The Bank is a Washington-chartered commercial bank and its deposits are insured by the FDIC under the Deposit Insurance Fund. The Bank is headquartered in Olympia, Washington and conducts business from its thirty-six branch offices located throughout Washington state and the greater Portland, Oregon area. The Bank’s business consists primarily of lending and deposit relationships with small businesses and their owners in its market areas and attracting deposits from the general public. The Bank also makes real estate construction and land development loans and consumer loans and originates first mortgage loans on residential properties located in western and central Washington State and the greater Portland, Oregon area.

The Company has expanded its footprint through acquisitions beginning with the FDIC-assisted acquisition of Cowlitz Bank ("Cowlitz"), a Washington chartered commercial bank headquartered in Longview, Washington effective on July 30, 2010. Heritage Bank entered into a definitive agreement with the FDIC, pursuant to which Heritage Bank acquired certain assets and assumed certain liabilities of Cowlitz Bank (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. It also included the Trust Services Division of Cowlitz Bank.

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 ("Pierce"), a Washington 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 and the Bank entered into a definitive agreement to acquire Northwest Commercial Bank (“NCB”), a Washington chartered commercial bank headquartered in Lakewood, Washington (the “NCB Acquisition”). The NCB Acquisition was completed on January 9, 2013, with the merger of NCB into Heritage Bank. The NCB Acquisition included two branches, and one of those branches was consolidated into an existing Heritage Bank location.

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”). The Valley Acquisition was completed on July 15, 2013 and included eight branches, four of which were initially maintained by Heritage Bank following the completion of the transaction. At the time of the acquisition, one of the four branches, an owned branch building, was considered held for sale. During the fourth quarter of 2013, the leases for the remaining three leases were terminated by Heritage Bank.

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 and on a consolidated basis had no accounting impact on the Company. 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, and immediately thereafter, Whidbey will merge with and into the Bank (the "Washington Banking Merger"). Washington Banking branches will adopt the Heritage Bank name in all markets, with the exception of six branches in the Whidbey Island markets that will continue to operate using the Whidbey Island Bank name. The corporate headquarters of the combined company will be in Olympia, Washington. The Washington Banking Merger is anticipated to be completed in the second quarter of 2014. See "Note 13 - Proposed Merger" for additional information.

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(b) Basis of Presentation

The accompanying unaudited Condensed Consolidated Financial Statements have been prepared in accordance with Generally Accepted Accounting Principles (“GAAP”), for interim financial information, pursuant to the rules and regulations of the SEC. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. These Condensed Consolidated Financial Statements and accompanying Notes should be read with our December 31, 2013 audited Consolidated Financial Statements and the accompanying Notes included in our Annual Report on Form 10-K (“2013 Annual Form 10-K”). In our opinion, all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the three months ended March 31, 2014 are not necessarily indicative of the results that may be expected for the year ending December 31, 2014. In preparing the Condensed Consolidated Financial Statements, we are required to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, and expenses. Actual results could differ from those estimates. Estimates related to the allowance for loan losses, other than temporary impairments in the fair value of investment securities, expected cash flows of purchased loans and related indemnification asset, fair value measurements, stock-based compensation, impairment of goodwill and other intangible assets and income taxes are particularly subject to change.

Certain prior period amounts have been reclassified to conform to the current period’s presentation. Reclassifications had no effect on prior periods' net income or stockholders’ equity.

The significant accounting policies used in preparation of our Condensed Consolidated Financial Statements are disclosed in our 2013 Annual Form 10-K. There have not been any material changes in our significant accounting policies from those contained in our 2013 Annual Form 10-K.

(d) Recently Issued Accounting Pronouncements

FASB ASU 2013-11, Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, A Similar Tax Loss, or a Tax Credit Carryforward Exists, was issued in July 2013. This Update provides that an unrecognized tax benefit, or a portion thereof, be presented in the financial statements as a reduction to a deferred tax asset for a net operating loss carryforward, a similar tax loss, or a tax credit carryforward, except to the extent that a net operating loss carryforward, a similar tax loss, or a tax credit carryforward is not available at the reporting date to settle any additional income taxes that would result from disallowance of a tax position, or the tax law does not require the entity to use, and the entity does not intend to use, the deferred tax asset for such purpose, then the unrecognized tax benefit should be presented as a liability. These amendments are effective for interim and annual reporting periods beginning after December 15, 2013. The adoption of this amendment did not have a material impact on the Condensed Consolidated Financial Statements.

FASB ASU 2014-04, Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure, was issued in January 2014. This Update intends to reduce diversity in practice by clarifying when an in substance repossession or foreclosure occurs, that is, when a creditor should be considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan such that the loan receivable should be derecognized and the real estate property recognized. The amendment states that the real estate property should be recognized upon either the creditor obtaining legal title or the borrower convening all interest through a deed in lieu of foreclosure or similar legal agreement. These amendments are effective for interim and annual reporting periods beginning after December 15, 2014. Early adoption is permitted. The Company adopted the amendments in first quarter of 2014. The adoption did not have an impact on the Condensed Consolidated Financial Statements.


(2)	Cash and Cash Equivalents

Since the fourth quarter of 2013, the Company has been required to maintain an average reserve balance with the Federal Reserve or maintain such reserve balance in the form of cash. The average required reserve balance for the three months ended March 31, 2014 was approximately $46.1 million and was met by holding cash and maintaining an average balance with the Federal Reserve. The Company did not have a cash reserve requirement for the three months ended March 31, 2013.

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(3)	Investment Securities

The Company’s investment policy is designed primarily to provide and maintain liquidity, generate a favorable return on assets without incurring undue interest rate and credit risk, and complement the Bank’s lending activities. Securities are classified as either available for sale or held to maturity when acquired.

(a) Securities by Type and Maturity

The amortized cost, gross unrealized gains, gross unrealized losses and fair values of investment securities available for sale at the dates indicated were as follows:



	Securities Available for Sale
	March 31, 2014
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
	(In thousands)
U.S. Treasury and U.S. Government-sponsored agencies	$	6,582	$	4	$	(36	)	$	6,550
Municipal securities	51,559		942		(1,098		)	51,403
Mortgage backed securities and collateralized mortgage obligations-residential:
U.S. Government-sponsored agencies	81,338		307		(804		)	80,841
Total	$	139,479	$	1,253	$	(1,938	)	$	138,794



	Securities Available for Sale
	December 31, 2013
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
	(In thousands)
U.S. Treasury and U.S. Government-sponsored agencies	$	6,098	$	3	$	(62	)	$	6,039
Municipal securities	49,989		806		(1,735		)	49,060
Mortgage backed securities and collateralized mortgage obligations-residential:
U.S. Government agencies	108,466		898		(1,329		)	108,035
Total	$	164,553	$	1,707	$	(3,126	)	$	163,134

The amortized cost, gross unrealized gains, gross unrealized losses and fair values of investment securities held to maturity at the dates indicated were as follows:



	Securities Held to Maturity
	March 31, 2014
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
	(In thousands)
U.S. Treasury and U.S. Government-sponsored agencies	$	1,679	$	155	$	—		$	1,834
Municipal securities	24,974		319		(77		)	25,216
Mortgage backed securities and collateralized mortgage obligations-residential:
U.S. Government-sponsored agencies	11,527		157		(226		)	11,458
Private residential collateralized mortgage obligations	1,028		205		(28		)	1,205
Total	$	39,208	$	836	$	(331	)	$	39,713

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	Securities Held to Maturity
	December 31, 2013
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
	(In thousands)
U.S. Treasury and U.S. Government-sponsored agencies	$	1,687	$	153	$	—		$	1,840
Municipal securities	24,290		200		(184		)	24,306
Mortgage backed securities and collateralized mortgage obligations-residential:
U.S. Government-sponsored agencies	9,129		144		(284		)	8,989
Private residential collateralized mortgage obligations	1,048		185		(28		)	1,205
Total	$	36,154	$	682	$	(496	)	$	36,340

There were no securities classified as trading at March 31, 2014 or December 31, 2013.

The amortized cost and fair value of securities at March 31, 2014, by contractual maturity, are set forth below. Actual maturities may differ from contractual maturities because certain borrowers have the right to call or prepay obligations with or without call or prepayment penalties.



	Securities Available for Sale				Securities Held to Maturity
	Amortized Cost		Fair Value		Amortized Cost		Fair Value
	(In thousands)
Due in one year or less	$	1,145	$	1,148	$	1,757	$	1,768
Due after one year through three years	3,855		3,928		5,587		5,654
Due after three years through five years	9,848		10,047		5,007		5,079
Due after five years through ten years	38,375		38,276		18,391		18,588
Due after ten years	86,256		85,395		8,466		8,624
Total	$	139,479	$	138,794	$	39,208	$	39,713

(b) Unrealized Losses and Other-Than-Temporary Impairments

Available for sale investment securities with unrealized losses as of March 31, 2014 and December 31, 2013 were as follows:



	Securities Available for Sale
	March 31, 2014
	Less than 12 Months					12 Months or Longer					Total
	Fair Value		Unrealized Losses			Fair Value		Unrealized Losses			Fair Value		Unrealized Losses
	(In thousands)
U.S. Treasury and U.S. Government-sponsored agencies	$	1,551	$	(36	)	$	—	$	—		$	1,551	$	(36	)
Municipal securities	16,593		(556		)	7,981		(542		)	24,574		(1,098		)
Mortgage backed securities and collateralized mortgage obligations-residential:
U.S. Government-sponsored agencies	39,841		(702		)	6,891		(102		)	46,732		(804		)
Total	$	57,985	$	(1,294	)	$	14,872	$	(644	)	$	72,857	$	(1,938	)

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	Securities Available for Sale
	December 31, 2013
	Less than 12 Months					12 Months or Longer					Total
	Fair Value		Unrealized Losses			Fair Value		Unrealized Losses			Fair Value		Unrealized Losses
	(In thousands)
U.S. Treasury and U.S. Government-sponsored agencies	$	3,031	$	(62	)	$	—	$	—		$	3,031	$	(62	)
Municipal securities	21,471		(1,242		)	4,644		(493		)	26,115		(1,735		)
Mortgage backed securities and collateralized mortgage obligations-residential:
U.S. Government-sponsored agencies	56,327		(1,184		)	7,758		(145		)	64,085		(1,329		)
Total	$	80,829	$	(2,488	)	$	12,402	$	(638	)	$	93,231	$	(3,126	)

Held to maturity investment securities with unrealized losses as of March 31, 2014 and December 31, 2013 were as follows:



	Securities Held to Maturity
	March 31, 2014
	Less than 12 Months					12 Months or Longer					Total
	Fair Value		Unrealized Losses			Fair Value		Unrealized Losses			Fair Value		Unrealized Losses
	(In thousands)
Municipal securities	$	4,553	$	(77	)	$	—	$	—		$	4,553	$	(77	)
Mortgage backed securities and collateralized mortgage obligations-residential:
U.S. Government-sponsored agencies	7,501		(226		)	—		—			7,501		(226		)
Private residential collateralized mortgage obligations	161		(4		)	121		(24		)	282		(28		)
Total	$	12,215	$	(307	)	$	121	$	(24	)	$	12,336	$	(331	)



	Securities Held to Maturity
	December 31, 2013
	Less than 12 Months					12 Months or Longer					Total
	Fair Value		Unrealized Losses			Fair Value		Unrealized Losses			Fair Value		Unrealized Losses
	(In thousands)
Municipal securities	$	10,967	$	(184	)	$	—	$	—		$	10,967	$	(184	)
Mortgage backed securities and collateralized mortgage obligations-residential:
U.S. Government-sponsored agencies	4,869		(284		)	—		—			4,869		(284		)
Private residential collateralized mortgage obligations	211		(5		)	124		(23		)	335		(28		)
Total	$	16,047	$	(473	)	$	124	$	(23	)	$	16,171	$	(496	)

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The Company has evaluated these securities and has determined that, other than certain private residential collateralized mortgage obligations discussed below, the decline in their value is temporary. The unrealized losses are primarily due to increases in market interest rates and larger spreads in the market for mortgage-related products. The fair value of these securities is expected to recover as the securities approach their maturity date and/or as the pricing spreads narrow on mortgage-related securities. The Company has the ability and intent to hold the investments until recovery of the market value which may be the maturity date of the securities.

To analyze the unrealized losses, the Company estimated expected future cash flows of the private residential collateralized mortgage obligations by estimating the expected future cash flows of the underlying collateral and applying those collateral cash flows, together with any credit enhancements such as subordination interests owned by third parties, to the security. The expected future cash flows of the underlying collateral are determined using the remaining contractual cash flows adjusted for future expected credit losses (which considers current delinquencies and nonperforming assets, future expected default rates and collateral value by vintage and geographic region) and prepayments. The expected cash flows of the security are then discounted at the interest rate used to recognize interest income on the security to arrive at a present value amount. The average discount interest rate used in the valuations of the present value was 6.7% for both the three months ended March 31, 2014 and 2013, and the average prepayment rate for each period was 6.0%.

For the three months ended March 31, 2014, there were two private residential collateralized mortgage obligations determined to be other-than-temporarily impaired. All unrealized losses for the three months ended March 31, 2014 were deemed to be credit related, and the Company recorded the impairment in earnings. For the three months ended March 31, 2013, there was one private residential collateralized mortgage obligation determined to be other-than-temporarily impaired. The impairment for the three months ended March 31, 2013 was considered credit related and was recorded in earnings. No impairment for the three months ended March 31, 2014 and 2013 was recorded through other comprehensive income (loss). The following table summarizes activity for the three months ended March 31, 2014 and 2013 related to the amount of impairments on held to maturity securities:



	Life-to-Date Gross Other- Than-Temporary Impairments		Life-to-Date Other-Than- Temporary Impairments Included in Other Comprehensive Income (Loss)		Life-to-Date Net Other- Than- Temporary Impairments Included in Earnings
	(In thousands)
December 31, 2012	$	2,565	$	1,152	$	1,413
Subsequent impairments	2		—		2
March 31, 2013	$	2,567	$	1,152	$	1,415

December 31, 2013	$	2,603	$	1,152	$	1,451
Subsequent impairments	8		—		8
March 31, 2014	$	2,611	$	1,152	$	1,459

In May 2008, the Board of Trustees of the AMF Ultra Short Mortgage Fund (“Fund”) activated the Fund’s redemption-in-kind provision because of the uncertainty in the mortgage backed securities market. Exiting participants in the Fund were allowed to redeem and receive up to $250,000 in cash per quarter or receive 100% of their investment in “like-kind” securities equal to their proportional ownership in the Fund. The Company elected to receive the like-kind securities.

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Details of private residential collateralized mortgage obligation securities received from the redemption-in-kind election as of March 31, 2014 were as follows:



															Current Ratings
Type of Security	Par Value		Amortized Cost		Fair Value (1)		Aggregate Unrealized Gain		Year-to- date Change in Unrealized Gain		Year-to- date Impairment Charge		Life-to- date Impairment Charge (2)		AAA		AA		A		BBB		Below Investment Grade
	(Dollars in thousands)
Alt-A	$	723	$	245	$	263	$	18	$	3	$	8	$	690	—	%	—	%	—	%	—	%	100	%
Prime	1,202		783		942		159		17		—		769		—	%	—	%	—	%	7	%	93	%
Totals	$	1,925	$	1,028	$	1,205	$	177	$	20	$	8	$	1,459	—	%	—	%	—	%	6	%	94	%

(1)Level two valuation assumptions were used to determine the fair value of held to maturity securities in the Fund.

(2)Life-to-date impairment charge represents impairment charges recognized in earnings subsequent to redemption of the Fund.

(d) Pledged Securities

The following table summarizes the amortized cost and fair value of available for sale and held to maturity securities that are pledged as collateral for the following obligations at March 31, 2014 and December 31, 2013:



	March 31, 2014				December 31, 2013
	Amortized Cost		Fair Value		Amortized Cost		Fair Value
	(In thousands)
Washington and Oregon state to secure public deposits	$	74,572	$	74,706	$	80,386	$	80,881
Repurchase agreements	35,398		35,195		34,170		33,893
Total	$	109,970	$	109,901	$	114,556	$	114,774


(4)	Loans Receivable

The Company originates loans in the ordinary course of business. These loans are identified as “originated” loans. Disclosures related to the Company’s recorded investment in originated loans receivable generally exclude accrued interest receivable and net deferred loan origination fees and costs because they are insignificant. The Company has also acquired loans through FDIC-assisted and open bank transactions. Loans acquired in a business acquisition are designated as “purchased” loans. The Company refers to the purchased loans subject to the FDIC shared-loss agreements as “covered” loans, and those loans without shared-loss agreements are referred to as “non-covered” loans. Loans purchased with evidence of credit deterioration since origination for which it is probable that not all contractually required payments will be collected are accounted for under FASB ASC 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality. These loans are identified as “purchased impaired” loans. Loans purchased that are not accounted for under FASB ASC 310-30 are accounted for under FASB ASC 310-20, Receivables—Nonrefundable Fees and Other Costs. These loans are identified as “purchased other” loans.

(a) Loan Origination/Risk Management

The Company originates loans in one of the four segments of the total loan portfolio: commercial business, real estate construction and land development, one-to-four family residential and consumer. Within these segments are classes of loans to which management monitors and assesses credit risk in the loan portfolios. The Company has certain lending policies and procedures in place that are designed to maximize loan income within an acceptable level of risk. Management reviews and approves these policies and procedures on a regular basis. A reporting system supplements the review process by providing management with frequent reports related to loan production, loan quality, concentrations of credit, loan delinquencies, and nonperforming and potential problem loans. The Company also conducts internal loan reviews and validates the credit risk assessment on a periodic basis and presents the results of these reviews to management. The loan review process complements and reinforces the risk identification and assessment decisions made by loan officers and credit personnel, as well as the Company’s policies and procedures.

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A discussion of the risk characteristics of each loan portfolio segment is as follows:

Commercial Business:

There are three significant classes of loans in the commercial portfolio segment, including commercial and industrial loans, owner-occupied commercial real estate and non-owner occupied commercial real estate. The owner and non-owner occupied commercial real estate are both considered commercial real estate loans. As the commercial and industrial loans carry different risk characteristics than the commercial real estate loans, they are discussed separately below.

Commercial and industrial. Commercial and industrial loans are primarily made based on the identified cash flows of the borrower and secondarily on the underlying collateral provided by the borrower. The cash flows of borrowers, however, may not be as expected and the collateral securing these loans may fluctuate in value. Most commercial and industrial loans are secured by the assets being financed or other business assets such as accounts receivable or inventory and may include a personal guarantee; however, some short-term loans may be made on an unsecured basis. In the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers.

Commercial real estate. The Company originates commercial real estate loans within its primary market areas. These loans are subject to underwriting standards and processes similar to commercial and industrial loans, in addition to those of real estate loans. These loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate. Commercial real estate involves more risk than other classes of loans in that the lending typically involves higher loan principal amounts, and payments on loans secured by real estate properties are dependent on successful operation and management of the properties. Repayment of these loans may be more adversely affected by conditions in the real estate market or the economy.

One-to-Four Family Residential:

The majority of the Company’s one-to-four family residential loans are secured by single-family residences located in its primary market areas. The Company’s underwriting standards require that single-family portfolio 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 of maturity typically range from 15 to 30 years. Until the second quarter of 2013, the Company sold most single-family loans in the secondary market and retained a smaller portion in its loan portfolio. After the second quarter of 2013, the Company only originated single-family loans for its loan portfolio.

Real Estate Construction and Land Development:

The Company originates construction loans for one-to-four family residential and for five or more family residential and commercial properties. The one-to-four family residential construction loans generally include construction of custom homes whereby the home buyer is the borrower. The Company also provides financing to builders for the construction of pre-sold homes and, in selected cases, to builders for the construction of speculative residential property. Substantially all construction loans are short-term in nature and priced with variable rates of interest. 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, the Company’s estimates with regard 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 the Company’s 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 if the borrower does not repay the loan. Sources of repayment for these types of loans may be pre-committed permanent loans from approved long-term lenders, sales of developed property or an interim loan commitment from the Company until permanent financing is obtained. These loans are closely monitored by on-site inspections and are considered to have higher risks than other real estate loans due to their ultimate repayment being dependent upon successful completion of the construction project, interest rate changes, governmental regulation of real property, general economic conditions and the availability of long-term financing.

Consumer:

The Company originates consumer loans and lines of credit that are both secured and unsecured. The underwriting process for these loans ensures a qualifying primary and secondary source of repayment. Underwriting standards for home equity loans are significantly influenced by statutory requirements, which include, but are not limited to, a maximum loan-to-value percentage of 80%, collection remedies, the number of such loans a borrower can have at one time and documentation requirements. To monitor and manage consumer loan risk, policies and procedures

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are developed and modified, as needed. The majority of consumer loans are for relatively small amounts disbursed among many individual borrowers which reduces the credit risk for this type of loan. To further reduce the risk, trend reports are reviewed by management on a regular basis.

Originated loans receivable at March 31, 2014 and December 31, 2013 consisted of the following portfolio segments and classes:



	March 31, 2014			December 31, 2013
	(In thousands)
Commercial business:
Commercial and industrial	$	284,949		$	283,075
Owner-occupied commercial real estate	209,286			211,287
Non-owner occupied commercial real estate	361,602			354,451
Total commercial business	855,837			848,813
One-to-four family residential	40,866			39,235
Real estate construction and land development:
One-to-four family residential	19,302			18,593
Five or more family residential and commercial properties	49,929			45,184
Total real estate construction and land development	69,231			63,777
Consumer	30,599			28,130
Gross originated loans receivable	996,533			979,955
Net deferred loan fees	(2,622		)	(2,670		)
Originated loans receivable, net	993,911			977,285
Allowance for loan losses	(17,534		)	(17,153		)
Originated loans receivable, net of allowance for loan losses	$	976,377		$	960,132

The recorded investment of purchased covered loans receivable at March 31, 2014 and December 31, 2013 consisted of the following portfolio segments and classes:



	March 31, 2014			December 31, 2013
	(In thousands)
Commercial business:
Commercial and industrial	$	14,646		$	14,690
Owner-occupied commercial real estate	24,107			24,366
Non-owner occupied commercial real estate	13,399			14,625
Total commercial business	52,152			53,681
One-to-four family residential	4,306			4,777
Real estate construction and land development:
One-to-four family residential	1,554			1,556
Total real estate construction and land development	1,554			1,556
Consumer	3,462			3,740
Gross purchased covered loans receivable	61,474			63,754
Allowance for loan losses	(6,567		)	(6,167		)
Purchased covered loans receivable, net	$	54,907		$	57,587

The March 31, 2014 and December 31, 2013 gross recorded investment balance of purchased impaired covered loans accounted for under FASB ASC 310-30 was $37.3 million and $38.9 million, respectively. The gross recorded investment balance of purchased other covered loans was $24.2 million and $24.9 million at March 31, 2014 and December 31, 2013, respectively. At both March 31, 2014 and December 31, 2013, the recorded investment balance of purchased covered loans which are no longer covered under the FDIC shared-loss agreements was $2.6 million.

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Funds advanced on the purchased covered loans subsequent to acquisition, referred to as “subsequent advances,” are included in the purchased covered loan balances as these subsequent advances are covered under the shared-loss agreements. These subsequent advances are not accounted for under FASB ASC 310-30. The total balance of subsequent advances on the purchased covered loans was $5.6 million and $4.7 million as of March 31, 2014 and December 31, 2013, respectively.

The recorded investment of purchased non-covered loans receivable at March 31, 2014 and December 31, 2013 consisted of the following portfolio segments and classes:



	March 31, 2014			December 31, 2013
	(In thousands)
Commercial business:
Commercial and industrial	$	48,267		$	53,465
Owner-occupied commercial real estate	68,366			70,022
Non-owner occupied commercial real estate	44,246			45,528
Total commercial business	160,879			169,015
One-to-four family residential	2,747			3,847
Real estate construction and land development:
One-to-four family residential	1,134			1,131
Five or more family residential and commercial properties	4,398			3,471
Total real estate construction and land development	5,532			4,602
Consumer	12,494			13,417
Gross purchased non-covered loans receivable	181,652			190,881
Allowance for loan losses	(5,286		)	(5,504		)
Purchased non-covered loans receivable, net	$	176,366		$	185,377

The March 31, 2014 and December 31, 2013 gross recorded investment balance of purchased impaired non-covered loans accounted for under FASB ASC 310-30 was $32.8 million and $36.0 million, respectively. The recorded investment balance of purchased other non-covered loans was $148.9 million and $154.9 million at March 31, 2014 and December 31, 2013, respectively.

(b) Concentrations of Credit

Most of the Company’s lending activity occurs within Washington State, and to a lesser extent Oregon State. The Company’s primary market areas include Thurston, Pierce, King, Mason, Cowlitz, Yakima, Kittitas and Clark counties in Washington and Multnomah County in Oregon, as well as other contiguous markets. The majority of the Company’s loan portfolio consists of (in order of balances at March 31, 2014) non-owner occupied commercial real estate, commercial and industrial and owner-occupied commercial real estate. As of March 31, 2014 and December 31, 2013, there were no concentrations of loans related to any single industry in excess of 10% of the Company’s total loans.

As part of the on-going monitoring of the credit quality of the Company’s loan portfolio, management tracks certain credit quality indicators including trends related to (i) the risk grade of the loans, (ii) the level of classified loans, (iii) net charge-offs, (iv) nonperforming loans, and (v) the general economic conditions of the United States of America, and specifically the states of Washington and Oregon. The Company utilizes a risk grading matrix to assign a risk grade to each of its loans. Loans are graded on a scale of 0 to 10. A description of the general characteristics of the risk grades is as follows:

•

Grades 0 to 5: These grades are considered “pass grade” and include loans with negligible to above average but acceptable risk. These borrowers generally have strong to acceptable capital levels and consistent earnings and debt service capacity. Loans with the higher grades within the “pass” category may include borrowers who are experiencing unusual operating difficulties, but have acceptable payment performance to date. Increased monitoring of financials and/or collateral may be appropriate. Loans with this grade show no immediate loss exposure.

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•	Grade 6: This grade includes "Watch" loans and is considered a “pass grade”. The grade is intended to be utilized on a temporary basis for pass grade borrowers where a potentially significant risk-modifying action is anticipated in the near term.

•

Grade 7: This grade includes “Other Assets Especially Mentioned” (“OAEM”) loans in accordance with regulatory guidelines, and is intended to highlight loans with elevated risks. Loans with this grade show signs of deteriorating profits and capital, and the borrower might not be strong enough to sustain a major setback. The borrower is typically higher than normally leveraged, and outside support might be modest and likely illiquid. The loan is at risk of further decline unless active measures are taken to correct the situation.

•

Grade 8: This grade includes “Substandard” loans in accordance with regulatory guidelines, which the Company has determined have a high credit risk. These loans also have well-defined weaknesses which make payment default or principal exposure likely, but not yet certain. The borrower may have shown serious negative trends in financial ratios and performance. Such loans may be dependent upon collateral liquidation, a secondary source of repayment or an event outside of the normal course of business. Loans with this grade can be placed on accrual or nonaccrual status based on the Company’s accrual policy.

•

Grade 9: This grade includes “Doubtful” loans in accordance with regulatory guidelines, and the Company has determined these loans to have excessive credit risk. Such loans are placed on nonaccrual status and may be dependent upon collateral having a value that is difficult to determine or upon some near-term event which lacks certainty. Additionally, these loans generally have a specific valuation allowance.

•

Grade 10: This grade includes “Loss” loans in accordance with regulatory guidelines, and the Company has determined these loans have the highest risk of loss. Such loans are charged-off or charged-down when payment is acknowledged to be uncertain or when the timing or value of payments cannot be determined. “Loss” is not intended to imply that the loan or some portion of it will never be paid, nor does it in any way imply that there has been a forgiveness of debt.

Loan grades for all commercial business loans and real estate construction and land development loans are established at the origination of the loan. One-to-four family residential loans and consumer loans (“non-commercial loans”) are not numerically graded at origination date as these loans are determined to be “pass graded” loans. These non-commercial loans may subsequently require numeric grade if the credit department has evaluated the credit and determined it necessary to classify the loan. Loan grades are reviewed on a quarterly basis, or more frequently if necessary, by the credit department. Typically, an individual loan grade will not be changed from the prior period unless there is a specific indication of credit deterioration or improvement. Credit deterioration is evidenced by delinquency, direct communications with the borrower, or other borrower information that becomes known to management. Credit improvements are evidenced by known facts regarding the borrower or the collateral property.

The loan grades relate to the likelihood of losses in that the higher the grade, the greater the loss potential. Loans with a pass grade may have some estimated inherent losses, but to a lesser extent than the other loan grades. The OAEM loan grade is transitory in that the Company is waiting on additional information to determine the likelihood and extent of the potential loss. The likelihood of loss for OAEM graded loans, however, is greater than Watch graded loans because there has been measurable credit deterioration. Loans with a Substandard grade are generally loans for which the Company has individually analyzed for potential impairment. For Doubtful and Loss graded loans, the Company is almost certain of the losses, and the unpaid principal balances are generally charged-off to the realizable value.

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The following tables present the balance of the originated loans receivable by credit quality indicator as of March 31, 2014 and December 31, 2013.



	March 31, 2014
	Pass		OAEM		Substandard		Doubtful		Total
	(In thousands)
Commercial business:
Commercial and industrial	$	264,175	$	6,570	$	13,445	$	759	$	284,949
Owner-occupied commercial real estate	200,252		2,568		6,466		—		209,286
Non-owner occupied commercial real estate	343,354		11,989		6,259		—		361,602
Total commercial business	807,781		21,127		26,170		759		855,837
One-to-four family residential	39,974		268		624		—		40,866
Real estate construction and land development:
One-to-four family residential	11,291		1,021		6,990		—		19,302
Five or more family residential and commercial properties	40,057		—		9,872		—		49,929
Total real estate construction and land development	51,348		1,021		16,862		—		69,231
Consumer	30,413		17		169		—		30,599
Gross originated loans	$	929,516	$	22,433	$	43,825	$	759	$	996,533



	December 31, 2013
	Pass		OAEM		Substandard		Doubtful		Total
	(In thousands)
Commercial business:
Commercial and industrial	$	259,071	$	8,367	$	14,368	$	1,269	$	283,075
Owner-occupied commercial real estate	202,440		3,393		5,454		—		211,287
Non-owner occupied commercial real estate	340,732		7,927		5,792		—		354,451
Total commercial business	802,243		19,687		25,614		1,269		848,813
One-to-four family residential	38,330		269		636		—		39,235
Real estate construction and land development:
One-to-four family residential	10,608		4,159		3,826		—		18,593
Five or more family residential and commercial properties	42,780		—		2,404		—		45,184
Total real estate construction and land development	53,388		4,159		6,230		—		63,777
Consumer	27,986		—		144		—		28,130
Gross originated loans	$	921,947	$	24,115	$	32,624	$	1,269	$	979,955

The tables above include $29.3 million and $27.4 million of originated impaired loans as of March 31, 2014 and December 31, 2013, respectively, as detailed in the impaired loans section below. These impaired loans have been individually reviewed for probable incurred losses and have a specific valuation allowance, as necessary. The tables above also include potential problem loans. Potential problem loans are those loans that are currently accruing interest and are not considered impaired, but which management is monitoring because the financial information of the borrower causes concern as to their ability to meet their loan repayment terms. Potential problem originated loans as of March 31, 2014 and December 31, 2013 were $41.6 million and $34.5 million, respectively. The balance of

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potential problem originated loans guaranteed by a governmental agency, which reduces the Company's credit exposure, was $1.4 million and $1.8 million as of March 31, 2014 and December 31, 2013, respectively.

The following tables present the recorded invested balance of the purchased covered and non-covered loans receivable by credit quality indicator as of March 31, 2014 and December 31, 2013.



	March 31, 2014
	Pass		OAEM		Substandard		Doubtful		Total
	(In thousands)
Commercial business:
Commercial and industrial	$	50,841	$	4,520	$	6,683	$	869	$	62,913
Owner-occupied commercial real estate	88,100		897		3,223		253		92,473
Non-owner occupied commercial real estate	45,753		1,151		7,402		3,339		57,645
Total commercial business	184,694		6,568		17,308		4,461		213,031
One-to-four family residential	4,795		429		1,829		—		7,053
Real estate construction and land development:
One-to-four family residential	754		—		1,934		—		2,688
Five or more family residential and commercial properties	3,449		—		949		—		4,398
Total real estate construction and land development	4,203		—		2,883		—		7,086
Consumer	13,015		343		2,038		560		15,956
Gross purchased covered and non-covered loans	$	206,707	$	7,340	$	24,058	$	5,021	$	243,126



	December 31, 2013
	Pass		OAEM		Substandard		Doubtful		Total
	(In thousands)
Commercial business:
Commercial and industrial	$	55,404	$	4,703	$	7,183	$	865	$	68,155
Owner-occupied commercial real estate	87,774		2,739		3,619		256		94,388
Non-owner occupied commercial real estate	47,157		1,165		7,562		4,269		60,153
Total commercial business	190,335		8,607		18,364		5,390		222,696
One-to-four family residential	5,654		882		2,088		—		8,624
Real estate construction and land development:
One-to-four family residential	1,672		—		1,015		—		2,687
Five or more family residential and commercial properties	2,552		—		919		—		3,471
Total real estate construction and land development	4,224		—		1,934		—		6,158
Consumer	14,562		354		2,241		—		17,157
Gross purchased covered and non-covered loans	$	214,775	$	9,843	$	24,627	$	5,390	$	254,635

The tables above include $6.7 million of purchased other impaired loans as of both March 31, 2014 and December 31, 2013 as detailed in the impaired loans section below. These purchased other impaired loans have been individually reviewed for potential losses and have a specific valuation allowance, as necessary.

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(d) Nonaccrual loans

Originated nonaccrual loans, segregated by segments and classes of loans, were as follows as of March 31, 2014 and December 31, 2013:



	March 31, 2014		December 31, 2013
	(In thousands)
Commercial business:
Commercial and industrial	$	5,148	$	4,497
Owner-occupied commercial real estate	1,006		1,024
Non-owner occupied commercial real estate	3		3
Total commercial business	6,157		5,524
One-to-four family residential	334		340
Real estate construction and land development:
One-to-four family residential	4,074		1,045
Total real estate construction and land development	4,074		1,045
Consumer	62		38
Gross originated nonaccrual loans (1)	$	10,627	$	6,947


(1)	$1.8 million and $1.7 million of nonaccrual originated loans were guaranteed by governmental agencies at March 31, 2014 and December 31, 2013, respectively.

The recorded investment balance of purchased other nonaccrual loans, segregated by segments and classes of loans, were as follows as of March 31, 2014 and December 31, 2013:



	March 31, 2014		December 31, 2013
	(In thousands)
Commercial business:
Commercial and industrial	$	276	$	151
Owner-occupied commercial real estate	429		—
Total commercial business	705		151
Consumer	644		647
Gross purchased other nonaccrual loans (1)	$	1,349	$	798


(1)	$7,000 of purchased other nonaccrual loans were covered by the FDIC shared-loss agreements at both March 31, 2014 and December 31, 2013.

(e) Past due loans

The Company performs an aging analysis of past due loans using the categories of 30-89 days past due and 90 or more days past due. This policy is consistent with regulatory reporting requirements.

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The balances of originated past due loans, segregated by segments and classes of loans, as of March 31, 2014 and December 31, 2013 were as follows:



	March 31, 2014
	30-89 Days		90 Days or Greater		Total Past Due		Current		Total		90 Days or More and Still Accruing
	(In thousands)
Commercial business:
Commercial and industrial	$	2,279	$	3,376	$	5,655	$	279,294	$	284,949	$	—
Owner-occupied commercial real estate	168		578		746		208,540		209,286		—
Non-owner occupied commercial real estate	74		3		77		361,525		361,602		—
Total commercial business	2,521		3,957		6,478		849,359		855,837		—
One-to-four family residential	89		—		89		40,777		40,866		—
Real estate construction and land development:
One-to-four family residential	315		1,045		1,360		17,942		19,302		—
Five or more family residential and commercial properties	—		—		—		49,929		49,929		—
Total real estate construction and land development	315		1,045		1,360		67,871		69,231		—
Consumer	31