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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 June 30, 2017
OR
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
Commission File Number 000-29480 
 
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, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer
¨
 
Accelerated filer
x
Non-accelerated filer
¨
 
Smaller reporting company
¨
Emerging Growth Company
¨

 
 
 
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨
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 August 1, 2017 there were 29,930,530 shares of the registrant's common stock, no par value per share, outstanding.



Table of Contents


HERITAGE FINANCIAL CORPORATION
FORM 10-Q
INDEX
June 30, 2017
 
 
Page
 
 
 
 
Part I.
Item 1.
 
 
 
 
 
 
Item 2.
Item 3.
Item 4.
 
 
 
Part II.
Item 1.
Item 1A.
Item 2.
Item 3.
Item 4.
Item 5.
Item 6.
 
 
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: 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 nonperforming 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 mergers, acquisitions or similar transactions and adversely affect our liquidity and earnings; legislative or regulatory changes; our ability to control operating costs and expenses; 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 growth strategies; our ability to successfully integrate any assets, liabilities, customers, systems, and management personnel we may 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; 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 including our Annual Report on Form 10-K for the year ended December 31, 2016.
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
(Unaudited)
 
 
June 30, 2017
 
December 31, 2016
 
 
(Dollars in thousands)
ASSETS
 
 
 
 
Cash on hand and in banks
 
$
81,912


$
77,117

Interest earning deposits
 
42,322


26,628

Cash and cash equivalents
 
124,234


103,745

Investment securities available for sale, at fair value
 
790,594


794,645

Loans held for sale
 
5,787

 
11,662

Loans receivable, net
 
2,749,507

 
2,640,749

Allowance for loan losses
 
(32,751
)
 
(31,083
)
Total loans receivable, net
 
2,716,756

 
2,609,666

Other real estate owned
 
786


754

Premises and equipment, net
 
60,603


63,911

Federal Home Loan Bank stock, at cost
 
9,083


7,564

Bank owned life insurance
 
71,112

 
70,355

Accrued interest receivable
 
11,081


10,925

Prepaid expenses and other assets
 
75,162


79,351

Other intangible assets, net
 
6,727


7,374

Goodwill
 
119,029


119,029

Total assets
 
$
3,990,954


$
3,878,981

LIABILITIES AND STOCKHOLDERS' EQUITY
 
 
 
 
Deposits
 
$
3,291,250

 
$
3,229,648

Federal Home Loan Bank advances
 
110,900

 
79,600

Junior subordinated debentures
 
19,863

 
19,717

Securities sold under agreement to repurchase
 
21,255

 
22,104

Accrued expenses and other liabilities
 
47,638

 
46,149

Total liabilities
 
3,490,906

 
3,397,218

Stockholders’ equity:
 
 
 
 
Preferred stock, no par value, 2,500,000 shares authorized; no shares issued and outstanding at June 30, 2017 and December 31, 2016
 

 

Common stock, no par value, 50,000,000 shares authorized; 29,928,232 and 29,954,931 shares issued and outstanding at June 30, 2017 and December 31, 2016, respectively
 
359,535

 
359,060

Retained earnings
 
138,956

 
125,309

Accumulated other comprehensive income (loss), net
 
1,557

 
(2,606
)
Total stockholders’ equity
 
500,048

 
481,763

Total liabilities and stockholders’ equity
 
$
3,990,954

 
$
3,878,981

See accompanying Notes to Condensed Consolidated Financial Statements.

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2017
 
2016
 
2017
 
2016
 
 
(Dollars in thousands, except per share amounts)
INTEREST INCOME
 
 
 
 
 
 
 
 
Interest and fees on loans
 
$
31,500

 
$
30,503

 
$
61,985

 
$
60,680

Taxable interest on investment securities
 
3,141

 
2,838

 
6,190

 
5,634

Nontaxable interest on investment securities
 
1,304

 
1,193

 
2,572

 
2,364

Interest and dividends on other interest earning assets
 
142

 
58

 
203

 
149

Total interest income
 
36,087

 
34,592

 
70,950

 
68,827

INTEREST EXPENSE
 
 
 
 
 
 
 
 
Deposits
 
1,407

 
1,242

 
2,673

 
2,496

Junior subordinated debentures
 
249

 
216

 
487

 
426

Other borrowings
 
251

 
49

 
464

 
60

Total interest expense
 
1,907

 
1,507

 
3,624

 
2,982

Net interest income
 
34,180

 
33,085

 
67,326

 
65,845

Provision for loan losses
 
1,131

 
1,120

 
1,998

 
2,259

Net interest income after provision for loan losses
 
33,049

 
31,965

 
65,328

 
63,586

NONINTEREST INCOME
 
 
 
 
 
 
 
 
Service charges and other fees
 
4,426

 
3,476

 
8,639

 
6,832

Gain on sale of investment securities, net
 
117

 
201

 
117

 
761

Gain on sale of loans, net
 
4,138

 
1,242

 
5,333

 
1,971

Interest rate swap fees
 
282

 
227

 
415

 
363

Other income
 
1,700

 
1,430

 
3,508

 
3,639

Total noninterest income
 
10,663

 
6,576

 
18,012

 
13,566

NONINTEREST EXPENSE
 
 
 
 
 
 
 
 
Compensation and employee benefits
 
16,272

 
14,898

 
32,296

 
30,019

Occupancy and equipment
 
3,818

 
4,111

 
7,628

 
7,947

Data processing
 
2,002

 
1,829

 
3,917

 
3,621

Marketing
 
805

 
781

 
1,612

 
1,509

Professional services
 
1,053

 
833

 
2,062

 
1,678

State and local taxes
 
639

 
604

 
1,188

 
1,211

Federal deposit insurance premium
 
357

 
528

 
657

 
1,020

Other real estate owned, net
 
21

 
61

 
52

 
472

Amortization of intangible assets
 
323

 
363

 
647

 
698

Other expense
 
2,519

 
2,469

 
4,973

 
4,671

Total noninterest expense
 
27,809

 
26,477

 
55,032

 
52,846

Income before income taxes
 
15,903

 
12,064

 
28,308

 
24,306

Income tax expense
 
4,075

 
3,169

 
7,164

 
6,320

Net income
 
$
11,828

 
$
8,895

 
$
21,144

 
$
17,986

Basic earnings per common share
 
$
0.40

 
$
0.30

 
$
0.71

 
$
0.60

Diluted earnings per common share
 
$
0.39

 
$
0.30

 
$
0.70

 
$
0.60

Dividends declared per common share
 
$
0.13

 
$
0.12

 
$
0.25

 
$
0.23

See accompanying Notes to Condensed Consolidated Financial Statements.

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited)

 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2017
 
2016
 
2017
 
2016
 
 
(Dollars in thousands)
Net income
 
$
11,828

 
$
8,895

 
$
21,144

 
$
17,986

Change in fair value of investment securities available for sale, net of tax of $1,491, $2,267, $2,285 and $5,553, respectively
 
2,766

 
4,203

 
4,239

 
10,278

Reclassification adjustment for net gain from sale of investment securities available for sale included in income, net of tax of $(41), $(71), $(41) and $(267), respectively
 
(76
)
 
(130
)
 
(76
)
 
(494
)
Other comprehensive income
 
2,690

 
4,073

 
4,163

 
9,784

Comprehensive income
 
$
14,518

 
$
12,968

 
$
25,307

 
$
27,770

See accompanying Notes to Condensed Consolidated Financial Statements.


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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(Unaudited)
 
Number of
common
shares
 
Common
stock
 
Retained
earnings
 
Accumulated
other
comprehensive income, net
 
Total
stock-
holders’
equity
 
(Dollars in thousands, except per share amounts)
Balance at December 31, 2015
29,975

 
$
359,451

 
$
107,960

 
$
2,559

 
$
469,970

Restricted stock awards granted, net of forfeitures
115

 

 

 

 

Exercise of stock options (including excess tax benefits from nonqualified stock options)
26

 
390

 

 

 
390

Stock-based compensation expense

 
872

 

 

 
872

Net excess tax benefits from vesting of restricted stock

 
76

 

 

 
76

Common stock repurchased
(124
)
 
(2,126
)
 

 

 
(2,126
)
Net income

 

 
17,986

 

 
17,986

Other comprehensive income, net of tax

 

 

 
9,784

 
9,784

Cash dividends declared on common stock ($0.23 per share)

 

 
(6,894
)
 

 
(6,894
)
Balance at June 30, 2016
29,992

 
$
358,663

 
$
119,052

 
$
12,343

 
$
490,058

 
 
 
 
 
 
 
 
 
 
Balance at December 31, 2016
29,955

 
$
359,060

 
$
125,309

 
$
(2,606
)
 
$
481,763

Restricted stock awards forfeited
(7
)
 

 

 

 

Exercise of stock options
8

 
109

 

 

 
109

Stock-based compensation expense

 
1,040

 

 

 
1,040

Common stock repurchased
(28
)
 
(674
)
 

 

 
(674
)
Net income

 

 
21,144

 

 
21,144

Other comprehensive income, net of tax

 

 

 
4,163

 
4,163

Cash dividends declared on common stock ($0.25 per share)

 

 
(7,497
)
 

 
(7,497
)
Balance at June 30, 2017
29,928

 
$
359,535

 
$
138,956

 
$
1,557

 
$
500,048

See accompanying Notes to Condensed Consolidated Financial Statements.


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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
 
 
Six Months Ended June 30,
 
 
2017
 
2016
 
 
(Dollars in thousands)
Cash flows from operating activities:
 
 
 
 
Net income
 
$
21,144

 
$
17,986

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
 
Depreciation and amortization
 
5,459

 
6,483

Changes in net deferred loan costs, net of amortization
 
(509
)
 
(455
)
Provision for loan losses
 
1,998

 
2,259

Net change in accrued interest receivable, prepaid expenses and other assets, accrued expenses and other liabilities
 
3,482

 
(3,071
)
Stock-based compensation expense
 
1,040

 
872

Net excess tax benefit from exercise of stock options and vesting of restricted stock
 

 
(97
)
Amortization of intangible assets
 
647

 
698

Gain on sale of investment securities, net
 
(117
)
 
(761
)
Origination of loans held for sale
 
(54,449
)
 
(57,975
)
Gain on sale of loans, net
 
(5,333
)
 
(1,971
)
Proceeds from sale of loans
 
71,436

 
60,498

Earnings on bank owned life insurance
 
(747
)
 
(695
)
Valuation adjustment on other real estate owned
 

 
383

Gain on sale of assets held for sale
 
(53
)
 

Gain on sale of other real estate owned, net
 

 
(42
)
Loss on sale or write-off of furniture, equipment and leasehold improvements
 
12

 
244

Net cash provided by operating activities
 
44,010

 
24,356

Cash flows from investing activities:
 
 
 
 
Loans originated, net of principal payments
 
(114,390
)
 
(126,335
)
Maturities of other interest earning deposits
 

 
1,248

Maturities, calls and payments of investment securities available for sale
 
52,461

 
60,803

Purchase of investment securities available for sale
 
(57,972
)
 
(128,046
)
Purchase of premises and equipment
 
(1,382
)
 
(1,088
)
Proceeds from sales of other real estate owned
 

 
770

Proceeds from sales of investment securities available for sale
 
15,032

 
75,837

Proceeds from sale of assets held for sale
 
265

 

Proceeds from redemption of Federal Home Loan Bank stock
 
16,456

 
10,460

Purchases of Federal Home Loan Bank stock
 
(17,975
)
 
(12,012
)
Investment in low-income housing tax credit partnership
 
(7
)
 
(2,254
)
Net cash used in investing activities
 
(107,512
)
 
(120,617
)
Cash flows from financing activities:
 
 
 
 
Net increase in deposits
 
61,602

 
50,619

Federal Home Loan Bank advances
 
442,700

 
294,500

Repayments of Federal Home Loan Bank advances
 
(411,400
)
 
(261,500
)
Common stock cash dividends paid
 
(7,497
)
 
(6,894
)
Net decrease in securities sold under agreement to repurchase
 
(849
)
 
(6,499
)
Proceeds from exercise of stock options
 
109

 
369

Net excess tax benefit from exercise of stock options and vesting of restricted stock
 

 
97

Repurchase of common stock
 
(674
)
 
(2,126
)
Net cash provided by financing activities
 
83,991

 
68,566


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Six Months Ended June 30,
 
 
2017
 
2016
 
 
(Dollars in thousands)
Net increase (decrease) in cash and cash equivalents
 
20,489

 
(27,695
)
Cash and cash equivalents at beginning of period
 
103,745

 
126,640

Cash and cash equivalents at end of period
 
$
124,234

 
$
98,945

 
 
 
 
 
Supplemental disclosures of cash flow information:
 
 
 
 
Cash paid for interest
 
$
3,688

 
$
3,008

Cash paid for income taxes
 
1,007

 
6,000

 
 
 
 
 
Supplemental non-cash disclosures of cash flow information:
 
 
 
 
Transfers of loans receivable to other real estate owned
 
$
32

 
$
652

Transfers of loans receivable to loans held for sale
 
5,779

 

Transfers of premises and equipment, net to prepaid expenses and other assets for properties held for sale
 
2,687

 

Investment in low income housing tax credit partnership and related funding commitment
 

 
10,224

Purchases of investment securities available for sale not settled
 
2,268

 
1,164

See accompanying Notes to Condensed Consolidated Financial Statements.

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(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. The Bank is headquartered in Olympia, Washington and conducts business from its 59 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, consumer loans and originates first mortgage loans on residential properties primarily located in its market areas.
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 ('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 (“U.S. 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, 2016 (“2016 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 six months ended June 30, 2017 are not necessarily indicative of the results that may be expected for the year ending December 31, 2017. 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.
(c) Significant Accounting Policies
The significant accounting policies used in preparation of the Company's Condensed Consolidated Financial Statements are disclosed in the 2016 Annual Form 10-K. There have not been any material changes in the Company's significant accounting policies from those contained in the 2016 Annual Form 10-K, except for accounting policies for stock-based compensation relating to the issuance of restricted stock units, including grants subject to performance-based and market-based vesting conditions, adopted January 1, 2017 as discussed below.
Stock-Based Compensation
Compensation cost is recognized for stock options, restricted stock awards and restricted stock units issued to employees and directors, based on the fair value of these awards at the date of grant. Compensation cost is recognized over the requisite service period, generally defined as the vesting period, on a straight-line basis. Compensation cost for restricted stock units with market-based vesting is recognized over the service period to the extent the restricted stock units are expected to vest. With the adoption of FASB ASU 2016-09 on January 1, 2017, forfeitures are recognized as they occur.

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The market price of the Company’s common stock at the date of grant is used to fair value the restricted stock awards and restricted stock units. The fair value of stock options granted is estimated based on the date of grant using the Black-Scholes-Merton option pricing model. Certain restricted stock unit grants are subject to performance-based vesting as well as other approved vesting conditions and cliff vest based on those conditions, and the fair value is estimated using a Monte Carlo simulation pricing model. The assumptions used in the Black-Scholes-Merton option pricing model and the Monte Carlo simulation pricing model include the expected term based on the valuation date and the remaining contractual term of the award; the risk-free interest rate based on the U.S. Treasury curve at the valuation date of the award; the expected dividend yield based on expected dividends being payable to the holders; and the expected stock price volatility over the expected term based on the historical volatility over the equivalent historical term.
(d) Recently Issued Accounting Pronouncements
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 original effective date for this Update was deferred in FASB ASU 2015-14 below.
FASB ASU 2015-14Revenue from Contracts with Customers (Topic 606), was issued in August 2015 and defers the effective date of the above-mentioned FASB 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 expects to adopt the revenue recognition guidance on January 1, 2018 using the modified retrospective approach.  A significant amount of the Company’s revenues are derived from net interest income on financial assets and liabilities, which are excluded from the scope of the amended guidance.  With respect to noninterest income and related disclosures, the Company is in its preliminary stages of identifying and evaluating the revenue streams and underlying revenue contracts within the scope of the guidance. The Company is expecting to begin developing processes and procedures during 2017 to ensure it is fully compliant with these amendments. To date, the Company has not yet identified any significant changes in the timing of revenue recognition when considering the amended accounting guidance; however, the Company’s implementation efforts are ongoing and such assessments may change prior to the January 1, 2018 implementation date.
FASB ASU 2016-01Recognition and Measurement of Financial Assets and Financial Liabilities (Subtopic 825-10), was issued in January 2016, to enhance the reporting model for financial instruments to provide users of financial statements with more decision-useful information. This Update contains several provisions, including but not limited to 1) requiring equity investments, with certain exceptions, to be measured at fair value with changes in fair value recognized in net income; 2) simplifying the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment; 3) eliminating the requirement to disclose the method(s) and significant assumptions used to estimate fair value; and 4) requiring separate presentation of financial assets and liabilities by measurement category and form of financial asset on the balance sheet or the accompanying notes to the financial statements. The Update also changes certain financial statement disclosure requirements, including requiring disclosures of the fair value of financial instruments be made on the basis of exit price. The Update is effective for public entities for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The Company does not expect the adoption of this Update will have a significant impact on the Company’s statements of financial condition or income.  Management is in the planning stages of developing processes and procedures to comply with the disclosures requirements of this Update, which could impact the disclosures the Company makes related to fair value of its financial instruments.
FASB ASU 2016-02Leases (Topic 842), was issued in February 2016, to increase transparency and comparability of leases among organizations and to disclose key information about leasing arrangements. The Update

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sets out the principles for the recognition, measurement, presentation and disclosure of leases for both lessees and lessors. The Update requires lessees to apply a dual approach, classifying leases as either a finance or operating lease. This classification will determine whether the lease expense is recognized based on an effective interest method or on a straight-line basis over the term of the lease. A lessee is also required to record a right-of-use asset and a lease liability for all leases with a term greater than 12 months regardless of their classification. All cash payments will be classified within operating activities in the statement of cash flows. In transition, lessees and lessors are required to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach. The Update is effective for public entities for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. The Company anticipates adopting the Update on January 1, 2019. Upon adoption of the guidance, the Company expects to report increased assets and increased liabilities on its Condensed Consolidated Statements of Financial Condition as a result of recognizing right-of-use assets and lease liabilities related to certain banking offices and certain equipment under noncancelable operating lease agreements, which currently are not reflected in its Condensed Consolidated Statements of Financial Condition.  The Company is anticipating electing an accounting policy to not recognize lease assets and lease liabilities for leases with a term of twelve months or less. The Company was committed to $14.7 million of minimum lease payments under noncancelable operating lease agreements at December 31, 2016.  The Company does not expect the adoption of this amendment will have a significant impact to its Condensed Consolidated Financial Statements.
FASB ASU 2016-08Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations, was issued in March 2016 and it clarifies the implementation guidance of the above-mentioned FASB ASU 2014-09 as it relates to principal versus agent considerations. The Update addresses identifying the unit of account and nature of the goods or services as well as applying the control principle and interactions with the control principle. The amendments to the Update do not change the core principle of the guidance. The effective date, transition requirements and impact on the Company's Condensed Consolidated Financial Statements for this Update are the same as those described in FASB ASU 2015-14 above.
FASB ASU 2016-09Stock Compensation (Topic 718), issued in March 2016, is intended to simplify several aspects of the accounting for share-based payment award transactions. For public business entities, the guidance is effective for annual periods after December 15, 2016, including interim periods within those annual periods with early adoption permitted. Certain amendments are required to be applied using a modified retrospective transition method by means of a cumulative-effect adjustment to equity as of the beginning of the period in which the guidance is adopted. Other amendments are applied retroactively (such as presentation of employee taxes paid on the statement of cash flows) or prospectively (such as recognition of excess tax benefits on the income statement). The Company adopted this standard effective January 1, 2017. The Company made an accounting policy election to account for forfeitures as they occur and this change resulted in a cumulative adjustment that was immaterial to all periods presented. Changes to the statement of cash flows have been applied prospectively and the Company recorded excess tax benefits in its income tax expense. Adoption of all other changes under this Update did not have a material impact on the Condensed Consolidated Financial Statements.
FASB ASU 2016-10Revenue from Contracts with Customers (Topic 606): Identifying Performance Obligations and Licensing, was issued in April 2016 which clarifies the implementation guidance of the above-mentioned FASB ASU 2014-09 as it relates to identifying performance obligations and licensing. The effective date, transition requirements and impact on the Company's Condensed Consolidated Financial Statements for this Update are the same as those described in FASB ASU 2015-14 above.
FASB ASU 2016-12Revenue from Contracts with Customers (Topic 606): Narrow-scope Improvements and Practical Expedients, was issued in May 2016. The amendments in this Update do not change the core principle of the guidance in Topic 606. Rather, the amendments in this Update affect only the narrow aspects of Topic 606. The effective date, transition requirements and impact on the Company's Condensed Consolidated Financial Statements for this Update are the same as those described in FASB ASU 2015-14 above.
FASB ASU 2016-13Financial Instruments: Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, was issued in June 2016. Commonly referred to as the current expected credit loss model ("CECL"), this Update requires financial assets measured at amortized cost basis to be presented at the net amount expected to be collected. The allowance for credit losses is a valuation account that is deducted from the amortized cost basis of the financial asset to present the net carrying value at the amount expected to be collected on the financial asset. The measurement of expected credit losses is based on relevant information about past events including historical experience, current conditions and reasonable and supportable forecasts that affect the collectibility of the reported amount. The amendment affects loans, debt securities, trade receivables, net investments in leases, off-balance-sheet credit exposures, reinsurance receivables and any other financial asset not excluded from the scope that have the contractual right to receive cash. The Update replaces the incurred loss impairment methodology, which

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generally only considered past events and current conditions, with a methodology that reflects the expected credit losses and required consideration of a broader range of reasonable and supportable information to estimate all expected credit losses. The Update additionally addresses purchased assets and introduces the purchased financial asset with a more-than-insignificant amount of credit deterioration since origination ("PCD"). The accounting for these PCD assets is similar to the existing accounting guidance of FASB Accounting Standards Codification ("ASC") 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality, for purchased credit impaired ("PCI") assets, except the subsequent improvements in estimated cash flows will be immediately recognized into income, similar to the immediate recognition of subsequent deteriorations in cash flows. Current guidance only allows for the prospective recognition of these cash flow improvements. Because the terminology has been changed to a "more-than-insignificant" amount of credit deterioration, the presumption is that more assets might qualify for this accounting under the Update than those under current guidance. For public business entities, the Update is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years with early adoption permitted for fiscal years after December 15, 2018. An entity will apply the Update through a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is adopted. A prospective transition approach is required for debt securities. An entity that has previously applied the guidance of FASB ASC 310-30 will prospectively apply the guidance in this Update for PCD assets. A prospective transition approach should be used for PCD assets where upon adoption, the amortized cost basis should be adjusted to reflect the addition of the allowance for credit losses. The Company is anticipating adopting the Update on January 1, 2020. Upon adoption, the Company expects a change in the processes and procedures to calculate the allowance for loan losses, including changes in assumptions and estimates to consider expected credit losses over the life of the loan versus the current accounting practice that utilizes the incurred loss model. The new guidance may result in an increase in the allowance for loan losses which will also reflect the new requirement to include the nonaccretable principal differences on PCI loans; however, the Company is still in the process of determining the magnitude of the increase and its impact on the Condensed Consolidated Financial Statements. In addition, the current accounting policy and procedures for other-than-temporary impairment on investment securities available for sale will be replaced with an allowance approach. The Company created a CECL steering committee which will begin developing and implementing processes and procedures to ensure it is fully compliant with the amendments at the adoption date.
FASB ASU 2016-15Statement of Cash Flows (Topic 213): Classification of Certain Cash Receipts and Cash Payments, was issued in August 2016. The Update addresses eight specific cash flow issues with the objective of reducing the existing diversity in practice. For public business entities, the guidance is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. Early adoption is permitted and must be applied using a retrospective transitional method to each period presented. The Company has evaluated the new guidance and does not anticipate that its adoption of this Update on January 1, 2018 will have a significant impact on its Condensed Consolidated Financial Statements.
FASB ASU 2017-03, Accounting Changes and Error Corrections (Topic 250) and Investments—Equity Method and Joint Ventures (Topic 323): Amendments to SEC Paragraphs Pursuant to Staff Announcements at the September 22, 2016 and November 17, 2016 EITF Meetings (SEC Update), was issued in January 2017. The SEC staff view is that a registrant should evaluate FASB ASC Updates that have not yet been adopted to determine the appropriate financial disclosures about the potential material effects of the updates on the financial statements when adopted. If a registrant does not know or cannot reasonably estimate the impact of an update, then in addition to making a statement to that effect, the registrant should consider additional qualitative financial statement disclosures to assist the reader in assessing the significance of the impact. The staff expects the additional qualitative disclosures to include a description of the effect of the accounting policies expected to be applied compared to current accounting policies. Also, the registrant should describe the status of its process to implement the new standards and the significant implementation matters yet to be addressed. The amendments specifically addressed recent FASB ASC amendments to Topic 326, Financial Instruments - Credit Losses; Topic 842, Leases; and Topic 606, Revenue from Contracts with Customers; although, the amendments apply to any subsequent amendments to guidance in the FASB ASC. The Company adopted the amendments in this Update during the fourth quarter of 2016 and appropriate disclosures have been included in this Note for each recently issued accounting standard.
FASB ASU 2017-04Goodwill (Topic 350), was issued in January 2017 and eliminates Step 2 from the goodwill impairment test. Under the amendments, an entity should perform its goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount. An entity should recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value. The loss recognized, however, should not exceed the total amount of goodwill allocated to that reporting unit. Additionally, an entity should consider income tax effects from any tax deductible goodwill on the carrying amount of the reporting unit when measuring the goodwill impairment loss, if applicable.  The Update is effective for annual periods or any interim goodwill impairment tests beginning after

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December 15, 2019 using a prospective transition method and early adoption is permitted. The Company does not expect the Update will have a material impact on its Condensed Consolidated Financial Statements.

FASB ASU 2017-09, Compensation--Stock Compensation (Topic 718): Scope of Modification Accounting was issued in May 2017 to provide clarity as to when to apply modification accounting when there is a change in the terms or conditions of a share-based payment award. According to this Update, an entity should account for the effects of a modification unless the fair value, vesting conditions and balance sheet classification of the award is the same after the modification as compared to the original award prior to the modification. The standard is effective for reporting periods beginning after December 15, 2017, with early adoption permitted. The Company does not expect the Update will have a material impact on its Condensed Consolidated Financial Statements.

(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.
(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:
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
 
(In thousands)
June 30, 2017
 
 
 
 
 
 
 
U.S. Treasury and U.S. Government-sponsored agencies
$
9,468

 
$
9

 
$
(29
)
 
$
9,448

Municipal securities
239,881

 
5,313

 
(864
)
 
244,330

Mortgage-backed securities and collateralized mortgage obligations(1):
 
 
 
 
 
 
 
Residential
282,997

 
851

 
(2,012
)
 
281,836

Commercial
210,079

 
825

 
(2,245
)
 
208,659

Collateralized loan obligations
6,798

 
14

 
(17
)
 
6,795

Corporate obligations
13,552

 
213

 

 
13,765

Other securities
25,406

 
360

 
(5
)
 
25,761

Total
$
788,181

 
$
7,585

 
$
(5,172
)
 
$
790,594

 
 
 
 
 
 
 
 
December 31, 2016
 
 
 
 
 
 
 
U.S. Treasury and U.S. Government-sponsored agencies
$
1,563

 
$
6

 
$

 
$
1,569

Municipal securities
237,305

 
2,427

 
(2,476
)
 
237,256

Mortgage-backed securities and collateralized mortgage obligations(1):
 
 
 
 
 
 
 
Residential
310,391

 
985

 
(2,200
)
 
309,176

Commercial
211,259

 
599

 
(3,540
)
 
208,318

Collateralized loan obligations
10,505

 
4

 
(31
)
 
10,478

Corporate obligations
16,611

 
104

 
(9
)
 
16,706

Other securities
11,005

 
156

 
(19
)
 
11,142

Total
$
798,639

 
$
4,281

 
$
(8,275
)
 
$
794,645


(1)
Issued and guaranteed by U.S. Government-sponsored agencies.
There were no securities classified as trading or held to maturity at June 30, 2017 or December 31, 2016.

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The amortized cost and fair value of investment securities available for sale at June 30, 2017, 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.
 
Amortized Cost
 
Fair Value
 
(In thousands)
Due in one year or less
$
5,612

 
$
5,653

Due after one year through five years
110,610

 
111,912

Due after five years through ten years
248,162

 
248,257

Due after ten years
423,752

 
424,644

Investment securities with no stated maturities
45

 
128

Total
$
788,181

 
$
790,594

(b) Unrealized Losses and Other-Than-Temporary Impairments
The following table shows the gross unrealized losses and fair value of the Company's investment securities available for sale that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that the individual securities have been in continuous unrealized loss positions as of June 30, 2017 and December 31, 2016:
 
Less than 12 Months
 
12 Months or Longer
 
Total
 
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
 
(In thousands)
June 30, 2017
 
 
 
 
 
 
 
 
 
 
 
U.S. Treasury and U.S. Government-sponsored agencies
$
4,533

 
$
(29
)
 
$

 
$

 
$
4,533

 
$
(29
)
Municipal securities
36,220

 
(812
)
 
2,498

 
(52
)
 
38,718

 
(864
)
Mortgage-backed securities and collateralized mortgage obligations(1):
 
 
 
 
 
 
 
 
 
 
 
Residential
145,878

 
(1,897
)
 
12,541

 
(115
)
 
158,419

 
(2,012
)
Commercial
129,184

 
(2,148
)
 
6,820

 
(97
)
 
136,004

 
(2,245
)
Collateralized loan obligations
2,883

 
(17
)
 

 

 
2,883

 
(17
)
Other Securities
2,933

 
(5
)
 

 

 
2,933

 
(5
)
Total
$
321,631

 
$
(4,908
)
 
$
21,859

 
$
(264
)
 
$
343,490

 
$
(5,172
)
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2016
 
 
 
 
 
 
 
 
 
 
 
Municipal securities
$
90,188

 
$
(2,476
)
 
$

 
$

 
$
90,188

 
$
(2,476
)
Mortgage-backed securities and collateralized mortgage obligations(1):
 
 
 
 
 
 
 
 
 
 
 
Residential
181,562

 
(2,148
)
 
10,854

 
(52
)
 
192,416

 
(2,200
)
Commercial
157,055

 
(3,446
)
 
12,597

 
(94
)
 
169,652

 
(3,540
)
Collateralized loan obligations
2,976

 
(1
)
 
2,969

 
(30
)
 
5,945

 
(31
)
Corporate obligations
4,032

 
(9
)
 

 

 
4,032

 
(9
)
Other Securities
6,998

 
(19
)
 

 

 
6,998

 
(19
)
Total
$
442,811

 
$
(8,099
)
 
$
26,420

 
$
(176
)
 
$
469,231

 
$
(8,275
)
(1) Issued and guaranteed by U.S. Government-sponsored agencies.

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The Company has evaluated these investment securities available for sale as of June 30, 2017 and December 31, 2016 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. None of the underlying issuers of the municipal securities had credit ratings that were below investment grade levels at June 30, 2017 or December 31, 2016. The Company has the ability and intent to hold the investments until recovery of the securities' amortized cost, which may be the maturity date of the securities.
For the three and six months ended June 30, 2017 and 2016, there were no investment securities determined to be other-than-temporarily impaired.

(c) Pledged Securities
The following table summarizes the amortized cost and fair value of investment securities available for sale that are pledged as collateral for the following obligations at June 30, 2017 and December 31, 2016:
 
June 30, 2017
 
December 31, 2016
 
Amortized
Cost
 
Fair
Value
 
Amortized
Cost
 
Fair
Value
 
(In thousands)
Washington and Oregon state to secure public deposits
$
208,907

 
$
210,420

 
$
214,834

 
$
215,247

Repurchase agreements
32,731

 
32,591

 
29,481

 
29,294

Other securities pledged
3,534

 
3,536

 
3,557

 
3,546

Total
$
245,172

 
$
246,547

 
$
247,872

 
$
248,087


(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. Disclosures related to the Company's recorded investment in loans receivable generally exclude accrued interest receivable and net deferred costs because they are insignificant.
Loans acquired in a business combination are 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 ASC 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality. These loans are identified as "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.
(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 for 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 business portfolio segment: commercial and industrial, 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 and Industrial loans carry more risk than other loans because the borrowers’ cash flow is less predictable, and in the event of a default, loss given default is potentially greater because the value of the collateral securing these loans is more difficult to quantify.
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 that these loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate properties. Commercial real estate lending typically involves higher loan principal amounts and payments on loans, and repayment is dependent on successful operation and management of the properties. The value of the real estate securing these loans can be adversely affected by conditions in the real estate market or the economy. There is little difference in risk between owner-occupied commercial real estate loans and non-owner occupied commercial real estate loans.
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. The Company sells most of its single-family loans in the secondary market and retains a smaller portion in 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, 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

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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.
The Company also originates 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.
Loans receivable at June 30, 2017 and December 31, 2016 consisted of the following portfolio segments and classes:
 
June 30, 2017
 
December 31, 2016
 
(In thousands)
Commercial business:
 
 
 
Commercial and industrial
$
659,621

 
$
637,773

Owner-occupied commercial real estate
586,236

 
558,035

Non-owner occupied commercial real estate
904,195

 
880,880

Total commercial business
2,150,052

 
2,076,688

One-to-four family residential
80,941

 
77,391

Real estate construction and land development:
 
 
 
One-to-four family residential
49,479

 
50,414

Five or more family residential and commercial properties
135,959

 
108,764

Total real estate construction and land development
185,438

 
159,178

Consumer
330,215

 
325,140

Gross loans receivable
2,746,646

 
2,638,397

Net deferred loan costs
2,861

 
2,352

 Loans receivable, net
2,749,507

 
2,640,749

Allowance for loan losses
(32,751
)
 
(31,083
)
 Total loans receivable, net
$
2,716,756

 
$
2,609,666

(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 majority of the Company’s loan portfolio consists of (in order of balances at June 30, 2017) non-owner occupied commercial real estate, commercial and industrial and owner-occupied commercial real estate. As of June 30, 2017 and December 31, 2016, there were no concentrations of loans related to any single industry in excess of 10% of the Company’s total loans.
(c) Credit Quality Indicators
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 1 to 10. A description of the general characteristics of the risk grades is as follows:
Grades 1 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

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payment performance to date. Increased monitoring of financial information 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 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 loans are established at the origination of the loan. Loan grades are reviewed on a quarterly basis, or more frequently if necessary, by the credit department. 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. 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 outstanding 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 June 30, 2017 and December 31, 2016.
 
June 30, 2017
 
Pass
 
OAEM
 
Substandard
 
Total
 
(In thousands)
Commercial business:
 
 
 
 
 
 
 
Commercial and industrial
$
619,060

 
$
9,349

 
$
31,212

 
$
659,621

Owner-occupied commercial real estate
561,816

 
6,198

 
18,222

 
586,236

Non-owner occupied commercial real estate
872,877

 
14,157

 
17,161

 
904,195

Total commercial business
2,053,753

 
29,704

 
66,595

 
2,150,052

One-to-four family residential
79,602

 

 
1,339

 
80,941

Real estate construction and land development:
 
 
 
 
 
 
 
One-to-four family residential
44,510

 
493

 
4,476

 
49,479

Five or more family residential and commercial properties
133,102

 
1,128

 
1,729

 
135,959

Total real estate construction and land development
177,612

 
1,621

 
6,205

 
185,438

Consumer
325,000

 

 
5,215

 
330,215

Gross loans receivable
$
2,635,967

 
$
31,325

 
$
79,354

 
$
2,746,646


 
December 31, 2016
 
Pass
 
OAEM
 
Substandard
 
Total
 
(In thousands)
Commercial business:
 
 
 
 
 
 
 
Commercial and industrial
$
601,273

 
$
5,048

 
$
31,452

 
$
637,773

Owner-occupied commercial real estate
532,585

 
4,437

 
21,013

 
558,035

Non-owner occupied commercial real estate
841,383

 
14,573

 
24,924

 
880,880

Total commercial business
1,975,241

 
24,058

 
77,389

 
2,076,688

One-to-four family residential
76,020

 

 
1,371

 
77,391

Real estate construction and land development:
 
 
 
 
 
 
 
One-to-four family residential
44,752

 
500

 
5,162

 
50,414

Five or more family residential and commercial properties
105,723

 
1,150

 
1,891

 
108,764

Total real estate construction and land development
150,475

 
1,650

 
7,053

 
159,178

Consumer
320,140

 

 
5,000

 
325,140

Gross loans receivable
$
2,521,876

 
$
25,708

 
$
90,813

 
$
2,638,397


Potential problem loans are loans classified as OAEM or worse 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 may include PCI loans as these loans continue to accrete loan discounts established at acquisition based on the guidance of FASB ASC 310-30. Potential problem loans as of June 30, 2017 and December 31, 2016 were $84.1 million and $87.8 million, respectively. The balance of potential problem loans guaranteed by a governmental agency, which guarantee reduces the Company's credit exposure, was $3.5 million and $1.1 million as of June 30, 2017 and December 31, 2016, respectively.

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(d) Nonaccrual Loans
Nonaccrual loans, segregated by segments and classes of loans, were as follows as of June 30, 2017 and December 31, 2016:
 
June 30, 2017
 
December 31, 2016
 
(In thousands)
Commercial business:
 
 
 
Commercial and industrial
$
3,613

 
$
3,531

Owner-occupied commercial real estate
3,795

 
3,728

Non-owner occupied commercial real estate
1,271

 
1,321

Total commercial business
8,679

 
8,580

One-to-four family residential
87

 
94

Real estate construction and land development:
 
 
 
One-to-four family residential
2,008

 
2,008

Five or more family residential and commercial properties

 

Total real estate construction and land development
2,008

 
2,008

Consumer
199

 
227

Nonaccrual loans
$
10,973

 
$
10,909

The Company had $1.6 million and $2.8 million of nonaccrual loans guaranteed by governmental agencies at June 30, 2017 and December 31, 2016, respectively.
PCI loans are not included in the nonaccrual loan table above because these loans are accounted for under FASB 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 contractual 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.
The balances of past due loans, segregated by segments and classes of loans, as of June 30, 2017 and December 31, 2016 were as follows:
 
June 30, 2017
 
30-89 Days
 
90 Days or
Greater
 
Total Past 
Due
 
Current
 
Total
 
(In thousands)
Commercial business:
 
 
 
 
 
 
 
 
 
Commercial and industrial
$
440

 
$
1,866

 
$
2,306

 
$
657,315

 
$
659,621

Owner-occupied commercial real estate

 
1,338

 
1,338

 
584,898

 
586,236

Non-owner occupied commercial real estate

 
3,052

 
3,052

 
901,143

 
904,195

Total commercial business
440

 
6,256

 
6,696

 
2,143,356

 
2,150,052

One-to-four family residential

 

 

 
80,941

 
80,941

Real estate construction and land development:
 
 
 
 
 
 
 
 
 
One-to-four family residential
100

 
865

 
965

 
48,514

 
49,479

Five or more family residential and commercial properties
366

 

 
366

 
135,593

 
135,959

Total real estate construction and land development
466

 
865

 
1,331

 
184,107

 
185,438

Consumer
1,442

 
673

 
2,115

 
328,100

 
330,215

Gross loans receivable
$
2,348

 
$
7,794

 
$
10,142

 
$
2,736,504

 
$
2,746,646



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December 31, 2016
 
30-89 Days
 
90 Days or
Greater
 
Total Past 
Due
 
Current
 
Total
 
(In thousands)
Commercial business:
 
 
 
 
 
 
 
 
 
Commercial and industrial
$
2,687

 
$
1,733

 
$
4,420

 
$
633,353

 
$
637,773

Owner-occupied commercial real estate
1,807

 
2,915

 
4,722

 
553,313

 
558,035

Non-owner occupied commercial real estate
733

 

 
733

 
880,147

 
880,880

Total commercial business
5,227

 
4,648

 
9,875

 
2,066,813

 
2,076,688

One-to-four family residential
523

 

 
523

 
76,868

 
77,391

Real estate construction and land development:
 
 
 
 
 
 
 
 
 
One-to-four family residential
90

 
2,008

 
2,098

 
48,316

 
50,414

Five or more family residential and commercial properties

 
377

 
377

 
108,387

 
108,764

Total real estate construction and land development
90

 
2,385

 
2,475

 
156,703

 
159,178

Consumer
2,292

 
105

 
2,397

 
322,743

 
325,140

Gross loans receivable
$
8,132

 
$
7,138

 
$
15,270

 
$
2,623,127

 
$
2,638,397


There were no loans 90 days or more past due that were still accruing interest as of June 30, 2017 or December 31, 2016, excluding PCI loans.

(f) Impaired loans
Impaired loans include nonaccrual loans and performing troubled debt restructured ("TDR") loans. The balances of impaired loans as of June 30, 2017 and December 31, 2016 are set forth in the following tables.
 
June 30, 2017
 
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
$
1,912

 
$
8,930

 
$
10,842

 
$
11,311

 
$
1,338

Owner-occupied commercial real estate
1,094

 
3,726

 
4,820

 
5,083

 
696

Non-owner occupied commercial real estate
4,796

 
6,495

 
11,291

 
11,410

 
907

Total commercial business
7,802

 
19,151

 
26,953

 
27,804

 
2,941

One-to-four family residential

 
310

 
310

 
316

 
95

Real estate construction and land development:
 
 
 
 
 
 
 
 
 
One-to-four family residential
1,671

 
1,082

 
2,753

 
3,438

 
59

Five or more family residential and commercial properties

 
1,062

 
1,062

 
1,063

 
64

Total real estate construction and land development
1,671

 
2,144

 
3,815

 
4,501

 
123

Consumer

 
259

 
259

 
280

 
66

Total
$
9,473

 
$
21,864

 
$
31,337

 
$
32,901

 
$
3,225


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December 31, 2016
 
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
$
1,739

 
$
10,636

 
$
12,375

 
$
13,249

 
$
1,199

Owner-occupied commercial real estate
1,150

 
3,574

 
4,724

 
5,107

 
511

Non-owner occupied commercial real estate
4,905

 
6,413

 
11,318

 
11,386

 
797

Total commercial business
7,794

 
20,623

 
28,417

 
29,742

 
2,507

One-to-four family residential

 
321

 
321

 
325

 
97

Real estate construction and land development:
 
 
 
 
 
 
 
 
 
One-to-four family residential
2,243

 
828

 
3,071

 
3,755

 
6

Five or more family residential and commercial properties

 
1,079

 
1,079

 
1,079

 
60

Total real estate construction and land development
2,243

 
1,907

 
4,150

 
4,834

 
66

Consumer
48

 
262

 
310

 
325

 
64

Total
$
10,085

 
$
23,113

 
$
33,198

 
$
35,226

 
$
2,734


The Company had governmental guarantees of $1.9 million and $3.5 million related to the impaired loan balances at June 30, 2017 and December 31, 2016, respectively.
The average recorded investment of impaired loans for the three and six months ended June 30, 2017 and 2016 are set forth in the following table.
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2017
 
2016
 
2017
 
2016
 
(In thousands)
Commercial business:
 
 
 
 
 
 
 
Commercial and industrial
$
6,925

 
$
10,192

 
$
8,742

 
$
9,933

Owner-occupied commercial real estate
3,278

 
5,209

 
3,760

 
4,904

Non-owner occupied commercial real estate
11,252

 
11,665

 
11,274

 
11,287

Total commercial business
21,455

 
27,066

 
23,776

 
26,124

One-to-four family residential
312

 
269

 
315

 
271

Real estate construction and land development:
 
 
 
 
 
 
 
One-to-four family residential
2,636

 
3,310

 
2,781

 
3,438

Five or more family residential and commercial properties
1,067

 
1,816

 
1,070

 
1,864

Total real estate construction and land development
3,703

 
5,126

 
3,851

 
5,302

Consumer
235

 
977

 
260

 
716

Total
$
25,705

 
$
33,438

 
$
28,202

 
$
32,413

For the three and six months ended June 30, 2017 and 2016, no interest income was recognized subsequent to a loan’s classification as nonaccrual. For the three and six months ended June 30, 2017, the Bank recorded $281,000 and $646,000, respectively, of interest income related to performing TDR loans. For the three and six months ended June 30, 2016, the Bank recorded $167,000 and $345,000, respectively, of interest income related to performing TDR loans.

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(g) Troubled Debt Restructured Loans
A TDR loan is a restructuring in which the Bank, for economic or legal reasons related to a borrower’s financial difficulties, grants a concession to the borrower that it would not otherwise consider. TDRs are considered impaired and are separately measured for impairment under FASB ASC 310-10-35, whether on accrual ("performing") or nonaccrual ("nonperforming") status. The Company has more stringent definitions of concessions and impairment measures for PCI loans as these loans have known credit deterioration and are generally accreting income at a lower discounted rate as compared to the contractual note rate based on the guidance of FASB ASC 310-30.
The majority of the Bank’s TDR loans are a result of granting extensions of maturity on troubled credits which have already been adversely classified. The Bank grants such extensions to reassess the borrower’s financial status and to develop a plan for repayment. The second most prevalent concessions are certain modifications with extensions that also include interest rate reductions. Certain TDRs were additionally re-amortized over a longer period of time. These modifications would all be considered a concession for a borrower that could not obtain similar financing terms from another source other than from the Bank.
The financial effects of each modification will vary based on the specific restructure. For the majority of the Bank’s TDR loans, the loans were interest-only with a balloon payment at maturity. If the interest rate is not adjusted and the modified terms are consistent with other similar credits being offered, the Bank may not experience any loss associated with the restructure. If, however, the restructure involves forbearance agreements or interest rate modifications, the Bank may not collect all the principal and interest based on the original contractual terms. The Bank estimates the necessary allowance for loan losses on TDRs using the same guidance as used for other impaired loans.
The recorded investment balance and related allowance for loan losses of performing and nonaccrual TDR loans as of June 30, 2017 and December 31, 2016 were as follows:
 
June 30, 2017
 
December 31, 2016
 
Performing
TDRs
 
Nonaccrual
TDRs
 
Performing
TDRs
 
Nonaccrual
TDRs
 
(In thousands)
TDR loans
$
20,364

 
$
6,455

 
$
22,288

 
$
6,900

Allowance for loan losses on TDR loans
2,163

 
432

 
1,965

 
437


The unfunded commitment to borrowers related to TDRs was $129,000 and $249,000 at June 30, 2017 and December 31, 2016, respectively.
Loans that were modified as TDRs during the three and six months ended June 30, 2017 and 2016 are set forth in the following tables:
 
Three Months Ended June 30,
 
2017
 
2016
 
Number of
Contracts
(1)
 
Outstanding
Principal Balance 
(1)(2)
 
Number of
Contracts
(1)
 
Outstanding
Principal Balance 
(1)(2)
 
(Dollars in thousands)
Commercial business:
 
 
 
 
 
 
 
Commercial and industrial
5

 
$
3,439

 
5