Edgar Filing: HERITAGE FINANCIAL CORP /WA/

10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q



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

For the quarterly period ended September 30, 2015



¨	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 October 27, 2015 there were 29,967,410 shares of the registrant's common stock, no par value per share, outstanding.

Table of Contents

HERITAGE FINANCIAL CORPORATION

FORM 10-Q

INDEX

September 30, 2015



		Page
FORWARD LOOKING STATEMENTS

Part I.	FINANCIAL INFORMATION	4
Item 1.	FINANCIAL STATEMENTS	4
	Condensed Consolidated Statements of Financial Condition as of September 30, 2015 and December 31, 2014	4
	Condensed Consolidated Statements of Income for the Three and Nine Months Ended September 30, 2015 and 2014	5
	Condensed Consolidated Statements of Comprehensive Income for the Three and Nine Months Ended September 30, 2015 and 2014	6
	Condensed Consolidated Statements of Stockholders’ Equity for the Nine Months Ended September 30, 2015 and 2014	7
	Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2015 and 2014	8
	Notes to Condensed Consolidated Financial Statements	10
Item 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	49
Item 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	70
Item 4.	CONTROLS AND PROCEDURES	70

Part II.	OTHER INFORMATION	70
Item 1.	LEGAL PROCEEDINGS	70
Item 1A.	RISK FACTORS	70
Item 2.	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS	71
Item 3.	DEFAULTS UPON SENIOR SECURITIES	71
Item 4.	MINE SAFETY DISCLOSURES	72
Item 5.	OTHER INFORMATION	72
Item 6.	EXHIBITS	72
	SIGNATURES	74
	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 the Cowlitz Bank, Pierce Commercial Bank, Northwest Commercial Bank, Valley Community Bancshares, Inc. and 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 effected 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 and of our bank subsidiary by the Federal Deposit Insurance Corporation ("FDIC"), the Washington State Department of Financial Institutions, Division of Banks or other regulatory authorities, including the possibility that any such regulatory authority may, among other things, initiate an enforcement action against the Company or our bank subsidiary which could require us to increase our allowance for loan losses, write-down assets, change our regulatory capital position, affect our ability to borrow funds or maintain or increase deposits, or impose additional requirements on us, any of which could affect our ability to continue our growth through merger, acquisitions or similar transactions and 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 Dodd-Frank Wall Street Reform and Consumer Protection 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 Statements 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; 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, 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 including our Annual Report on Form 10-K for the year ended December 31, 2014.

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 results 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 subsidiaries, unless the context otherwise requires.

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PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

September 30, 2015 and December 31, 2014

(Dollars in thousands)

(Unaudited)



	September 30, 2015			December 31, 2014
ASSETS
Cash on hand and in banks	$	58,930		$	74,028
Interest earning deposits	83,547			47,608
Cash and cash equivalents	142,477			121,636
Other interest earning deposits	5,244			10,126
Investment securities available for sale, at fair value	703,093			742,846
Investment securities held to maturity (fair value of $34,023 and $36,874, respectively)	32,832			35,814
Loans held for sale	7,981			5,582
Loans receivable, net	2,404,044			2,251,077
Allowance for loan losses	(29,004		)	(27,729		)
Total loans receivable, net	2,375,040			2,223,348
FDIC indemnification asset	—			1,116
Other real estate owned	2,071			3,355
Premises and equipment, net	63,356			64,938
Federal Home Loan Bank stock, at cost	4,148			12,188
Bank owned life insurance	60,945			35,176
Accrued interest receivable	10,831			9,836
Prepaid expenses and other assets	59,019			61,871
Other intangible assets, net	9,312			10,889
Goodwill	119,029			119,029
Total assets	$	3,595,378		$	3,457,750
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits	$	3,054,198		$	2,906,331
Junior subordinated debentures	19,351			19,082
Securities sold under agreement to repurchase	22,829			32,181
Accrued expenses and other liabilities	30,304			45,650
Total liabilities	3,126,682			3,003,244
Stockholders’ equity:
Preferred stock, no par value, 2,500,000 shares authorized; no shares issued and outstanding at September 30, 2015 and December 31, 2014	—			—
Common stock, no par value, 50,000,000 shares authorized; 29,967,555 and 30,259,838 shares issued and outstanding at September 30, 2015 and December 31, 2014, respectively	358,927			364,741
Retained earnings	104,762			86,387
Accumulated other comprehensive income, net	5,007			3,378
Total stockholders’ equity	468,696			454,506
Total liabilities and stockholders’ equity	$	3,595,378		$	3,457,750

See accompanying Notes to Condensed Consolidated Financial Statements.

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

For the Three and Nine Months Ended September 30, 2015 and 2014

(Dollars in thousands, except per share amounts)

(Unaudited)



	Three Months Ended September 30,						Nine Months Ended September 30,
	2015			2014			2015			2014
INTEREST INCOME:
Interest and fees on loans	$	30,179		$	31,841		$	91,213		$	75,738
Taxable interest on investment securities	2,187			2,212			7,199			4,663
Nontaxable interest on investment securities	1,056			855			3,137			1,928
Interest and dividends on other interest earning assets	62			123			173			338
Total interest income	33,484			35,031			101,722			82,667
INTEREST EXPENSE:
Deposits	1,335			1,534			3,961			3,685
Junior subordinated debentures	195			171			627			285
Other borrowings	14			19			50			52
Total interest expense	1,544			1,724			4,638			4,022
Net interest income	31,940			33,307			97,084			78,645
Provision for loan losses	851			594			3,247			1,743
Net interest income after provision for loan losses	31,089			32,713			93,837			76,902
NONINTEREST INCOME:
Service charges and other fees	3,593			3,524			10,575			7,700
Merchant Visa income, net	66			278			458			839
Change in FDIC indemnification asset	—			(647		)	(497		)	(575		)
Gain (loss) on sale of investment securities, net	393			(13		)	1,362			254
Gain on sale of loans, net	1,411			742			3,828			975
Other income	4,081			1,599			9,043			3,377
Total noninterest income	9,544			5,483			24,769			12,570
NONINTEREST EXPENSE:
Compensation and employee benefits	14,918			15,579			42,984			36,369
Occupancy and equipment	3,970			3,978			11,511			9,412
Data processing	2,398			1,978			5,950			6,977
Marketing	899			841			2,595			1,843
Professional services	894			1,113			2,602			5,173
State and local taxes	619			576			1,808			1,378
Impairment loss on investment securities, net	—			—			—			45
Federal deposit insurance premium	499			403			1,537			1,115
Other real estate owned, net	(5		)	650			854			915
Amortization of intangible assets	523			603			1,577			1,248
Other expense	2,607			2,642			8,021			5,661
Total noninterest expense	27,322			28,363			79,439			70,136
Income before income taxes	13,311			9,833			39,167			19,336
Income tax expense	3,819			2,765			11,171			5,577
Net income	$	9,492		$	7,068		$	27,996		$	13,759
Basic earnings per common share	$	0.32		$	0.23		$	0.93		$	0.57
Diluted earnings per common share	$	0.32		$	0.23		$	0.93		$	0.57
Dividends declared per common share	$	0.11		$	0.09		$	0.32		$	0.25

See accompanying Notes to Condensed Consolidated Financial Statements.

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

For the Three and Nine Months Ended September 30, 2015 and 2014

(Dollars in thousands)

(Unaudited)



	Three Months Ended September 30,						Nine Months Ended September 30,
	2015			2014			2015			2014
Net income	$	9,492		$	7,068		$	27,996		$	13,759
Change in fair value of securities available for sale, net of tax of $1,657, $(744), $1,256 and $663, respectively	3,064			(1,384		)	2,324			1,231
Reclassification adjustment for net gain from sale of investment securities included in income, net of tax of $(138), $4, $(478) and $(89), respectively	(255		)	8			(884		)	(166		)
Accretion of other-than-temporary impairment on investment securities, net of tax of $0, $9, $4 and $27, respectively	—			13			11			43
Reclassification of other-than-temporary impairment on securities from sale of investment securities, net of tax $0, $0, $99, $0	—			—			178			—
Other comprehensive income (loss)	2,809			(1,363		)	1,629			1,108
Comprehensive income	$	12,301		$	5,705		$	29,625		$	14,867

See accompanying Notes to Condensed Consolidated Financial Statements.

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

For the Nine Months Ended September 30, 2015 and 2014

(In thousands, except per share amounts)

(Unaudited)



	Number of common shares		Common stock			Retained earnings			Accumulated other comprehensive (loss) income, net			Total stock- holders’ equity
Balance at December 31, 2013	16,211		$	138,659		$	78,265		$	(1,162	)	$	215,762
Restricted and unrestricted stock awards issued, net of forfeitures	124		—			—			—			—
Stock option compensation expense	—		20			—			—			20
Exercise of stock options (including excess tax benefits from nonqualified stock options)	71		766			—			—			766
Restricted stock compensation expense	—		896			—			—			896
Excess tax benefits from restricted stock	—		60			—			—			60
Common stock repurchased	(127	)	(2,119		)	—			—			(2,119		)
Net income	—		—			13,759			—			13,759
Other comprehensive income, net of tax	—		—			—			1,108			1,108
Common stock issued in business combination	13,973		226,724			—			—			226,724
Cash dividends declared on common stock ($0.25 per share)	—		—			(5,325		)	—			(5,325		)
Balance at September 30, 2014	30,252		$	365,006		$	86,699		$	(54	)	$	451,651

Balance at December 31, 2014	30,260		$	364,741		$	86,387		$	3,378		$	454,506
Restricted and unrestricted stock awards issued, net of forfeitures	118		—			—			—			—
Exercise of stock options (including excess tax benefits from nonqualified stock options)	53		686			—			—			686
Restricted stock compensation expense	—		1,125			—			—			1,125
Excess tax benefits from restricted stock	—		105			—			—			105
Common stock repurchased	(464	)	(7,730		)	—			—			(7,730		)
Net income	—		—			27,996			—			27,996
Other comprehensive income, net of tax	—		—			—			1,629			1,629
Cash dividends declared on common stock ($0.32 per share)	—		—			(9,621		)	—			(9,621		)
Balance at September 30, 2015	29,967		$	358,927		$	104,762		$	5,007		$	468,696

See accompanying Notes to Condensed Consolidated Financial Statements.

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

For the Nine Months Ended September 30, 2015 and 2014

(Dollars in thousands)

(Unaudited)



	Nine Months Ended September 30,
	2015			2014
Cash flows from operating activities:
Net income	$	27,996		$	13,759
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization	10,486			9,043
Changes in net deferred loan fees, net of amortization	(1,257		)	(1,200		)
Provision for loan losses	3,247			1,743
Net change in accrued interest receivable, FDIC indemnification asset, prepaid expenses and other assets, accrued expenses and other liabilities	(4,085		)	209
Restricted and unrestricted stock compensation expense	1,125			896
Stock option compensation expense	—			20
Excess tax benefits from stock options and restricted and unrestricted stock	(125		)	(60		)
Amortization of intangible assets	1,577			1,248
Gain on sale of investment securities, net	(1,362		)	(254		)
Impairment loss on investment of securities, net	—			45
Origination of loans held for sale	(102,310		)	(35,046		)
Gain on sale of loans, net	(3,828		)	(975		)
Proceeds from sale of loans held for sale	103,739			35,303
Earnings on bank owned life insurance	(769		)	(241		)
Valuation adjustment on other real estate owned	415			—
Loss on sale of other real estate owned, net	94			312
Gain on termination of FDIC shared-loss agreements	(1,747		)	—
(Gain) loss on sale or write-off of furniture, equipment and leasehold improvements	(1		)	466
Net cash provided by operating activities	33,195			25,268
Cash flows from investing activities:
Loans originated, net of principal payments	(156,106		)	30,363
Maturities of other interest earning deposits	4,836			2,487
Maturities of investment securities available for sale	91,915			37,480
Maturities of investment securities held to maturity	1,897			1,003
Purchase of investment securities available for sale	(158,048		)	(251,200		)
Purchase of investment securities held to maturity	—			(3,313		)
Purchase of premises and equipment	(1,409		)	(3,330		)
Proceeds from sales of other real estate owned	3,199			5,173
Proceeds from sales of investment securities available for sale	102,937			158,640
Proceeds from sales of investment securities held to maturity	972			—
Proceeds from redemption of Federal Home Loan Bank stock	8,040			442
Proceeds from sale of premises and equipment	10			835
Purchase of bank owned life insurance	(25,000		)	—
Investment in new market tax credit partnership	—			(25,000		)
Investment in low-income housing tax credit partnership	(442		)	—
Net cash used for termination of FDIC shared-loss agreements	(7,110		)	—
Net cash received from acquisitions	—			31,564
Net cash used in investing activities	(134,309		)	(14,856		)

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	Nine Months Ended September 30,
	2015			2014
Cash flows from financing activities:
Net increase in deposits	147,867			69,986
Common stock cash dividends paid	(9,621		)	(5,325		)
Net (decrease) increase in securities sold under agreement to repurchase	(9,352		)	5,970
Proceeds from exercise of stock options	666			766
Excess tax benefits from stock options and restricted and unrestricted stock	125			60
Repurchase of common stock	(7,730		)	(2,119		)
Net cash provided by financing activities	121,955			69,338
Net increase in cash and cash equivalents	20,841			79,750
Cash and cash equivalents at beginning of period	121,636			130,400
Cash and cash equivalents at end of period	$	142,477		$	210,150

Supplemental disclosures of cash flow information:
Cash paid for interest	$	4,841		$	3,667
Cash paid for income taxes	12,286			11,952

Supplemental non-cash disclosures of cash flow information:
Transfers of loans receivable to other real estate owned	$	2,424		$	677
Investment in low income housing tax credit partnership and related funding commitment	—			4,400
Purchases of investment securities available for sale not settled	—			9,365
Common stock issued for business combinations	—			226,724
Assets acquired (liabilities assumed) in acquisitions:
Investment securities available for sale	—			458,312
Loans held for sale	—			3,923
Loans receivable	—			895,978
Loans receivable, covered at merger date	—			107,050
Other real estate owned	—			7,121
Premises and equipment	—			31,776
Federal Home Loan Bank stock	—			7,064
FDIC indemnification asset	—			7,174
Accrued interest receivable	—			4,943
Bank owned life insurance	—			32,519
Prepaid expenses and other assets	—			15,194
Other intangible assets	—			11,194
Deposits	—			(1,433,894		)
Junior subordinated debentures	—			(18,937		)
Accrued expenses and other liabilities	—			(23,803		)

See accompanying Notes to Condensed Consolidated Financial Statements.

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

For the Three and Nine Months Ended September 30, 2015 and 2014

(Unaudited)


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

(a) Description of Business

Heritage Financial Corporation ("Heritage" or 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 67 branch offices located throughout Washington State and the greater Portland, Oregon area. The Bank’s business consists primarily of commercial 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 primarily located in its market area.

The Company has expanded its footprint through mergers and acquisitions. The largest of these transactions was the strategic merger with Washington Banking Company (“Washington Banking”) and its wholly owned subsidiary bank, Whidbey Island Bank ("Whidbey"). Effective May 1, 2014, Washington Banking merged with and into Heritage and Whidbey merged with and into Heritage Bank and this transaction is referred to herein as the "Washington Banking Merger". In connection with the Washington Banking Merger, Heritage also acquired as a subsidiary the Washington Banking Master Trust, a Delaware statutory business trust. Pursuant to the merger agreement, Heritage assumed the performance and observance of the covenants to be performed by Washington Banking under an indenture relating to $25.0 million in trust preferred securities issued in 2007 and the due and punctual payment of the principal of and premium and interest on such trust preferred securities. For additional information, see Note (8) Junior Subordinated Debentures.

(b) Basis of Presentation

The accompanying unaudited Condensed Consolidated Financial Statements have been prepared in accordance with the accounting principles generally accepted in the United States (“GAAP”) for interim financial information and pursuant to the rules and regulations of the Securities and Exchange Commission ("SEC"). Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. It is recommended that these unaudited Condensed Consolidated Financial Statements and accompanying Notes be read with the audited Consolidated Financial Statements and the accompanying Notes included in the Company's Annual Report on Form 10-K for the year ended December 31, 2014 (“2014 Annual Form 10-K”). In management's opinion, all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the three and nine months ended September 30, 2015 are not necessarily indicative of the results that may be expected for the year ending December 31, 2015. In preparing the unaudited Condensed Consolidated Financial Statements, management is required to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures. Management believes that the judgments, estimates and assumptions used in the preparation of the financial statements are appropriate based on the facts and circumstances at the time. Actual results, however, could differ from those estimates.

Certain prior period amounts have been reclassified to conform to the current period’s presentation. Specifically, the Company has eliminated the classification of "noncovered" and "covered" loans from the Condensed Consolidated Financial Statements based on the termination of the FDIC shared-loss agreements during the three months ended September 30, 2015. For more information on the termination agreement, see Note (5) Indemnification Asset. Accordingly, all loans receivable previously reported as "noncovered" and those previously reported as "covered" by FDIC shared-loss agreements have been combined and reclassified as "loans receivable" for all periods presented. Reclassifications had no effect on prior periods' net income or stockholders’ equity.

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The significant accounting policies used in preparation of the Company's Condensed Consolidated Financial Statements are disclosed in the 2014 Annual Form 10-K. There have not been any material changes in the Company's significant accounting policies from those contained in the 2014 Annual Form 10-K.

(d) Recently Issued Accounting Pronouncements

Financial Accounting Standards Board ("FASB") Accounting Standards Update ("ASU" or "Update") 2014-09, Revenue from Contracts with Customers, was issued in May 2014. Under this Update, FASB created a new Topic 606 which is in response to a joint initiative of FASB and the International Accounting Standards Board to clarify the principles for recognizing revenue and to develop a common revenue standard for U.S. GAAP and international financial reporting standards that would:


•	Remove inconsistencies and weaknesses in revenue requirements.


•	Provide a more robust framework for addressing revenue issues.


•	Improve comparability of revenue recognition practices across entities, industries, jurisdictions, and capital markets.


•	Provide more useful information to users of financial statements through improved disclosure requirements.


•	Simplify the preparation of financial statements by reducing the number of requirements to which an entity must refer.

The Update is effective for annual reporting periods beginning after December 15, 2017, including interim periods within that reporting period. Early application is not permitted. The Company is currently evaluating the impact that this Update will have on its Condensed Consolidated Financial Statements.

FASB ASU 2014-11, Transfers and Servicing: Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosures, was issued in June 2014. This Update aligns the accounting for repurchase-to-maturity transactions and repurchase agreements executed as a repurchase financing with the accounting for other typical repurchase agreements, such as secured borrowings. The guidance eliminates sale accounting and supersedes the guidance under which a transfer of a financial asset and a contemporaneous repurchase financing could be accounted for on a combined basis as a forward agreement. The Update requires new and expanded disclosures that are effective for interim or annual reporting periods beginning after December 15, 2014, with certain requirements applicable for periods beginning after March 31, 2015. The adoption of this Update did not have a material impact on the Company's Condensed Consolidated Financial Statements.

FASB ASU 2015-14, Revenue from Contracts with Customers, was issued in August 2015 and defers the effective date of the above-mentioned ASU 2014-09 for certain entities. Public business entities, certain not-for-profit entities, and certain employee benefit plans should apply the guidance in Update 2014-09 to annual reporting periods beginning after December 15, 2017, including interim reporting periods within that reporting period. Earlier application is now permitted, but only as of annual reporting periods beginning after December 15, 2016, including interim reporting periods within that reporting period. The Company is a public business entity and will not early adopt as permitted in this Update. The Company is currently evaluating the impact that this Update will have on its Condensed Consolidated Financial Statements upon adoption.

FASB ASU 2015-14, Business Combinations (Topic 805), was issued in September 2015. Topic 805 requires that an acquirer retrospectively adjust provisional amounts recognized in a business combination, during the measurement period. To simplify the accounting for adjustments made to provisional amounts, the Update requires that the acquirer recognize adjustments to provisional amounts that are identified during the measurement period in the reporting period in which the adjustment amount is determined. The acquirer is required to also record, in the same period’s financial statements, the effect on earnings of changes in depreciation, amortization, or other income effects, if any, as a result of the change to the provisional amounts, calculated as if the accounting had been completed at the acquisition date. In addition, an entity is required to present separately on the face of the income statement or disclose in the notes to the financial statements the portion of the amount recorded in current-period earnings by line item that would have been recorded in previous reporting periods if the adjustment to the provisional amounts had been recognized as of the acquisition date. The Update did not have an impact on the Company's Condensed Consolidated Financial Statements as of September 30, 2015.


(2)	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.

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(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
	September 30, 2015
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
	(In thousands)
U.S. Treasury and U.S. Government-sponsored agencies	$	15,115	$	47	$	—		$	15,162
Municipal securities	186,239		3,797		(267		)	189,769
Mortgage backed securities and collateralized mortgage obligations-residential:
U.S. Government-sponsored agencies	482,771		5,000		(807		)	486,964
Corporate obligations	9,283		—		(67		)	9,216
Mutual funds and other equities	1,965		17		—			1,982
Total	$	695,373	$	8,861	$	(1,141	)	$	703,093



	Securities Available for Sale
	December 31, 2014
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
	(In thousands)
U.S. Treasury and U.S. Government-sponsored agencies	$	21,414	$	44	$	(31	)	$	21,427
Municipal securities	170,082		3,139		(184		)	173,037
Mortgage backed securities and collateralized mortgage obligations-residential:
U.S. Government-sponsored agencies	539,859		4,015		(1,475		)	542,399
Corporate obligations	4,034		—		(24		)	4,010
Mutual funds and other equities	1,956		17		—			1,973
Total	$	737,345	$	7,215	$	(1,714	)	$	742,846

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



	Securities Held to Maturity
	September 30, 2015
	Amortized Cost		Gross Unrecognized Gains		Gross Unrecognized Losses			Fair Value
	(In thousands)
U.S. Treasury and U.S. Government-sponsored agencies	$	1,578	$	169	$	—		$	1,747
Municipal securities	21,362		619		—			21,981
Mortgage backed securities and collateralized mortgage obligations-residential:
U.S. Government-sponsored agencies	9,892		454		(51		)	10,295
Total	$	32,832	$	1,242	$	(51	)	$	34,023

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	Securities Held to Maturity
	December 31, 2014
	Amortized Cost		Gross Unrecognized Gains		Gross Unrecognized Losses			Fair Value
	(In thousands)
U.S. Treasury and U.S. Government-sponsored agencies	$	1,591	$	167	$	—		$	1,758
Municipal securities	22,486		643		(11		)	23,118
Mortgage backed securities and collateralized mortgage obligations-residential:
U.S. Government-sponsored agencies	10,866		364		(74		)	11,156
Private residential collateralized mortgage obligations	871		75		(104		)	842
Total	$	35,814	$	1,249	$	(189	)	$	36,874

There were no securities classified as trading at September 30, 2015 or December 31, 2014.

The amortized cost and fair value of securities at September 30, 2015, 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	$	3,527	$	3,534	$	2,980	$	2,989
Due after one year through three years	20,512		20,637		3,617		3,662
Due after three years through five years	41,714		42,327		6,747		7,066
Due after five years through ten years	159,618		162,025		16,370		17,168
Due after ten years	468,037		472,588		3,118		3,138
Investment securities with no stated maturities	1,965		1,982		—		—
Total	$	695,373	$	703,093	$	32,832	$	34,023

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

Available for sale investment securities with unrealized losses as of September 30, 2015 and December 31, 2014 were as follows:



	Securities Available for Sale
	September 30, 2015
	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	$	30,047	$	(260	)	$	923	$	(7	)	$	30,970	$	(267	)
Mortgage backed securities and collateralized mortgage obligations-residential:
U.S. Government-sponsored agencies	56,641		(255		)	49,605		(552		)	106,246		(807		)
Corporate obligations	8,221		(54		)	995		(13		)	9,216		(67		)
Total	$	94,909	$	(569	)	$	51,523	$	(572	)	$	146,432	$	(1,141	)

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	Securities Available for Sale
	December 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	$	3,567	$	(31	)	$	—	$	—	$	3,567	$	(31	)
Municipal securities	25,176		(184		)	—		—		25,176		(184		)
Mortgage backed securities and collateralized mortgage obligations-residential:
U.S. Government-sponsored agencies	182,970		(1,475		)	—		—		182,970		(1,475		)
Corporate obligations	2,119		(24		)	—		—		2,119		(24		)
Total	$	213,832	$	(1,714	)	$	—	$	—	$	213,832	$	(1,714	)

Held to maturity investment securities with unrecognized losses as of September 30, 2015 and December 31, 2014 were as follows:



	Securities Held to Maturity
	September 30, 2015
	Less than 12 Months				12 Months or Longer					Total
	Fair Value		Unrecognized Losses		Fair Value		Unrecognized Losses			Fair Value		Unrecognized Losses
	(In thousands)
Mortgage backed securities and collateralized mortgage obligations-residential:
U.S. Government-sponsored agencies	$	—	$	—	$	2,028	$	(51	)	$	2,028	$	(51	)
Total	$	—	$	—	$	2,028	$	(51	)	$	2,028	$	(51	)



	Securities Held to Maturity
	December 31, 2014
	Less than 12 Months					12 Months or Longer				Total
	Fair Value		Unrecognized Losses			Fair Value		Unrecognized Losses		Fair Value		Unrecognized Losses
	(In thousands)
Municipal securities	$	2,196	$	(11	)	$	—	$	—	$	2,196	$	(11	)
Mortgage backed securities and collateralized mortgage obligations-residential:
U.S. Government-sponsored agencies	2,553		(74		)	—		—		2,553		(74		)
Private residential collateralized mortgage obligations	558		(104		)	—		—		558		(104		)
Total	$	5,307	$	(189	)	$	—	$	—	$	5,307	$	(189	)

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The Company has evaluated these securities and has determined that 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.

During the nine months ended September 30, 2015, the Company sold its entire portfolio of private residential collateralized mortgage obligations with a carrying value of $829,000, all of which were classified as held-to-maturity. Since acquisition, these securities had been downgraded below the Company's acceptable investment grades. As a result of these downgrades and the effects on the risk-weighting of sub-investment grade securities based on the final rule effective in July 2013 of the Federal banking regulators' capital adequacy standards of the Basel Committee on Banking Supervision, commonly called "Basel III", the Company's intent to hold these securities changed and management elected to divest of its interest in the downgraded securities. The Company recorded a realized loss of $125,000 on this sale during the nine months ended September 30, 2015. The Company's intent and ability to hold the remaining held-to-maturity securities was not impacted by this sale.

Prior to the above mentioned sale of the private residential collateralized mortgage obligations, to analyze the unrealized losses, the Company estimated expected future cash flows of these investments by estimating the expected future cash flows of the underlying collateral and applying those collateral cash flows, together with any credit enhancements such as subordinated interests owned by third parties, to the security. The expected future cash flows of the underlying collateral were 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 were then discounted at the interest rate used to recognize interest income on the security to arrive at a present value amount. The average prepayment rate and average discount rate used in the valuation of the present value as of September 30, 2014 were 6.0% and 9.4%, respectively.

For the nine months ended September 30, 2015, there were no investment securities determined to be other-than-temporarily impaired and the Company recorded no unrealized losses for the nine months ended September 30, 2015 in earnings or other comprehensive income. In comparison, for the nine months ended September 30, 2014, there were four private residential collateralized mortgage obligations determined to be other-than-temporarily impaired. All unrealized losses for the three and nine months ended September 30, 2014 were deemed to be credit related, and the Company recorded the impairment in earnings.

The following table summarizes activity for the nine months ended September 30, 2014 related to the amount of impairments on held to maturity securities. There were no initial or subsequent impairments recorded during the nine months ended September 30, 2015.



	Life-to-Date Gross Other-Than-Temporary Impairments (1)		Life-to-Date Other-Than-Temporary Impairments Included in Other Comprehensive Income		Life-to-Date Net Other-Than-Temporary Impairments Included in Earnings
	(In thousands)
December 31, 2013	$	2,603	$	1,152	$	1,451
Subsequent impairments	45		—		45
September 30, 2014	$	2,648	$	1,152	$	1,496

(1) Life-to-date gross other-than-temporary impairments disclosed in this table are not reflective of subsequent recoveries, if any. As of September 30, 2015, the Company had no securities with other-than-temporary impairments because all such securities were sold as of September 30, 2015.

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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 September 30, 2015 and December 31, 2014:



	September 30, 2015				December 31, 2014
	Amortized Cost		Fair Value		Amortized Cost		Fair Value
	(In thousands)
Washington and Oregon state to secure public deposits	$	218,478	$	222,564	$	150,507	$	153,785
Federal Reserve Bank of San Francisco and Federal Home Loan Bank to secure borrowing arrangements	509		510		4,430		4,460
Repurchase agreements	29,712		30,111		43,676		44,457
Other securities pledged	2,136		2,173		14,828		14,922
Total	$	250,835	$	255,358	$	213,441	$	217,624

At September 30, 2015 and December 31, 2014, the total carrying value of pledged securities was $254.2 million and $216.7 million, respectively.


(3)	Loans Receivable

The Company originates loans in the ordinary course of business and has also acquired loans through FDIC-assisted and open bank transactions.

Loans acquired in a business combination may be further classified as “purchased” 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 Accounting Standards Codification ("ASC") 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality. These loans are identified as “purchased credit impaired” ("PCI") 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 and are referred to as "non-PCI" loans.

On August 4, 2015, the Company signed an agreement with the FDIC to terminate the shared-loss agreements. As a result, the Company eliminated the designation of "covered" and "noncovered" loans from current and all prior periods. All loans, including purchased loans, are included in the "loans receivable" classification. For additional information on the termination agreement with the FDIC, see Note (5) FDIC Indemnification Asset.

(a) Loan Origination/Risk Management

The Company categorizes loans in one of the four segments of the total loan portfolio: commercial business, one-to-four family residential, real estate construction and land development 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.

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: 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

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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. Owner-occupied commercial real estate loans are generally of lower credit risk than non-owner occupied commercial real estate loans as the borrowers' businesses are likely dependent on the properties.

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. Historically, the Company sold most single-family loans in the secondary market and retained a smaller portion in its loan portfolio. From the second quarter of 2013 until May 1, 2014, the Company only originated single-family loans for its loan portfolio. As a result of the Washington Banking Merger, since May 1, 2014 the Company is originating and selling a majority of its single-family mortgages.

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, government 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 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.

As a result of the Washington Banking Merger, the Company began originating indirect consumer loans. These loans are for new and used automobile and recreational vehicles that are originated indirectly by selected dealers located in the Company's market areas. The Company has limited its purchase of indirect loans primarily to dealerships that are established and well known in their market areas and to applicants that are not classified as sub-prime.

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Loans receivable at September 30, 2015 and December 31, 2014 consisted of the following portfolio segments and classes:



	September 30, 2015			December 31, 2014
	(In thousands)
Commercial business:
Commercial and industrial	$	618,390		$	570,453
Owner-occupied commercial real estate	603,372			594,986
Non-owner occupied commercial real estate	703,771			643,636
Total commercial business	1,925,533			1,809,075
One-to-four family residential	70,577			69,530
Real estate construction and land development:
One-to-four family residential	49,745			49,195
Five or more family residential and commercial properties	73,328			64,920
Total real estate construction and land development	123,073			114,115
Consumer	284,541			259,294
Gross loans receivable	2,403,724			2,252,014
Net deferred loan costs (fees)	320			(937		)
Loans receivable, net	2,404,044			2,251,077
Allowance for loan losses	(29,004		)	(27,729		)
Total loans receivable, net	$	2,375,040		$	2,223,348

(b) Concentrations of Credit

Most of the Company’s lending activity occurs within Washington State, and to a lesser extent Oregon. The Company’s primary market areas are concentrated along the I-5 corridor from Whatcom County to Clark County in Washington State and Multnomah County in Oregon, as well as other contiguous markets. The Washington Banking Merger allowed the expansion of the Company's market area north of Seattle, Washington to the Canadian border. The majority of the Company’s loan portfolio consists of (in order of balances at September 30, 2015) non-owner occupied commercial real estate, commercial and industrial and owner-occupied commercial real estate. As of September 30, 2015 and December 31, 2014, 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.


•	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

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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 or have been partially charged-off for the amount considered uncollectible.

•

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.

Numerical loan grades for all commercial business loans and real estate construction and land development loans are established at the origination of the loan. Prior to November 2014, one-to-four family residential loans and consumer loans (“non-commercial loans”) were not numerically graded at origination date as these loans were determined to be “pass graded” loans. A numeric grade was assigned to these non-commercial loans if subsequent to origination, the credit department evaluated the credit and determined it necessary to classify the loan. Subsequent to November 2014, non-commercial loans were designated a loan grade “4” at origination date to reflect a "pass grade". The Bank follows the FDIC’s Uniform Retail Credit Classification and Account Management Policy for subsequent classification in the event of payment delinquencies or default. 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 loans receivable by credit quality indicator as of September 30, 2015 and December 31, 2014.



	September 30, 2015
	Pass		OAEM		Substandard		Doubtful		Total
	(In thousands)
Commercial business:
Commercial and industrial	$	584,337	$	9,906	$	23,839	$	308	$	618,390
Owner-occupied commercial real estate	571,283		11,955		19,878		256		603,372
Non-owner occupied commercial real estate	654,621		17,695		30,310		1,145		703,771
Total commercial business	1,810,241		39,556		74,027		1,709		1,925,533
One-to-four family residential	68,441		—		2,136		—		70,577
Real estate construction and land development:
One-to-four family residential	40,356		1,361		8,028		—		49,745
Five or more family residential and commercial properties	68,633		—		4,695		—		73,328
Total real estate construction and land development	108,989		1,361		12,723		—		123,073
Consumer	276,929		4		7,608		—		284,541
Gross loans receivable	$	2,264,600	$	40,921	$	96,494	$	1,709	$	2,403,724



	December 31, 2014
	Pass		OAEM		Substandard		Doubtful		Total
	(In thousands)
Commercial business:
Commercial and industrial	$	520,780	$	14,618	$	32,491	$	2,564	$	570,453
Owner-occupied commercial real estate	536,591		27,903		30,145		347		594,986
Non-owner occupied commercial real estate	593,918		17,683		32,035		—		643,636
Total commercial business	1,651,289		60,204		94,671		2,911		1,809,075
One-to-four family residential	66,599		740		2,191		—		69,530
Real estate construction and land development:
One-to-four family residential	36,534		3,977		8,684		—		49,195
Five or more family residential and commercial properties	58,783		—		6,137		—		64,920
Total real estate construction and land development	95,317		3,977		14,821		—		114,115
Consumer	249,866		—		9,428		—		259,294
Gross loans receivable	$	2,063,071	$	64,921	$	121,111	$	2,911	$	2,252,014

Potential problem loans are loans classified as OAEM, Substandard, Doubtful and Loss 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 loans also include PCI loans as these loans continue to accrete loan discounts established at acquisition based on the guidance of ASC 310-30. Potential problem loans as of September 30, 2015 and December 31, 2014 were $113.3 million and $162.9 million, respectively. The balance of potential problem loans guaranteed by a governmental agency, which guarantee reduces the Company's credit exposure, was $920,000 and $2.0 million as of September 30, 2015 and December 31, 2014, respectively.

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(d) Nonaccrual Loans

Nonaccrual loans, segregated by segments and classes of loans, were as follows as of September 30, 2015 and December 31, 2014:



	September 30, 2015		December 31, 2014
	(In thousands)
Commercial business:
Commercial and industrial	$	4,387	$	5,784
Owner-occupied commercial real estate	2,806		2,295
Non-owner occupied commercial real estate	—		517
Total commercial business	7,193		8,596
One-to-four family residential	40		—
Real estate construction and land development:
One-to-four family residential	2,612		2,831
Total real estate construction and land development	2,612		2,831
Consumer	62		145
Gross nonaccrual loans	$	9,907	$	11,572

The Company had $1.4 million and $1.6 million of nonaccrual loans guaranteed by governmental agencies at September 30, 2015 and December 31, 2014, respectively.

PCI loans are not included in the nonaccrual loan table above because these loans are accounted for under ASC 310-30, which provides that accretable yield is calculated based on a loan's expected cash flow even if the loan is not performing under its conventional terms.

(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 past due loans, segregated by segments and classes of loans, as of September 30, 2015 and December 31, 2014 were as follows:



	September 30, 2015
	30-89 Days		90 Days or Greater		Total Past Due		Current		Total		90 Days or More and Still Accruing (1)
	(In thousands)
Commercial business:
Commercial and industrial	$	1,789	$	1,789	$	3,578	$	614,812	$	618,390	$	—
Owner-occupied commercial real estate	1,806		2,244		4,050		599,322		603,372		—
Non-owner occupied commercial real estate	1,664		183		1,847		701,924		703,771		—
Total commercial business	5,259		4,216		9,475		1,916,058		1,925,533		—
One-to-four family residential	—		—		—		70,577		70,577		—
Real estate construction and land development:
One-to-four family residential	636		2,350		2,986		46,759		49,745		—
Five or more family residential and commercial properties	415		42		457		72,871		73,328		—
Total real estate construction and land development	1,051		2,392		3,443		119,630		123,073		—
Consumer	1,966		159		2,125		282,416		284,541		—
Gross loans receivable	$	8,276	$	6,767	$	15,043	$	2,388,681	$	2,403,724	$	—

(1) Excludes PCI loans.



	December 31, 2014
	30-89 Days		90 Days or Greater		Total Past Due		Current		Total		90 Days or More and Still Accruing (1)
	(In thousands)
Commercial business:
Commercial and industrial	$	4,765	$	3,125	$	7,890	$	562,563	$	570,453	$	—
Owner-occupied commercial real estate	1,683		2,780		4,463		590,523		594,986		—
Non-owner occupied commercial real estate	1,826		531		2,357		641,279		643,636		—
Total commercial business	8,274		6,436		14,710		1,794,365		1,809,075		—
One-to-four family residential	312		—		312		69,218		69,530		—
Real estate construction and land development:
One-to-four family residential	240		2,225		2,465		46,730		49,195		—
Five or more family residential and commercial properties	—		596		596		64,324		64,920		—
Total real estate construction and land development	240		2,821		3,061		111,054		114,115		—
Consumer	2,676		852		3,528		255,766		259,294		—
Gross loans receivable	$	11,502	$	10,109	$	21,611	$	2,230,403	$	2,252,014	$	—

(1) Excludes PCI loans.

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(f) Impaired loans

Impaired loans include nonaccrual loans and performing troubled debt restructured loans ("TDRs"). The table below excludes $11.7 million and $10.4 million, respectively, as of September 30, 2015 and December 31, 2014, of certain performing TDR loans classified as PCI loans. The majority of these loans have remaining fair value discounts compared to outstanding principal balances and may not have further impairment. The balance of impaired loans as of September 30, 2015 and December 31, 2014 are set forth in the following tables.



	September 30, 2015
	Recorded Investment With No Specific Valuation Allowance		Recorded Investment With Specific Valuation Allowance		Total Recorded Investment		Unpaid Contractual Principal Balance		Related Specific Valuation Allowance
	(In thousands)
Commercial business:
Commercial and industrial	$	1,168	$	7,675	$	8,843	$	10,953	$	943
Owner-occupied commercial real estate	—		5,150		5,150		5,233		1,016
Non-owner occupied commercial real estate	3,720		6,854		10,574		10,581		968
Total commercial business	4,888		19,679		24,567		26,767		2,927
One-to-four family residential	—		277		277		278		86
Real estate construction and land development:
One-to-four family residential	2,549		1,150		3,699		4,327		39
Five or more family residential and commercial properties	—